B5 - Stabilisation part 2 (Discretion vs Rules)

Question 1

What does discretion in policy-making involve?

Answer 1

Discretion in policy-making involves policymakers setting policy on a period-by-period basis, as they see fit, ideally informed by empirical evidence.

Question 2

How does discretion relate to the type of policy approach?

Answer 2

Discretion suggests an ‘active’ policy approach, where decisions are made and adjusted regularly.

Question 3

What do rules in policy-making entail?

Answer 3

Rules in policy-making entail policymakers announcing in advance how they will respond to various situations and committing to act in this way.

Question 4

What is a key difference between discretion and rules in policy-making?

Answer 4

Discretion allows for flexible, case-by-case decision-making, while rules involve predetermined responses to economic situations.

Question 4

Can rules-based policy be active or passive?

Answer 4

Yes, rules-based policy can be either active, involving systematic interventions based on pre-set guidelines, or passive, involving minimal intervention.

Question 5

What is the political business cycle?

Answer 5

The political business cycle refers to the phenomenon where economic policy is influenced by political motives, potentially leading to misguided decisions.

Question 6

How might vested interests influence economic policy?

Answer 6

Vested interests, such as pressure groups, may exert undue influence over policymakers, leading to decisions that benefit specific groups rather than the overall economy.

Question 7

What is an example of opportunism in the political business cycle?

Answer 7

An example of opportunism is when politicians implement expansionary fiscal or monetary policies to reduce unemployment and stimulate the economy just before an election to gain favor with voters.

Question 8

Why might discretionary policy-making lead to a misguided economic policy?

Answer 8

Discretionary policy-making may be misguided due to incompetence, vested interests, or opportunistic actions by politicians aiming to achieve short-term political gains.

Question 9

What is an example of a passive rule in monetary policy?

Answer 9

An example of a passive rule is Friedman’s k-percent rule:
MoneyGrowth
=𝑘% per year.

Question 10

What is an example of an active rule in monetary policy?

Answer 10

An example of an active rule is the McCallum rule:
MoneyGrowth
=𝑘% +𝜃𝑢 (𝑢% − 𝑢𝑛%) where 𝜃𝑢>0.

Question 11

What does the Taylor rule specify in terms of setting interest rates?

Question 12

How does the McCallum rule adjust money growth?

Question 13

How does the Taylor rule incorporate inflation and output gaps into its formula?

Question 14

What does discretionary pWhat does discretionary policy allow policymakers to do?

Answer 14

Discretionary policy allows policymakers to respond to prevailing economic conditions as they see fit.

Question 15

What is the problem with discretionary policy?

Answer 15

The problem with discretionary policy is that policymakers may announce a policy to influence expectations and then renege on it later, effectively “cheating.”

Question 16

How might policymakers “cheat” under discretionary policy?

Answer 16

Policymakers might “cheat” by announcing a policy to influence economic agents’ expectations and then not following through with the announced policy.

Question 17

How do rational economic agents respond to the incentives faced by the government?

Answer 17

Rational economic agents anticipate that the government might renege on its policy, and they set their expectations accordingly, often discounting the announced policy.

Question 18

What is the concept of time inconsistency in discretionary policy?

Answer 18

Time inconsistency in discretionary policy refers to the situation where policymakers have an incentive to deviate from a previously announced policy after economic agents have adjusted their expectations, leading to a lack of credibility.

Question 19

What is a non-economic example of time inconsistency involving negotiating with terrorists?

Answer 19

Governments state they will not negotiate with terrorists, but may renege if a hostage situation becomes dire, undermining the credibility of their stance.

Question 20

What is a non-economic example of time inconsistency in the context of examinations?

Answer 20

A lecturer announces an examination at the end of a module but might decide to cancel it later, which could lead students to question the credibility of the announcement.

Question 21

Do policies like not negotiating with terrorists or announcing exams achieve their objectives fully? Why or why not?

Answer 21

No, these policies are not fully credible because there are clear incentives to renege on them at a later stage, reducing their effectiveness.

Question 22

What general principle is suggested to overcome the problem of time inconsistency?

Answer 22

The general principle is to remove discretion from the government, central bank, or lecturer and impose a credible rule to achieve objectives reliably.

Question 23

Why is it important to impose a credible rule in policy-making?

Answer 23

Imposing a credible rule is important because it eliminates the possibility of reneging, thereby ensuring that policies are taken seriously and achieve their intended objectives.

Question 24

What is the social loss function of unemployment and inflation?

Question 25

What happens under a monetary policy regime of unfettered discretion?

Answer 25

The government does not issue the central bank (C.B.) with any objectives or targets, and the general public is aware of this.

Question 26

What is the process of the economy working under discretion? (3)

Answer 26

1. Private agents form their inflation expectations (𝐸𝜋).
2. The central bank chooses the actual level of inflation (𝜋).
3. Unemployment (𝑢) is determined by the Phillips curve.

