Measuring monetary policy: rules versus discretion

Abstract

In this paper, we propose a novel method to measure the strength of commitment versus discretion in monetary policy. We estimate a Taylor-type monetary policy rule with time-varying heteroskedasticity, decomposing the policy into rule-based and discretionary components. Deviations from the committed rule, in form of volatility of a policy shock, are linked to macroeconomic variables, disclosing the nature and strength of discretion of a central banker. We estimate our model for the period 1967–2005 focusing on the determinants of volatility of policy shocks in the USA. The proposed heteroskedastic model provides a better fit to the data than the standard Taylor rule. Inflation has positive significant effects on volatility of shocks in the full sample, pre-Volcker, and Volcker periods, while during the Greenspan era, the degree of discretion is decreasing in headline inflation, but increasing in core inflation. We also find significant positive association between stock market volatility and policy discretion, but no relationship between the shock volatility and output gap.