This paper develops a positive model of monetary policy that allows fo
r persistent unemployment and electoral uncertainty. The common credib
ility problem associated with low-inflation monetary policy results in
both a more severe inflation bias and a stabilization bias. However,
a simple state contingent performance contract eliminates both biases.
Monetary policy is also subject to two different strategic political
considerations: It is used to influence future policy decisions as wel
l as to increase the incumbent party's probability of re-election This
results in a political business cycle which, however, is fundamentall
y different for left-wing and right-wing governments.