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May/June 1996, 
Vol. 78, No. 3
Posted 1996-05-01

Discretion, Rules and Volatility

by Costas Azariadis and Vincenzo Galasso

Economic models with multiple equilibria have become increasingly useful in analyzing volatility in financial markets and in business cycles. In many of these models, indeterminacy is a result of incomplete financial markets or technological nonconvexities. In this article, the authors identify economic policy discretion to be another distinct cause of indeterminate equilibrium and examine how discretion affects the number of equilibria, as well as their volatility. They also study an environment dominated by constitutional rules, that is, institutions that restrict the freedom to alter policies inherited from the past. In particular, a constitution that gives current policymakers some veto power over changes in future policies endows public choices with an element of precommitment that makes current policy a genuine state variable.