The Optimal Degree of Discretion in Monetary Policy

51 Pages Posted: 19 Nov 2003 Last revised: 17 Aug 2022

See all articles by Susan Athey

Susan Athey

Stanford Graduate School of Business

Andrew Atkeson

University of California, Los Angeles (UCLA) - Department of Economics; National Bureau of Economic Research (NBER)

Patrick J. Kehoe

Federal Reserve Bank of Minneapolis - Research Department; University of Minnesota - Twin Cities - Department of Economics; National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: November 2003

Abstract

How much discretion should the monetary authority have in setting its policy? This question is analyzed 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 discretion to react to its private information against society's need to guard against the time inconsistency problem arising from the temptation to stimulate the economy with unexpected inflation. Although this dynamic mechanism design problem seems complex, society can implement the optimal policy simply by legislating an inflation cap that specifies the highest allowable inflation rate. The more severe the time inconsistency problem, the more tightly the cap constrains policy and the smaller is the degree of discretion. As this problem becomes sufficiently severe, the optimal degree of discretion is none.

Suggested Citation

Carleton Athey, Susan and Atkeson, Andrew G. and Kehoe, Patrick J., The Optimal Degree of Discretion in Monetary Policy (November 2003). NBER Working Paper No. w10109, Available at SSRN: https://ssrn.com/abstract=468796

Susan Carleton Athey (Contact Author)

Stanford Graduate School of Business ( email )

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Andrew G. Atkeson

University of California, Los Angeles (UCLA) - Department of Economics ( email )

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National Bureau of Economic Research (NBER) ( email )

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Patrick J. Kehoe

Federal Reserve Bank of Minneapolis - Research Department ( email )

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University of Minnesota - Twin Cities - Department of Economics ( email )

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National Bureau of Economic Research (NBER) ( email )

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