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Optimal Discretion

Yvan Lengwiler () and Athanasios Orphanides ()

Scandinavian Journal of Economics, 2002, vol. 104, issue 2, 261-76

Abstract: We investigate the desirability of adopting a rule in favor of discretionary monetary policy in a model exhibiting Kydland and Prescott's dynamic inconsistency problem but no fundamental incompatibility between the policymaker's price stability and full employment objectives. We show that if discretion provides a policy flexibility benefit, then a rule is optimal only when inflation exceeds an endogenously determined threshold. This gives rise to a discretionary policy zone for inflation with the central bank taking more drastic action towards stabilizing inflation when inflation veers outside the zone. Imperfect credibility narrows the scope for discretion and enhances the benefits of adopting a rule. Copyright 2002 by The editors of the Scandinavian Journal of Economics.

Date: 2002
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Working Paper: Optimal discretion (1999) Downloads
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Scandinavian Journal of Economics is currently edited by Richard Friberg, Matti Liski and Kjetil Storesletten

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