Optimal Contracts for Central Bankers: Calls on Inflation

13 Pages Posted: 5 Jul 2010 Last revised: 18 Oct 2012

See all articles by Christian-Oliver Ewald

Christian-Oliver Ewald

University of Glasgow; Høgskole i Innlandet

Johannes Geissler

University of St. Andrews - School of Economics and Finance

Date Written: October 17, 2012

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 provide a mechanism to implement inflation contracts as discussed in the classical literature.

Keywords: Inflation linked bonds, Monetary policy, rational expectation

JEL Classification: C73, Q22, Q57

Suggested Citation

Ewald, Christian-Oliver and Geissler, Johannes, Optimal Contracts for Central Bankers: Calls on Inflation (October 17, 2012). Available at SSRN: https://ssrn.com/abstract=1633894 or http://dx.doi.org/10.2139/ssrn.1633894

Christian-Oliver Ewald (Contact Author)

University of Glasgow ( email )

Adam Smith Building
Glasgow, Scotland G12 8RT
United Kingdom

Høgskole i Innlandet ( email )

Lillehammer, 2624
Norway

Johannes Geissler

University of St. Andrews - School of Economics and Finance ( email )

The Scores, Castlecliff
St. Andrews, Fife KY16 8RD
United Kingdom

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