In a discretionary framework, policy-makers have wide latitude to design the best policy response for the given circumstances. In sum, rules would be the everyday framework, while discretion would represent an extreme resort. the rule inferior to discretion. How have the various rules suggested for monetary policy changed over time? But there is one thing that should be remembered i.e. As a policy conclusion, the timeless perspective in its standard formulation is not optimal for all economies at all times. Cancel Unsubscribe. Expert Solution. pure gold standard is a fully automatic monetary system. Do you need help with your Should Monetary Policy Be Made by Rule Rather Than by Discretion?? The next part of the paper systematically lays out the argument for rejecting policy by rules. In bad times, as discretionally assessed by the authorities themselves, banks would be allowed to release buffers. 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. Should this institutional setting be considered too ambitious, a rigorous peer review process, as suggested also by the Financial Stability Board (2010), would ensure that national authorities either comply with their own pre-commitment or explain possible deviations to a group of peer authorities. 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). This does not mean that discretion is bad policy, it is absolutely essential, but it does mean that lawmakers need to do a better job when forming policy and only give officers good options to pick from in using that discretion. Edward Lotterman: Should government policy be… Share this: Click to share on Facebook (Opens in new window) Click to share on Reddit (Opens in … check_circle . Indeed, economists debated the value of rules in monetary policy for most of the 20th century. 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. Policy can be conducted by rules or discretion. 2020. december. 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. monetary policy, Macroprudential policies, checks and balances, Principal Bank Sector Analyst at the European Banking Authority (EBA), Economist, Regulation and Supervisory Policies Department, Banca d’Italia, Bozio, Garbinti, Goupille-Lebret, Guillot, Piketty, 9 - 10 December 2020 / Online / Cornell University, 9 - 9 December 2020 / Webinar / CEPR and LSE, Eichengreen, Avgouleas, Poiares Maduro, Panizza, Portes, Weder di Mauro, Wyplosz, Zettelmeyer, Baldwin, Beck, Bénassy-Quéré, Blanchard, Corsetti, De Grauwe, den Haan, Giavazzi, Gros, Kalemli-Ozcan, Micossi, Papaioannou, Pesenti, Pissarides , Tabellini, Weder di Mauro, The Macroprudential Approach to Regulation and Supervision, Improving Financial Regulation - Report of the Financial Stability Board to G20 Leaders, FSB Framework for Strengthening Adherence to International Standards, Addressing Procyclicality in the Financial System, Group of Central Bank Governors and Heads of Supervision reinforces Basel Committee reform package, Rules Rather than Discretion: The Inconsistency of Optimal Plans, Revitalising multilateralism: A new eBook, 7th Empirical Management Conference – Virtual Edition, Human Mobility: Towards Enhanced Integrationand Social Cohesion: Webinar IV of the Maryam Annual Forum 2020, How to Lead Better Responses to Global Emergencies? Advocates of rules for monetary policy argue that this rule might be better than the discretionary policy as it prevents problems of incompetence and time inconsistency. • Policy is conducted by rule if policymakers announce in advance how policy will respond to various situations and commit themselves to following through on this announcement. 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. 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. 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. Geared to a Main Street audience, this e‑newsletter provides a sampling of the latest speeches, research, podcasts, videos, lesson plans and more. Cancel Unsubscribe. Loading... Unsubscribe from Mindbitesdotcom? “rules versus discretion.” It was “rules versus chaotic monetary policy” whether the chaos was caused by discretion or unpredictable exogenous events like gold discoveries or shortages. Suppose, for example, a river that seldom floods rises above its banks and sweeps away homes. But they do, at different times and in response to different pressures, tend to emphasize one over the other. For example, should bank supervisors be given absolute discretion over bank closings? Indeed, the adoption of a purely rule-based framework focusing on a macroeconomic indicator (as in either a simple rule such as Friedman’s or an inflation target framework) has faced several drawbacks including, for instance, the inability to face unexpected structural changes. And no floodplain construction today means no need for flood relief tomorrow—a time-consistent outcome. For one thing, you lose flexibility. 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 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. New York: Fordham University Press, 1960. 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. An earlier rules-versus-discretion debate had taken place in the 1920s and 1930s. Arguments that Fed should follow rule, such as… a.i. 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. 473-91. 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. 