The conventional and new inflation bias theories present two distinct facets to explain the outcome of excess inflation without output gains by a discretionary central banker. First is the temptation to achieve a higher than potential output, and, second is not to let it falter. The authors explicitly account for these two distinct dimensions in empirical formulations both exogenously and endogenously. Specifically, the purpose of this paper is to investigate what monetary discretion can and cannot do in terms of dual objectives – inflation and growth – across boom and bust cycles, both directly and indirectly.
(i) Segregate the economic activity into boom and bust cycles; (ii) Explicitly account for the two dimensions of conventional and new inflation bias theories; and (iii) model and estimate the direct and indirect effects of monetary discretion across business cycles.
The results indicate considerable asymmetries in the effects of monetary discretion and distribution thereof across objectives and cycles. The direct impact of monetary discretion tends to induce significantly higher inflation in boom and bust cycles, while it exerts a positive but insignificant effect on output. The inflation effects are more pronounced in boom than bust cycles and vice versa are the output effects. The indirect effects on output via inflation are significantly pernicious, which are more pronounced in expansions than recessions.
In a nutshell, instead of benefiting, monetary discretion tends to harm in terms of both the dual policy objectives, which cautions about its well calculated and constrained use only.
The views expressed are those of the authors and may not be associated with their employer in any way.
Hayat, Z., Ahmed, J. and Balli, F. (2019), "What monetary discretion can and cannot do under boom and bust cycles? Evidence from an emerging economy", Journal of Economic Studies, Vol. 46 No. 6, pp. 1224-1240. https://doi.org/10.1108/JES-03-2018-0114
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