Policy Rules, Inflationary Bias, and Cyclical Stability

Abstract

STATUTORY POLICY RULES, such as a k-percent rule for money growth, can restrain officials from pursuing their own welfare at the expense of the public good. Toma (1982) and Barro and Gordon (1983), among others, have presented theoretical models showing how macroeconomic policymakers who pursue their own interests can produce policies that are biased toward too much inflation. Strict rules are a possible remedy to this problem. Yet while strict policy rules may reduce inflationary bias, they also limit the flexibility of officials to respond to random shocks. Researchers such as Canzoneri (1985) have shown that this can be an important limitation if officials possess information advantages that permit policy to modify economic disturbances effectively. If the public dislikes variations in real output, this loss of flexible stabilization may offset any gain from a reduction in inflationary bias. There is then a potential trade-off between reducing inflationary bias and cyclical stability. Yet to date, none of the dimensions of this trade-off has been documented. Evidence of an inflationary bias has been scarce, in part because it requires identification of the socially preferred inflation rate. Similarly, the extensive research on electorate concerns with real output has focused on the income level rather than its variance. Moreover, since this research has not been cast in a framework that permits voters to recognize the potential inflationary cost of stabilizing output, the validity of these findings is open to question. Indeed, recent work by Lucas ( 1987) suggests that citizens would willingly pay very little to reduce cyclical fluctuations.

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