How much discretion should the monetary authority have in setting its policy? This question is analyzed in an economy with an agreed-upon social welfare function that
depends on the economy’s randomly fluctuating state. The monetary authority has private
information about that state. Well designed rules trade off society’s desire to give
the monetary authority discretion to react to its private information against society’s
need to prevent that authority from giving in to the temptation to stimulate the economy
with unexpected inflation, the time inconsistency problem. Although this dynamic
mechanism design problem seems complex, its solution is simple: legislate an inflation
cap. The optimal degree of monetary policy discretion turns out to shrink as the severity
of the time inconsistency problem increases relative to the importance of private
information. In an economy with a severe time inconsistency problem and unimportant
private information, the optimal degree of discretion is none