Academic journal article Federal Reserve Bank of St. Louis Review

Discretion, Rules, and Volatility

Academic journal article Federal Reserve Bank of St. Louis Review

Discretion, Rules, and Volatility

Article excerpt

Economic models with multiple equilibria, such as Diamond and Dybvig (1983), have become increasingly useful in analyzing volatility in financial markets and in business cycles. In many of these models, indeterminacy is a result of incomplete financial markets or technological nonconvexities. Here we identify economic policy discretion to be another distinct cause of indeterminate equilibrium and examine how discretion affects the number of equilibria, as well as their volatility.

By discretion, we mean institutions that assign to successive policymakers the freedom to change, without cost, the decisions of their predecessors. Policy making looks forward in environments of this type: Today's decisions depend on the expectations of how tomorrow's policymakers will react to situations they expect to prevail the day after tomorrow, and so on forever. Policy choice is indeterminate because there is no way to pin down the behavior of the policymaker at +[infinity]. One possible class of equilibria under this institutional framework will display large swings in policy variables of the sort that Milton Friedman (1948 and 1968) and other monetarist writers identified as the source of many business cycles.

As a counterpoint to discretion, we also study an environment dominated by constitutional rules, that is, institutions that restrict the freedom to alter policies inherited from the past. In particular, a constitution that gives current policymakers some veto power over changes in future policies endows public choices with an element of precommitment that makes current policy a genuine state variable. This setting makes future policies more predictable when one knows past policies. It also delivers two desirable properties claimed for rules by Friedman (1948 and 1968) and by Kydland and Prescott (1977): Fluctuations are completely eliminated from the set of equilibria, and all equilibrium allocations are social optima.

The specific policy question we study is the evolution of social security transfers among finite-lived households in an infinite economy, where individual preferences over fiscal transfers are single-peaked, and policy conforms to the wishes of a well-defined median voter household. Analyzing social security naturally sheds light on a number of issues related to intergenerational resource transfers, for example, public debt, currency, and the generational distribution of the tax burden. As we shall see later, the reasons why societies maintain a social security system stem in part from a social compact and, hence, apply with equal force to issues like defaulting on public debt and preserving the purchasing power of currency

For the time being we focus on social security in the overlapping generations model of pure exchange without fiat money. Selfish individuals live two periods and are endowed with (and consume) a single good. This good is private, and claims on it (consumption loans) are the only assets in the economy. We assume away altruistic preferences and the provision of public goods -- two key elements in the political economy of fiscal policy -- to bring out more clearly the impact of political institutions on fiscal policy outcomes.(1)

Political institutions in this article define the authority of the government, that is, of the median voter, to tax away endowment income. We study two institutional environments that allow more and less of this power. The more discretionary of the two political systems we study is pure majority voting that permits the larger of the two population groups (young and old) in our economy to reduce the consumption of the minority group to its minimum feasible level. The less discretionary system is a constitution requiring the majority to obtain the approval of the minority to any changes in social security taxes and benefits.

Constitutional limits to fiscal transfers serve as an endogenous mechanism of partial policy commitment, one that has certain similarities with the standard assumptions used in the literature to exclude from the median voter's strategy set an off-equilibrium plays that depend on what might have transpired two or more periods earlier. …

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