Lecture 7 Rules versus Discretion Prof. Dr. Johann Graf Lambsdorff Anticorruption and the Design of...

Lecture 7

Rules versus Discretion

Prof. Dr. Johann Graf Lambsdorff

Anticorruption and the Design of Institutions 2008/09

ADI 2008/09

Blinder, A. (1998), Central Banking in Theory and Practice: 36-51.

Jarchow, H.-J.: Theorie und Politik des Geldes, Band 1: Geldtheorie,

11. neu bearb. und wesentl. erw. Aufl., Göttingen: UTB, 2003. S. 279-

303.

Kydland und Prescott (1977), Rules Rather than Discretion, Journal

of Political Economy, Jg. 85: 473-91.

Literature

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Rational economic policymaking was often approached in a

technocratic manner: policymakers start by analyzing the functioning

of an economic system. This embraces how this system will react to

stimuli, which can be controlled by the policymaker. It also embraces

finding out societies preferred goals. Once (rational and benevolent)

policymakers understand these two issues, they must weigh the costs

and benefits of using stimuli and bring these in line with society‘s

preferences.

In this perspective, policymaking is the maximizing of a social welfare

function (or minimizing a cost function) given the known constraints.

Rational policymaking

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Against this widely held view, Kydland und Prescott (1977) argued:

“Even if there is an agreed-upon, fixed social objective function and

policymakers know the timing and the magnitude of the effects of

their actions, discretionary policy, namely, the selection of that

decision which is best, given the current situation and a correct

evaluation of the end-of-period position, does not result in the social

objective function being maximized. that the social welfare function is

not maximized by determining the optimal use of instruments in a

given economic situation.”

The reason for this seemingly paradox statement is that economic

planning is not a game against nature but a game against other

rational economic actors.

The following model for optimal central bank policy helps us

understand this argument.

Rational policymaking

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The supply side is characterized by a Philipps-curve:

with : being the rate of inflation; : expected rate of inflation (which is formed in the previous period for the current period); Yr : real domestic product; : potential domestic production where labor is employed to an extent that does not induce changes in wages and inflation. For the sake of simplicity we omitted a coefficient preceding the output gap.

In case of rational expectations, economic subjects utilize all

available information and know the model. If they are not surprised by

unanticipated shocks we obtain:

rY

,r r= *+ Y -Y

Output gap

The time inconsistency model

= *.

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Inserting this into the supply side yields: . The central bank

has thus no possibility of influencing production in the long run.

If the central bank, in the short run, manages to set inflation larger

than the level that is expected by private agents, production increases

above its potential level.

This can be justified by the wage setting process. Wages are

negotiated based on expected inflation.

But if inflation increases above this level, employer’s profits

increase. This induces firms to increase production.


r rY =Y

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In our model, the central bank directly controls the inflation rate. This

is certainly a simplification. We disregard the problem that inflation is

only indirectly controlled by influencing macroeconomic demand by

setting the interest rate.

Thus, in our model the central bank can reduce inflation without

temporarily reducing macroeconomic demand.

But the central bank faces another major problem: its announcement

of zero inflation may not be credible.

Private agents must anticipate inflation well in advance. Lenders, for

example, would suffer form inflation unless they well anticipate its

magnitude. Should private agents trust the central bank’s

announcements? May the central bank have reason to mislead private

agents?


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In reality we find many reasons why central banks fail to stick to their

announcements. Why else are many central banks announcing

inflation rates lower than those who are finally achieved?

One reason relates to the government being a net borrower.

Unanticipated inflation helps the government reduce its debt. The

government also profits from central banks that excessively print

money, without giving due consideration to the subsequent risk of

inflation.

The central bank may even profit itself from printing money – there

are cases of outright corruption among central bankers or the

politicians who control central banks.


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In 1979 Erwin Blumenthal, who served as an IMF representative in

Zaire and was the central bank’s vice governor there, experienced

such a case. There was no clear dividing line between the state budget

and President Mobutu’s personal account. Equally, the central bank

was largely regarded the personal property of the President and his

cronies. Blumenthal was repeatedly forced to hand out the central

bank’s money for purely private purposes. Once he rejected payment

he was threatened with submachine guns to comply with the orders of

an army general, Lambsdorff and Schinke (2002).

President Fujimori in Peru embezzled gold reserves from the central

bank and transferred them to Japan. The loss in the central bank's net

equity must be compensated somehow, for example by printing

money and disregarding future inflation.


