Rules or Forward Guidance versus Discretion in Monetary Policy, Evidence from two Behavioral Experiments

Abstract

This paper examines the impact of rules or forward guidance versus unpredictable discretion in monetary policy on economic performance with two behavioral experiments. It simulates two distinct environments for investment decision-makers: one characterized by a fixed interest rate and another with variable interest rates. When the central bank deviates from clear and transparent rules, its monetary policy becomes unpredictable for economic decision-makers, which hinders the efficient functioning of the economy. In the discretionary experimental scenario, fluctuations in interest rates resulted in monetary business cycles. Consequently, the Wicksell hypothesis was confirmed by the experiment: errors made by the central bank in controlling interest rates can trigger economic fluctuations. If central banks do not communicate their policies clearly or do not apply transparent rules, this will cost jobs and growth.