The Optimal Degree of Discretion in Monetary Policy

49 Pages Posted: 1 Jun 2004

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: April 2004

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.

Keywords: rules vs. discretion, time inconsistency, optimal monetary policy, inflation targets, inflation caps

JEL Classification: E5, E6, E52, E58, E61

Suggested Citation

Carleton Athey, Susan and Atkeson, Andrew G. and Kehoe, Patrick J., The Optimal Degree of Discretion in Monetary Policy (April 2004). Federal Reserve Board of Governors International Finance Discussion Papers. Available at SSRN: https://ssrn.com/abstract=551641 or http://dx.doi.org/10.2139/ssrn.551641

Susan Carleton Athey (Contact Author)

Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States

Andrew G. Atkeson

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

Box 951477
Los Angeles, CA 90095-1477
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
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Patrick J. Kehoe

Federal Reserve Bank of Minneapolis - Research Department ( email )

90 Hennepin Avenue
Minneapolis, MN 55480
United States
612-204-5525 (Phone)
612-204-5515 (Fax)

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

271 19th Avenue South
Minneapolis, MN 55455
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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