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Optimal Discretion
Author(s) -
Lengwiler Yvan,
Orphanides Athanasios
Publication year - 2002
Publication title -
scandinavian journal of economics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.725
H-Index - 64
eISSN - 1467-9442
pISSN - 0347-0520
DOI - 10.1111/1467-9442.00285
Subject(s) - economics , discretion , credibility , monetary policy , flexibility (engineering) , inflation (cosmology) , imperfect , monetary economics , stabilization policy , scope (computer science) , macroeconomics , microeconomics , linguistics , philosophy , physics , management , theoretical physics , political science , computer science , law , programming language
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. JEL classification : E 58; D 82; C 72