ADI 2008/09 In 1999 surprise inflation was created by a central banker himself in Brazil.

Francisco Lopes headed the Brazilian Central Bank as a governor for only

three weeks. Upon his appointment he devalued the Brazilian currency, the

Real, by eight percent. Such a devaluation increases import prices and, thus,

inflation. Before the devaluation, Lopes gave advance notice of the new

exchange rate to several private Brazilian banks, enabling them to profit from

the “unexpected move” (BBC, April 14, 1999). Furthermore, a few days after

the devaluation, Lopes sold dollars at favorable prices to the same banks. A

Brazilian weekly news magazine quoted Salvatore Cacciola, an owner of one of

the banks, as saying that he had a paid informant within the central bank. This

informant would alert him to important events, such as changes of the interest

rates or currency movements (BBC, April 26, 1999). A raid on Lopes’ house by

the Brazilian police revealed several documents showing that Lopes, while

working as a public servant, had maintained close connections to a private

consulting firm and had more than $1.5 million in a foreign bank account

(BBC, April 26, 1999). One year later, in February 2000, Lopes was charged

with fraud (BBC, February 3, 2000) and with maintaining a foreign bank

account that he had not declared to the tax office or the central bank (BBC,

January 20, 2001). This event is reported in Schinke (2006).

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But even benevolent central banks may have reason to depart from

their announcement. This is best investigated by considering the

central bank‘s cost function. The central bank dislikes inflation and

deviations of production from its desired level. It weights the latter by

, its employment preference:

We call central bankers with a small “conservative”. Those with a

large are called “populist”. The domestic product which is preferred

by society and the central bank alike is denoted by ( ). It is larger

than potential production and the difference is denoted by z:


22 ˆ .rK Y Y

Y

ˆ 0rz Y Y

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A plausible reason relates to unemployment aid. This aid implies

that individual costs of unemployment are lower than social costs. In

an extreme case where unemployment pay equals the regular salary

an individual would not suffer from unemployment, while society at

large but have to bear the full burden.

This cost function assumes that desired inflation is zero (otherwise a

nonzero target rate for inflation would have to be considered).

The cost function entails another plausible assumption: A mixture of

two “evils”, unemployment and inflation, is preferred to being hit

excessively by only one “evil”. For this reason the two terms are

squared, expressing increasing marginal disutilities.


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The game is played by letting private agents act first. They determine

expected inflation. These expectations are used to sign labor

contracts. In case of high expected inflation, high increases in wages

are negotiated. If low levels of inflation are expected, moderate wage

increases result. The central bank acts in the final period by fixing the

true level of inflation.

Private agents expect inflation.

Wages are negotiated

Central bank fixes inflation.


t

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Inserting for z and the supply function into the cost function yields:

The central bank takes * as given, because it is determined at the

beginning of the game.

For the solution of the game three cases must be distinguished:

1. Rule

2. Cheating

3. Discretion


22 * .K z

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Rule

The central bank announces price stability (=0) and the private

agents believe in this announcement, (*=0).

Due to the supply side implies that production equals its

potential level, .

Costs for the central bank amount to:


r rRY Y

2.RK z

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Cheating

When determining actual inflation the central bank observes that

expected inflation is given. All wages are already fixed and will not

react to the central bank’s choice.

The central bank will minimize its costs. A cost minimum requires:

Assuming that private agents trusted the central bank (*=0), we

obtain:

The central bank will thus fix the following inflation rate:


2 2 * 0.dK d z

2 2 0.dK d z

0.1C z

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In spite of its announcement of price stability the central bank

chooses a positive rate of inflation.

Production increases to the following level:

Due to surprise inflation the central bank is thus able to increase

production and lower unemployment towards a level preferred by

society. The costs amount to

These costs are lower as compared to the rules based solution:


* .1

r r rC CY Y z Y

2 22

1 1 1CK z z z z

2 2.1C RK z K z

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RK

rr YY

rY

*

CK

*

C


Y

0 r r= + Y -Y

R

C

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Discretion

Rational private agents will anticipate the central bank’s temptation

to cheat.

This will increase their expected level of inflation. But by how much?

Rational private agents know the central bank‘s calculus and the

model. They thus know that the central bank maximizes according to

Solving for yields the central bank’s reaction function,

Inflation, , thus increases with expected inflation and z.


2 2 * 0.dK d z

1 * .z

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Rationality now assumes that private actors will not make systematic

errors when anticipating the level of inflation. Since there are no

stochastic shocks, this implies that they will not err: *. Inserting

this into the reaction function yields

Due to a lack of central bank credibility private agents and the

central bank bias upwards the level of inflation (“inflation bias“).

