Recent developments in the theory of rules versus discretion OR。 Robert J. barro The Economic Journal, Vol. 96, Supplement: Conference Papers. (1986), pp 23-37 Stable url: g/ sici?sici=0013-0133%281986%2996%3C23%3 ARDITTO%3E20C0%3B2-P The Economic Journal is currently published by Royal Economic Society Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/about/terms.htmlJstOr'sTermsandConditionsofUseprovidesinpartthatunlessyouhaveobtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the jsTOR archive only for your personal, non-commercial use Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at Each copy of any part of a JSTOR transmission must contain the same copyright notice that ap on the screen or printed page of such transmission STOR is an independent not-for-profit organization dedicated to and preserving a digital archive of scholarly journals. For more information regarding JSTOR, please contact support @jstor. org Thu mar1522:37:242007
Recent Developments in the Theory of Rules Versus Discretion Robert J. Barro The Economic Journal, Vol. 96, Supplement: Conference Papers. (1986), pp. 23-37. Stable URL: http://links.jstor.org/sici?sici=0013-0133%281986%2996%3C23%3ARDITTO%3E2.0.CO%3B2-P The Economic Journal is currently published by Royal Economic Society. Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/about/terms.html. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/journals/res.html. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is an independent not-for-profit organization dedicated to and preserving a digital archive of scholarly journals. For more information regarding JSTOR, please contact support@jstor.org. http://www.jstor.org Thu Mar 15 22:37:24 2007
RECENT DEVELOPMENTS IN THE THEORY OF RULES VERSUS DISCRETION Robert j. Barro . GENERAL FEATURES OF RULES AND DISCRETION The older literature on rules versus discretion focused on the intentions and capability of the policymaker. Arguments for rules were based on imperfed knowledge about the economy and on policymakers' tendencies to furthe inappropriate ends, possibly motivated by interest groups. But an intelligen policymaker could take account of incomplete information about the economy when deciding on the optimal discretionary policy. Then if the policymaker were also well-meaning, there was no obvious defense for using a rule in order to bind his hands in advance. Discretion seemed to be synonymous with flexibility, which one had no reason to deny to a smart, benevolent This perspective on rules versus discretion was changed by Kydland and Prescott(1977), who looked at rules as a form of commitment. A commitment amounts to a binding contract, which specifies in advance the actions that someone will take, possibly contingent on some exogenous variables that everyone can observe. In contrast, under discretion, a person promises only to take those future actions that will best further his objectives later on. (Such promises are easy to keep! Thus, discretion is the special case of a rule or contract in which none of today's provisions restrict a persons future actions In the area of private business dealings, it is natural to think about optimal forms of contracts, which would not usually be pure discretion. Similarly, for public policy, the perspective becomes the optimal form of rules or prior restrictions-even the smart, benevolent policymaker is likely to desire and use an ability to make binding promises Kydland and Prescott discuss various areas of public policy in which commitments are important. One example is patents, which encourage inventions, but also restrict the supply of goods ex post. Under discretion, a policymaker who cares about social welfare would invalidate old patents Conce and for all,), but continue to issue new ones. However, the perception of this policy by potential inventors has adverse effects on new inventions, which soon become old inventions. Hence, the optimal policy contains a mechanism to preclude or at least inhibit the abolition of old patents. Then the details of this policy involve the standard tradeoff between the incentive to invent and the ex post restriction of supply s i have benefited from researd from the National Science Foundation. The present paper is an extel f results contained in a previous paper(Barro, 1984. xample, Friedman( 1960, Chapter 4)
THE ECONOMIC JOURNAL The manner of committing future actions varies with the area of public policy. In some cases, such as the duration and scope of patents, the rules are set out in formal law. Then the costs of changing laws(possibly coming under constitutional restrictions ag x post facto laws)enforces the governments commitments However, in the case of the Gold Standard Act in the United States, the existence of a law proved in 1933 to be inadequate protection for those who held gold or made contracts denominated in gold More often a government's commitments rely on the force of reputation hereby people's expectations of future policy are tied in some fashion to past behaviour. For instance, if a government defaults on its debts then potential bondholders are deterred by the perception that future defaults are more likely If a municipality sharply raises property taxes, and thereby reduces property values, then potential residents are deterred from moving in. But, as a general matter, the linkages between past actions and expectations of future behaviour are difficult to formalise in a model II. MONETARY POLICY UNDER DISCRETION A major contribution of Kydland and Prescott was the recognition that monetary policy involves the same issues about commitments as do such areas accumulated capital(via changes in property taxes or in other taxes that lalo k as patents, default on government debt, and imposition of levies on previousl capital). In the case of patents it is obvious that a policymaker must worry about the link between current actions -such as eliminating past patents or changing the form of patent law-and people's perceptions about the value of presently issued patents. Similarly, the monetary authority must consider the interplay between today's choices- whether to engineer a monetary expansion or to change the 'law' governing monetary policy- and peoples beliefs about future money and prie ces Consider the example about the Phillips curve, as discussed in Kydland and Prescott( 1977)and in Barro and Gordon(1983a, b). These models involve the following main ingredients. First, monetary policy works by affecting the general price level. In the simplest setting the monetary authority can use its instruments in order to achieve perfect control over the price level in each period. Second, unexpected increases in the price level (but not expected changes in prices)expand real economic activity. In other words, there is an expectational Phillips Curve. Third, the representative person, and hence the benevolent policymaker, value these expansions of activity at least over some range(which means that existing distortions make the natural level of output too small). In order to focus on the distinction between rules and discretion, tI models assume unanimity about the public's desires and a willingness of the policymaker to go along with this objective. This is, there are no principal-agent problems. Finally, inflation is itself a bad- people value it only as a device to For a discussion of the abrogation of gold clauses in public and private contracts, see Yeager (1966, p. 305). Additional discussions are in Nussbaum(1950, pp. 283-91)and McCulloch (1980)
