Optimal Commitment in Monetary Policy: Credibility Versus Flexibility

This paper examines the optimal design of a central banking institution which lends credibility to a low inflation monetary policy while allowing for a flexible response to unforeseen contingencies. A policy-maker appoints a conservative central banker, who generates a lower average time consistent inflation rate at the cost of a distorted response to output shocks. By retaining the option to dismiss the central banker at a cost, the policy-maker forces the central banker to accommodate when extreme shocks are realized.