Contract Approach gOvernment construct a contract to punish central bank for inflation 2 B'E t+S +e t+s mIn ∠z 2 2 t+S S.t.2=-(+E Time Consistent Solution is z+∠ 1 Clearly if government sets u=-u, zero expected inflation can be achieved. which is the first-best outcome. This result was first pointed out by Walsh(1995, AER) Has the time inconsistency problem been killed by this simple incentive contract? The answer is unfortunately, negative First note that the above result is crucially this ad-hoc assumption, it would be impossible to 复9大学经 dependent upon the linear Phillips Curve. Without derive any feasible incentive contract Second, contract implicitly removes time inconsistency to another level, i.e. who insures the government's commitment to the contract?Contract Approach ❖ Government construct a contract to punish central bank for inflation ( ) ( ) t e t t t T s t s t s t s t s st u u u E        = − − +       + + − = + + + . . 2 2 min 0 2 2 • Time Consistent Solution is t t u      + + + = − 1 1 • Clearly if government sets μ = -u, zero expected inflation can be achieved, which is the first-best outcome. This result was first pointed out by Walsh (1995, AER). • Has the time inconsistency problem been killed by this simple incentive contract? The answer is, unfortunately, negative. • First note that the above result is crucially dependent upon the linear Phillips Curve. Without this ad-hoc assumption, it would be impossible to derive any feasible incentive contract. • Second, contract implicitly removes time inconsistency to another level, i.e. who insures the government’s commitment to the contract?