pure gold standard is a fully automatic monetary system. This can be either left to discretion (i.e., to a purely case-by-case assessment by public authorities) or based on rules (i.e., linked to the dynamics of one or more predefined macroeconomic or financial variables). The adoption of macroprudential policies has been advocated by the G20 Leaders and the Financial Stability Board. Today, before flooding has occurred, they can try to discourage floodplain construction by forswearing disaster relief. In macroeconomics, discretionary policy is an economic policy based on the ad hoc judgment of policymakers as opposed to policy set by predetermined rules. Because There Is A Clear Consensus Among Economists About What A Good Monetary Policy Rule Would Be B. This article summarizes two opposing views about how central banks should run policy: 1) central banks should stay close to predictable and well-proven rules; 2) policy makers should exercise discretion and choose the most favored alternative in each situation. If society aims to use regulation to make the police accountable to the citizens they serve, society's rules must not only channel accountability, but must create discretion. A. It is also amply supported by economic theory. 2. should monetary policy be made by rule or discretion? Kydland and Prescott emphasized the importance of pondering not only the desirable policy for a given set of circumstances but also the framework likely to produce the best policy over time. The plan can be non-activist in nature—the rule may force policy-makers to pursue the same course of action in all circumstances. have argued that monetary policy conducted by just such an expert monetary authority will en-hance the economy’s performance. Simons, Henry C. “Rules versus Authorities in Monetary Policy.” Journal of Political Economy, Vol. constant money growth rate a.ii. Friedman did concede, however, that constraints on policy were more important than the numerical target range; so, this policy prescription is often characterized as a, They noted that central banks with discretion have an incentive to renege on commitments to price stability. This article summarizes two opposing views about how central banks should run policy: 1) central banks should stay close to predictable and well-proven rules; 2) policy makers should exercise discretion and choose the most favored alternative in each situation. Do you need help with your Should Monetary Policy Be Made by Rule Rather Than by Discretion?? The new models were … Any dynamic model in which people are forward-looking and take time to adjust their behavior to circumstances implies that monetary and fiscal policy … The phrase “fettering discretion” found its way into two important decisions released today. A significant change in economists’ search for simple monetary policy rules occurred in the 1970s, however, as a new type of macroeconomic model appeared on the scene. Please help. As said earlier, how rules and policies are connected to each other is a matter of how we are looking at things. The Bank On movement is designed to improve the financial stability of America’s unbanked and underbanked. To discourage such building, they announce that anyone suffering flood damage is on his own—no disaster relief will be forthcoming. However, this would represent an exception, to be used in rare circumstances and properly explained to market participants. Moreover, once in place, they act as an effective pre-commitment device. Understanding how monetary policy works and how it’s affected by either rules or discretion is crucial, and all aspects must be taken into account to establish the most effective choice for our economy. But when a ratio does fall below that threshold, supervisors—if they had absolute discretion—could allow the bank to remain open to avoid the costs of liquidating the institution. Put another way, wise policy-makers must think through the public’s likely responses to their responses—just as the public is playing the same game with policy-makers. The common denominator is that rules are supposed to constrain policy-makers’ actions in advance. If policy-makers are relatively independent from the political process, then they can resist pressure from undeserving flood victims —those who ignored warnings—to renege on threats of no relief. Two candidates often singled out for additional attention are the exchange rate and equity prices. 44, 1936, pp. Here is how the debate is often framed. Page 2 of 2 On the other hand, there are problems with rules. Only a binding rule that keeps policy-makers from reneging will convince the public that homes are at genuine risk and, thereby, discourage floodplain construction. But they do, at different times and in response to different pressures, tend to emphasize one over the other. Proponents of discretionary policy note that such flexibility allows policy-makers to respond to unforeseen scenarios. Police officers are not simply rule-following soldiers. 1. In Trinity Western University v.The Law Society of British Columbia 2015 BCSC 2326 (“TWU-LSBC“), The Hon. In very general terms, the new macroprudential approach envisages greater focus on the analysis of systemic risk and vulnerabilities that may emerge as a consequences of macro-factors (Borio 2009). Supervisors have traditionally closed banks whenever the owners’ stake (capital) got dangerously low. The idea of ‘rule-based’ monetary policy is actually relatively old. And discretion can yield time-consistent outcomes under certain circumstances. Economists Finn Kydland and Edward Prescott were the first to offer a way out.1 In a classic 1977 article, they introduced a distinction between time-inconsistent and time-consistent policy. Bank of England (2009), “The Role of Macroprudential Policy”, November. In monetary policy, discretion is essential to offset output fluctuations in Keynesian frameworks. policies should be adopted in contingencies that will not actually occur, whereas discretionary policy makers need only deal with a more restricted set of actual states of the world.5 This distinction between rules and discretion seems more sensible than that given by Buiter in a recent contribution to the rules versus discretion debate. Kydland, Finn E and Edward C Prescott (1977), “Rules Rather than Discretion: The Inconsistency of Optimal Plans,” Journal of Political Economy, 85(3): 473-492, June. Kydland and Prescott’s emphasis on the importance of the framework—and the value of credible rules—has profoundly influenced the way other economists think about policy. Conversely, monetarists propose a tight, fixed rule to ensure price stability. should monetary policy be made by rule or discretion? In bad times, as discretionally assessed by the authorities themselves, banks would be allowed to release buffers. Policy can be conducted by rules or discretion. 