Discretion vs Rule: The eatery edition
Posted January 28, 2008on:
What do the Reserve Bank and eateries have in common? Both implement rule based policies instead of discretionary policies and both suffer criticism from their clientèle for doing so even though it is in the clients ultimate interest.
I noticed this today when I went to get some food for lunch. A man in front of me was trying to get cash out, when there is a sign that says “no cash out” at the counter. The man was irritated by this rule, he wanted cash and there was cash in the till. The service person tried to explain to him that if they let people get cash out, then they ran out of change in the counter, which causes delays later in the day – furthermore, if they give him cash they run the chance that other people may begin expecting that they can get cash out, and employees would feel more obliged to. As there was a cash machine just outside, the cost of getting the cash somewhere else was very low for the man, however the delays later in the day would have been costly for both the firm and the consumers involved. In this case, the rule improved the social outcome – any deviation from this rule may change peoples beliefs and lead to a case where most people are worse off.
The reasoning behind the eatery’s choice to prevent cash being taken out mirror the situation the Reserve Bank follows. If monetary policy is rule based, households and firms know interest rates will increase at a certain inflation rate, and they will set prices accordingly. If we have a discretionary monetary authority then they may be unable to commit to a given path for monetary policy – we may have time inconsistency. In this case, the monetary authority may know that it must keep rates high now and in the short term future to control inflation, however when it reaches that future it decides that the cost appears too high to keep price increases in this period down. If this is the case, consumers will not believe that the Bank will be hard on inflation, and so they will set higher prices as a result – creating more inflation than we had in the rule based case.
Central Banks, such as the RBNZ, try to achieve the rule based outcome by setting inflation targets and being single minded with inflation. Once they begin discussing things such as output, and exchange rates, then price setters start to doubt the Bank’s commitment to keeping inflation low, which leads to higher ‘inflation expectations’ – in turn leading to higher inflation.
This is the common argument for rule based monetary policy, something I think I subscribe to relatively strongly (as strongly as an economist can subscribe to anything 🙂 ). My question is, in what way may the rules practiced by the eatery and Central Banks be suboptimal?