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Unformatted text preview: Schools Brief: Rules v Discretion Anonymous. The Economist. London: Mar 2, 1991. Vol. 318, Iss. 7696; pg. 71, 2 pgs Abstract (Summary) A brief in the series on the modern classics of economics considers whether economic policy should be left to the discretion of governments or conducted according to binding rules. It is suggested that game theory can be applied to macroeconomic policy - the issue of rules versus discretion. While economists agree that, at least in the short term, changes in monetary policy can affect output, jobs, and prices, they disagree over whether governments should tailor policies to current economic conditions (discretionary policy) or conduct policy according to pre- announced rules. The most recent argument for constraints to be placed on central banks is based on credibility. According to this view, rules must be made binding to get around a problem known as time inconsistency, which occurs when a policy that seemed optimal at the start no longer seems so when the time comes to act on it. Copyright Economist Newspaper Group, Incorporated Mar 2, 1991 THE previous brief introduced game theory and its use in microeconomics; this brief looks at how game theory can be applied to macroeconomic policy -- the issue of rules v discretion. Most economists agree that, in the short term at least, changes in monetary policy can affect output and jobs as well as prices. But they disagree over whether governments should tailor policies to current economic conditions (discretionary policy) or conduct policy according to pre-announced rules, such as a constant rate of monetary growth. The rules v discretion debate goes back many years, during which economists have put forward three main arguments for constraints to be placed on central banks. * In the 1940s Milton Friedman argued that central banks lacked the knowledge and information necessary for successful discretionary policy. It is difficult to forecast the future path of the economy, let alone when or by how much it will respond to changes in monetary policy, which feed through only after long and variable time lags. So there is a risk that discretionary fine- tuning could make the economy less stable -- not more, as intended. Mr Friedman's recommended rule was a constant rate of monetary growth. * The second argument in favour of rules came from the rational-expectations camp. They believe that changes in monetary policy have no effect on output and jobs, because workers and firms take account of policy changes in forming their inflationary expectations. If there is a monetary expansion, argue advocates of rational expectations, then people anticipate higher inflation and so will immediately increase their wage demands, leaving output and jobs unchanged. If monetary policy can affect only inflation, central banks might just as well stick to a constant rate of monetary growth to minimise uncertainty about inflation. * The most recent argument --and the subject of this week's chosen paper -- is based on...
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