Rules, Discretion and Reputation in a Model of Monetary Policy*

In a discretionary regime the monetary authority can print more money and create more inflation than people expect. But, although these inflation surprises can have some benefits, they cannot arise systematically in equilibrium when people understand the policymaker’s incentives and form their expeziations accordingly. Because the policymaker has the power to create inflation shocks ex pest, the equilibrium growth rates of money and prices turn out to be higher than otherwise. Ther,zfore, enforced commitments (rules) for monetary behavior can improve matters. Given the repeated interaction between the policymaker and the private agents, it is possible that reputational forces can substitute for formal rules. Here, we develop an example of a reputational equilibrium where the outcomes turn out to be weighted averages of those from discretion and those from the ideal rule. In particular, the rates of inflation and monetary growth look more like. those under discretion when the discount rate is high.