Optimal Discretion

35 Pages Posted: 12 Dec 1999

See all articles by Yvan Lengwiler

Yvan Lengwiler

University of Basel - Faculty of Business and Economics (WWZ)

Athanasios Orphanides

Massachusetts Institute of Technology (MIT) - Sloan School of Management; Asia School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: July 1999

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.

JEL Classification: E58, D82, C72

Suggested Citation

Lengwiler, Yvan and Orphanides, Athanasios, Optimal Discretion (July 1999). Available at SSRN: https://ssrn.com/abstract=186310 or http://dx.doi.org/10.2139/ssrn.186310

Yvan Lengwiler

University of Basel - Faculty of Business and Economics (WWZ) ( email )

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Basel, CH-4002
Switzerland
+41 61 267 3369 (Phone)

HOME PAGE: http://wwz.unibas.ch/lengwiler

Athanasios Orphanides (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-416
Cambridge, MA 02142
United States

HOME PAGE: http://mitsloan.mit.edu/faculty/detail.php?in_spseqno=54058

Asia School of Business ( email )

Jalan Kuching, Kuala Lumpur, Wilayah Persekutuan K
Kuala Lumpur, MA
Malaysia

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