No sorry, it was supposed to be a support of the status quo type post, I am happy with the current level of discretion

“Do you actually think we live in a world characterized by RBC theory?”

No I don’t :P. However, I also do not believe that monetary and fiscal policy should always be used to stabilise output.

“I think we might be having a semantic argument about what a policy target means in terms of rules versus discretion.”

Yes definitely, when I’m talking about rule policy I’m mearly stating that the Bank’s actions are constrained in some way, so that they can precommit to the optimal path. When I talk about discretion I am talking about their ability to deviate from this path.

“All systems have some discretionary element, but all shades of grey are not the same.”

Thats completely right, it is a continuum of potential choices rather than the black and white – rule vs discretion case I have laid out above. That is what makes the optimal choice so difficult to figure out.

Do you actually think we live in a world characterized by RBC theory? I don’t, so obviously I think that monetary/fiscal policy can (in theory at least) stabilise output. I think that recessions as a result of a lack of demand are possible and can be minimized.

I don’t think agents have completely rational expectations, so I think time inconsistency can potentially have payoffs providing you don’t try and get away with it too often. I’m not certain that such situations actually arise in practice: again using the recent Fed moves as an example, one can always argue that inflation wouldn’t persist in a recessionary environment.

Even assuming that there was some way to enforce an absolute commitment to a rules-based system (bombs implanted in central bankers skulls triggered by cpi deviating too far from target?) I think it is extremely unlikely that it would maximize welfare relative to a system with discretion. The best justification I can think of is that the feasible gains in terms of lesser inflation/output variability compared to now seem pretty small, but the list of unforeseen circumstances that could lead to major policy errors seems potentially quite big.

I think we might be having a semantic argument about what a policy target means in terms of rules versus discretion. Implementation of most policy targets seem to involve plenty of discretion, and hence it is never precisely clear what the policy response will be to any given set of economic variables. I agree with the consensus view that credibility and consistency is important for monetary policy; I just think situations could arise where you’d be willing to sacrifice some consistency for short-term gains and it would be welfare-maximizing over the longer-run.

rauparaha: point taken, but I’d argue that the (notional) independence of modern central banks is about as far as you can take pre-commitment. There doesn’t seem to be any way to further reduce the main remaining time-inconsistency problem which is regime change (e.g. the government deciding that inflation isn’t as important as a low exchange rate). Although maybe free financial markets + exchange rate plus mainstreaming of central bank independance does provide a growing incentive for the government not to deviate from current policy.

Although now that I think about it I guess making the workings of the RB model public and allowing no deviation from the model forecast interest rate track would have even more commitment value. Or some rule that tied interest rates to expected inflation as measured by inflation indexed bonds? Too much commitment methinks.

All systems have some discretionary element, but all shades of grey are not the same. Systems that provide greater precommitment result in better outcomes because they reduce the likelihood of time inconsistent behaviour. Even imperfect precommitment devices have value for central bankers.

By rule vs discretion I’m talking about policy target vs no policy target in a sense, that is why I say:

“Central Banks, such as the RBNZ, try to achieve the rule based outcome by setting inflation targets and being single minded with inflation”

“The second problem is that I don’t see a single-minded inflation target as appropriate in all situations.”

True, but all that matters is that welfare ex-ante is greater from a rule than from an alternatives.

The question then is, is current Reserve Bank policy appropriate and why/why not? You mention costs from ‘weak growth’, but what type of costs do you mean? (I do agree there are costs, I just want to know which ones you want to discuss) After all if we live in a world that is explained by real business cycle theory, then the business cycle is the equilibrium reaction of agents to a supply side shock, which implies that any policy that aims to ‘stabilise output’ will be sub-optimal.

PS. “The decision to give cash out seems to be very discretion based across businesses, as a result the customer never knows until you get to the counter whether you can get cash”. I agree in general but the place where I grab lunch is in the middle of a bunch of offices, and will mainly service the same people over and over again. In this case people have full information before they go and buy food. That explains why it might be efficient for them to enforce this policy.

Perhaps I misunderstand you, but are you suggesting you’d prefer a computer with some variant of a taylor rule over the current framework? (although you seem to be suggesting an even simpler reaction function than this, nothing but the inflation gap).

The first problem I see is that it just wouldn’t work – even a rules based framework would have to have some discretion (e.g. can we ignore a one-off price change due to government policy, and when do we get get to re-estimate the variables in our model, or change the model’s workings?).

The second problem is that I don’t see a single-minded inflation target as appropriate in all situations. I think that too weak growth is more prone to becoming a lingering recession than high inflation is of becoming hyper-inflation. Hence I would generally agree with the path the Fed has taken recently, which I would characterize as suggestive of a belief that the growth risks are strong enough to out-weigh temporarily the inflation risks.

PS eatery is sub-optimal too in my opinion. The decision to give cash out seems to be very discretion based across businesses, as a result the customer never knows until you get to the counter whether you can get cash. Information costs!! Plus we have a case here of irrational actors putting costs on others by arguing, which we should incorporate into our decision about optimal policy. 🙂