The optimal degree of discretion in monetary policy

Susan Athey, Andrew Atkeson, Patrick J. Kehoe

Research output: Contribution to journalReview articlepeer-review

59 Scopus citations

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.

Original languageEnglish (US)
Pages (from-to)1431-1475
Number of pages45
JournalEconometrica
Volume73
Issue number5
DOIs
StatePublished - Sep 2005

Keywords

  • Activist monetary policy
  • Inflation caps
  • Inflation targets
  • Optimal monetary policy
  • Rules vs. Discretion
  • Time inconsistency

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