Inflation Targeting and the Performance Contract

Some policy may not be optimal when it is carried out, in spite of being so at the time of designing it. This is called dynamic inconsistency or time inconsistency. Such a possibility was pointed out by Kydland and Prescott(1977). They gave an example concerning monetary policy. Unlike fiscal policy, monetary policy can be implemented promptly if neccesary and modified flexibly according to circumstances. As a result it is apt to suffer from such dynamic inconsistency. Dynamic inconsistency in the monetary policy has a serious consequence for the following reason. The principal aims of monetary policy are to stabilize the prices and to attain the full employment. But the policymaker can not achieve these aims at the same time because many factors in the labor market make the output level consistent with price stabilization smaller than that of the full employment. In such a case, if the commitment mechanism is feasible, the policymaker can not change the ex ante designed monetary policy and dynamic inconsistency does not arise. But in the real world such commitment mechanism is in feasible. So the policymaker has the incentive to trigger a surprise inflation that people can not anticipate. This is because unanticipated inflation makes the real wage lower and firms increase employment. However people rationally expect the policymaker to have such incentive and her intention turn out a failure. After all, despite the higher inflation rate, the output level is the same as that consistent with the price stabilization so that full employillent can not be achieved. Therefore this produces an inefficient result as the social welfare deteriorates. Many researchers have studied to improve such inefficiency and suggested several measures. Among those, two measures seem to be promising in terms of actual implementation. One is the performance contract that the government concludes with the central bank about the realized inflation. The other is the inflation target that the government assigns to the central bank. The central bank that concludes such a contract or is assigned the inflation target designs the monetary policy at its discretion under each measure. We focuses on these two measures as the promising one that improve the inefficiency caused by dynamic inconsistency. The aim of this paper is to survey the recent literatures and have some perspective on the possibility of implementing these measures in the real economy