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The optimal degree of discretion in monetary policy

Author

Listed:
  • Susan Athey
  • Andrew Atkeson
  • Patrick J. Kehoe

Abstract

How much discretion is it optimal to give the monetary authority in setting its policy? We analyze this mechanism design question in an economy with an agreed-upon social welfare function that depends on the randomly fluctuating state of the economy. The monetary authority has private information about that state. In the model, well-designed rules trade off society's desire to give the monetary authority flexibility to react to its private information against society's need to guard against the standard time inconsistency problem arising from the temptation to stimulate the economy with unexpected inflation. We find that the optimal degree of monetary policy discretion is decreasing in the severity of the time inconsistency problem. As this problem becomes sufficiently severe, the optimal degree of discretion is none at all. We also find that, despite the apparent complexity of this dynamic mechanism design problem, society can implement the optimal policy simply by legislating an inflation cap that specifies the highest allowable inflation rate. (Replaced by Staff Report No: 326)

Suggested Citation

  • Susan Athey & Andrew Atkeson & Patrick J. Kehoe, 2002. "The optimal degree of discretion in monetary policy," Working Papers 626, Federal Reserve Bank of Minneapolis.
    • Handle: RePEc:fip:fedmwp:626
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    JEL classification:

    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook

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