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CHAPTER THIRTEEN
Rules versus Discretion —
Can Policymakers Stick to Their Promises?
I. Fundamental Issues
1. What are the ultimate goals of policymakers in open economies?
2. What are the main problems with discretionary policymaking?
3. Why is policy credibility a crucial factor in maintaining low inflation, and how might nations attain
policy credibility?
4. What is structural interdependence, and how can it lead nations to cooperate or coordinate their
policies?
5. What are the benefits and costs of international policy coordination?
6. Could nations gain from adopting a common currency?
II. Chapter Outline
1. Policy Goals in Open Economies
a. Internal Goals
b. External Goals
2. Rules versus Discretion in Economic Policymaking
a. Time Lags and Rules Versus Discretion
b. Is Policy Discretion Unavoidable?
c. Visualizing Global Economics Issues: The Inflation Bias of Discretionary Policy
d. Establishing Policy Credibility
e. Policy Notebook: Can Unemployment Insurance Substitute for a Conservative Central Banker?
3. Policymaking in an Interdependent World
a. Structural Interdependence and International Policy Externalities
b. Accounting for Interdependence: International Policy Cooperation and Coordination
4. The Pros and Cons of International Policy Coordination
a. Potential Benefits of International Policy Coordination
b. Potential Drawbacks of International Policy Coordination
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5. Optimal Currency Areas and Monetary Unions
a. Optimal Currency Areas
b. Is Europe an Optimal Currency Area?
c. Policy Notebook: The United Kingdom Studies Hard for What Turns Out to Be a Practice Exam
6. Questions and Problems
III. Chapter in Perspective
Chapter 13 returns to a discussion of monetary policy. The primary internal and external goals are first
discussed, followed by an explanation of how the inflation bias that can occur with discretionary
policymaking. The advantages and disadvantages of international policy cooperation and coordination
constitute the second major theme of the chapter. The chapter concludes with a brief discussion of the
characteristics of an optimal currency area.
IV. Teaching Notes
1. Policy Goals in Open Economies
a. Internal Goals
The objectives of national economic policies are termed policy goals. Internal goals include:
 Minimizing inflation and its variability: Text Table 13-1 presents the costs of inflation and
inflation variability.

Maximizing real GDP and reducing its variability:

Maximizing employment and reducing its variability.
Teaching Tip:
Discussion question for students: Can these latter two goals differ? Is maximizing real output
the same as maximizing employment? When would they be different?
Rules versus Discretion — Can Policymakers Stick to Their Promises?
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b. External Goals
External goals include:
 Balancing international payments: Large deficits on international flows of funds can cause
problems for countries.
 Managing the value of the currency in the foreign exchange market: Many central banks
cannot resist the temptation to intervene in the currency markets, if only to limit volatility
(leaning against the wind). Reducing volatility of currency values can reduce business risk.

Teaching Tip:
Recall the tradeoff between freedom to manage domestic monetary policy and the exchange
rate. This tradeoff provides a major motivation for international policy cooperation (see
below).
At times in the past countries pursued mercantilist policies. Under mercantilism, a country
attempts to maximize its exports and eliminate all imports. Special interest groups seeking
protection from international competition sometimes still promote mercantilist ideas today. With
a mercantilist policy, the external goals can become of paramount importance to a central bank.
2. Rules versus Discretion in Economic Policymaking
Discretionary monetary policy means that central bankers use monetary policy to respond to
changing conditions in a countercyclical fashion. Obviously to use discretionary policy effectively,
the bankers must be able to recognize what phase of the cycle the economy is currently in and how
current events are affecting economic performance. The alternative is for a central bank to follow a
policy rule that determines money supply growth or the appropriate interest rate for example.
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a. Time Lags and Rules versus Discretion
All economic policy faces policy time lags. There are three main lags in monetary policy:
 The recognition lag is the time between when the need for a policy action arises and when
the central bank recognizes the need. Problems in collecting and disseminating data and
measurement error complicate this process and lengthen the recognition lag. This lag could
be a few weeks to a few months, or perhaps longer.
 The response lag is the time from when the central bank recognizes the need until the central
bank responds. For monetary policy this lag should be short because most monetary
authorities meet regularly. The typical lag should not be more than a few weeks, although a
lack of consensus could lengthen this lag appreciably.
 The transmission lag is the time from when the central bank responds until the full affects of
a policy change are felt in the economy. This lag is variable and depends on market
conditions and the degree of anticipation, but it can last months or years. The average is
usually quoted at something over 12 months.