This inflation bias is the higher the higher the central bank‘s

preference for employment, , and the more desired production

exceeds potential production, z.

Due to * production equals its potential level, .


1 * .Dz z z

r rDY Y

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RK

rr YY

rY

*

CK

D

DK

*

D

C

(1 ) ( * )z


Y

r r= *+ Y -Y

0 r r= + Y -Y

R

C

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Graphically the equilibrium is reached where both, the supply curve

and the isocost-curve intersect with the -curve and have the

same slope.

The costs in the discretionary solution are given by:

As expected, inflation has increased relative to the cheating solution:

Costs are also higher as in “rules”:


2 21 .D RK z K z

.1D Cz z

2 2 21 .DK z z z

rr YY

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To conclude, economic policy should not be carried out by

determining an optimal use of instruments in specific situations.

Instead, politics should strive to impose rules on its own conduct.

Politics must strive to make these rules binding, so that decision

makers can sustain the temptations when they arise.

This viewpoint is parallel to that of Ulysses and the Sirens. Ulysses

was curious to hear the Sirens' songs but mindful of the danger. He

ordered his men to stop their ears with beeswax and ties himself to

the mast of the ship. He orders his men not to pay attention to his

cries while they pass the Sirens. He anticipated his irrational behavior

and bound himself to a commitment mechanism (i.e. the mast) to

survive.


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Problems of time inconsistency not only arise with central bank

policy.

Taxation is another widely used example. Investors are sometimes

promised preferential taxation in an attempt to attract their capital.

Once these commit their capital, the advantages from increased

capital are reached. Suddenly it is no longer optimal to stick to

promise of reduced taxation.

The same also applies to issues of regulation, for example on

environmental issues.

Investors value the governments announcements on its future policy

when assessing the attractiveness of a country. But along with their

content, they focus on the credibility of these announcements.


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In reality, the central bank’s temptation to surprise with a high level

of inflation may be less severe, (Blinder 1998).

But this may relate to the fact that most central banks already

operate under conditions that ameliorate our problem.

One such condition is that central banks operate repeatedly with

private agents and thus can establish a reputation of trustworthiness.

In order to better understand the resulting game, we must investigate

the impact of repeated play.

Current inflation is likely to impact on expected inflation in

subsequent periods. The short term gains from reduced

unemployment would then be seen against the long term losses from

increased expected inflation.

Repeated play and reputation

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A first theoretical conclusion is that this disciplining effect arises

only if there is no final period (or if private agents do not know when

there might be one).

Imagine such a final period (t=n). In this period the central bank will

minimize its costs because it does not care about future expectations.

This will be anticipated by private agents who expect ==D. We

obtain the simple discretionary solution in the final period.

Since the result for the last period is already fixed, the central bank

obtains no incentive to try to influence the last period‘s expectations.

Why then should it abstain from a surprise inflation in the penultimate

period (t=n–1)? Indeed, it will also act according to its reaction

function and minimize costs. Private agents will anticipate this again.

By backward induction we observe that the discretionary solution is

obtained in all periods.


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There are straightforward implications for the design of institutions:

Central banks and similar institutions should not be confronted with a

final period. This can be practically achieved by allowing continuity in

the pursuit of its obligations.

First, employment contracts with central bankers should last for a

long term.

Second, there should be overlapping time horizons for the central

bankers’ employment contract. This introduces the continuity

necessary for the central bank’s tasks and avoids end period

problems that would arise if a complete cohort of central bankers

leaves office.

If, indeed, end period problems are overcome, we can model the

central bank’s problem as one with an infinite time horizon.


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In case of an infinite time horizon the central bank‘s incentive to

cheat with *=0 is:

Cheating once induces private agents to disbelief in future

announcements of the central bank. They will expect *=D and the

central bank will act accordingly by setting =D. This future inflation

bias goes along with increasing costs:

These costs arise in the future. Their present value depends on the

degree to which central banks discount future costs (r) and the length

(s) by which private agents sanction the central bank‘s malfeasance by

disbelieving in its announcements.


2 2 2 21 1 .R TK K z z z

2 2 2 2(1 ) .D RK K z z z

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The central bank will stick to its promise of zero inflation if

This implies:

Apparently, this is achieved with and s being large and r being

small. If we assume the special case of s=1, private agents would

sanction the central bank only once and afterwards again believe in an

announcement of zero inflation. We obtain:


2 2 22 2

2 ... .1 1 1 1

s

z z zz

r r r

2

1 1 1 1... .

