Advanced Macroeconomics An Easy Guide Rules vs Discretion

CHAPTER 20 Rules Discretion Now , let move back to the new world of Chapter 15 where the existence of nominal ties implies that monetary policy ( can have real effects , Most central banks believe this a more realistic description of the environment , at least in the short run . In such a world , has to assess the when it comes to stabilising versus stabilising output In this chapter we develop a framework that will let us analyse this . Abasic framework Fortunately , we have already developed most of the ingredients of such framework its the canonical New model ! As you may recall , it is founded on two basic equations , the New IS curve ( and the New Phillips curve ( which we rewrite here for your convenience , First , the ( This is exactly as we had before , with corresponding to an ( aggregate demand ) shock . We specify shocks being a random , disturbance . Now , the it , 14 , with uf corresponding to an ( aggregate supply ) shock . If you check this against the specification of previous chapters , the main difference you will notice is the existence of these demand and supply shocks . You will recall that , when we discussed the canonical model , we talked about an interest rate rule , namely the celebrated Taylor rule . Now is the time to think about the nature of monetary policy rules more broadly . Time inconsistency The thing we have to do is to think about what the central ( for shorthand ) wants to do . We assume that , when it comes to , it wants to minimise departures from the optimal level , which we normalize to zero . Again , it could be positive , could be negative it just How to cite this book chapter , and , A . 2021 . Advanced An Easy Guide . 20 . Rules Discretion , London Press . DOI License .

I RULES a normalization . When it comes to output , we will introduce a more consequential assumption we take that the wants to minimise deviations not from the natural rate ( but rather from what we may call the rate of output , which we call . Think of this as the output level that would prevail in the absence of any market distortions , such as monopoly power or taxation . The idea is that it is almost surely the case that monopolies produce suboptimal quantities , taxes lead to suboptimal effort , etc . In order to capture this idea , we will usually think of the as minimising a loss function like this emf ( where I denotes the relative importance of as compared to output deviations . To discuss the implications , let develop a model to deal with this issue in the spirit of ( 1985 ) The details follow ( 1996 ) which uses a simpler Phillips curve , but which captures the spirit of ( In this version the economy is fully characterised by the Phillips curve , where it is the actual rate of , its is the expected rate , is actual output , is steady state ( or natural rate ) output , and , is a random shock ( which should be interpreted here as a supply shock ) with mean zero and variance ' The term ( Ir , implies that whenever actual is below expected , output falls . Notice that the supply shock is the only shock here ( we assume away demand shocks , whether of the nominal or real kind ) The social loss function is ( The function ( indicates that society dislikes in both and output . Notice that the bliss output rate is , is above the natural rate of . This will be a source of problems . The timing of actions is as follows . The economy has a natural output rate which is known by all players . The public moves first , setting its expectations of . The shock , is then realised . The moves next , setting It to minimise ( subject to ( the realisation of the shock ( known to the ) and the public expectations of . Notice this timing implies the has an informational advantage over the public . By assuming that the can control Ir , directly , we are the issue of whether that control is exercised via a money rule ( and , therefore , exchange rates ) an interest rate rule , or an exchange rate rule . What is key is that the authorities can set whatever policy tool is at their disposal once expectations have been set . The policy maker , acting with discretion sets , It , taking ( which has been already set ) as given . Substituting ( into ( the objective function becomes ( Minimising with respect to Ir , yields air , Ir ,

