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Optimal contracts for central bankers: Calls on inflation

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  • Ewald, Christian-Oliver
  • Geißler, Johannes

Abstract

We consider a framework featuring a central bank, private and financial agents as well as a financial market. The central bank’s objective is to maximize a functional, which measures the classical trade-off between output and inflation plus income from the sales of inflation linked calls minus payments for the liabilities that the inflation linked calls produce at maturity. Private agents have rational expectations and financial agents are averse against inflation risk. Following this route, we explain demand for inflation linked calls on the financial market from a no-arbitrage assumption and derive pricing formulas for inflation linked calls, which lead to a supply–demand equilibrium. We then study the consequences that the sales of inflation linked calls have on the observed inflation rate and price level. Similar as in Walsh (1995) we find that the inflationary bias is significantly reduced, and hence that markets for inflation linked calls provide a mechanism to implement inflation contracts as discussed in the classical literature.

Suggested Citation

  • Ewald, Christian-Oliver & Geißler, Johannes, 2017. "Optimal contracts for central bankers: Calls on inflation," Applied Mathematics and Computation, Elsevier, vol. 292(C), pages 57-62.
    • Handle: RePEc:eee:apmaco:v:292:y:2017:i:c:p:57-62
    DOI: 10.1016/j.amc.2016.07.011
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    References listed on IDEAS

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    1. Svensson, Lars E O, 1997. "Optimal Inflation Targets, "Conservative" Central Banks, and Linear Inflation Contracts," American Economic Review, American Economic Association, vol. 87(1), pages 98-114, March.
    2. Robert Jarrow & Yildiray Yildirim, 2008. "Pricing Treasury Inflation Protected Securities and Related Derivatives using an HJM Model," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 16, pages 349-370, World Scientific Publishing Co. Pte. Ltd..
    3. Christian-Oliver Ewald & Johannes Geissler, 2015. "Markets For Inflation-Indexed Bonds As Mechanisms For Efficient Monetary Policy," Mathematical Finance, Wiley Blackwell, vol. 25(4), pages 869-889, October.
    4. Persson, Torsten & Tabellini, Guido, 1993. "Designing institutions for monetary stability," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 53-84, December.
    5. Walsh, Carl E, 1995. "Optimal Contracts for Central Bankers," American Economic Review, American Economic Association, vol. 85(1), pages 150-167, March.
    6. Muscatelli, V Anton, 1999. "Inflation Contracts and Inflation Targets under Uncertainty: Why We Might Need Conservative Central Bankers," Economica, London School of Economics and Political Science, vol. 66(262), pages 241-254, May.
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    More about this item

    Keywords

    Monetary policy; Inflation contracts; Inflationary bias; Mechanisms; Inflation indexed securities;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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