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The optimal degree of discretion in monetary policy

  • Susan Athey
  • Andrew Atkeson
  • Patrick J. Kehoe

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)

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Paper provided by Federal Reserve Bank of Minneapolis in its series Working Papers with number 626.

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Date of creation: 2002
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Handle: RePEc:fip:fedmwp:626
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  1. Chari, V V & Kehoe, Patrick J, 1990. "Sustainable Plans," Journal of Political Economy, University of Chicago Press, vol. 98(4), pages 783-802, August.
  2. A. Rampini, Adriano, 2005. "Default and aggregate income," Journal of Economic Theory, Elsevier, vol. 122(2), pages 225-253, June.
  3. Athey, Susan & Bagwell, Kyle, 2001. "Optimal Collusion with Private Information," RAND Journal of Economics, The RAND Corporation, vol. 32(3), pages 428-65, Autumn.
  4. Christopher Phelan & Ennio Stacchetti, 1999. "Sequential equilibria in a Ramsey tax model," Staff Report 258, Federal Reserve Bank of Minneapolis.
  5. George-Marios Angeletos & Christian Hellwig & Alessandro Pavan, 2004. "Coordination and Policy Traps," Levine's Bibliography 122247000000000294, UCLA Department of Economics.
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  8. Stefania Albanesi & V. V. Chari & Lawrence J. Christiano, 2003. "Expectation Traps and Monetary Policy," Review of Economic Studies, Wiley Blackwell, vol. 70(4), pages 715-741, October.
  9. V. V. Chari & Lawrence J. Christiano & Martin Eichenbaum, 1996. "Expectation Traps and Discretion," NBER Working Papers 5541, National Bureau of Economic Research, Inc.
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  12. David Backus & John Driffill, 1984. "Inflation and Reputation," Working Papers 560, Queen's University, Department of Economics.
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  15. Barro, Robert J. & Gordon, David B., 1983. "Rules, discretion and reputation in a model of monetary policy," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 101-121.
  16. Kocherlakota, Narayana R, 1996. "Implications of Efficient Risk Sharing without Commitment," Review of Economic Studies, Wiley Blackwell, vol. 63(4), pages 595-609, October.
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  18. 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.
  19. David H. Romer & Christina D. Romer, 2000. "Federal Reserve Information and the Behavior of Interest Rates," American Economic Review, American Economic Association, vol. 90(3), pages 429-457, June.
  20. Kyle Bagwell, 2004. "Collusion and Price Rigidity," Theory workshop papers 658612000000000081, UCLA Department of Economics.
  21. Green, Edward J & Porter, Robert H, 1984. "Noncooperative Collusion under Imperfect Price Information," Econometrica, Econometric Society, vol. 52(1), pages 87-100, January.
  22. Persson, Torsten & Tabellini, Guido, 1993. "Designing institutions for monetary stability," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 53-84, December.
  23. Carlos E. da Costa & Iván Werning, 2008. "On the Optimality of the Friedman Rule with Heterogeneous Agents and Nonlinear Income Taxation," Journal of Political Economy, University of Chicago Press, vol. 116(1), pages 82-112, 02.
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