1 1 1 1sr r r

1 1.

1 1r

r

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With r being small, future losses are little discounted and thus larger.

This induces the central bank to avoid future sanctions by private

agents.

Suggestions have been made that this discount rate is lower for

independent central banks. Political actors can boost their chances of

being reelected by increasing employment during the electoral

campaign. Inflation would thus increase during electoral cycles – and

they are difficult to reduce afterwards. For politicians r is rather large

during elections. Independent central bankers would act less myopic.

With s being large, malfeasance is heavily sanctioned and thus

becomes unattractive. There are apparent conclusions of this finding

for the design of institutions. Environments with a good memory for

past misbehavior appear better in deterring malfeasance.


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The result for is paradox. Shouldn‘t a large preference for

employment increase the central bank‘s temptation to cheat? Indeed,

it does so but it also increases the future costs of malfeasance. This

impact on the future costs is even higher.

An employment preferring central banker is aware of the high future

costs of his malfeasance and more deterred to avoid cheating.

This is comparable to a self-help group of anonymous alcoholics.

Those engaging in such a group are well aware of the temptation to

drink. While the temptation is higher for them, they suffer heavier from

malfeasance. One drink alone is likely to put them back on the slope to

addiction. Rational behavior thus induces them to strictly avoid any

alcohol.


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The likelihood of drunk driving is thus lower for such an alcoholic.

Parents seeking someone to drive back their children after a party may

have good reason to entrust their offspring to such an alcoholic rather

than anyone else.

Our results, however, are valid only for a central banker who is aware

of the future sanctions that follow his malfeasance.

If a populist central banker disbelieves in the private agents

sanctions, he would not be deterred from surprise inflation. The

deterrence effect is thus restricted to central bankers who accept our

model.


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The model has been deterministic. In reality, shocks are likely to hit

the economy.

1. The central bank may stochastically err in setting the inflation rate.

It aims at a certain level but misses this level. For example, after

aiming at =D import prices drop suddenly or macroeconomic

demand declines and produce = As long as private agents observe

the shocks, the impact on the model are minor. We do not further

investigate this here.

2. Another type of shock relates to the supply side. These shocks are

problematic for the central bankers because they confront him with a

dilemma. Should he stick to his rigid rules or prefer some flexibility

that is responsive to the shock?

Stochastic Supply Shocks

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rr YY

rY

D

Y

r r= *+ Y -Y w

R

0 r r= + Y -Y w R

D


C

A Negative Supply

Shock

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Should we worry about shocks? They might be good or bad!

Indeed, we should care about shocks: inflation and the output gap

enter the cost function with quadratic terms. Extreme deviations are

particularly bad. In case of a large shock, the desire to balance one

disutility with another may become stronger.

Imagine Ulysses and the Sirens again. His strict commitment helped

him survive. But what would have been the outcome if his ship sank?

His solution of tying himself to the mast would turn out to be dreadful

and he may have preferred to somewhat cope with the Sirens instead.


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The game is played only once. A shock, w, is normally distributed

with expected mean E(w)=0 and variance V(w)=s2 . If w>0 inflation

rises. This is equal to saying that production drops.

The game is played according to the following sequence:


)r r= *+(Y -Y w .r rY *+Y w

Private agents expect inflation.

Wages are negotiated

Central bank fixes inflation.

t

Nature determines shock

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If the central bank is strictly bound by a rule (=0), it cannot

recognize the shock‘s impact on production.

We obtain R =*=0 and

The variance of production is determined by:

Since we obtain

To see this, observe that and E(w)=0.


.r rRY Y w

.2

r r rR R RV Y E Y E Y

r rRE Y Y

2.2r r r

RV Y E Y w Y s 2 ( )

2s E w E w

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For the costs we obtain:

For expected costs we obtain due to R=*=0:

Due to and E(w)=0

As compared to the deterministic model costs increased due to the

shock because situations of reduced production are particularly

painful (variations of production enter the costs function in squared

form).


2 2( * ) .K w z

2 2( ).RE K z s

2 2 2( ) ( 2 ) .E K E w z E w wz z

2 2s E w

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In case of discretionary policy the central bank observes the shock,

w, prior to determining its policy. It will minimize:

A cost minimum requires:

The central bank sets inflation according to:

On average the following inflation rate can be expected:


2 2( * ) .K w z

2 2 ( * ) 0.dK d w z

( * ).1

w z

( * ).1

E z

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Due to rational expectations private agents know this calculus of the

central bank. They cannot be systematically misled and expect

inflation equal to the mean inflation set by the central bank, *= E().

