Original article (link) posted: 07/11/2005
Athey, Atkeson and Kehoe (2005) "The Optimal Degree of Discretion in Monetary Policy" Econometrica
The paper examines a monetary policy game in which the monetary authority has private information about the state of the economy. In the literature, two seminal papers, Taylor (1983) and Canzoneri (1985), established no discretion should be left to the monetary authority if there is no such private information; the best outcomes can be achieved by rules that specify the action of the monetary authority as a function of observables. The introduction of private information creates a tension between discretion and time inconsistency. Tight constraints on discretion mitigate the time inconsistency problem in which the monetary authority is tempted to claim repeatedly that the current state of the economy justifies a monetary stimulus to output. However, tight constraints leave little room for the monetary authority to time-tune its policy to its private information. In short, loose constraints allow the monetary authority to do that fine tuning, but they also allow more room for the monetary authority to stimulate the economy with surprise inflation.
Making use of dynamic mechanism design techniques, they find that the optimal mechanism is quite simple; for a broad class of economics, the optimal mechanism is static (policies depend only on the current report by the monetary authority) and can be implemented by setting an inflation cap, an upper limit on the permitted inflation rate. It is also shown that the optimal degree of monetary policy discretion turns out to shrink as the severity of the time inconsistency problem increases relative to the importance of private information.
The results they derive seem to be very interesting. In particular, the “inflation cap” result is directly related to the optimal inflation targets and has strong importance with actual monetary policies. As they mention, their work provides one theoretical rationale for the type of constrained discretion advocated by Bernanke and Mishkin (1997). This paper might become a must-read paper for those who work in monetary policies.
Bernanke and Mishkin (1997) "Inflation Targeting: A New Framework for Monetary Policy?" J. of Econ, Perspectives, 11
Canzoneri (1985) "Monetary Policy Games and the Role of Private Information" AER, 75
Taylor (1983) "Rules, Discretion, and Reputation in a Model of Monetary Policy: Comments" JME, 12