 Consequently, the total policy time lag can easily be over a year. This complicates the
process of discretionary monetary policy and brings up the possibility that discretionary
policy actions intended to be countercyclical can indeed be destabilizing in the event that
their effects occur after economic conditions have changed.
b. Is Policy Discretion Unavoidable?
Capacity output is the output level that could be produced if all resources were used to their
utmost. It is possible that central bankers will manipulate monetary policy to achieve capacity
output (perhaps due to political pressures to do so.) Capacity output is higher than the output
level that a nation’s economy produces in the long run. If the central bank tries to force output
above its long run equilibrium point this will result in inflation. This causes what is termed the
inflation bias in discretionary monetary policy. The inflation bias is the tendency for an
economy to experience ongoing inflation as a result of the pursuit of discretionary monetary
policy.
Rules versus Discretion — Can Policymakers Stick to Their Promises?
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Price Level
AS2
AS1
C
P2
B
D
A
P1
AD2
AD1
y1
y*
Real Output
The central bank attempts to increase aggregate demand from AD1 to AD2 to move from point A
to point B to increase real output from y1 toward capacity y*. Because the short run aggregate
supply curve AS1 is upward sloping, this generates inflation. Wage earners recognize the
inflation and push wages up so that the aggregate supply curve shifts up from AS1 to AS2,
bringing real output back to y1, but only after generating inflation because the price level has now
risen from P1 to P2. P2 – P1 is the inflation bias of discretionary policy. Point D occurs if the
central bank promises to not increase aggregate demand, but the public feels the promise is not
credible. Wage earners then push wages up anyway which then creates stagflation (higher prices
and lower real output) and moves the outcome to point D. This implies that point A is an
equilibrium point only if the central bank’s promise not to increase aggregate demand is credible.
This points out the time inconsistency problem, which simply means that even if the central
bank keeps its promise today, it might not tomorrow. Particularly given the policy lags involved,
the time inconsistency problem creates an incentive for laborers to go ahead and seek wage
increases unless there is a policy rule or some other incentive in place that limits central banker’s
ability to pursue discretionary monetary policy.
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c. Visualizing Global Economics Issues: The Inflation Bias of Discretionary Policy
For Critical Analysis: How could a policymaker who currently lacks policy credibility go
about developing it?
See the next section.
d. Establishing Policy Credibility
Solutions to the credibility problem include:
 Constitutional limits on discretionary monetary policy as Friedman has advocated.
 Credibility may be built by establishing an anti-inflation reputation. This is a key point that is
necessary to limit the inflation bias and to maintain a stable currency value, both of which can
be influential in determining the amount of foreign investment a country can attract.
 Employing a conservative central banker. A conservative central banker is one who makes
fighting inflation a higher priority than reducing unemployment.
 Establishing an independent central bank. This entails both political and economic
independence. Political independence is the ability to conduct monetary policy free from
interference from politicians seeking reelection (or any other self-interested goal). Economic
independence is the ability to set its own budget and not be dependent on the political process
for funding. Without economic independence, political independence is unlikely. Evidence
indicates that more independent central banks tend to have lower inflation and lower inflation
variability.
 Utilizing anti-inflation contracts for central bankers. The central banker contract is a legally
binding agreement that holds the central bank official(s) responsible for keeping the national
inflation rate within specified bounds and may include sanctions for failure to do so. New
Zealand apparently employs one of these.
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e. Policy Notebook: Can Unemployment Insurance Substitute for a Conservative Central
Banker?
For Critical Analysis: What are the pros and cons of seeking to reduce inflation by
establishing a generous program of unemployment insurance instead of trying to identify
and appoint conservative central bankers?
If one cannot find a conservative central banker, or if the central bank is not independent of the
political process, then a generous welfare system may make some sense in this context. Cost’s to
society will generally be one of the major problems of increasing unemployment insurance
however. This may also increase the natural rate of unemployment and can reduce real output (or
perhaps increase immigration pressures as in the German Asparagus critical analysis in Chapter
10).
3. Policymaking in an Interdependent World
a. Structural Interdependence and International Policy Externalities
With international trade of all types growing, linkages between economies are becoming more
important. This implies that markets for goods, services and financial assets are becoming
structurally interdependent. This interdependence implies that monetary policy actions in one
country are likely to cause spillover effects in other countries. These international policy
externalities can be negative externalities or positive externalities. The latter are called
locomotive effects. Devaluing the domestic currency provides a simple example of a potential
negative policy externality if the result is an increase in the domestic trade surplus accompanied
by a decrease in another country’s trade surplus. Strategic policymaking can help limit negative
externalities, or perhaps promote positive externalities. Strategic policymaking is conducting
policy in light of the structural interdependencies and accounting for the possible responses by
other countries’ policymakers.
