Scandinavian Working Papers in Economics

Research Papers in Economics,
Stockholm University, Department of Economics

No 1997:12: Optimal Inflation Targets, Inflation Contracts and Political Cycles

Xiang Lin
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Xiang Lin: Dept. of Economics, Stockholm University

Abstract: It has been widely accepted that politically induced variance can be generated when the wage contract is written before an election. In this paper, we show that inflation contracts and inflation targets can eliminate both the inflation bias and politically induced variance, if electoral uncertainty is merely due to different preferences. In contrast to the independent central bank that is based on cooperation between competing parties prior to the target can be delegated by the winning party after election. Concern for reputation can lead to the convergence of the inflation targets assigned by different parties. We also consider the case where uncertsinty is caused not only by different preferences, but also by different desired rates inflation. We show that it is quite possible to reduce inflation but increase the variances of inflation and output by adopting the inflation target regime.

Keywords: central bank independence; inflation contract; inflation target; and electoral uncertainty.

JEL-codes: A10

28 pages, April 1, 1998

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