Rules or discretion
Three of Mankiw's six policy debates about stabilisation and monetary policy, with the case each side makes.
FinanceThe economy behind your investmentsAbout 6 min: 4 reading, 2 practiceUpdated
General education, not financial advice.
- Set out the case for and against monetary policy by rule
- Explain the political business cycle and time inconsistency
- Weigh the arguments for and against aiming for zero inflation
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The economy behind your investments: lesson 11 of 16
- The economy behind your investments
- Financial markets and intermediaries 5 min
- The market for loanable funds 5 min
- Banks and the money supply 5 min
- The quantity theory of money 5 min
- The aggregate-demand curve 5 min
- Monetary policy and aggregate demand 5 min
- Aggregate supply and the business cycle 5 min
- Fiscal policy and the multiplier 5 min
- The Phillips curve 5 min
- Expectations and the cost of lower inflation 5 min
- Rules or discretion 6 min
- Deficits and the case for balance 7 min
- Exchange rates and purchasing-power parity 5 min
- Exports, imports and capital flows 5 min
- The market for foreign-currency exchange 5 min
- Policies and shocks in an open economy 5 min
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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 23
What it is
Mankiw ends the book with six debates, giving each side's case without settling them. This lesson covers the three about stabilisation and monetary policy. The views below are the sides' arguments as Mankiw presents them, not this site's.
1. Should policymakers try to stabilise the economy?
- Yes: left alone, economies fluctuate, and recessions waste resources and cause hardship. Monetary and fiscal policy can "lean against the wind": boosting demand when it is weak and restraining it when it is excessive.
- No: policy works with long lags (about six months for monetary policy, possibly years for fiscal policy), and forecasts are imprecise, so well-meant policy can arrive at the wrong time and make fluctuations worse. Policymakers should intervene rarely and be content to do no harm.
2. Should monetary policy be made by rule rather than by discretion?
Supporters of a rule (for example, steady money growth, or a formula for setting interest rates) point to two problems with discretion:
- Incompetence and abuse of power. Central bankers may be tempted to boost the economy before an election, causing a political business cycle.
- Time inconsistency. Central banks announce low inflation, but once expectations are set they are tempted to allow more inflation to cut unemployment. Knowing this, people expect more inflation than announced, so inflation ends up higher than it needs to be. A binding rule would make low inflation credible.
Supporters of discretion answer:
- Flexibility. No rule can foresee every shock: the bank failures of the 1930s, the oil shocks of the 1970s, the 22% one-day stock-market fall of October 1987, the housing and financial crisis of 2007–2009.
- The problems are largely hypothetical. Paul Volcker, appointed by President Carter in 1979, tightened policy anyway, helping cause a recession that hurt Carter's re-election. And in the 1990s the Fed kept inflation low without a rule.
Mankiw notes a middle ground many central banks have adopted: inflation targeting, an announced inflation goal (often a range such as 1–3%) that still leaves room for judgement.
Quick check
Tap an answer to check it.
A central bank announces low inflation, then, once wages are set, allows higher inflation to cut unemployment. What is this called?
- That is about timing policy around elections
- That is a commitment to an inflation goal
Show answer
Time inconsistency. What policymakers say and what they later do differ.
Why it matters
3. Should the central bank aim for zero inflation?
For:
- Inflation brings no benefit but has real costs: shoeleather and menu costs, relative-price variability, tax distortions, confusion, and arbitrary redistribution. The public clearly dislikes it.
- The cost of getting there is a temporary recession; the benefits are permanent. Mankiw notes that Volcker cut inflation from about 10% in 1980 to about 4% in 1983; unemployment in 1982 was the highest since the Great Depression, but the economy recovered with low inflation, and Volcker is now admired among central bankers.
Against:
- The benefits of zero inflation over moderate inflation are small; the costs are large. With a sacrifice ratio of about 5, cutting inflation from 4% to zero costs about 20% of a year's output.