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b. Accounting for Interdependence: International Policy Cooperation and Coordination
International policy cooperation is forming relationships and institutions to collaborate on
policy goals, provide and share information about policy approaches, and share economic data.
The G7 and the Bank of International Settlements (BIS) are examples. The BIS was originally
founded to handle war reparations after World War I. It has since evolved into what is sometimes
termed the central banks’ central bank. It serves as a economic policy and research center, as a
trustee on government loans and perhaps most importantly as a promoter of global financial
regulations. The BIS proposed the international capital standards Basel I, and the recent Basel II,
and continues to provide a forum for implementing safeguards into the global financial system.
International policy coordination is a step beyond cooperation. In international policy
coordination, the different central banks operate as if they were a single entity, jointly
determining national economic policies for the mutual benefit of all parties.
4. The Pros and Cons of International Policy Coordination
a. Potential Benefits of International Policy Coordination
The potential benefits include:
 Internalizing international policy externalities: Coordinating policies can allow central banks
to affect the extent of externalities. For instance, if one country desires to eliminate
subsidies, but fears that its domestic industry cannot compete internationally because a
trading partner subsidizes its firms, then bilateral negotiations can result in simultaneous
elimination of subsidies in both countries.
 Reducing the tradeoff in simultaneously pursuing internal and external policy goals: For
instance, suppose that one country desires to increase its money supply, but not decrease its
currency value against a trading partner. The domestic country can increase its money supply,
while the trading partner also increases its money supply so that the relative supply
conditions of the currencies can be kept the same to help maintain the currency value.
 Gaining support to withstand domestic political pressures: A central bank may be able to
claim that it cannot increase the money supply as the domestic government wishes (this is the
usual case) because of outstanding international agreements.
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b. Potential Drawbacks of International Policy Coordination
The potential drawbacks include:
 A possible loss of national sovereignty: Sovereignty is defined as the nation’s ability to
manage its own resources solely for its own benefit and as it sees fit. A coordination
agreement may limit sovereignty that may induce the central bank to act in ways not in the
best interests of the domestic country, particularly in the short run.
 Other countries in the agreement may not be trustworthy: The text presents the typical
prisoner’s dilemma scenario in Text Figure 13-5 where the two countries can maximize
welfare by not cheating, but one country has an incentive to cheat if the other does not.
 Other policymakers in the agreement may not be competent even if they are trustworthy.
 Even if policy coordination is successful, the result may sometimes be worse than if no
cooperation occurred. The textbook uses the example of a positive spillover effect related to
an increase in aggregate demand in two countries. Due to the inflation bias, the increase in
demand resulted in higher inflation in both countries without increasing real output.
5. Optimal Currency Areas and Monetary Unions
a. Optimal Currency Areas
Recall that a group of countries that adopt a common currency is termed a monetary union. In
theory, the countries adopting the common currency should comprise an optimal currency area.
An optimal currency area is an area where the net costs and risks of maintaining and continuing
to convert separate currencies outweigh the benefits of maintaining separate currencies. The
benefits of maintaining separate currencies are:
 Separate currencies allow a more speedy adjustment to changing comparative advantages.
Suppose that two countries form a common currency area for instance. If relative advantage
shifts to favor Country A over Country B and currencies are allowed to float then the
exchange rate of Country B will fall relative to A, restoring competitiveness to Country B’s
products. If the exchange rate cannot change and labor cannot move to Country A then
sustained unemployment in Country B is the likely result.
 Separate currencies allow a more speedy adjustment to changing relative economies.
Continuing the above example, if inflation in Country B is higher than in Country A, the
value of Country B’s currency will fall, adjusting relative prices back in line.
 Sovereignty is maintained. The above two points indicate that combining the currencies
entails a loss of sovereignty to some extent.
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Advantages to combining currencies include:
 reduced currency conversion costs, which for diversified firms operating in multiple
countries, can be quite substantial,
 reduced currency risk and reduction in currency hedging costs, and
 increased price transparency for products in multiple markets and the resulting increased
competition.
Several factors affect the optimal currency area, but in particular the major determinants are
whether labor and capital are freely mobile within the countries that comprise the currency area
and the extent of economic convergence or divergence among the countries in the area.
b. Is Europe an Optimal Currency Area?
