Discretion Rather than Rules? Binding Commitments versus Discretionary Policymaking

Jensen, Christian (2016): Discretion Rather than Rules? Binding Commitments versus Discretionary Policymaking.

Abstract

Because optimal plans are time-inconsistent, continuing one from a previous period is not optimal from today's perspective, and may not outperform discretion, even ignoring gains from surprise deviations. Hence, contrary to conventional wisdom, a binding and credible commitment does not always outperform discretion over time, even if a non-credible commitment does. Forward-looking policymakers might therefore not want to irrevocably bind themselves to the optimal plan from any particular period, even if they could. The vast literature proposing different commitment mechanisms illustrates that it is a common misconception that a credible commitment to the optimal plan is always preferable to discretion.

• Item Type: MPRA Paper
• Language: English
• Keywords: Commitment; discretion; policy rules; expectations
• Subjects: E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy; E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E61 - Policy Objectives ; Policy Designs and Consistency ; Policy Coordination; H - Public Economics > H3 - Fiscal Policies and Behavior of Economic Agents > H30 - General

References

al-Nowaihi, A. and Levine, P. (1994) “Can Reputation Resolve the Monetary Policy Credibility Problem?” Journal of Monetary Economics 33: 355-380.

Atkeson, A. and Lucas, R. (1992) “On efficient distribution with private information.” Review of Economic Strudies 59: 427-453.

Assenmacher-Wesche, K. (2006) “Estimating Central Banks preferences from a time-varying empirical reaction function.” European Economic Review 50: 1951-1974.

Barro, R. J. and Gordon, D. B. (1983a) “A Positive Theory of Monetary Policy in a Natural Rate Model.” Journal of Political Economy 91: 589-610.

Barro, R. J. and Gordon, D. B. (1983b) “Rules, discretion and reputation in a model of monetary policy.” Journal of Monetary Economics 12: 101-121.

Blake, A. P. (2001) “A ‘timeless perspective’ on optimality in forward-looking rational expectations models.” Working paper, NIESR.

Calvo, G. A. (1978) “On the Time Consistency of Optimal Policy in a Monetary Economy.” Econometrica 46: 1411-1428.

Calvo, G. A. (1983) “Staggered Prices in a Utility Maximizing Framework.” Journal of Monetary Economics 12: 383-398.

Chari, V. V. and Kehoe, P. J. (1990) “Sustainable Plans,” Journal of Political Economy 98: 783-802.

Clarida, R., Gali, J. and Gertler, M. (1999) “The science of monetary policy: A new Keynesian perspective.” Journal of Economic Literature 37: 1661-1707.

Currie, D. and Levine, P. (1993) Rules, Reputation and Macroeconomic Policy Coordination, Cambridge University Press.

Dennis, R. (2001) “Pre-commitment, the timeless perspective, and policymaking from behind a veil of uncertainty.” Working paper, Federal Reserve Bank of San Francisco.

Dennis, R. (2004) “Inferring Policy Objectives from Economic Outcomes.” Oxford Bulletin of Economics and Statistics 66: 735-764.

Dennis, R. (2010) “When is discretion superior to timeless perspective policymaking?” Journal of Monetary Economics 57: 266-277.

Givens, G. E. (2012) “Estimating Central Bank Preferences under Commitment and Discretion.” Journal of Money, Credit and Banking 44: 1033-1061.

Green, E. (1987) “Lending and the smoothing of uninsurable income” In Contractual arrangements for intertemporal trade, edited by Prescott, E. and Wallace, N. University of Minnesota Press.

Jensen, C. (2001) “Optimal Monetary Policy in Forward-Looking Models with Rational Expectations.” Working paper, Carnegie Mellon University.

Jensen, C. and McCallum, B. T. (2010) “Optimal Continuation versus the Timeless Perspective in Monetary Policy.” Journal of Money, Credit and Banking 42, 1093-1107.

King, R. G. and Wolman, A. (1999) “What Should the Monetary Authority Do When Prices Are Sticky?” In Monetary Policy Rules, edited by Taylor, J. B. University of Chicago Press: 349-404.

