Introduction

This chapter examines one aspect of the ‘rules versus discretion’ (or, more accurately, the ‘precommitment versus discretion’) debate over the conduct of macroeconomic policy. Given that precommitment yields better outcomes than discretion what form should it take?

Much of the literature proposes that precommitment should be in the form of a non-contingent or ‘open-loop’ k percentage money supply rule. The problem with open-loop policies however is that they provide no flexibility for the government to respond to unforeseen shocks to the economy. A feedback rule can provide this flexibility and, in addition, constitutes a form of precommitment.

The use of control theory provides feedback rules which perform this twin function: flexibility and precommitment. One difficulty with contingent rules however is they may prove difficult for a sceptical private sector to monitor. How are contingencies to be distinguished from reneging on the commitment, in which case how can contingent rules be credible?

Monitoring is irrelevant to the credibility question where the relationship between the private sector and the government is modelled as a game of complete information, with the private sector in particular knowing the full nature of the government's calculations. In this case the private sector can evaluate for itself the precommitment rule and deduce the relevant policies for different contingencies. The incentive compatibility of the rule then requires a trigger mechanism on the part of the private sector which ‘punishes’ the government who reneges by only believing in discretionary policy for some ‘punishment period’.