Question

According to the Kydland-Prescott I Barro-Gordon perspective, why does the inflation rate rise with a shift from a rules-based to a discretionary policy regime?

Answer 1

Kydland-Prescott reinforces argument of Friedman’s on favoring constant monetary growth rules with a rational expectations and natural rate model. They stated that a policy rule is better compared to a discretionary policy which optimizes at each period. The similar arguments were stated by Barro and Gordon however introduces a key innovation. They were of a belief that adoption of the rules can create problems for their lack of credibility if there are no binding legal mechanisms to enforce them. They instead propose fundamental reforms in monetary institutions for the establishment of strict rules such as the monetary constitution or a gold standard.

Kydland-Prescott contributed a politico-economic explanation on the process of process of self-generating inflation. Kydland-Prescott theory stated inflation to be higher when equilibrium unemployment is higher relative to the target unemployment that politicians wants to achieve, however are not able, to attain. Barro-Gordon perspective introduced stabilization policy and supply shocks into the model. Barro-Gordon (and Kydland-Prescottbefore them) shift the problem of inconsistency in time (time lag) from the private sector to the public sector. As the government now acts as an agent who cannot fulfill an optimal plan as a result of its discretionary power causes a inflation rate rise.