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The optimal degree of discretion in monetary policy

Athey, S; Atkeson, A; Kehoe, PJ; (2005) The optimal degree of discretion in monetary policy. Econometrica , 73 (5) pp. 1431-1475. 10.1111/j.1468-0262.2005.00626.x. Green open access

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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 economy’s randomly fluctuating state. The monetary authority has private information about that state. 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 prevent that authority from giving in to the temptation to stimulate the economy with unexpected inflation, the time inconsistency problem. Although this dynamic mechanism design problem seems complex, its solution is simple: legislate an inflation cap. The optimal degree of monetary policy discretion turns out to shrink as the severity of the time inconsistency problem increases relative to the importance of private information. In an economy with a severe time inconsistency problem and unimportant private information, the optimal degree of discretion is none.

Type: Article
Title: The optimal degree of discretion in monetary policy
Open access status: An open access version is available from UCL Discovery
DOI: 10.1111/j.1468-0262.2005.00626.x
Publisher version: https://doi.org/10.1111/j.1468-0262.2005.00626.x
Language: English
Additional information: The copyright to this article is held by the Econometric Society, http://www.econometricsociety.org/. It may be downloaded, printed and reproduced only for personal or classroom use. Absolutely no downloading or copying may be done for, or on behalf of, any for-profit commercial firm or for other commercial purpose without the explicit permission of the Econometric Society.
Keywords: Rules vs. discretion, time inconsistency, optimal monetary policy, inflation targets, inflation caps, activist monetary policy.
UCL classification: UCL
UCL > Provost and Vice Provost Offices
UCL > Provost and Vice Provost Offices > UCL SLASH
UCL > Provost and Vice Provost Offices > UCL SLASH > Faculty of S&HS
URI: https://discovery.ucl.ac.uk/id/eprint/10054404
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