Rules versus Discretion: A Reconsideration

Abstract

In this paper, I evaluate the relative merits of rules versus discretion in making monetary policy, from both empirical and theoretical perspectives. Empirically, I argue that in the 2009–10 period, the Federal Open Market Committee aimed for a slow recovery, in large part because its judgments about appropriate monetary policy were unduly influenced by the Taylor rule (which was seen as a good approximation of its pre-2007 reaction function). Theoretically, I use the delegation framework of Bengt Holmström (1984) to show that, as long as the central bank’s inflation bias is sufficiently small, it is socially desirable to give the central bank discretion so that it can respond effectively to inflation shocks that cannot be encoded into predetermined rules.

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