Presentation of Barro & Gordon 1983 paper. They find that enforced commitments for monetary behavior can keep inflation rates low.

1. Rules, Discretion and Reputation in a
Model of Monetary Policy
Robert J. Barro
David B. Gordon
American University
ECON-630
Achim Braunsteffer
October 28th, 2015

2. Key Points
• Discretionary regime: monetary authority can print more money and
create more inflation than expected
• “Surprise inflation” not possible when people understand policymaker’s
incentives and form expectations accordingly
• Equilibrium growth rates of money and prices higher than in ideal world
Enforced commitments for monetary behavior can improve matters.
 Barro/Gordon develop an example of reputational equilibrium

3. Model
• Compare discretionary regime, ideal rule, and reputational forces
• Monetary rules can be enforced by policymaker‘s potential loss of
reputation
1. Policymaker‘s Objective
 Reflecting preferences of representative private agent
 Benefits from positive inflation shocks, but costs attached to higher rates of inflation

4. Model
2. Benefits from Surprise Inflation (π 𝑡 > π 𝑡
𝑒
)
 Expansion of economic activity (Phillips Curve, lower unemployment)
 Reduction in the real value of the government‘s nominal liabilities
3. Costs of Inflation
 Rising with π 𝑡
 Direct costs of changing prices
 Model predicts a lot of inflation if actual inflation is not perceived as costly

5. Model
4. Setup
 Cost for each period
 Policymaker‘s objective
5. Discretionary Policy vs. Rule vs. Cheating and Temptation
3) Discretion
2) Rule
1) Cheating
𝒛 𝒕 =
𝒂
𝟐
𝝅𝒕
𝟐
− 𝒃 𝒕 𝝅𝒕 − 𝝅𝒕
𝒆
, where a, 𝑏𝑡 > 0
min 𝑍𝑡 = 𝐸 𝑧𝑡 +
1
1 + 𝑟𝑡
𝑧𝑡+1 +
1
(1 + 𝑟𝑡)(1 + 𝑟𝑡)
𝑧𝑡+2 + ⋯
𝑧𝑡 =
1
2
𝑏²
𝑎
𝑧𝑡
∗
= 0
𝐸( 𝑧𝑡) = −
1
2
𝑏2
𝑎
𝜋 𝑡
∗
= 0
𝜋 𝑡
∗
=
𝑏
𝑎
𝜋 𝑡
∗
=
𝑏
𝑎

6. Enforcement
 Temptation < Enforcement
 Ideal Rule (zero inflation) is
NOT enforceable due to
higher temptation
 Best enforceable rule is
weighted average of ideal rule
and discretion
 Modifications: contingent
rules and optimal length for
punishment interval
𝑬 𝒛 𝒕
∗
− 𝒛 𝒕 < 𝑬 𝒒 𝒕( 𝒛 𝒕+𝟏 − 𝒛 𝒕+𝟏
∗
)

7. Best Enforceable Rule
 Intersection of curves for temptation and enforcement
 Weighted average between the ideal rule, 0, and discretion
𝑏
𝑎
 High rates of discount (small values of 𝑞) implies relatively high weight
on discretion and a high inflation
 Rising benefits attached to an inflation shock ( 𝑏 ↑) or inflation becoming
less costly (𝑎 ↓) lead to higher inflation
𝟏 − 𝒒
𝟏 + 𝒒
𝒃
𝒂

8. Critique
• Harbinger of rule-based decision making (with Kydland & Prescott) as
well as more transparency and independency of central banks
• BG see variance of inflation as costly, not inflation by itself
• Rational expectations do not hold in real world
• No empirical foundation for objectives and functions
• Outcome depends on the discount rate and perception of costs of
inflation
Inflation targeting better strategy to minimize variance in inflation