Commitment versus Discretion in Monetary Policy
Dotsey, Michael, Business Review (Federal Reserve Bank of Philadelphia)
The debate over whether it is better for a policymaker to commit to a particular course of action or to approach each situation with perfect flexibility has been and continues to be a central question in the design of monetary policy. In 1977, economists Finn Kydland and Edward Prescott wrote the seminal article analyzing the benefits of carrying out plans based on commitment as opposed to discretion. Since then, the benefits of commitment have been analyzed in many settings and in many economic models. Indeed, in a 2007 speech to the New York Association for Business Economics, Philadelphia Fed President Charles Plosser explained his views on credibility and commitment in monetary policymaking. This article elaborates and expands on some of these ideas.
To start with, let me first define what we mean by commitment versus discretion. Commitment is the ability to deliver on past promises no matter what the particular current situation is. I should stress that, under commitment, promised behavior is generally contingent on future events. Promises are not typically blanket commitments to be fulfilled irrespective of future situations. The key aspect of commitment is that the policymaker keeps his promise to act in a certain way when a particular future event comes to pass. The absence of this ability is called discretion. Under discretion, a policymaker is allowed to change policy depending on current circumstances and to disregard any past promises. Because the discretionary planner does not make any binding commitments, it would appear that discretion offers more flexibility and it would seem to be preferable to a policy whereby the policymaker must honor past promises.
The idea that it is better for 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 only are better long-run outcomes achieved under commitment, but monetary policy is also better able to respond to shocks if the central bank is constrained to honor past promises concerning its future behavior. As I'll discuss below, lower inflation, with no adverse effects to economic activity, is obtained under a policy of commitment, and such a policy can achieve less volatility in both inflation and output as well. Indeed, the inability to commit often leads to problems for policymakers.
Comparing policymaking under discretion and under commitment is an analysis of two polar cases. It sidesteps the question of how a central bank can act in a committed fashion even if it desires to do so. Also, how could a central bank convince the public that it is operating in a manner consistent with commitment when the institutional setting places little restriction on future policies? For instance, the members of the policy-making boards change over time as do the legislators that monitor the behavior of monetary policy. Commitment requires tying the hands of future policymakers, and in reality, we don't even know who they will be.
Research analyzing ways that policy can come close to the ideal of full commitment has generally proceeded along two lines. One is institutional design. How does one set up institutions that will improve on discretionary outcomes? The other is the role of reputation and the credibility an institution can achieve by behaving like a committed planner over time. While of tremendous interest, investigations into these areas are beyond the scope of this article. But we cannot hope to understand these more advanced investigations without first understanding the different nature of policy under commitment and under discretion.
Economists refer to the desire to alter previously made plans as the time-consistency problem because, at each date, an individual or policymaker finds it tempting to deviate from what an earlier plan dictated. The temptation to alter strategies affects how others view your proposed plan, and it is the interaction between the public's expectations and the policymaker's decisions that leads to problems for a policymaker who cannot commit. …