CENTRAL BANKING AS A POLITICAL PRINCIPAL-AGENT PROBLEM

Due to their ties with elected leaders, central bankers may pursue pol icies that are not in society's best interests. Consequently, the rela tionship between the public and the central bank can be characterized as a principal-agent problem. An inflation and stabilization bias aris e as a result of this agency problem and the magnitudes of these biase s depend on the political environment. Various institutional proposals for eliminating these biases are examined, and we find that central b ank independence and performance contracts work best. However, we argu e that central bank independence is preferable for resolving the agenc y problem.