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

Considering a terrible dilemma

Here’s an illustration of the rules-or-discretion dilemma at work.

Imagine that (God forbid) your parents are kidnapped by terrorists while on holiday. The kidnappers demand £10 million in order to release them. You love your parents but you don’t have that kind of cash. You’re a British citizen, so you ask the UK government to help you negotiate the release. The friendly people at the Foreign Ministry agree to send their top hostage negotiator. Unfortunately, no amount of sweet-talking is going to convince the kidnappers – they want to see the money, as it were.

Tired of waiting, you decide to go straight to the top. You petition the Prime Minister directly and explain that in the big scheme of things, ten-mil is a small sum to pay for the safe release of your parents. The PM listens sympathetically (the situation even brings a tear to her eye) and explains that if it were up to her discretion she’d pay the ransom. But she explains that she’s bound to the policy rule of not negotiating with terrorists in the hope of deterring future hostage-takers.

Clearly this is devastating news, seems harsh and you’d never agree, but from the wider viewpoint it can be seen as the least bad course of action.

We now spend a bit of time making clearer the distinction between policy rules and discretionary policy, illustrating some different types of each approach.


Allowing the rules to rule


When policy makers follow rules, they are attempting to tie their hands so they have to follow through on their promises; they establish these rules so people will believe that the policy makers will do what they’ve promised. This is the main benefit of following rules: it gives policy makers credibility. A downside of following rules is that policy makers may face situations where they need flexibility to respond effectively to some unforeseen economic problem. Ultimately, whether to follow a rule or have discretion is a matter of judgement.

Here we discuss three examples of policy rules: balanced budget rule, inflation targeting and always repaying your debts.