There is always a confusion between the formation of the
monetary policy of the central bank_ whether the monetary policy
should be framed on the basis of certain rules or should it be on
the based on certain discretion. If the monetary policy is based on
rules then it has to be clearly specified. On the other hand, if
the policy is framed on the basis of the changes in the economic
activities that takes place on a daily basis, then we can say that
the policy is discretionary in nature.
The factors that support framing of the monetary policy on the
basis of rules are
- There is an element of trust. The decisions based on the rules
are more trustworthy than the one that is based on discretion.
Immediate deviations are unlikely to occur.
- The problems due to time inconsistency are less likely to
occur. The decisions based on the discretion will always have a
tendency to change from the long run plan which is optimal.
The factors that support framing of the monetary policy on the
basis of discretion are
- The macroeconomic model needn't be reliable for framing the
policy based on discretion. But it is not the case with rules.
Reliability of economic model is essential for framing rule based
policy.
- The stability of the economic structure is not necessary for
framing the monetary policy based on discretion. If the economic
structure is unstable then also policy can be framed according to
discretion.
- The forecasting of every economic variable is not possible by a
rule based policy. Whereas the discretionary monetary policy is
based on day to day activities.
- Discretionary policy allows room for judgement, whereas a rule
based policy don't allow this. The policies can be adjusted in
accordance with the judgement.
- Like the policies framed with the help of rules, the policies
framed with the help of discretion are also trustworthy.
The proposed constrained discretion policy making is a path that
lies in between the rules and discretion. It can be implemented in
the following ways:
- By framing rule targeting a particular variable. This will
solve the time inconsistency problem as the policies framed will
not deviate too far from the target variable.
- The after effects of a monetary policy should be clearly told.
That means how the policy will change in accordance with the
changes in the economic scenario.