Academic journal article Federal Reserve Bank of St. Louis Review

Reexamining the Monetarist Critique of Interest Rate Rules

Academic journal article Federal Reserve Bank of St. Louis Review

Reexamining the Monetarist Critique of Interest Rate Rules

Article excerpt

Monetarist economists argued long ago that central bank interest rate rules exacerbate macro economic fluctuations, essentially by not allowing the interest rate to respond promptly to shifts in the supply and demand for loans. To support this critique, they pointed to the procyclicality of the money stock. Yet, when there are real shocks and a real business cycle, modern macroeconomic models imply that some procyclicality of money is desirable, to stabilize the price level. A simple interest rate rule illustrates that the monetarist critique can be valid within this model, since the rule exacerbates the response of real activity to real shocks. Other interest rate rules instead limit the macro economy's response to real shocks. But, while these interest rate rules have diverse effects on real activity, there is an important common implication: By smoothing the nominal interest rate in the short run, the rules all lead to increases in the longer-run variability in inflation and nominal interest rates.


Once upon a time, the nature of the short-term nominal interest rate was a central dispute among macroeconomists. Keynesian economists stressed that it was the opportunity cost of holding money. Monetarist economists stressed that the nominal rate was a central part of an intertemporal price, with the real interest rate the equating market for loan supply and demand.

Such divergent perspectives led these groups of macroeconomists to subscribe to different policies for the management of interest rates. Viewing the demand for money as fluctuating substantially over time and viewing the short-term nominal interest rate as principally affected by monetary factors, Keynesian macroeconomists argued for holding the interest rate fixed as economic activity fluctuated or, at least, varying it gradually over time. Viewing loan supply and demand as subject to important real shocks, monetarist economists argued for allowing interest rates to fluctuate more widely, while seeking to control a monetary aggregate for stabilization purposes. More specifically, Brunner (1978), Friedman (1968, 1985), and particularly Peele (1978) argued that the Federal Reserve System's unwillingness to change interest rates over time exacerbated the business cycle, leading the central bank to make the money supply procyclical. (1)

In recent years, macroeconomic analysis has increasingly used small, fully articulated quantitative macroeconomic models to study the effects of alternative monetary policies. In the terminology of King and Wolman (1996), these are the "St. Louis models of the 21st Century," capable of exploring alternative policies in a manner consistent with the recommendations of Lucas (1976). (2) Increasingly, these models are studied with a focus on interest rate rules for monetary policy, particularly variants of the rule put forward by Taylor (1993). In this article, we return to the concerns of Brunner, Friedman, and Poole, studying the effect of some alternative interest rate rules within a modern quantitative macroeconomic model. We are specifically interested in whether monetarist concerns about the exacerbation of the business cycle carry through to modern model economies under alternative interest rate rules related to Taylor's specification. Therefore, in our analysis, we consider three interest rate rules and we explore how each affects the dynamic response of the macroeconomy to two real shocks: shifts in government purchases and productivity. First, we consider an "inflation only" variant of the Taylor rule, in which there is no output gap response. Second, we consider the original Taylor specification. Third, we consider a more dynamically complicated interest rate rule estimated by Orphanides and Wieland (1998), which includes a lagged nominal interest rate term.

To consider how these rules alter the behavior of economic activity, we exploit the fact that there is a "neutral" solution for real activity--the solution that would obtain under flexible prices--that can be brought about by the monetary authority if it fully stabilizes the price level. …

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