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. After the public has formed expectations of inflation, the central bank can increase monetary growth to reduce unemployment. Subscribe Subscribed Unsubscribe 33.4K. Discretion may better serve the public interest when the environment is uncertain and policy-maker pronouncements are believable. Policy rules, at least in a general way, presume some understanding of how economic forces work. : The MIT Press, 1998. An example of monetary policy rule can be setting money growth at 3 percent per year. A time-inconsistent policy may make the public happy in the short run but will ultimately fail to produce the long-run policy goal. Authors' note: The opinions expressed are those of the authors and do not necessarily reflect those of the Bank of Italy. To discourage such building, they announce that anyone suffering flood damage is on his own—no disaster relief will be forthcoming. The common denominator is that rules are supposed to constrain policy-makers’ actions in advance. [, See Blinder (1998) for a discussion of the value of discretionary monetary policy expressed in the Kydland-Prescott framework. : Rules are clear set of instructions rather dictation which MUST be followed and if rules are not obeyed i.e. The arguments for rules in general developed by Milton Friedman are described mo appraised; alternative rules including the constant money growth ratio rule, interest rate rules, nominal GNP targeting, and price level rules are analyzed. Or the plan can be activist in nature—the rule may direct policy-makers to respond to different circumstances in different pre-determined ways. In fact, macroprudential capital buffers, targeting the state of health and risk conditions of the banking sector as a whole, would be independent of idiosyncratic solvency situations, that constitute the raison d'etre of microprudential capital requirement. Conversely, monetarists propose a tight, fixed rule to ensure price stability. What is the right level for inflation? : Rules are clear set of instructions rather dictation which MUST be followed and if rules are not obeyed i.e. When capital ratios fall below these thresholds, however, explicit supervisory responses are required. over whether monetary policy should be conducted according to rules or left to the discretion of the policymaker. HOULD MONETARY POLICY be determined by a legislated rule or by a monetary authority’s discretion? Simons ar-gued that the Federal Reserve be required to keep the price level constant rather than be left to pursue other possible goals. Economics: Monetary Policy by Rule or Discretion? Improvement Act of 1991 (FDICIA), bank supervisors had almost complete discretion over bank closings. In the case of macroprudential regulation and supervision the same policy instrument – bank capital – would be used to address both microeconomic purposes (reducing the probability of default of individual institutions) and macroeconomic goals (reducing system-wide risks and procyclicality), violating Tinbergen’s rule. A. In our view, a more extensive use of discretion may determine competition in laxity across jurisdictions and reduction in cross-country comparability. Admittedly, micro- and macro-stability are compatible most of the time, but they may conflict in some circumstances. Do you need help with your Should Monetary Policy Be Made by Rule Rather Than by Discretion?? Such a rule could be made binding—and therefore credible—in a number of ways, say, by passing a constitutional amendment against flood relief. Whethermonetary policy should be made by rule rather than by discretion. Page 2 of 2 On the other hand, there are problems with rules. 12]. 44, 1936, pp. The work I provide is guaranteed to be plagiarism free, original, and written from scratch. Under a discretionary regime, policy-makers would have the flexibility to bail out innocent victims. In terms of regulation, the objective is to create a more disciplined and less procyclical financial system that better supports balanced, sustainable economic growth (FSB 2009). Police officers are not simply rule-following soldiers. This discussion follows naturally from the debates over the causes of macroeconomic instability. The debate over “rules vs. discretion” was a centerpiece of disputes over monetary policy during the 1960s-1980s. 6 With respect to monetary policy, that conclusion would seem to favor a policy rule over discretion. Today, before flooding has occurred, they can try to discourage floodplain construction by forswearing disaster relief. Rules offer time consistency—the outcome demanded by the public in the short run is consistent with the outcome desired in the long run. More over, it’s difficult to specify the right rules. For example, the long-run goal of flood policy is to prevent building in floodplains. So, can a combination of rules and discretion be a viable solution also for macroprudential supervision? Policy can be conducted by rules or discretion. Should Monetary Policy Be Made by Rule Rather Than by Discretion? Bank of England (2009), “The Role of Macroprudential Policy”, November. In fact, strategic responses of rational, utility-maximising agents lead to an ex-post sub-optimal arrangement; rules ensure that – ex-po… Page 2 of 2 On the other hand, there are problems with rules. 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. ifthegovernmenthasfull“discretion” (freedomtochooseˇ)andlittle“internalcommitment”,then the economy ends up in a high-inﬂation trap. Mindbitesdotcom. Following a public clamor, policy-makers announce a bailout—100 percent compensation for flood-related damage. This is difficult to achieve for inflation targeting, much more so for identifying financial instability. 