RULES DISCRETION 317 Rearranging we arrive at 67 , a If , in addition , we impose the rational expectations condition that , we have from ( that where A A emf ( Hence , under discretion , expectations are positive as long as ( is positive . Since ( is the difference between the natural rate of output and the target rate in the loss function , we conclude that , as long as this difference is positive , the economy exhibits an bias expected is positive . Using ( in ( yields , or , more simply , so that actual depends on the shock as well as on the bias term . The fact that the wants to boost output above its natural level leads to a problem of dynamic inconsistency and bias that was originally pointed out by and Prescott ( 1977 ) and and Gordon ( 1983 ) This is one of the most important and results for modern , and its intuition points squarely at the limits of systematic policy in a world where people are rational and they will out the incentives , and , because of that , the tradeoff that the would like to exploit vanishes . Rational expectations implies that the will occur at an rate sufficiently high so that the cost of increasing further would not be desirable to the . Once this anticipation is included in the model , discretion does not help expand output . In fact , if all could agree to a lower , everybody would be better off . The main takeaway is that credibility is a key element of monetary policy practice if people believe the commitment to and not to exploit the tradeoff systematically , the terms of the tradeoff in the short run become more favourable . This idea has been encapsulated in the mantra of rules discretion are better off in the long run if they are able to commit to rules , rather than trying to make policy in discretionary fashion . A brief history of monetary policy In common policy parlance , the lesson is that being subject to time inconsistency , the needs to an anchor for monetary policy . This anchor helps keep expectations in check , and ameliorate the time inconsistency problem . The drawback is that the anchor may be too rigid , and make monetary policy less effective or have other side effects . Therefore the key issue is how to an anchor that delivers credibility while not jeopardising the ability to react to shocks . One such mechanism is to appoint conservative central bankers , who would have a low or insuring the independence of the and having it focus squarely on . These two policies , now widely used , have helped to reduce the bias as shown in Figure . But in addition to these obvious solutions , the quest to

RULES Figure advanced economies ( blue line ) and emerging markets ( red line ) Inflation ( Va ) 120 10 90 60 30 1980 1990 2000 2010 2020 1980 1990 2000 2010 2020 Year Year build a monetary framework that provides credibility and has gone on for decades . 1999 ) provides a nice narrative that we summarize as follows . The age of discretion lasted until the early when there was a belief that there was a long term tradeoff between and output . During this period there were no major objections to the use of monetary policy . The debate focused on the relative merits of monetary policy The rise of in the led to increased skepticism on the role of monetary policy , and led to the acknowledgement that a nominal anchor was required . The discussion took place mostly in the as most other countries still had a exchange rate that they carried over from the Woods system ( and therefore no monetary policy of their own ) But once countries started recovering their monetary policies by the exchange rate , monetary became the prime nominal anchor . Central banks committed to a certain growth in monetary over the medium term , while retaining in the short run . By the , it was clear that monetary aggregate targeting was not working very well , mostly due to instability in the demand for money . Gerald , then governor of the Bank of Canada , described the situation in his famous quote We didn abandon monetary , they Starting in the , central banks have increasingly used itself as the nominal get . This is the so called targeting regime . Other central banks ( the Fed in the ) have remained committed to low , but without adopting an explicit target ( though Fed governors embrace openly the idea of a target for annual recently updated to an average of over time ) Other countries remained using exchange rates , while targeting went in disuse . targeting , however , has a drawback it output volatility when the economy is subject to substantial supply shocks . As a response many central bankers do not run a strict tion targeting but a targeting , where the target is a long run objective retaining substantial in the short More recently , some central banks have veered away from targeting and started ing expectations instead ( see Adrian et ( 2018 )

RULES DISCRETION 319 The emergence of targeting Given its increasing popularity , let spend some time analysing the monetary framework of targeting . We laid the framework above which gave us a solution for the rate . Recall that using ( in ( yields A ( so that actual depends on the shock as well as on the fixed bias term . Subtracting ( from ( yields 19 ( or , That is , deviations of output from the natural rate are random and depend on the shock and on the parameter Finally , using ( 2012 ) and ( in ( yields ( Az , and taking expectations we have ( 01 ELd 72 , where is the variance of , and the expectation is unconditional that is , taken without knowing the realisation of , Hence , expected social loss is increasing in the natural rate , in the difference between and , and in the variance of the shock . rule Consider what happens , on the other hand , if the has not to manipulate , therefore setting , The Phillips curve dictates that , If , in addition , the rule is credible , so that , we have ) Notice that , unlike the case of discretionary policy ( see expression ( 2014 ) here output absorbs the full impact of the shock ( the coefficient is missing ) The corresponding loss is ' The unconditional expectation of ( is EL '

