Optimal contract length in a reputational model of monetary policy

We develop a reputational model of monetary policy with endogenous contract length. In choosing contract length private sector agents trade off recontracting costs against the expected costs resulting from trading under contracts based on incorrect inflation expectations. However, due to an externality, the private and socially optimal contract lengths differ. When selecting individual contract length private agents do not consider the effect of contract length on the surprise inflation/output trade-off. In a reputational model of monetary policy this results in an excessive equilibrium inflation rate. The socially optimal outcome may be achieved by public policies that reduce recontracting costs.