ECON102: Principles of Macroeconomics (2021.A.01)

LEARNING OBJECTIVE

• Understand the difference between discretionary and rules-based monetary policy.
  
  

KEY POINTS

• A discretionary policy allows policymakers to respond quickly to events.

• A rule-based policy can be more credible because it is more transparent and easier to anticipate, unlike discretionary policy.

• A strict rules-based approach does not allow for flexibility and as a result may limit choices or be inapplicable in certain circumstances, creating a need for a compromise between discretionary and rules-based policy.
  
  

Discretionary policies refer to actions taken in response to changes in the economy, but they do not follow a strict set of rules; instead, they use subjective judgment to treat each situation in a unique manner. For much of the 20th century, governments adopted discretionary policies to correct the business cycle. These typically used fiscal and monetary policy to adjust inflation, output, and unemployment. However, following the stagflation of the 1970s, policymakers were attracted to policy rules.

Discretionary Policy

A discretionary policy is supported because it allows policymakers to respond quickly to events. However, discretionary policy can be subject to dynamic inconsistency: a government may say it intends to raise interest rates indefinitely to bring inflation under control, but then relax its stance later. This could make the policy noncredible and ultimately ineffective.

Rules-based Policy

A rule-based policy can be more credible, because it is more transparent and easier to anticipate, unlike discretionary policy. Policy is implemented based on indicator events in the economy and the policy is expected and carried out in a timely manner. Further, as commented by Milton Friedman who argued in favor of a rules-based approach, the dynamics of discretionary policy present a lag between observation and implementation. This can create compounding issues related to the discretionary policy enacted. However, a strict rules-based approach does not allow for flexibility and as a result may limit choices or be inapplicable in certain circumstances.

Compromise

A compromise between strict discretionary and strict rule-based policy is to grant discretionary power to an independent body. For instance, the Federal Reserve Bank, European Central Bank, Bank of England, and Reserve Bank of Australia all set interest rates without government interference, but do not adopt a strict rules-based policy stance. In this case the central banking authorities have autonomy and are able to use monetary policy to enable their mandate of economic growth and full employment. The policies they enact cannot be destabilized by government fiscal policy.