For half a century now, the “rules versus discretion” debate in monetary economics has focused on the so-called “time inconsistency” problem. The problem is that, although a discretionary central bank might promise not to allow the inflation rate to rise above zero (or some other ideal value), the fact that an inflation “surprise” can boost employment and output in the short run will tempt it to break its promise. Realizing this, market participants will anticipate higher inflation. The long-run result is a higher inflation rate with no improvement in either employment or output. By limiting the central bankers’ options, a monetary rule solves the time inconsistency problem.
An earlier rules-versus-discretion debate had taken place in the 1920s and 1930s.1 The later one, which was inspired by the stagflation of the 1970s, differed in that it was influenced by the New Classical revolution that was taking place around the same time. Consequently, the later critics of monetary discretion, including Finn Kydland and Edward Prescott, Guillermo Calvo, Benn McCallum, Robert Barro and David Gordon, and John Taylor,2 differed from their predecessors by building their arguments on the premise that central bankers were both well (if not quite perfectly) informed and well intentioned. Discretion, according to them, leads to less than ideal outcomes not because central bankers are ignorant or misguided, but because of misaligned incentives.