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 alternate intermediate monetary targets.
An Earlier version appeared as International Finance Discussion Paper 230 (September 1983). See also "Social Institutions for Overcoming Monetary Policy Credibility Problems." (Paper presented to the American Economics Association Annual Meetings, New Orleans, December 1986.)
© 1985 by the President and Fellows of Harvard College. Posted by permission of the MIT Press. One copy may be printed for individual use only.