Optional Contracts for Central Banker and Public Debt Policy

Abstract

We examine the institutional arrangements which achieve the second-best allocation corresponding to an optimal rule under the policy commitment of a fiscal authority and a central bank, whose policies interact through a consolidated government budget constraint, under the assumption that those policy makers are unable to commit themselves to their optimal policies and they ignore the strategic interaction between their policies. Our results suggest that the practically best institutional arrangement is an instrument-independent central bank which controls for money supply to determine the rate of inflation and commits itself to some numerical inflation target that depends on fiscal variables. Although the second-best allocation could be supported by an instrument-independent central bank with a performance contract, it is practically difficult to implement a lump-sum transfer payment for a central banker. Furthermore, the second-best allocation cannot be attained by a performance contract or a targeting scheme for the fiscal authority alone. These results indicate that the numerical targets for the budget deficit together with the independent central bank, observed in the United States and the EU countries, do not ensure the good performance of the economy. The simpler and better solution is to have an independent central bank with an inflation target.