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Discretion Vs Rules Debate Notes
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Pip Reeve HT 10 W5 16.02.10 Would policy makers better attain their macroeconomic objectives if they had their discretion taken away from them? What does your conclusion imply for the argument that responsibility for monetary policy should be devolved to central banks?
The majority of policy makers use an inflation target as their primary macroeconomic objective. This is for several reasons, including receiving regular and complete information on the price level, and inflation being more easily understood by the public than, say, nominal gross domestic product (GDP). So, in this essay, I will primarily focus on the use of inflation as a macroeconomic objective. I will discuss the relative advantages and disadvantages of policy makers having heavily enforced rules to follow versus being able to use their own discretion. Then I will argue that I believe rules used more as guidelines are the most advantageous, allowing policy makers to use their discretion in abnormal times, such as during the recent financial crisis. I will conclude by suggesting that in the majority of cases it is beneficial for monetary policy to be devolved to central bank, except perhaps in exceptional cases such as that of the liquidity trap currently occurring in Japan. I will begin by briefly discussing what the objectives are of a central bank who is targeting inflation. The central bank is aiming to minimise (π - π T)2, which does mean that they would lose the same amount of utility from a level of inflation which is 2% below the target, than a level of inflation which is 2% above it. Furthermore, they are likely to indirectly want to minimise (y - y e)2. Hence the utility function of a central bank in this situation is: L = (y - ye)2 + β (π - πT)2 where β is the relative weight attached to the loss from inflation. So, if β is greater than one, the central bank places less weight on deviations in output than inflation, meaning they are inflation averse. Using this utility function, it is possible to derive a monetary rule (MR).
A more inflation averse central bank will have a steeper MR curve. Central banks often have similar rules to follow, in order to achieve their target rate of inflation, and some policy makers are given more discretion than others. So, for example, some central banks will follow these rules regardless of any shocks that occur to the economy, while others are able to use their discretion to disobey the rule in the event of a large shock. A purely discretionary central bank would not have any such rules. So, in the medium run equilibrium, inflation equals the inflation target so long as the central bank seek to stabilise unemployment around the equilibrium rate of unemployment (ERU). However, this then presents the problem of what to set the inflation target as. An inflation rate that is too high can create a very volatile economy, while a target that is too low can create deflation which could lead to a negative real interest rate, and, in extreme examples, a liquidity trap. One of the major advantages of taking the discretion away from policy makers is that it should reduce inflation bias. If we now assume that the government has set a target of full employment, or
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