The EMU instituted convergence criteria before any country could join and now has similar
criteria (detailed on page 436 of the text) which applicant countries must meet. The EMU is
probably not an optimal currency area as we have defined it, and the applicant countries certainly
are not. Labor mobility and cultural homogeneity is much lower in the EMU than in the U.S. We
are likely to see regional problems in parts of the EMU requiring transfer payments to certain
areas.
c. Policy Notebook: The United Kingdom Studies Hard for What Turns Out to Be a Practice
Exam
For Critical Analysis: What factors might explain the hesitancy of the United Kingdom to
join the European Monetary Union?
The UK and Denmark have opted out. No doubt, part of their reluctance to join is a fear of loss
of sovereignty that would result. This is particularly true for the UK, which along with the
pound, have long played a key role in international trade and finance. Probably their reluctance
also stems from concerns about the long-term viability of the EMU and the costs of maintaining
it. Concerns about labor mobility in and out of their country (and its desirability) are likely also a
motivating factor. Certainly, it can be argued that the two countries perceive that the benefits of
joining in the common currency do not outweigh the costs and perceived risks.
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6. Answers to End of Chapter Questions
1. To a mercantilist, the greatest “success” would entail maximizing exports and eliminating imports.
Doing this, however, means forgoing gains from trade, which all residents of countries are typically
unwilling to give up. Hence, at least some imports normally occur even in nations where
mercantilism is a reigning idea.
2. The recognition lag is the time that passes between the need for a countercyclical policy action and
the recognition of this need by a policymaker. The response lag is the interval between the
recognition of a need for a countercyclical policy action and the actual implementation of the policy
action. Finally, the transmission lag is elapsed time between the implementation of an intended
countercyclical policy and its ultimate effects on an economic variable. Monetary policymakers often
meet daily and can implement policy changes rapidly, so the response lag is likely to be least
problematic for monetary policy. The most problematic policy time lag is likely to be the
transmission lag, because it can take at least several months for monetary policy actions to exert their
final effects on economic activity.
3. If the central bank’s target level of output exceeds the natural, full-information output level, then
workers and firms will recognize that once wages are set the central bank has the ability to increase
aggregate demand and push output above its natural level. Hence, worker and firms will negotiate a
higher nominal wage to take into account the higher price level that they anticipate will result. The
central bank, in turn, will realize that workers and firms will behave this way, so that if aggregate
demand does not rise, the wage boost will induce aggregate supply to decline and generate higher
prices and lower output. Hence, the central bank induces a rise in aggregate demand to prevent
output from declining, and on net the single result is an increase in the price level. This price-level
increase is the inflation bias. Appointing a conservative central banker entails putting a person in
charge of the central bank who particularly dislikes inflation and who thereby is less likely to boost
aggregate demand. As a result, the inflation bias will be smaller.
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4. This is an accurate statement. The performance of the central banker is based primarily on his or her
ability to achieve a certain inflation target. These contracts permit the central banker to use
discretionary policy, but with an aim to achieve the inflation target.
5. Political independence refers to the freedom that the central bank has to make its own judgments
about appropriate policy actions. Economic independence refers to budgetary freedom for central
banks to be able to implement these policy actions. Yes, both types of independence typically would
be required. One can easily envision situations in which a central bank could not successfully reduce
inflation unless it can make its own decisions and follow through with appropriate actions that affect
its own balance sheet and income statement.
6. The discussion in this chapter indicates that the German leaders were correct. The approach that the
German leaders suggested would create a more conservative central bank that would be less prone to
implementing policies that would create an inflationary bias.
7. If two nations coordinate their policies, then they essentially behave as if the two countries together
constitute a single entity. If they engage in policy cooperation, then they merely share information
about their understanding of the global economic situation they confront, inform one another of their
basic policy strategies, and perhaps provide advance notice of coming changes in their policies.
8. When two nations jointly determine their policies and act as though the two countries together
constitute a single entity, thereby internalizing the spillover effects that their policy actions might
entail. In addition, if each nation’s policymaker has few policy instruments but several goals, then by
working together to coordinate their instrument choices the two policymakers potentially can do a
better job of achieving their objectives. Finally, policymakers in one nation may gain strength to
withstand domestic political pressures when they receive support or counteracting pressures from
policymakers in the other nation.
9. One disadvantage is the loss of sovereignty that international monetary policy coordination entails.
Another is that it is possible that a nation can gain from cheating on its policy-coordinating agreement
with another country, making it difficult to set up such an agreement. In addition, policymakers may
disagree about how their economies function and interact, so they may have different goals and
motivations. Furthermore, it is possible that coordination can heighten the potential for discretionary
policymaking to induce an inflationary bias, thereby worsening the problem.
10. The main argument likely would be a claim that in Europe, the advantages summarized in the answer
to question 8 above outweigh the potential disadvantages summarized in the answer to question 9.