Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Following Rules or Using Discretion: Two Approaches to Economic Policy


In This Chapter


Pitting rules against discretion


Discussing the problems of discretionary policy


Improving your reputation with rules
Imagine that you’re on a diet – or perhaps just think about the one you’re already on. To lose weight you need to follow the rules: a maximum number of calories each day; no carbs or all carbs; watch the fat and don’t feed the gremlins after midnight. These rules – you can see them as comprising a policy – are crucial to your dieting success. But you also face other pressures: your own darned appetite, your spouse who likes you ‘plump and friendly, not thin and grumpy’ and the upcoming office Christmas dinner at which colleagues are sure to push you into letting go. These pressures tempt you to throw those pesky rules out the window! Or in other words, you’re tempted to use your discretion.

Now relate these competing approaches of following rules or exercising discretion to macroeconomics, and you have the crux of this chapter: whether policy makers should carry out economic policy by following a fixed set of rules or whether they should be free to use their discretion.

In this chapter we describe a number of areas of macroeconomic policy that feature a tension between policy rules and discretion. We discuss the two options in detail, including some types of each, and lay out some problems with discretion that lead us to advocate rules over discretion in most situations. We describe the advantages that policy makers gain by following rules, notably increasing their credibility.

Introducing the Rules versus Discretion Debate
In the 20th century, macroeconomists realized that policy makers might be better off having to follow rules rather than having the ability to change their decisions whenever they want – that is, to have discretion.

This is quite a profound and counterintuitive realization. On the face of it, discretion looks superior to rules because by having discretion you can always make the same choices as those dictated by the rules. At the same time, discretion gives you many more options. So you might think that at the very worst, discretion would give you the same outcome as rules, and in most cases, discretion should give you a better outcome.

However, in this chapter you see that this intuition is wrong. Having discretion changes others’ expectations about what you are likely to do. This leads to what economists call the time inconsistency of discretionary policy – basically, where it’s no longer in your interest to follow through on what you said you were going to do. Don’t worry if that sounds confusing. All will become clear shortly!

Here’s an in-a-nutshell comparison of the two approaches:


Rules-based policy: When conducting economic policy via rules, policy makers announce in advance how policy will respond to any given scenario in the future. As time unfolds, they stick to their announcements
– in essence doing what they said they would.


Discretionary policy: Here, policy makers aren’t tied to preset rules and can exercise their own discretion at any point in time. They aren’t committed to anything, including any past announcements they may have made.

For a description of a dilemma that we hope you never face but that illustrates the two approaches in a life-at-stake scenario, see the nearby sidebar ‘Considering a terrible dilemma’.