Monetary politics and unemployment persistence

This paper develops a positive model of monetary policy that allows for persistent unemployment and electoral uncertainty. The common credibility 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 well as to increase the incumbent party's probability of re-election This results in a political business cycle which, however, is fundamentally different for left-wing and right-wing governments.