Rules Vs Discretion

Fall Semester ’04-’05 Akila Weerapana

Lecture 11: Rules vs. Discretion
I. OVERVIEW
• The basic framework for evaluating monetary policy showed that expectations about future inflation, and the manner in which those expectations are formed have a critical role to play in determining macroeconomic outcomes in the economy. In other words, the current state of the economy depends on expectationsof future inflation, which presumably would be affected by expected policy changes in the future. • The impact of expected future policy changes on current macroeconomic variables led to the idea that there were clear gains to transparency in conducting monetary policy: the less uncertainty there was about future policy, the easier it would be for agents to form expectations about the future.Furthermore, policy makers would not be able to systematically pursue policies that produced unexpected inflation because individuals would quickly catch on. • The increased role of expectations led to some economists arguing that it would be best to force monetary policy makers to commit to following a policy rule instead of allowing them to pick the appropriate policy at their discretion. The basicintuition was that under a rule, the policy maker would be able to credibly commit to a sequence of policy decisions that would bring about the best long run outcome. • Under discretion, the policymaker could always deviate to satisfy some short run objective, hence it would be harder for individuals to form expectations about policy decisions in the future. This distinction between monetary policyunder a rule and monetary policy under discretion was explored in a couple of groundbreaking papers by Barro and Gordon, which we shall study in the next two lectures.

II. INTRODUCTION TO THE BARRO/GORDON PAPER
• Let’s focus initially on the first, and simpler, Barro/Gordon (BG) paper. The motivation for the paper, according to BG, comes from two stylized facts: average rates of inflation andmoney growth were high in most countries (recall that BG were writing in the early 1980s) and that countries had a tendency to pursue “activist, countercyclical monetary policies” (i.e. countries tended to use contractionary policy to slow down the economy in good times and use expansionary monetary to speed up the economy in times of recession.) • Putting these two observations together, BG suspectthat the activist, discretionary monetary policy may be contributing to the high rates of money growth and inflation. They want to develop a model that can explain the link between the discretionary policy and the high inflation. • BG develop a model in which individuals act rationally and anticipate the actions of the monetary policy maker. In the context of this model, BG compare the economicoutcomes when the monetary policy maker is acting under discretion with the outcome when the monetary policy maker follows a rule.

• BG find that, under discretion, the monetary policy maker picks a rate of money growth that is high and as a result inflation rates become high as well. The actual inflation rate that prevails in the economy under discretionary policy depends on the natural rate ofunemployment and the parameters of the Phillips curve that describe the tradeoff between inflation and unemployment. The model also shows that the monetary policy maker acts in a countercyclical fashion, thus replicating the last of the stylized facts mentioned earlier. • Finally, the unemployment rate (or the real economy) is unaffected by changes in monetary policy. This makes sense because the modelBG are using has no nominal rigidities: if inflation is free to adjust then monetary policy will not have any impact on the economy. Monetary policy doesn’t have an impact in this model unless it takes individuals completely by surprise: only surprise inflation matters. • The basic structure of the paper is that BG first describe the model, then describe the preferences of the monetary policy maker...