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Commitment Versus Discretion in Monetary Policy* by MICHAEL DOTSEY

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Commitment Versus Discretion in Monetary Policy* by MICHAEL DOTSEY Commitment Versus Discretion In Monetary Policy* BY MICHAEL DOTSEY hether policymakers should commit to a event comes to pass. The absence of this ability is called discretion. W certain course of action or have the flexibility Under discretion, a policymaker is to approach each situation as it arises allowed to change policy depending on current circumstances and to continues to be a central question in the disregard any past promises. Because design of monetary policy. A seminal article written by the discretionary planner does not make any binding commitments, it two prominent economists in 1977 analyzed the benefits would appear that discretion offers of carrying out plans based on commitment rather than more flexibility and it would seem to be preferable to a policy whereby the discretion. Since then, others have joined the debate. policymaker must honor past promises. In this article, Mike Dotsey elaborates on the merits of The idea that it is better for commitment versus discretion in setting monetary policy. a central bank to follow through on policies promised in the past, rather than being free to respond to conditions as they evolve, is a subtle and perhaps surprising one. Not The debate over whether it is the New York Association for Business only are better long-run outcomes better for a policymaker to commit Economics, Philadelphia Fed President achieved under commitment, but to a particular course of action or to Charles Plosser explained his views monetary policy is also better able to approach each situation with perfect on credibility and commitment in respond to shocks if the central bank flexibility has been and continues to monetary policymaking. This article is constrained to honor past promises be a central question in the design of elaborates and expands on some of concerning its future behavior. As monetary policy. In 1977, economists these ideas. I’ll discuss below, lower inflation, Finn Kydland and Edward Prescott To start with, let me first define with no adverse effects to economic wrote the seminal article analyzing what we mean by commitment activity, is obtained under a policy the benefits of carrying out plans versus discretion. Commitment is the of commitment, and such a policy based on commitment as opposed to ability to deliver on past promises no can achieve less volatility in both discretion. Since then, the benefits of matter what the particular current inflation and output as well. Indeed, commitment have been analyzed in situation is. I should stress that, under the inability to commit often leads to many settings and in many economic commitment, promised behavior problems for policymakers. models. Indeed, in a 2007 speech to is generally contingent on future Comparing policymaking under events. Promises are not typically discretion and under commitment blanket commitments to be fulfilled Mike Dotsey is an analysis of two polar cases. It is a irrespective of future situations. The vice president and sidesteps the question of how a central senior economic key aspect of commitment is that the bank can act in a committed fashion policy advisor in policymaker keeps his promise to act in even if it desires to do so. Also, how the Philadelphia a certain way when a particular future Fed’s Research could a central bank convince the Department. public that it is operating in a manner This article is consistent with commitment when available free of *The views expressed here are those of the charge at www. the institutional setting places little author and do not necessarily represent philadelphiafed. the views of the Federal Reserve Bank of restriction on future policies? For org/research-and-data/publications/business- Philadelphia or the Federal Reserve System. instance, the members of the policy- review/. www.philadelphiafed.org Business Review Q4 2008 1 making boards change over time by Kydland and Prescott to illustrate and in areas not subject to flooding. as do the legislators that monitor the benefits of commitment over Thus, the best outcome is for people the behavior of monetary policy. discretion is that of the flood plain. to decide not to build houses in Commitment requires tying the hands Recently, Robert King provided a areas subject to floods and for the of future policymakers, and in reality, detailed description of this example, government to choose not to build we don’t even know who they will be. which highlights the importance of dams. If the government can commit Research analyzing ways that expectations and the role they play to never building a dam, this will be policy can come close to the ideal in economic outcomes.1 The role of the outcome. Everyone will believe of full commitment has generally expectations will also be a central that the government will not build proceeded along two lines. One is aspect in the analysis of monetary a dam and no one wants a flooded institutional design. How does one policy. house. As a result, no one chooses to set up institutions that will improve on discretionary outcomes? The other is the role of reputation and the Economists refer to the desire to alter credibility an institution can achieve previously made plans as the time-consistency by behaving like a committed planner over time. While of tremendous problem because, at each date, an individual interest, investigations into these areas or policymaker finds it tempting to deviate from are beyond the scope of this article. But we cannot hope to understand what an earlier plan dictated. these more advanced investigations without first understanding the In this example, people make a build near the water. The individual’s different nature of policy under single decision: whether they wish to decision about where to build a house commitment and under discretion. live near the water. Unfortunately, is a relatively simple one and does not Economists refer to the desire areas near the water are subject to depend on where other individuals to alter previously made plans flooding. The government can prevent decide to build their houses. If you as the time-consistency problem flooding by building dams, but doing want to avoid flooding, stay away from because, at each date, an individual so is expensive. The government also the water. or policymaker finds it tempting to has a single decision: whether to build Under discretion the government deviate from what an earlier plan a dam. Furthermore, the government cannot commit to not building a dictated. The temptation to alter wants its policies to conform to dam. As King explains, this inability strategies affects how others view your individual preferences. It wants to do complicates the problem considerably. proposed plan, and it is the interaction what makes society as a whole better The government’s decision is now between the public’s expectations off. There is no conflict between what based on how many people live near and the policymaker’s decisions that individuals think is best and what the water. If a sufficient number leads to problems for a policymaker the government thinks is best. The decide to live near the water, it is who cannot commit. Economics has problem is determining what the best now better to build a dam than to many examples of the time-consistency outcome will be, given that people subject many people to floods. Now, problem, and although I will primarily prefer living near the water and the an individual’s decision about where focus on monetary policy, I will start fact that building dams is costly. Of to build is complicated. If he thinks with a simpler setting that lays out the course, the best outcome will depend a lot of people will build houses near basic issues in a fairly transparent way. on how costly dams are relative to the the water, he should too because a pleasures of living near the water. dam will be built, and he will have to THE EXAMPLE OF THE The problem is interesting only if pay his share of the dam’s cost. If he FLOOD PLAIN we assume that, all things considered, anticipates that only a few people may Before we delve into monetary dams are prohibitively expensive, build houses near the water, he should policy, it will be helpful to look at the and therefore, the best outcome is not follow their example because he difference between commitment and for people to live away from water will be subject to the risk of floods. discretion in a simpler setting. One In either instance, if he anticipates correctly, he either lives near the water of the more famous examples used 1 See the article by Robert King. 2 Q4 2008 Business Review www.philadelphiafed.org protected by a dam or he lives in safety going to increase the money supply, this rate is viewed as undesirable. away from the water. If incorrect, he they respond by increasing prices. To A second feature of the economy is lives near the water and his house is be concrete, consider the case where that the central bank and the public periodically flooded, or he pays for individuals anticipate a doubling of desire output to be somewhat greater a dam and lives in a less desirable the money supply. In this case firms than potential.3 The justification for location. respond by doubling their prices and this assumption is that other features If we focus on situations where workers similarly respond by doubling of the economy, such as the lack of everyone behaves in a similar fashion, their wage demands. Workers would perfect competition or the presence there are two potential outcomes. like to be able to purchase the same of distortionary taxes, prevent the Everyone believes that no one else will number of goods for a given number economy from operating efficiently, build near the water; no one does; and of hours worked and firms are willing and to some extent, it is desirable for no dam is built.
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