Keywords: Rules, discretion, credibility, dynamic inconsistency, disinflation, inflation targeting.
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.
Full paper (202 KB PDF)
| Full paper (451 KB Postscript)
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Last update: September 27, 1999