This implies:

Inserting this into the central bank’s calculus, we obtain:

Inflation in case of discretion is thus:


* ( * ) * .1

E z z

2 2 ( ) 0

1 1 0.

dK d z w z

w z

.1D z w

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From this we can determine production. Due to -*=/(1+)·w:

Variance of production is:

This is smaller than s2. This reveals that the impact of shocks on

production is dampened in case of a discretionary policy.


r rDY *+Y w

1.

1 1r r rDY w Y w Y w

1

1

22

r r r r rD D DV Y E Y E Y E Y w Y

2

2

1 1

1 1

2

E w s

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This advantage, however, comes at a cost: average inflation

increases due to an increased inflation bias.

Another downside effect is that variation of inflation has increased.

While it was zero in case of a rules-based policy, variation of inflation

now amounts to /(1+ )w.

Strict rules avoid the inflation bias. But they also disallow a more

flexible reaction towards supply shocks. Shocks would impact

completely on production, without any dampening reaction.

There is a trade off between credibility (rules) and flexibility

(discretion).

Which policy to prefer can be revealed by comparing expected costs.


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In case of discretion we obtain:

Inserting yields:

Due to E(w)=0 we obtain:


2 2( ) ( * ) .D D DE K E E w z

2 2

( )1 1DE K E z w E w w z

22 2 2

2( ) 21 1

DE K E z z w w

2 2

2 2 .11

w wz z

2 2 2 2( ) .1DE K z z s

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Comparing this to the costs of rules yields that discretion is

preferable if:

Simplifying this, we obtain:

Discretionary policy should be preferred in case of

a high variance of supply shocks, (s2 is large)

a low preference for employment ( is small),

a small difference between desired and potential production

(z is small).


2 2 2 2 2 2.1

z z s z s

2 2 2 2 211 .

1z s s z s

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As we observed, rules are preferable with respect to containing

inflation.

Discretion is preferable with respect to stabilizing production.

Is there some optimal policy in between these two extreme cases?

In research four different variants have been discussed:

1. A flexible rule

2. Incentive contracts for central bankers

3. A moderately conservative central banker

4. Rules with exceptions

Optimal Design of Central Bank Policy

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1. A flexible rules for the central bank would be:

a is the long-term desired value for inflation.

b is the central bank‘s flexible reaction towards shocks (w > 0).

Both parameters can be determined so as to minimize costs.

We assume that the flexible rule is binding and announced upfront.

Apparently, we then obtain *=a.

Inserting this and the flexible rule into the cost function, it follows:


, 0, 0FR a bw a b

2 2( ) ( )E K E a bw bw w z 2 2 2 2 2 2( 1) .E a b w b w z

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Partial differentiation yields:

The optimal flexible rule is thus:

This allows to achieve long-term price stability. At short sight,

deviation from price stability are allowed so as to dampen supply

shocks. Production would be equal to the discretionary value:

With inflation being zero on average, total costs are lower than in

both previous solutions: strict rules or strict discretion.


.1FR w

( )2 0 0.

E Ka a

a

2 2( )

2 2 ( 1) 0 .1

E Kbs b s b

b

1.

1r rFRY Y w

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Such a solution, however, faces practical problems: How should

private agents distinguish between a central bank that cheats and one

that reacts to a shock? Maybe it cannot! How can the central bank

commit to such a flexible rule, if nobody can observe its adherence to

the rule?

One attempt could be that the central bank upfront identifies various

observable shocks and determines its quantitative reaction to these

shocks. But supply shocks may range from natural catastrophes, oil

price shocks, sudden technological innovations to warfare.

Determining upfront how to react to such crises is not an easy task.

Apart from that, determination of the output gap may contain a high

degree of discretion. Whether a drop in production is due to a

shortage in demand or a decrease in supply is commonly disputed.

A central bank may use its discretion to cheat and private agents

may therefore disbelieve in its announcements.


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2. An optimal solution can also be achieved by providing incentives to

central bankers. A government that seeks to approach the optimal

solution would confront a central banker with a penalty in case of

excessive inflation.

