Optimal Discretion

16 Pages Posted: 6 Feb 2003

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

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Abstract

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

Lengwiler, Yvan and Orphanides, Athanasios, Optimal Discretion. Scandinavian Journal of Economics, Vol. 104, pp. 261-276, 2002. Available at SSRN: https://ssrn.com/abstract=317381

Yvan Lengwiler (Contact Author)

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

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

Athanasios Orphanides

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

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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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