Kotlikoff, L. J., Persson, T. and Svensson, L. E. O. (1988) “Social Contracts as Assets: A Possible Solution to the Time-Consistency Problem.”, American Economic Review 78: 662-677.

Kydland, F. E. and Prescott, E. C. (1977) “Rules Rather than Discretion: The Inconsistency of Optimal Plans.” Journal of Political Economy 85: 473-492.

Mankiw, N. G. and Reis, R. (2007) “Sticky Information in General Equilibrium.” Journal of the European Economic Association 5: 603-613.

McCallum, B. T. (1995) “Two Fallacies Concerning Central-Bank Independence.” American Economic Review 85: 207-211.

Persson. T. and Tabellini, G. (1993) “Designing institutions for monetary stability.” Carnegie-Rochester Conference Series on Public Policy 39: 53-84.

Persson. T. and Tabellini, G. (1994) Monetary and fiscal policy - Volume I: Credibility. MIT Press.

Phelan, C. (1998) “On the long run implications of repeated moral hazard.” Journal of Economic Theory 79: 174-191.

Rogoff, K. (1985) “The Optimal Degree of Commitment to an Intermediate Monetary Target.” Quarterly Journal of Economics 100: 1169-1189.

Rogoff, K. (1987) “Reputational Constraints on Monetary Policy.” Carnegie-Rochester Conference Series on Public Policy 26: 141-82.

Rotemberg, J. J. (1982) “Monopolistic Price Adjustment and Aggregate Output.” Review of Economic Studies 49: 517-531.

Rotemberg, J. J. and Woodford, M. (1999) “Interest Rate Rules in an Estimated Sticky Price Model.” In Monetary Policy Rules, edited by Taylor, J. B. University of Chicago Press: 57-126.

Sbordone, A. M. (2007) “Inflation Persistence: Alternative Interpretations and Policy Implications.” Journal of Monetary Economics 54: 1311-1339.

Schorfheide, F. (2008) “DSGE Model-Based Estimation of the New Keynesian Phillips Curve.” Federal Reserve Bank of Richmond Economic Quarterly 94: 397-433.

Sleet, C. and Yeltekin, S. (2005) “Credible Social Insurance.” Working paper, Carnegie Mellon University.

Soderstrom, U., Soderlind, P. and Vredin, A. (2005) “New-Keynesian Models and Monetary Policy: A Re-examination of the Stylized Facts.” The Scandinavian Journal of Economics 107: 521-546.

Stokey, N. (1991) “Credible public policy.” Journal of Economic Dynamics and Control 15: 367-390.

Svensson, L. E. O. (1997) “Optimal Inflation Targets, ‘Conservative’ Central Banks, and Linear Inflation Contracts.” American Economic Review 87: 98-114.

Svensson, L. E. O. and Woodford, M. (2002) “Indicator Variables for Optimal Policy.” Journal of Monetary Economics 50: 691-720.

Svensson, L. E. O. and Woodford, M. (2005) “Implementing Optimal Policy through Inflation-Forecast Targeting.” In The Inflation-Targeting Debate, edited by Bernanke, B. S. and Woodford, M. University of Chicago Press: 19-92.

Taylor, J. B. (1979a) “Estimation and control of a macroeconomic model with rational expectations.” Econometrica 47: 1267-1286.

Taylor, J. B. (1979b) “Staggered Wage Setting in a Macro Model.” American Economic Review 69: 108-113.

Thomas, J. and Worrall, T. (1990) “Income fluctuation and asymmetric information: an example of a repeated principal-agent problem.” Journal of Economic Theory 51: 367-390.

Woodford, M. (1999) Commentary: How Should Monetary Policy Be Conducted in an Era of Price Stability. In New Challenges for Monetary Policy. Federal Reserve Bank of Kansas City: 277-316.

Woodford, M. (2000) “Pitfalls of Forward-Looking Monetary Policy.” American Economic Review 90: 100-104.

Woodford, M. (2003) Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton University Press.