Assume this penalty to be Kp=2z. The cost function of the central

bankers is then modified to:

A cost minimum requires:

This simplifies to:

Taking expectations on both sides, we observe that and


2 2( * ) 2 .K w z z

2 2 ( * ) 2 0.dK d w z z

* 0 1 ( * ) 0.w

1 .w

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The solution thus equals that of the flexible rule. The impact of

shocks on production are dampened and inflation is allowed to vary.

The advantage of this solution is that private agents do not have to

verify the magnitude of a shock. Even if the magnitude of a shock is

known only to central bank, the central bank does not obtain an

incentive to cheat.

A disadvantage is that central bankers commonly earn less than

private bankers. Punishing central bankers would not be feasible, as

they prefer to quit. Another problem is that the contract would be

exercised by the government. But the government faces the same (or

in case of a forthcoming election even a larger) incentive to cheat.

Why should a government punish a central banker for an action that it

considers to be optimal? Due to these incentives the government may

fail in committing the exercising of such a contract.


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3. Another option arises be employing a central banker who is known

to be moderately conservative.

This central banker should have a nonzero preference for

employment (k>0).

The central banker’s preference should be lower than that of the

government (k<).

This allows for a cost-minimizing mixture of the two disutilities,

inflation and unemployment. A small inflation bias is accepted, while

the impact of the shock on output is a little dampened.


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4. A final solution arises with a simple rule plus an escape clause. In

case of a large shock the central bank would obtain the chance to shift

to a discretionary policy, (Lohmann 1992).

This policy can be represented by the following curve:


w

* (1 ) w

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Private agents determine expected inflation by multiplying the

regular inflation bias with the likelihood that the escape clause is

applied (*>0). In normal times, the central bank sticks to =0 and

produces a little unemployment. The larger the horizontal part of the

reaction curve (rule) the lower will be expected inflation, *, and thus

the intercept of the upward sloping part of the curve.

Who should verify the size of the shock? Rather than letting the

central bank try to prove its size it (and provide it with an incentive to

cheat) one may require high efforts among the central bank for using

the escape clause.

One simple idea would be to require a parliamentary approval for

using the escape clause. It would not be the parliament‘s expertise

that makes the difference, but rather the central bank‘s effort required

for convincing parliament (and its unhappiness with delegating

authority to someone else).


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The central bank’s cost function is:

The supply function is:

with K being costs in the central bank’s calculus, being inflation, *

expected inflation, Yr production, 16 the desired level for production

and 10 potential domestic production.

a) Determine the costs if private agents believe in the central banks

announcement of and the central bank sticks to its announcement

(rule).

b) Contrary to a) the central bank minimizes its cost function after

observing *=0 (cheat). Determine the rate of inflation and the central

bank‘s costs.

2 2 0.5 ( 16) .rK Y

* ( 10)rY

Exercise

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c) Private agents observe the central bank’s incentive to cheat and

adjust upward their expectation of inflation to a rational level

(discretion). Determine this level of inflation and the central bank’s

costs.

d) Use your findings from a)-c) to explain what is meant by “time

inconsistency”.

e) A new government has a higher preference for employment

according to The government

considers firing the old central bankers and employ bankers with

preferences equal to those of the government. Determine the new

discretionary solution. Is the firing of the old central banker’s a

good idea?

Exercise

2 2 2 ( 16) .rK Y

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The central bank’s cost function is:

The supply function is:

with K being costs in the central bank’s calculus, being inflation, *

expected inflation, Yr production, 10 the desired level for production

and 6 potential domestic production. The shock, w, is normally

distributed with mean E(w)=0 and variance V(w)=s2. Private agents

form expectations for levels of inflation first, nature determines w and

finally the central bank determines the level of inflation.

a) Determine the expected costs if private agents believe in the central

banks announcement of =0 and the central bank sticks to its

announcement (rule).

2 23 ( 24) .

2rK Y

* ( 16)rY w

Exercise

ADI 2008/09

b) Determine the discretionary solution where announcements lack

credibility, the central bank minimizes costs and private agents

rationally anticipate the equilibrium level of inflation. Determine the

central bank‘s expected costs.

c) Compare your findings in b) to those in a). Would you recommend a

strict rule if variance obtains alternative values of s2=100, 200 or 300?

d) The government finds a central banker with an employment

preference =1/2. Assuming s2=100, would it make sense to employ

this central banker?

e) The government penalizes a central bank for excessive inflation.

What level of penalty would you recommend so that price stability

results in the discretionary solution?

Exercise

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Lecture 7 Rules versus Discretion Prof. Dr. Johann Graf Lambsdorff Anticorruption and the Design of...

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