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Optimal discretion

  • Yvan Lengwiler
  • Athanasios Orphanides

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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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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  1. McCallum, Bennett T., 1999. "Issues in the design of monetary policy rules," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 23, pages 1483-1530 Elsevier.
  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, 1999. "Inflation zone targeting," Working Paper Series 0008, European Central Bank.
  4. Robert J. Barro & David B. Gordon, 1981. "A Positive Theory of Monetary Policy in a Natural-Rate Model," NBER Working Papers 0807, National Bureau of Economic Research, Inc.
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  6. 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.
  7. Jeff Fuhrer & George Moore, 1993. "Inflation persistence," Finance and Economics Discussion Series 93-17, Board of Governors of the Federal Reserve System (U.S.).
  8. 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.
  9. John M. Roberts, 1994. "Is inflation sticky?," Working Paper Series / Economic Activity Section 152, Board of Governors of the Federal Reserve System (U.S.).
  10. Lars E O Svensson, 1996. "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets," Bank of England working papers 56, Bank of England.
  11. 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.
  12. Mervyn King, 1996. "How should central banks reduce inflation? conceptual issues," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 53-91.
  13. Ben S. Bernanke & Ilian Mihov, 1995. "Measuring Monetary Policy," NBER Working Papers 5145, National Bureau of Economic Research, Inc.
  14. Ben S. Bernanke & Frederic S. Mishkin, 1997. "Inflation Targeting: A New Framework for Monetary Policy?," Journal of Economic Perspectives, American Economic Association, vol. 11(2), pages 97-116, Spring.
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  16. 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.
  17. William Poole, 1999. "Monetary policy rules?," Review, Federal Reserve Bank of St. Louis, issue Mar, pages 3-12.
  18. Meltzer, Allan H, 1987. "Limits of Short-run Stabilization Policy: Presidential Address to the Western Economic Association, July 3, 1986," Economic Inquiry, Western Economic Association International, vol. 25(1), pages 1-14, January.
  19. D. Backus & J. Driffil, 1998. "Inflation and Reputation," Levine's Working Paper Archive 625, David K. Levine.
  20. Lohmann, Susanne, 1992. "Optimal Commitment in Monetary Policy: Credibility versus Flexibility," American Economic Review, American Economic Association, vol. 82(1), pages 273-86, March.
  21. John B. Taylor, 1996. "How should monetary policy respond to shocks while maintaining long-run price stability? Conceptual issues," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 181-195.
  22. John B. Taylor, 1999. "Monetary Policy Rules," NBER Books, National Bureau of Economic Research, Inc, number tayl99-1, December.
  23. 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.
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