I’d like to begin by asking a question. How many of you have ever decided that you would be healthier and happier if you lost a few pounds and so made a New Year’s resolution to go on a diet? I know I have. But, if you are like me, tomorrow comes and it’s your wife’s or husband’s birthday and you celebrate with a fine dinner, a bottle, or two, of wine, and a delicious soufflé for dessert. Then over the weekend there is a party in the neighborhood and the food is outstanding, so you decide that the diet can wait until next week. But as the days and weeks go by, next week just never comes, and you, in effect, abandon your dieting plan altogether. We all know we would have been better off if we had just stuck to our diet. Yet somehow we failed to follow through consistently on what was basically a good plan.
At this point some of you may be thinking, "What does this have to do with monetary policy?" But the fact is that policymakers often have a good plan, as well, but may not be able to resist eating that soufflé. Consequently, not only would the good plan go out the window, but the public would lose confidence in the policymaker’s credibility to follow through on its promises.
The Federal Reserve as the monetary authority has a mandate to provide a stable price level and promote maximum sustainable growth. These are important goals that can contribute to a more efficiently functioning economy and thus help to promote higher living standards. So the question becomes: How can the Federal Reserve System best go about achieving these goals? Today, I am going to address one critical element of the Fed’s ability to achieve its objectives—the importance of making credible commitments
Commitment vs. Discretion
The issue of whether it is better for a policymaker to commit to a policy or to operate with pure discretion has long been a central question for many areas of policymaking, including monetary policy. In the late 1970s, Nobel Laureates Finn Kydland and Edward Prescott showed that a regime that pre-commits policymakers to behave in a particular way is preferable to a regime that allows policymakers pure discretion—that is, to choose a policy independently at each point in time.
This idea is very counter-intuitive to most people. After all, the policymaker could choose the same set of actions under discretion as he could under commitment. So it seems that a discretionary policy can certainly be no worse than a policy that entails pre-commitment. Therefore, so the argument goes, there is value in retaining "flexibility" so that the policymaker can respond "appropriately" to the current environment. Thanks to Kydland and Prescott, and many others that followed, we now know that this argument is fundamentally flawed. The fatal flaw in this conventional wisdom stems from its failure to recognize the important role played by expectations of future policy in economic decisions made today. I hope to convince you of that today and to highlight some of the important implications of that reasoning for how we ought to think about monetary policy.
Before I continue, I want to be precise and define what I mean by commitment and discretion. Commitment means delivering, in any particular situation, on past promises. In other words, the policymaker unequivocally will follow through on a promise made about future actions.
Discretion, on the other hand, means that the policymaker is not bound by previous actions or plans and thus is free to make an independent decision every period. Recall my choice to have that soufflé for dessert. It seemed like a great decision at the time, and I certainly enjoyed it. Moreover, each time I chose to eat more extravagantly as opposed to dieting I was making a choice that made me feel better. Yet the consequences of those meal-by-meal or day-by-day choices added up to a very poor outcome—I gained ten pounds rather than lost them.
Well, policymakers can find themselves in similar situations. Discretion means the policymaker may find it preferable to change his mind, or re-optimize, and do something other than what was initially promised. The temptation to renege on previous promises or plans is what economists refer to as the time-inconsistency problem, and it has surprisingly troublesome consequences. In particular, it can mean that outcomes under a discretionary regime are likely to be worse than those under a regime where the policymaker is constrained to follow through on previous commitments. A few examples may help illustrate this seemingly surprising but important idea.
Research and development by the private sector is an important source of innovation in our economy. From new drugs to computers, research has led to new products that have enhanced our health and productivity. Thus investment in research generates important social returns that contribute to the improvement in living standards both here and around the world.
To encourage investment, governments frequently seek to ensure that the private returns to innovation are sufficient to elicit the socially optimal amount of investment in new ideas. In practice, governments often give temporary monopoly rights to companies, in the form of a patent, as a means of assuring the private inventor that he can earn a sufficient rate of return on what may be a very costly and risky investment project.
Once the new drug or invention is discovered, however, the discretionary and myopic policymaker might be tempted to revoke the patent and make the new product’s design freely available to all. Such an action will likely result in more competition, and the ensuing price reductions will make society better off. In this case the policymaker is acting in a way that is conditioned on previous outcomes and that may appear, at the time, to be optimal for society as a whole. But I think you can all see that such change in policy, while having short-term benefits, is likely to have devastating effects on future investments in research and inventive activity. In particular, since the potential returns to innovation might well vanish at the discretion of the policymaker, the incentive to invest in risky research will fall.
On the other hand, if the policymaker could commit to enforcing the patent rights, the potential payoff to risky research and innovation would remain. Thus removing the discretion of the policymaker to revoke the patent — that is, constraining the policymaker’s choices — actually raises overall welfare. Of course, an unanswered question is: How can the policymaker commit to this policy in a credible way? I will have more to say about this later, but, in this case, commitment is attempted through legislation. The idea is that while passing a law is not a binding commitment because laws can always be changed, it does substantially raise the barrier to policymakers acting in a time inconsistent fashion.
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