Monetary and Fiscal Policy

Monetary Policy: Alternative Approaches

Hot Topic: Should Monetary Policy Be Made by Rule or Discretion? Page 1 of 2

Monetary policy is a powerful tool. Small changes in the money supply can affect interest rates, the
price level, and touch every aspect of the macro economy. So, is monetary policy best governed by
rules, so that it’s predictable, or is best left completely to the discretion of central banks, so they
can respond to trouble as it arises? Rules or discretion? It’s an old debate, and we won’t settle it
here. We can, however, look more closely at the points of the argument.

Let’s start with monetary policy rules. What might they look like? Well, they might be specific
targets for key variables like interest rates or inflation. For instance, in the United Kingdom the
Bank of England follows an inflation rate target. The Chancellor of the Exchequer, an elected official
who’s the head of the Bank of England, governs the inflation rate by targeting it at some level, say
2%, and if the inflation rate goes above that target it is the Exchequers responsibility to restrict the
growth of the money supply until prices come within the acceptable range.

We can also have rules that target a combination of variables, like the Taylor Rule, often discussed
by economists. The Taylor rule says shoot for a target for the real interest rate, say 2%; however,
if a gap opens in real gross domestic product so that it falls below its full employment level, then
stimulate the economy by increasing the money supply. Also, however, keep an eye on inflation,
and if it goes above its target, say 2%, then restrict the growth of the money supply so as to bring
inflation under control. You could have a Taylor rule, you could have an inflation target, the idea
here is just some rule that markets can count on.

Now, on the other side, you might say that discretionary policy could be very good for the economy.
After all, things happen that require quick responses that may be outside of some ban specified by
law. For instance, it is argued by many economists that the rules the Fed was bound by during the
time of the Great Depression made the Great Depression worse by forcing the Fed to restrict the
growth of the money supply at the very time that people were trying to take money out of banks
and creating a liquidity crisis that closed banks and plunged the economy into despair. In modern
times, the Fed was able to respond very flexibly when the traumatic feeling in the economy after the
attacks of September 11, 2001 sent people to their banks withdrawing money out of fear and the
Fed pumped liquidity into the system so that people could get the cash that they wanted. In fact,
the Fed made public announcements that plenty of liquidity would be available and there would be
no runs on banks. This kind of flexibility in the event of an emergency is very, very good for the
economy and made it possible for us to avoid banking trouble.

So, on balance, which is better, the kind of flexibility that responds rapidly or the kind of rules that
make things predictable? It depends on what you believe the biggest worries are. Some of the
biggest arguments against flexibility are that it leaves monetary policy subject to being co-opted by
politicians. After all, politicians at election time want people to feel good about the economy in the
short-term, and they want to pump up the money supply, lower interest rates, and have a lot of
easy credit. However, too much of that and in the long-run you’ve got a big hang over which can
result in a lot of inflation. Also, there’s the concern about lags. If you’re trying to target
the…making changes in the economy, small tacking and adjustment, well, how do you know that the
problem today will persist tomorrow? You’re responding to an output gap but it may be closing for
other reasons, and if you pump up the money supply to stimulate the economy, it may hit too late,
too heavily, and create inflation. The problem with discretion, it gives too much power to politicians
and the lag’s unpredictability make it difficult to fine tune.
Monetary and Fiscal Policy
Monetary Policy: Alternative Approaches
Hot Topic: Should Monetary Policy Be Made by Rule or Discretion? Page 2 of 2

On the other hand, there are problems with rules. For one thing, you lose flexibility. It was the
rules the Fed was following that made the Great Depression worse perhaps. More over, it’s difficult
to specify the right rules. What is the right level for inflation? And a rule like the Taylor rule is
difficult to come up with and difficult to implement in practice.

Rules and discretion both have good things going for them and yet neither of them is so definitively
right for running monetary policy that it’s been able to vanquish the other. We’ll continue this
discussion probably for a long time about rules and discretion, and the reason is monetary policy is
so important to the economy we want to do it right.