Question 27

How does the central bank determine the actual level of inflation (𝜋) it chooses?

Answer 27

The central bank aims to minimize the loss function,
𝐿(𝑢,𝜋) =(𝑢𝑛 − 𝛼(𝜋 −𝐸𝜋)) + 𝛾𝜋^2

Question 28

What is the loss function the central bank seeks to minimize?

Answer 28

This is the loss function that central bank tends to minimise: 𝐿(𝑢,𝜋) =(𝑢𝑛 − 𝛼(𝜋 −𝐸𝜋)) + 𝛾𝜋^2

Question 29

What is the first-order condition (FOC) for minimizing the loss function?

Question 30

What is the ‘optimal’ level of inflation for the central bank to choose under unfettered discretion?

Answer 30

The ‘optimal’ level of inflation is
𝜋 = 𝛼/2𝛾.

Question 31

How do rational private agents form their inflation expectations under unfettered discretion ?

Answer 31

Rational private agents understand the central bank’s optimal choice and set their expectations accordingly:
𝐸𝜋 = 𝜋 = 𝛼/ 2𝛾.

Question 32

What happens to unemployment when inflation expectations match the actual inflation?

Answer 32

𝐸𝜋 = 𝜋 = 𝛼/ 2𝛾, unemployment u is equal to the natural rate un

Question 33

What is the loss under discretion when substituting the solutions for 𝜋 and 𝑢 into the loss function?

Question 34

How is the loss under discretion compared to the loss under inflation targeting?

Answer 34

The loss under discretion will be compared to the loss under an alternative monetary policy regime, such as inflation targeting, to evaluate the effectiveness and desirability of each approach.

Question 35

What does an inflation target regime involve? (MPR 2)

Answer 35

An inflation target regime involves the government issuing the central bank (C.B.) with a clear policy objective/target, which is announced to the general public.

Question 36

What does full credibility in an inflation target imply?

Answer 36

Full credibility implies that the public’s inflation expectations
𝐸
𝜋
Eπ match the target inflation
𝜋
π set by the C.B., i.e.,
𝐸
𝜋
=
𝜋
=
𝜋
∗
Eπ=π=π
∗
.

Question 37

What is the relationship between unemployment and a fully credible inflation target?

Answer 37

If the inflation target is fully credible, unemployment
𝑢 will be equal to the natural rate 𝑢𝑛.

Question 38

What should the government consider when setting an inflation target?

Answer 38

The government should set an inflation target π* that aligns with minimizing the loss function while ensuring credibility and stability in the economy.

Question 39

How does the loss function look under a fully credible inflation target?

Answer 39

With 𝐸𝜋 = 𝜋 = 𝜋∗ and
𝑢 = 𝑢𝑛 , the loss function
𝐿 (𝑢,𝜋) simplifies, and we need to calculate the resulting value to compare it with the loss under discretion.

Question 40

What does the loss under inflation target look like?

Question 41

Compare the two regimes

Question 42

Why does the inflation targeting regime produce a smaller loss compared to unfettered discretion?

Answer 42

The inflation targeting regime produces a smaller loss because the central bank cannot credibly commit to
𝜋 = 0 under discretion, illustrating the time inconsistency problem.

Question 43

What is ‘flexible inflation targeting’ and who should exercise the remaining discretion under this regime?

Answer 43

‘Flexible inflation targeting’ allows for some element of discretion within the framework of a clear inflation target. This discretion should be exercised by the central bank to balance short-term economic fluctuations while maintaining credibility.

Question 44

What do advocates of active policy believe about the government’s ability to stabilize the economy?

Answer 44

Advocates of active policy are optimistic about the government’s ability to stabilize fluctuations in output and unemployment caused by shocks and believe the government has been successful in this in the past.

Question 45

Why are advocates of passive policy less optimistic about the government’s ability to stabilize the economy?

Answer 45

Advocates of passive policy are less optimistic due to practical considerations like policy lags, believing that attempts to stabilize the economy, no matter how well-intentioned, can lead to more instability.

Question 46

What is the main argument for discretion in policy-making?

Answer 46

The main argument for discretion is that it provides more flexibility for the government to react to economic events.

Question 47

Why do advocates of rules oppose discretion in policy-making?

Answer 47

Advocates of rules argue that politicians cannot be trusted or are prone to mistakes when given unfettered discretion, and that rules help to overcome the ‘time inconsistency problem’ by removing the ability of politicians to act on incentives.

Question 48

Can rules in policy-making be both active and passive? Give examples.

Answer 48

Yes, rules can be both active and passive. Examples include active rules like the McCallum or Taylor rules, and passive rules like Friedman’s k-percent rule. Active/passive and rules/discretion are separate but connected issues.