Abstract
The paper reviews the literature on dynamic inconsistency of monetary policy, and discusses, also in a formalized way, the different measures how to limit the incentive of policymakers to use inflation to maximize their objective function, leading to an inefficient outcome of higher than necessary inflation without any impact on real economy. The nature of the dynamic inconsistency problem is presented in a game theory framework and the paper then discusses the rules versus discretion dilemma, reputation building, flexibility versus credibility trade-off, independence of central banks, and optimal contracts for central bankers, i.e. issues in the monetary constitution that attracted a lot of attention over the last two decades.
The constitutional economics perspective is applied when discussing the role of rules in monetary policy and checks and balances as a means to solve the flexibility versus credibility problem.