Staff Report 326

The Optimal Degree of Discretion in Monetary Policy

Patrick J. Kehoe | Stanford University, University College London, Federal Reserve Bank of Minneapolis
Andrew Atkeson | Consultant
Susan Athey

Revised August 1, 2004

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 and the less important is private information, the smaller is the optimal degree of discretion. As either the time inconsistency problem becomes sufficiently severe or private information becomes sufficiently unimportant, the optimal degree of discretion is none.

Published In: Econometrica (Vol. 73, No. 5, September 2005, pp. 1431-1475)

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