320 RULES Which regime is better ?

If the unconditional expectation of the loss is the welfare criterion , then deciding which regime is better depends on parameter values . Expressions ( and ( reveal that ELM EL if and only if ( The is a proxy for the bias under discretion the is a proxy for the variability cost under a rigid rule . The rigid rule is better when the former is larger , and vice versa . In short , you prefer a fixed rule if your bias is large and the supply shocks small . The argument for targeting Suppose now that the social objective function is still given by ( but that now the is given the objective function ( a ( 2022 ) where is the bliss rate of for the . We can interpret this as the target assigned to the by society Substituting ( 204 ) into ( one gets ( Ir , Minimising with respect to Ir , yields a ( Rearranging we arrive at 971 , 6715 , 2025 ) Taking expectations we have 971 ( 97 , 2025 ) so the bias is positive or negative depending on the setting of . Suppose the target is set so that the bias is zero . Having implies ( 2027 ) Using this in ( yields 971 , Using this and in ( yields , so that deviations of output from its long run level are the same as under discretion .

RULES DISCRETION Finally , using ( 2028 ) and ( into the public loss function ( 205 ) yields ( Taking expectations and rearranging ( It is easy to check that EL is smaller than either ELd or EL . That is , targeting is better for welfare than fully discretionary policy and a rigid rule . The intuition should be simple targeting enjoys the of discretion and the credibility of a rule ( the bias is zero ) As in the world decreased , monetary policy entered into a happy consensus by the . Credibility had been restored , and even those central banks that did not explicitly target were widely understood to be essentially doing the same . The interest rate was the policy tool of choice . Enhanced credibility , or the so called of the Phillips curve made monetary policy more powerful as a stabilisation mechanism , and as a result became the tool of choice for steering the business cycle . Some central bankers even acquired heroic , status . But then , the crisis hit . The consensus was revealed inadequate to deal with the crisis at its worst , and questions were raised as to the extent to which monetary policy had failed to prevent ( and perhaps contributed to ) the Great Recession and , later on , the European Crisis . Perhaps with the of hindsight , the challenge proved to be central banks hour the recoveries were swift and remained low . The credibility provided the room for massive increases in liquidity , that shattered not a bit the credibility of the central banks and allowed to the drainage of liquidity during the crises . This was perhaps best in a celebrated quote by Mario , then governor of the European Central Bank who , in July 2012 , announced that the Central Bank would do whatever it takes . This phrase , as of today , is the symbol of the ing of age of modern when full discretion can be pursued without rising an eyebrow or affecting expectations ! Notes One way of illustrating this debate is to remember the discussion surrounding the creation of the European Central Bank . As a novel institution whose governance was in the hands of a number of countries , it was not clear how it would build its credibility Someone suggested to locate it in Frankfurt , so it could absorb ( by proximity ?

Germany conservative approach to monetary policy . The french wanted to control the presidency , but this was considered not strong at least at the beginning , so they compromised on a two year presidency with a Dutch . However , after two years , when French Marie took over , he still had to be overly conservative to build his , and the institutions , credibility . We should also keep in mind that targeting does not mean that the central bank or policy maker does not care about anything other than . As we show in the model in the next section , the central banks objective function may take deviations of output into account the relative weight of output will affect the tolerance of the central bank to deviations of from the target as a result of shocks .

322 RULES References Adrian , 2018 ) Advancing . national Monetary Fund . I . Gordon , 1983 ) Rules , discretion and reputation in a model of monetary policy . journal Economics , 12 ( Prescott , 1977 ) Rules rather than discretion The inconsistency of optimal plans . Economy , 85 ( 1999 ) International experiences with different monetary policy regimes . Journal of Monetary Economics , 43 ( 1985 ) The optimal degree of commitment to an intermediate monetary target . The Journal , 100 ( A . 1996 ) Fixed exchange rates Credibility , and multiplicity . European Economic Review , 40 ,