[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

years, many countries have attempted to reduce the influence of elected politicians
on monetary policy for just this reason.
Rules Versus Discretion Critics of intervention claim that historically, whether
because of politically motivated decisions or simply because of the lags described earlier,
government has actually exacerbated the economy’s fluctuations. When the
government attempts to dampen a boom, its policies aimed at reducing demand
take effect just as the economy is weakening, reinforcing the downward movement.
Conversely, when the government attempts to stimulate the economy, the increase
in demand kicks in as the economy is strengthening on its own, thereby igniting
inflation. Critics of government action such as Milton Friedman thus conclude that
better outcomes would result if policies were based on simple rules rather than on
the discretion of the government policymakers. Friedman proposed that the government
should expand the money supply at a constant rate rather than actively
tailor monetary policy to economic events in the hopes of stabilizing the economy.
According to Friedman and others, by sticking to rules, the government would eliminate
a major source of uncertainty and instability in the economy—uncertainty
about future government policies.
A second argument for rules stresses the importance of commitment. A government
might promise to keep inflation low. But as an election nears, politicians
might be tempted to try to expand the economy a bit to improve their reelection
chances, even though this action will lead to lower unemployment only temporarily
while leaving the economy with higher inflation. Knowing that the government will
face this temptation, individuals will not believe the initial promise to be steadfast;
they will anticipate higher inflation in the future. As we learned in Chapter 37, a rise
in inflation expectations increases current inflation. Lack of credible commitment
to a low-inflation policy may result in higher-than-desired inflation without even a
temporary gain of lower unemployment.
The uncertainty about whether a government will actually carry out a promised
course of action is called the problem of dynamic inconsistency. This problem
arises in many contexts. A city may promise to keep taxes low in order to
attract a new shopping mall. Once the mall is built, however, the city may find it
an irresistible source of tax revenues, despite earlier promises. Anticipating this
change of course, the developers may decide not to build the mall in the first
place.
For another example of dynamic inconsistency, consider the case of a final
exam. Because its purpose is to provide students with an incentive to study the
course material, teachers almost always think it good policy to announce a scheduled
final exam. By the morning of the exam, it is too late to influence whether students
have studied or not—the only thing a teacher has to look forward to is grading
all those exams. So it makes sense to cancel the test. But if students anticipate
this reprieve, they will not study, and announcing that there will be an exam will
no longer have any effect. Few teachers cancel final exams, because they know
that if they do it once, their future students will not prepare for an exam they
expect to be canceled. The teacher has a reputation to protect. Similarly, the desire
to maintain a reputation for doing what they promise can help governments fulfill
their promises.
846 ∂ CHAPTER 38 CONTROVERSIES IN MACROECONOMIC POLICY