- The cost falls unevenly, mostly on workers who lose their jobs, often those with the least skills.
- Many costs of inflation can be reduced without reducing inflation: by indexing the tax system to inflation, and by issuing inflation-indexed government bonds (the US began in 1997).
Worked example
The sacrifice-ratio arithmetic behind the zero-inflation debate (sacrifice ratio 5):
| Cut in inflation | Output lost (% of a year) |
|---|---|
| From 4% to 2% | 10 |
| From 4% to 0% | 20 |
| From 10% to 4% | 30 |
A supporter of zero inflation sees a one-off cost buying a permanent gain; an opponent sees a large cost for a small gain, borne by the most vulnerable.
Common mistake
Treating any one side as "the economics answer". Mankiw presents each debate with arguments on both sides because economists genuinely disagree, partly over facts (how long lags are, how costly inflation is) and partly over values (who should bear costs).
Key terms
- stabilisation policy
- using monetary and fiscal policy to reduce economic fluctuations
- discretion
- letting policymakers decide case by case
- policy rule
- a pre-set formula or commitment that policymakers must follow
- political business cycle
- fluctuations caused by policymakers boosting the economy around elections
- time inconsistency
- the gap between what policymakers announce and what they later do
- inflation targeting
- a central bank's commitment to an announced inflation goal or range
- indexation
- automatic adjustment of taxes, contracts or bonds for inflation
Practise the key terms
Tap a card to turn it over. 7 cards.
| Front | Back |
|---|---|
| stabilisation policy | using monetary and fiscal policy to reduce economic fluctuations |
| discretion | letting policymakers decide case by case |
| policy rule | a pre-set formula or commitment that policymakers must follow |
| political business cycle | fluctuations caused by policymakers boosting the economy around elections |
| time inconsistency | the gap between what policymakers announce and what they later do |
| inflation targeting | a central bank's commitment to an announced inflation goal or range |
| indexation | automatic adjustment of taxes, contracts or bonds for inflation |
Practice
Work it through
A country with a sacrifice ratio of 4 considers cutting inflation from 5% to 2%.
- 5 − 2
- 3 × 4
Sort it
Which group does this belong to?
Central bankers might boost the economy before elections
The political business cycleShow answer
Argument for rules. The political business cycle
No rule can foresee every crisis
FlexibilityShow answer
Argument for discretion. Flexibility
Announcements of low inflation aren't believed
Time inconsistencyShow answer
Argument for rules. Time inconsistency
The Fed kept inflation low in the 1990s without a rule
The problems may be hypotheticalShow answer
Argument for discretion. The problems may be hypothetical
Quick quiz
Tap an answer to check it.
How can the costs of inflation be reduced without reducing inflation, according to opponents of zero inflation?
- That would raise inflation
Show answer
Indexing the tax system and issuing inflation-indexed bonds. These remove tax distortions and arbitrary redistributions.
What is inflation targeting?
- Inflation targeting leaves central banks discretion
Show answer
A commitment to an announced inflation goal, often a range, that leaves room for judgement. Mankiw describes it as a middle ground.
In short
- Stabilise? For: recessions are costly. Against: lags and poor forecasts.
- Rules? For: limits abuse and time inconsistency. Against: rules can't foresee shocks; the problems may be hypothetical.
- Zero inflation? For: permanent benefits for a temporary cost. Against: small gains, big and unevenly shared costs.
- Inflation targeting is a common middle ground.
Mastery check
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Check yourself
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What is the political business cycle?
Show answer
Fluctuations caused when policymakers boost the economy around elections.
By Mankiw's figures, how far did Volcker bring inflation down?
Show answer
From about 10% in 1980 to about 4% in 1983.
With a sacrifice ratio of 5, what would cutting inflation from 4% to zero cost?
Show answer
About 20% of a year's output.
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 23.
- On this site: Expectations and the cost of lower inflation and Deficits and the case for balance.
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