Monetary rules as optimal incentive strategies

Abstract

In a Stackelberg Incentive Model, a monetary rule in the form of an incentive function is derived as an optimal strategy. A Stackelberg Incentive Equilibrium is solved for the widely used Barro-Gordon unemployment-inflation game. A dynamic version of the model is also considered. An equilibrium incentive strategy (a monetary rule) that leads to a team optimal solution of zero expected inflation and zero actual inflation is obtained. Providing a formal game equilibrium foundation for monetary rules may:

(i)

remove the policymaker's incentive to deviate from the rule, and (ii)

incite private agents to perceive monetary rules as credible policies.