THEORY OF RULES VERSUS DISCRETION create unexpected inflation and thereby higher levels of economic activity This setup for inflation is structurally similar to the example about patents. At any point in time the policymaker is motivated to generate unexpected inflation in order to stimulate the economy. The analogue is the expansion of supply via the abolition of past patents. But people understand these incentives in advance and therefore form high expectations of inflation Accordingly, the policymaker must choose a high rate of inflation just to stay even-that is, in order for unexpected inflation to be zero. Finally, this high inflation imposes costs on the economy. ( The parallel is the decrease in inventions because of the expectation that current patents will not be honoured later Barro and Gordon ( 1983a, b) analyse the equilibria for monetary policy and inflation for the Phillips-curve model. In the of pure discretion, the policymaker has no mechanisms for committing the future behaviour of money and prices. Rather, he has a free hand to maximise social welfare at each point in time, while treating past events as givens. In this situation there is an incentive at each point in time to create surprise inflation in order to generate economic boom. But individuals understand this motivation and form their expectations accordingly. Thus, actual inflation cannot end up being ystematically higher or lower than expected inflation Overall, two conditions must be satisfied in equilibrium. First, people xpectations of inflation are correct on average, which is a rational- expectations condition. Second, although the policymaker retains the power in each period to fool people via inflation surprises, he is not motivated to exercise this power. In order for this second condition to hold, the policy-maker's drive to create unexpected inflation must be balanced by the marginal cost of inflation itself. In other words, inflation must be high enough so that the marginal cost of inflation equals the marginal benefit from inflation surprises Only then will the chosen rate of inflation-which ends up equal on average to the rate that people expect- be incentive compatible in the sense of according with the policymakers desire to maximise social welfare at each point in time The important point is that this equilibrium involves inflation that is high, but not surprisingly high. Therefore, the economy bears the costs of high inflation but does not receive the rewards that would arise from unexpected inflation The solution just described rests on the presence of benefits from surprise inflation, but does not depend on the existence of the expectational Phillips curve. An alternative model recognises that surprise inflation amounts to a capital levy on assets, such are denominated in nominal terms. At a point in time, unexpected inflation works like a lump-sum tax as a device for generating government revenue. Given that other taxes are distorting, the policymaker(and the representative person in the economy) would value the use of this lump-sum tax. Therefore, this model parallels the previous one with the Phillips curve, even though the source nded to incorporate the standard inflation tax or other real effects from anticipated inflation. Then the best rate of inflation need not be
THE ECONOMIC JOURNAL of benefit from unexpected inflation is different. There is an analogous discretionary equilibrium with high inflation, but with no tendency for aspected inflation to be positive or negative the example of the Phillips curve, the incentive to create surprise inflation on the desire to expand economic activity. But this depends turn on some distortions that make the natural rate of output too low. The and transfer programmes are possible sources of these distortions. 2 Similarly, in the example where the government values surprise inflation as a lump-sum tax, there must be derlying environment in which alternative taxes are distorting. In both cases, the existence of initial distortions underlies the prediction of high inflation. Calvo (1978)discusses the general role of existing distortions in these types of models The main point is that the bad outcomes under discretion depend on the presence of these distortions Barro and Gordon(1983b)view the discret equilibrium as a positive theory of monetary policy and inflation present-day monetary arrangements. Aside from predicting highaverage inflation and monetary growth, the model indicates the reactions to changes in the benefits from unexpected inflation or in the costs of actual infation. For example, a rise in the natural rate of unemployment can raise the benefits from lowering unemploy ment through surprise inflation. It follows that a secular rise in the natural unemployment rate will lead to a secular rise in the mean rates of monetary growth and inflation. Similarly, the policymaker would particularly value reductions of unemployment during recessions. The implication is that monetary growth will be countercyclical, although such a policy can end up with no effect on the amplitude of business cycles a higher stock of nominally-denominated public debt raises the benefits from capital levies via surprise inflation. The model then implies that more public debt will lead to higher values of nominal interest rates(although not to higher unexpected inflation). In other words, the prediction is that deficits will be partly monetised. A similar analysis suggests that indexation of the public debt for inflation- which removes some of the benefits from surprise inflation -will tend to lower inflation and monetary growth. This prediction comes from the positive theory of the money-supply process, rather than from direct effects of indexation on the economy. Finally, a higher level of government spending tends to raise the benefits from lump-sum taxation, because the deadweight losses from other taxes would be higher. This change leads again to higher rates of inflation and monetary growth. The endo ry growth implies that government expenditures are inflationary The model assumes that actual inflation is costly, but does not explain the sourceof these costs. Two frequently mentioned possibilities are the administra I See Barro(1983)for an elaboration of this model These taxes and transfers may themselves be warranted as neces counterparts of (valuable) Hence, there is no implication that the government is failing to optimise on the