Intermediate Macroeconomics

Lecture 23: rules vs. discretion in

macroeconomic policy making

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 This lecture

• Fundamental issues in the design of monetary policy institutions

• Should policy follow a rule or be at policy maker’s discretion?

i) game-theoretic analysis
ii) numerical example

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 Rules vs. discretion
• Rule

– goals and instruments announced in advance

– central bank commits to a contingent plan

• Discretion

– policy makers evaluate events in real time

– optimise sequentially

• How could imposing constraints (a pre-specified rule) make for better outcomes?

• Surely policy makers can always use discretion to replicate rule outcome, and
discretion offers additional flexibility too...?

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 Time consistency problem

• Flexibility creates problem of non-credible policy announcements

• Consider a simple example: Hostage negotiation

– government would like to credibly commit to no-negotiation stance

– why?

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 Time inconsistency in monetary policy

• Central bank likes low inflation π and unemployment u. Minimises loss function

L(u, π) = u2 + γπ 2 , γ>0

• Policy tradeoff (an expectations-augmented Phillips curve)

u − u = −α(π − E(π)), α>0

• Study this as a game, two scenarios

– rule: central bank moves first, private sector second

– discretion: private sector moves first, central bank second

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 Central bank preferences
unemployment
u

(0, 0) inflation, π
decreasing loss

Central bank preferences given by a loss function L(u, π), dislikes both unemployment and inflation.
Prefers to be on indifference curves closer to the origin.

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 Rule scenario
• Central bank moves first, chooses an inflation rate π

• Private sector moves second, forms inflation forecast E(π)

• Unemployment determined by Phillips curve

• Result:

– central bank commits to π = 0

– under rule scenario, this commitment is credible
– private sector inflation forecast E(π) = π = 0
– then from Phillips curve, unemployment is

u = u − α(π − E(π)) = u

– this is the best sustainable outcome possible here

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 Rule scenario
unemployment
u

with commitment

(0, u)

(0, 0) inflation, π

Central bank commits to π = 0. Under rule scenario this commitment is credible and private sector’s
inflation forecast is E(π) = π = 0 too. Then from Phillips curve unemployment is u = u.

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 Discretion scenario

• Private sector moves first, forms inflation forecast E(π)

• Central bank moves second, chooses an inflation rate π

• Unemployment determined by Phillips curve

• Suppose private sector initially believes central bank will set π = 0

( perhaps because of some central bank announcement )

• What will central bank do if private sector believes E(π) = 0? Central bank chooses
inflation where Phillips curve is tangent to indifference curve.

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 Central bank tempted
unemployment
u

with discretion,
central bank faces temptation

(0, u)

û

(0, 0) π̂ inflation, π
u − u = −α(π − 0)

If private sector believes E(π) = 0, central bank is tempted to exploit Phillips curve tradeoff to get to a
lower indifference curve (lower loss) with lower unemployment û < u obtained at the expense of inflation
π̂ > 0. Knowing this, it is irrational for private sector to believe E(π) = 0, should believe inflation is at
least π̂.
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 Adverse shift in Phillips curve
unemployment
u

(0, u)

û
u − u = −α(π − π̂)

(0, 0) π̂ inflation, π

If private sector believes E(π) = π̂, Phillips curve shifts out so that central bank faces a more severe
constraint. Unemployment and inflation would be higher.

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 Central bank’s best response
unemployment
u
private inflation forecast π̂k
central bank’s best response π̂k+1
π̂k+1 = f (π̂k )

(0, u)

û
u − u = −α(π − π̂k )

(0, 0) π̂k π̂k+1 inflation, π

If private sector believes E(π) = π̂k , then Phillips curve is u − u = −α(π − π̂k ) and central bank chooses
inflation where Phillips curve is tangent to indifference curve. This gives the π̂k+1 = f (π̂k ) that is a best
response to π̂k .
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 Iterating on best response function
inflation
45◦ -line

π̂k+1 = f (π̂k )

π∗
π̂k+1

π̂k π̂k+1 π ∗ expected inflation

Starting with an initial π̂k we can keep iterating on the best response function π̂k+1 = f (π̂k ), then
π̂k+2 = f (π̂k+1 ), etc, until we obtain a fixed-point π ∗ such that π ∗ = f (π ∗ ). This is equilibrium inflation
where the central bank’s chosen inflation is consistent with private sector expectations.
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 Determining equilibrium inflation
unemployment
u
private inflation forecast π ∗
central bank’s best response π ∗

π ∗ = f (π ∗ )

(0, u)

u − u = −α(π − π ∗ )

(0, 0) π∗ inflation, π

In equilibrium, private sector inflation forecast is consistent with central bank’s incentives. Since inflation
equals expected inflation, π = E(π) = π ∗ , from Phillips curve unemployment is u = u. Under discretion,
inflation is higher than under rule, π ∗ > 0, and unemployment is same.
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 Discretion scenario: numerical example
• Loss function

L(u, π) = u2 + π 2 , (i.e., γ = 1)

• Central bank minimises loss subject to Phillips curve

u = 0.05 − (π − E(π)), (i.e., α = 1, u = 5%)

• Substitute Phillips curve into loss function

L = [0.05 − (π − E(π))]2 + π 2

• Minimise by choosing π. First order condition is

dL
=0
dπ

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 Discretion scenario: numerical example
• Calculating the derivative, first order condition is

dL
= −2[0.05 − (π − E(π))] + 2π = 0
dπ
• Solve first order condition for inflation

π = 0.025 + 0.5E(π)

• This gives the central bank’s best response to E(π). In equilibrium

π = E(π) = π ∗ ⇔ π ∗ = 0.025 + 0.5π ∗

• Solving this for π ∗ we get

π ∗ = 0.05

Result is that equilibrium inflation is 5% under discretion, instead of 0% under rule.

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 Implications

• Central bank cannot make private sector believe it will do the right thing and keep
inflation low

• There may be advantages to taking options “off the table”

– key difference between single-agent optimisation and a game

• But absolute commitment to a rule difficult to achieve in practice

– how can approximate rule-like outcomes be achieved?

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 Next lecture

• Last class!

• Wrap up and course review

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 Example #12: problem
Setup: The RBA loss function is

L(u, π) = u2 + 2π 2 ,

subject to the expectations augmented Phillips curve

u − u = −4(π − E(π))

(a) Suppose u is 5%. Calculate inflation under discretion.

(b) Suppose the Phillips curve steepens to u − u = −6(π − E(π)). What happens to
inflation under discretion?
(c) The government appoints an ‘inflation nutter ’ with L(u, π) = u2 + 12π 2 . Can they
get inflation back under control?