2. Moreover, once in place, they act as an effective pre-commitment device. A rule permitting the money supply to grow at k-percent, he reasoned, would at least keep monetary policy from doing economic harm.3 More recently, Geoffrey Brennan and James Buchanan have justified monetary rules on political grounds—discretion, they contend, permits the central bank to generate a higher-than-socially-optimal inflation rate so that it can enjoy the revenue from money creation.4 Kydland and Prescott’s contribution to the rules vs. discretion debate was to show that discretionary policy can produce undesirable long-run outcomes—in the monetary-policy case, higher inflation with no reduction in unemployment—even in a world with little uncertainty, good policy tools and public-spirited policy-makers.5, This is not to say that discretionary policy is never desirable, even in the Kydland-Prescott framework. Monetary policy is an extremely valuable guideline for our economy. Any dynamic model in which people are forward-looking and take time to adjust their behavior to circumstances implies that monetary and fiscal policy … CHAPTER 15 Stabilization Policy 17. We believe the Federal Reserve most effectively serves the public by building a more diverse and inclusive economy. Should policy be conducted by rule or discretion? A world without the WTO: what’s at stake? The principle behind the functioning of the countercyclical buffers is straightforward: capital should be built up in good times, when risk is accumulated in banks’ portfolios, and depleted in bad times, when risk actually materialises. What is the right level for inflation? [. Global governance Monetary policy, Tags: Policy can be conducted by rules or discretion. 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. This might imply significant political pressure on macroprudential authorities. Policy-makers do not want people to build homes in floodplains. Explanation of Solution. The use of policy rules or discretion. Should monetary policy be made by rule rather than by discretion? The new macroprudential objectives should be pursued (also) through the introduction of countercyclical tools, such as capital buffers (GHOS 2010). The phrase “fettering discretion” found its way into two important decisions released today. See page 477 of Kydland and Prescott (1977). decide that the boom is a cause of excessive risk-taking; impose capital savings for “rainy days”. Conversely, monetarists propose a tight, fixed rule to ensure price stability. In research conducted with psychologist Gary Klein, Kahneman has also investigated the conditions that are or are not favorable to discretionary decision making. Brennan, H. Geoffrey and Buchanan, James M. Monopoly in Money and Inflation. CHAPTER 15: Stabilization Policy : 14 : 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. 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. 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. The adoption of macroprudential policies has been advocated by the G20 Leaders and the Financial Stability Board. 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. 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. 2. should monetary policy be made by rule or discretion? As said earlier, how rules and policies are connected to each other is a matter of how we are looking at things. Accountability requires discretion. They went on to argue that rules produce time-consistent outcomes because they make policy-makers’ pronouncements credible. Arguments against discretion: b.i. Moreover, in effect, they anticipate that key causal connections observed in the past will remain fixed over time, or evolve only very slowly. A deeper issue, which has persisted for decades, is whether the Fed’s discretion in policy making should be constrained by rules. How much “freedom” should policymakers have? These may assume, for instance, the form of pre-defined objectives (ideally, a numerical target), decision-making frameworks (detailing the analyses underpinning decision making), accountability measures (public report, parliamentary scrutiny, etc). The new models were … 85, 1977, pp. This rule allows a policy response to the flood, thereby making it activist in nature, but that response is pre-defined. Through CASSIDI you are able to search for and view banking market definitions, find banking market concentrations and perform "What If" (pro forma) HHI analysis on banking market structures. is about how monetary policy should be conducted. Here is how the debate is often framed. In the 1920s the Strong Hearings, held by the House Committee on Banking and Cur-rency, offered a forum for debate over this question. Kydland, Finn E. and Prescott, Edward C. “Rules Rather than Discretion: The Inconsistency of Optimal Plans.” Journal of Political Economy, Vol. → The Federal Reserve has almost complete discretion over monetary policy a. 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. Home. Some macroeconomists thus have argued in recent years that monetary policy should be ‘rule-based’ rather than discretionary, that is, Central Bankers strictly would have to follow some kind of monetary policy rule without the authority to deviate from it. It is also amply supported by economic theory. The essay begins by summarizing the case in favor of rules and describing the specific monetary policy rules derived from this theory. Supervisors have traditionally closed banks whenever the owners’ stake (capital) got dangerously low. 1. Only a binding rule, Kydland and Prescott reasoned, can make the central bank’s commitment to price stability credible. The economics of insurance and its borders with general finance, Maturity mismatch stretching: Banking has taken a wrong turn. And discretion can yield time-consistent outcomes under certain circumstances. pure gold standard is a fully automatic monetary system. it is considered as breaking the rules and is punished. 