Working Paper: NBER ID: w10109
Authors: Susan Athey; Andrew Atkeson; Patrick J. Kehoe
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 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, the more tightly the cap constrains policy and the smaller is the degree of discretion. As this problem becomes sufficiently severe, the optimal degree of discretion is none.
Keywords: monetary policy; discretion; inflation cap; time inconsistency
JEL Codes: E5; E6; E52; E61; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| degree of discretion allowed to the monetary authority (E58) | time inconsistency problem (D15) |
| severity of the time inconsistency problem (D15) | optimal degree of discretion allowed to the monetary authority (E60) |
| optimal degree of discretion allowed to the monetary authority (E60) | constraints on discretion (K40) |
| inflation cap (E31) | monetary authority's behavior (E52) |
| inflation cap (E31) | economic outcomes (F61) |
| severity of the time inconsistency problem (D15) | inflation cap (E31) |