16 Pages Posted: 6 Feb 2003
We investigate the desirability of adopting a rule in favor of discretionary monetary policy in a model exhibiting Kydland and Prescott's dynamic inconsistency problem but no fundamental incompatibility between the policymaker's price stability and full employment objectives. We show that if discretion provides a policy flexibility benefit, then a rule is optimal only when inflation exceeds an endogenously determined threshold. This 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. Imperfect credibility narrows the scope for discretion and enhances the benefits of adopting a rule.
Keywords: rules, discretion, credibility, dynamic inconsistency, inflation targeting
JEL Classification: E58, D82, C72
Suggested Citation: Suggested Citation
Do you have a job opening that you would like to promote on SSRN?
This is a Wiley-Blackwell Publishing paper. Wiley-Blackwell Publishing charges $42.00 .
File name: Sjoe285.pdf
If you wish to purchase the right to make copies of this paper for distribution to others, please select the quantity.