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Optimal discretion

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  • Yvan Lengwiler
  • Athanasios Orphanides

Abstract

This paper investigates the desirability of adopting a rule in favor of discretionary monetary policy in a model exhibiting Kydland and Prescott's dynamic inconsistency problem. We deviate from earlier work by adopting assumptions regarding policymaker preferences and inflation dynamics that are compatible with empirically motivated models used for macroeconomic policy evaluation. In particular, we dispense with the notion of a fundamental incompatibility between the policymaker's price stability and full employment objectives and allow for stickiness in the determination of inflation. In this setting, we show that if discretion provides a policy flexibility benefit, adoption of a rule remains optimal but only under certain circumstances. If the central bank's preference to contain inflation is fully credible, then a rule is optimal only when inflation exceeds an endogenously determined threshold. This setup gives rise to a discretionary policy zone for inflation with the central bank taking more drastic action towards stabilizing inflation when inflation veers outside the zone. We also examine optimal policy when the central bank's inflation fighting determination is not fully credible. Then, adopting a rule becomes optimal even when inflation is lower. This result provides a reconciliation of the theory regarding the optimality of adopting a rule with the empirical observation that policymakers appear more willing to abandon discretion when facing either low credibility or high inflation but are less inclined to do so otherwise.

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Bibliographic Info

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 1999-42.

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Date of creation: 1999
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Handle: RePEc:fip:fedgfe:1999-42

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Keywords: Monetary policy ; Inflation (Finance);

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References

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  1. William Poole, 1999. "Monetary policy rules?," Speech, Federal Reserve Bank of St. Louis.
  2. Bennett T. McCallum, 1995. "Two Fallacies Concerning Central Bank Independence," NBER Working Papers 5075, National Bureau of Economic Research, Inc.
  3. Orphanides, Athanasios & Wieland, Volker, 2000. "Inflation zone targeting," European Economic Review, Elsevier, vol. 44(7), pages 1351-1387, June.
  4. David Backus & John Driffill, 1984. "Inflation and Reputation," Working Papers 560, Queen's University, Department of Economics.
  5. Lohmann, Susanne, 1992. "Optimal Commitment in Monetary Policy: Credibility versus Flexibility," American Economic Review, American Economic Association, vol. 82(1), pages 273-86, March.
  6. Svensson, L-E-O, 1996. "Inflation Forecast Targeting : Implementaing and Monitoring Inflation Targets," Papers 615, Stockholm - International Economic Studies.
  7. Robert J. Barro & David B. Gordon, 1983. "A Positive Theory of Monetary Policy in a Natural-Rate Model," NBER Working Papers 0807, National Bureau of Economic Research, Inc.
  8. Barro, Robert J., 1986. "Reputation in a model of monetary policy with incomplete information," Journal of Monetary Economics, Elsevier, vol. 17(1), pages 3-20, January.
  9. John B. Taylor, 1996. "How should monetary policy respond to shocks while maintaining long-run price stability? Conceptual issues," Proceedings, Federal Reserve Bank of Kansas City, pages 181-195.
  10. Jeff Fuhrer & George Moore, 1993. "Inflation persistence," Finance and Economics Discussion Series 93-17, Board of Governors of the Federal Reserve System (U.S.).
  11. Ben S. Bernanke & Ilian Mihov, 1998. "Measuring Monetary Policy," The Quarterly Journal of Economics, MIT Press, vol. 113(3), pages 869-902, August.
  12. Mervyn King, 1996. "How should central banks reduce inflation? - Conceptual issues," Economic Review, Federal Reserve Bank of Kansas City, issue Q IV, pages 25-52.
  13. Ben S. Bernanke & Frederic S. Mishkin, 1997. "Inflation Targeting: A New Framework for Monetary Policy?," NBER Working Papers 5893, National Bureau of Economic Research, Inc.
  14. John B. Taylor, 1999. "Monetary Policy Rules," NBER Books, National Bureau of Economic Research, Inc, number tayl99-1, July.
  15. John M. Roberts, 1994. "Is inflation sticky?," Working Paper Series / Economic Activity Section 152, Board of Governors of the Federal Reserve System (U.S.).
  16. Bennett T. McCallum, 1997. "Issues in the Design of Monetary Policy Rules," NBER Working Papers 6016, National Bureau of Economic Research, Inc.
  17. Mervyn King, 1996. "How should central banks reduce inflation? conceptual issues," Proceedings, Federal Reserve Bank of Kansas City, pages 53-91.
  18. Rogoff, Kenneth, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, MIT Press, vol. 100(4), pages 1169-89, November.
  19. Fischer, Stanley, 1990. "Rules versus discretion in monetary policy," Handbook of Monetary Economics, in: B. M. Friedman & F. H. Hahn (ed.), Handbook of Monetary Economics, edition 1, volume 2, chapter 21, pages 1155-1184 Elsevier.
  20. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  21. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
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Citations

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Cited by:
  1. Orphanides, Athanasios, 2003. "The quest for prosperity without inflation," Journal of Monetary Economics, Elsevier, vol. 50(3), pages 633-663, April.
  2. Athanasios Orphanides & John C. Williams, 2005. "Inflation scares and forecast-based monetary policy," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 8(2), pages 498-527, April.
  3. Athanasios Orphanides & John C. Williams, 2002. "Imperfect knowledge, inflation expectations, and monetary policy," Finance and Economics Discussion Series 2002-27, Board of Governors of the Federal Reserve System (U.S.).
  4. Orphanides, Athanasios & Wieland, Volker, 2000. "Inflation zone targeting," European Economic Review, Elsevier, vol. 44(7), pages 1351-1387, June.

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