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. A Program for Monetary Stability. Financial Stability Board (2010), “FSB Framework for Strengthening Adherence to International Standards”, January. In the flooding example, a non-activist rule might say: “no flood relief, period.” An activist rule might limit flood relief per victim to 10 percent of the pre-flood value of damaged property—no matter where it is located (floodplain or no floodplain). The plan can be non-activist in nature—the rule may force policy-makers to pursue the same course of action in all circumstances. Loading... Unsubscribe from Mindbitesdotcom? The Role of Other Variables in the Policy Rule Should policymakers respond only to actual or prospective changes in output and inflation, or would policy be improved if policy also responded directly to other variables? The advantage of decision making by rules is This would avoid time-inconsistency; moreover, authorities would be forced to identify the (still subjective) optimal balance between the micro and macro objectives once for all. Why Should Monetary Policy Be Made By Rule Rather Than Discretion? 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. The set of variables may be different across jurisdictions, but should be announced clearly and transparently ex-ante. Deciding that the law does not apply to some of us and then relying on the good discretion of a government official to decipher who they should apply to is bad policy. Our favourite setting is however slightly different, with greater emphasis on rules. Discretion may better serve the public interest when the environment is uncertain and policy-maker pronouncements are believable. In Trinity Western University v.The Law Society of British Columbia 2015 BCSC 2326 (“TWU-LSBC“), The Hon. Hall, John R.; King, Thomas B.; Meyer, Andrew P.; and Vaughan, Mark D. “Jumbo CDs Play Tiny Role in Policing Risky Banks—So Far. 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. Indeed, even economists who dislike rules couch their arguments in the Kydland-Prescott framework. 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. Opposed to using a strict rule based monetary policy, using discretion has many advantages of its own. [, Before the Federal Deposit Insurance Corp. This latitude is particularly valuable in an uncertain environment—say when policy-makers don’t have a clue about the volume of rain likely to fall or about the rivers likely to flood. 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. 6 With respect to monetary policy, that conclusion would seem to favor a policy rule over discretion. Hot Topic: Should Monetary Policy Be Made by Rule or Discretion? In the 1930s, Henry Simons argued that monetary rules reduce uncertainty about the price level and, thereby, facilitate private-sector planning.2 Later, Milton Friedman extended the argument, noting that real-world policy-makers have imperfect information and imperfect tools; so, even the best-intentioned attempts to combat fluctuations could end up destabilizing the economy. Two candidates often singled out for additional attention are the exchange rate and equity prices. As said earlier, how rules and policies are connected to each other is a matter of how we are looking at things. 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. Learn more about the Econ Lowdown Teacher Portal and watch a tutorial on how to use our online learning resources. Flexibility and adaptability of discretion do not come without costs. have argued that monetary policy conducted by just such an expert monetary authority will en-hance the economy’s performance. Policymakers announce in advance how policy will respond in various situations, and commit themselves to following through. Because There Is A Clear Consensus Among Economists About What A Good Monetary Policy Rule Would Be B. 2. should monetary policy be made by rule or discretion? constant money growth rate a.ii. In a rules framework, policy responses must follow a pre-specified plan. Discretion. 2020. december. Rule supporters criticize discretionary policy because it is conducted on a period- by-period basis without milking any connections between the policy choices made over time [McCallum, 1989, ch. Parallel with monetary policy be determined by a monetary authority ’ s discretion? type of analysis produce., because the public knows this from studying the past behavior of policy-makers (... The long-run policy goal, thereby making it activist in nature—the rule may force policy-makers to respond unforeseen., “ the macroprudential Approach to Regulation and supervision ”, January Fed should follow rule all! Is self-correcting and how long it takes for the self-correction to take threats... Voxeu.Org, 14 April announce that anyone suffering flood damage is on his own—no disaster relief discretionally assessed by public! Should bank supervisors be given absolute discretion, supervisors have discretion over bank closings systematically lays out the for... 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Means no need for flood relief tomorrow—a time-consistent outcome flexibility and adaptability of discretion may better serve the public when... For reducing the injus-tice of policing from observing the interaction of relevant stakeholders bailing. Its banks and sweeps away homes recognition that policy-makers MUST face up to these tradeoffs,... Rules and discretion has helped illuminate the tradeoffs inherent in a discretionary regime, authorities would require banks build-up! Column discusses to what extent the experience gained from monetary policy, conclusion!