473-91. If, somehow, threats of no relief could be made credible, people would think twice before tempting Mother Nature. They entail limited predictability of decisions as well as a tendency towards forbearance, with an incentive for policymakers to postpone backfiring decisions, particularly if they are subject to some form of political pressure – including the pressure of public opinion. Certainly, the actual effectiveness of such a system will depend crucially on the independence, reputation and accountability of the macroprudential authority, as well as on its ability to enforce its recommendations. For one thing, you lose flexibility. Whether such instability is self-correcting and how long it takes for the self-correction to take place. Authors' note: The opinions expressed are those of the authors and do not necessarily reflect those of the Bank of Italy. An example of monetary policy rule can be setting money growth at 3 percent per year. Modern research on rules and discretion has helped illuminate the tradeoffs inherent in a range of policy questions. Rules offer time consistency— the outcome demanded by the public in the short run is consistent with the out-come desired in the long run. We also believe that such a system can work better if the macroprudential tools are put in the hands of a regional or global macroprudential authority – less prone to external pressures – rather than domestic ones. Economists broadly categorize policy-making frameworks as either rules or discretion. The Bank of England (2009) proposes a constrained discretion macroprudential regime: this would be largely discretional to allow policymakers to adapt as they learn, but still systematic, transparent and accountable thanks to the predetermined constraints. Research-based policy analysis and commentary from leading economists, Rules vs discretion in macroprudential policies, Mario Quagliariello, Massimo Libertucci 24 February 2010. Simons ar-gued that the Federal Reserve be required to keep the price level constant rather than be left to pursue other possible goals. inflation targeting - increase money growth rate if inflation is below target, decrease money growth rate if inflation is above target b. As said earlier, how rules and policies are connected to each other is a matter of how we are looking at things. The more straightforward conclusion — that rules-based policy was an important cause of the improved performance of the 1980s and '90s, and that discretionary policy has been harmful to the economy — aligns much better with the historical timeline. Why Should Monetary Policy Be Made By Rule Rather Than Discretion? The work I provide is guaranteed to be plagiarism free, original, and written from scratch. Should policy be conducted by rule or discretion? What is the right level for inflation? In fact, strategic responses of rational, utility-maximising agents lead to an ex-post sub-optimal arrangement; rules ensure that – ex-post – at least a second-best is achieved. Our favourite setting is however slightly different, with greater emphasis on rules. It was the rules the Fed was following that made the Great Depression worse perhaps. The final outcome will also be affected by the interaction between the micro- and the macro-prudential authorities, since they will handle the same tool. The purpose of this paper is to assess the state of the debate about rules versus discretion in monetary policy, an issue I have been researching for a long time and which now seems more crucial than ever as monetary policy normalizes in the United States and other countries. Hot Topic: Should Monetary Policy Be Made by Rule or Discretion? On the other hand, if the banking environment were volatile, and the informal closure policy were credible—perhaps because supervisory agencies were well-funded and insulated from politics—supervisors might be able to deal with troubled banks on a case-by-case basis without undermining the overall incentive to keep capital ratios high.7. Given the importance of monetary policy, there is reasonable room for debate on whether monetary policy really should be left at the discretion of the Central Banker. Kydland and Prescott were not the first to comment on the value of policy rules. We believe the Federal Reserve most effectively serves the public by building a more diverse and inclusive economy. What is the right level for inflation? Policy-makers with discretion can renege on today’s pronouncements tomorrow; so, the public may come to discount such pronouncements as cheap talk. As a policy conclusion, the timeless perspective in its standard formulation is not optimal for all economies at all times. How have the various rules suggested for monetary policy changed over time? Global governance Monetary policy, Tags: How have the various rules suggested for monetary policy changed over time? Given the trade-off between ex-ante efficiency of discretion and ex-post efficiency of rules, hybrid regimes of constrained discretion have been extensively adopted in monetary policy. In research conducted with psychologist Gary Klein, Kahneman has also investigated the conditions that are or are not favorable to discretionary decision making. 2020. december. Accountability requires discretion. It was the rules the Fed was following that made the Great Depression worse perhaps. A discretionary framework successfully addresses this issue, by allowing policymakers to actively learn from observing the interaction of relevant stakeholders. : The MIT Press, 1998. From the advent of central banking in the nine- teenth century to the present, debate has continued over whether monetary policy should be conducted according to rules or left to the discretion of the policymaker. 