Barro (1986) makes the case for alternative monetary rules amidst the debate between discretionary and rules-based monetary policies. As posited by Barro, the question between discretionary or rules-based policies is not…
In this respect, this essay will assess the rationale in the Barro-Gordon Model of rules versus discretion to illustrate the relationship between monetary policies and inflation in achieving economic outcomes.
Monetary policies play a crucial role in achieving certain outcomes – low unemployment, high money supply, or low inflation – in the economy. Achieving these outcomes, however, depends on the existing conditions surrounding the economic environment, which is also affected both by an individual’s expectations on future policies and economic conditions and the manner that these expectations are formed (Barro 1984: 1-2). The weight given to individual expectations, in this regard, highlights the monetary rules versus discretion debate under monetary economics such that as illustrated by the Barro-Gordon Model, an individuals’ expectations regarding future policies can either offset the effects of inflation under discretionary policies or achieve the zero inflation outcome through rules (Barro and Gordon 1983).
Contrary to the traditional debate between rules and discretion focused on a policymaker’s capabilities and objectives; the Barro-Gordon Model is based on Kydland and Prescott’s work that identifies rules as a form of commitment similar to public policies and business dealings (Barro 1984: 1). In this respect, a monetary policy will only be as effective as the government’s reputation and its credibility in making a commitment to a policy because assuming that individuals are rational, they will always act in manner that predicts government behaviour and compensate for any losses that they believe will come from it. Hence, under monetary policies, where the output is always a consequent rise or fall in inflation, assuming that inflation is high and individuals are rational, these individuals will always expect a higher inflation rate and immediately adjust to these high rates, eliminating the ...
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