THE OPTIMAL DEGREE OF COMMITMENT TO AN INTERMEDIATE MONETARY TARGET* KENNETH ROGOFF
Society can sometimes make itself better off by appointing a central banker who does not share the social objective function, but instead places "too large" a weight on inflation-rate stabilization relative to employment stabilization. Although having such an agent head the central bank reduces the time-consistent rate of inflation, it suboptimally raises the variance of employment when supply shocks are large Using an envelope theorem, we show that the ideal agent places a large, but finite, weight on inflation. The analysis also provides a new framework for choosing among alternative intermediate monetary target* I. INTRODUCTION
It is now widely recognized that even if a country has a perfectly benevolent central bank (one that attempts to maximize the social welfare function), it may suffer from having an inflation rate which is systematically too high.' Suppwse, for example, that a distortion (such as income taxation) causes the market rate of employment to be suboptimal. Then inflation can arise because wage setters rationally fear that the central bank will try to take advantage of short-term nominal rigidities to raise employment systematically. Only by setting high rates of wage inflation can wage setters discourage the central bank from trying to reduce the real wage below their target level. This paper considers some institutional responses to the timeconsistency problem described above. In particular, we examine the practice of appointing "conservatives" to head the central bank, or of giving the central bank concrete incentives to achieve an intermediate monetary target. Our analysis of intermediate monetary targeting is quite different from conventional analyses in which the central bank is rigidly constrained to follow a particular feedback rule. Indeed, an important conclusion is that it is not generally optimal to legally constrain the central bank to hit its intermediate target (or follow its rule) exactly, or to choose *I am indebted to Matthew Canzoneri, David Folkerts-Landau, Maurice Obstfeld, Michael Parkin, Alessandro Penati, Franco Spinelli, Lawrence Summers, Clifford Wymer, and to three anonymous referees for helpful comments on an earlier drail. 1. See, for example, Phelps (1967], Kydland and Prescott 119771, or Barro and Gordon (1983a,b].
QUARTERLY JOURNAL OF ECONOMICS
"too" conservative an agent to head the central bank. By appointing a conservative or by providing the central bank with incentives to hit an intermediate monetary target, it is possible to induce less infiationary wage bargains. But this comes at the cost of distorting the central bank's responses to unanticipated disturbances, especially supply shocks. This is a cost because although the central bank cannot systematically raise employment (since private agents anticipate its incentives to inflate) monetary policy can still be used to stabilize inflation and employment around their mean market-determined levels.^ Thus, rigid targeting is appropriate only in certain very special cases. It is important to stress that, while "flexible" monetary targeting is preferable to either fully discretionary monetary policy or rigid monetary targeting, it is not necessarily thefirst-bestsolution to the problem of stagflation in this model. That depends on the source of the underlying labor market distortion which causes the market-determined level of employment to be too low. If this distortion can be removed at low social cost, then it would be possible both to raise employment and to lower inflation. A second-best solution, which does nothing to raise the mean level of employment, would be to legally impose a complete state-contingent money supply rule. As is discussed in Section III, there are a number of problems inherent in designing such a rule. But it is only when the first- and second-best solutions are too costly or unachievable that...
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