Question

Discuss how does a rule-based monetary policy differ from discretionary monetary policy (that is, monetary policy not based on a rule)? What are some of the arguments for each?

Answer 1

Discretionary policies refer to measures taken in response to economic developments but they do not obey a specific set of rules; rather, they use discretionary judgement to treat each situation in a particular way. Governments implemented unilateral measures for much of the 20th century to rectify the market cycle. These usually used monetary and fiscal policies to change inflation, production and unemployment. After the stagflation of the 1970s, however, politicians were drawn to the laws of procedure.

A discretionary policy is welcomed as it helps policy makers to respond to incidents rapidly. Discretionary policy, however, may be subject to complex inconsistency: a government can say it intends to increase interest rates indefinitely to bring inflation under control, but then later soften its stance. This might render the strategy impossible and eventually ineffectual.

A policy based on rules may be more credible, because, unlike discretionary policy, it is more transparent and easier to anticipate. Policy is implemented based on economic indicator events, and the policy is planned and enforced in a timely manner. Therefore, as stated by Milton Friedman who advocated for a rules-based strategy, discretionary policy processes pose a void between evaluation and implementation. This can generate compounding problems that are linked to the budgetary policies adopted. However, a strict rules-based approach does not allow flexibility, so choices can be limited or inapplicable in some circumstances.

Discretionary policies yield suboptimal outcomes as they deprive people the advantages of "private commitments." These commitments giving the public the impression that the game's basic rules are stable and reliable are important to a market economy's proper functioning. Commitment to a fairly sound rule even if it is far from a perfect rule is superior to discretionary policy.