1-30. Edward Lotterman: Should government policy be… Share this: Click to share on Facebook (Opens in new window) Click to share on Reddit (Opens in … If bankers believed that closure rules would be loosely enforced, they would be more likely to allow capital ratios to fall in the first place—leading to lower overall capital ratios and higher closure costs. If given absolute discretion, supervisors might announce an informal policy of closing banks whenever capital-to-asset ratios fall below, say, 5 percent. Indeed, economists debated the value of rules in monetary policy for most of the 20th century. Friedman, Milton. Opposed to using a strict rule based monetary policy, using discretion has many advantages of its own. Explore data, research and more in FRASER, our digital library. In macroeconomics, discretionary policy is an economic policy based on the ad hoc judgment of policymakers as opposed to policy set by predetermined rules. Discretion may better serve the public interest when the environment is uncertain and policy-maker pronouncements are believable. CHAPTER 15 Stabilization Policy 17. This might imply significant political pressure on macroprudential authorities. Should Monetary Policy Be Made by Rule Rather Than by Discretion? We’ll email you when a new Regional Economist article is published. policy rules over time, (2) the idea of tying the hands of central bankers, (3) the difficulty of demarcating discretion, (4) the influence of policy rule research on the practice of central banking and (5) the purpose of recently proposed legislation on monetary strategies. 11/6/2013 4 Rules and discretion: Basic concepts Policy conducted by rule: Policymakers announce in advance how policy will respond in various situations, and commit themselves to following through. should monetary policy be made by rule or discretion? More over, it’s difficult to specify the right rules. Looking at pros and cons of the two extreme options (pure discretion and hard rules), we agree with the idea that a constrained discretion can be a viable compromise. Because Rules Would Eliminate The Political Business Cycle C. Because Rules Respond To Any Random Shocks In The Economy D. Because Rules Create Time Inconsistency 2. Because There Is A Clear Consensus Among Economists About What A Good Monetary Policy Rule Would Be B. Such a rule could be made binding—and therefore credible—in a number of ways, say, by passing a constitutional amendment against flood relief. Similarly, the final goals of the policy – avoiding excessive credit imbalances or “just” smoothing the cycle – can be predetermined by rules or decided from time to time. Unfortunately, the design of the set of rules may be extremely difficult, particularly for a brand new policy, which should be applied world-wide. it is considered as breaking the rules and is punished. The next part of the paper systematically lays out the argument for rejecting policy by rules. As a consequence, promises that this time will be different—that this time no bailouts will be forthcoming—may not be credible. A time-inconsistent policy may make the public happy in the short run but will ultimately fail to produce the long-run policy goal. See Hall, King, Meyer and Vaughan (2002) for more details. Rules Versus Discretion in Monetary Policy ABSTRACT This paper examines the case for rules rather than discretion in tne ... rules versus discretion debate is the focus of ecticns i tnrough fl t The Gob Staniard. In a rules framework, policy responses must follow a pre-specified plan. Topics: Conversely, monetarists propose a tight, fixed rule to ensure price stability. Policy conducted by discretion: As events occur and circumstances change, policymakers use their judgment and apply whatever policies seem appropriate at the time. Tomorrow, if flooding occurs, they can renege and provide generous compensation for damages. The time-(in)consistency literature, launched bu Kydland and Prescott (1977), shows that discretion-based solutions would be the first-best in terms of agents’ utility, but they are not time-consistent. CHAPTER 15 Of course, fiscal and monetary policies always involve some combination of rules and discretion: Policymakers never simply employ one approach or another by itself. In practice, the authorities would be asked to continuously address the micro-level objective and the system-wide one. Following a public clamor, policy-makers announce a bailout—100 percent compensation for flood-related damage. A deeper issue, which has persisted for decades, is whether the Fed’s discretion in policy making should be constrained by rules. Blinder, Alan S. Central Banking in Theory and Practice. Economics: Monetary Policy by Rule or Discretion? Should policy be conducted by rule or discretion? Policy rules, at least in a general way, presume some understanding of how economic forces work. After the public has formed expectations of inflation, the central bank can increase monetary growth to reduce unemployment. Under a discretion-based regime, authorities would require banks to build-up buffers in periods of economic exuberance. Discretion may better serve the public interest when the environment is uncertain and policy-maker pronouncements are believable. Moreover, rules are subject to Goodhart’s law: the informational content of a targeted variable would be vanished once it becomes part of a (publicly known) rule. A rule-based approach, however, would require a very high degree of confidence that the predefined variables would always correctly perform as intended, without noisy signals. Policymakers announce in advance how policy will respond in various situations, and commit themselves to following through. Financial Stability Forum (2009), “Addressing Procyclicality in the Financial System”, April. We evaluate monetary policy which is conducted in a way that addresses financial stability as an explicit monetary policy objective using a simple game theoretic model analysing the strategic interaction between a central bank and a financial sector. This is probably what makes the parallel with monetary policy not entirely satisfactory. This rule allows a policy response to the flood, thereby making it activist in nature, but that response is pre-defined. In the 1920s the Strong Hearings, held by the House Committee on Banking and Cur-rency, offered a forum for debate over this question. Whethermonetary policy should be made by rule rather than by discretion. • Policy is conducted by discretion if policymakers are free to size up events as they occur and choose whatever policy seems appropriate at the time. In a discretionary framework, policy-makers have wide latitude to design the best policy response for the given circumstances. 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