On the Non-Optimality of Supposedly 'Optimal' Monetary Policy

Abstract

A burgeoning part of the monetary policy design literature posits that optimal monetary policy is the solution to a constrained optimization problem where the monetary authority has the discretion to minimize a social welfare function, taking the economy and other policies as given. Davig and Gurkaynak (2014) argue convincingly that the solution thus attained may fail to deliver the desired outcome. This note further argues that optimal outcomes are infeasible in an environment where policy discretion is encouraged and the central bank is assigned multiple conflicting objectives. In a democracy, no unelected and unaccountable policymaker should be or act as the residual claimant of all policy. Narrow mandates and rules are needed to protect society from harmful discretion. The Inflation Targeting framework and recent policy challenges faced by the Federal Reserve and the ECB are discussed in this context.

Keywords: Inflation Targeting, Federal Reserve, ECB, discretion, policy rules, optimal policy

JEL Classification: E32, E52, E58, E61