Academic journal article Independent Review

Some Political Economy of Monetary Rules

Academic journal article Independent Review

Some Political Economy of Monetary Rules

Article excerpt

In this paper, I evaluate the efficacy of various rules for monetary policy from the perspective of political economy. I present several rules that are popular in current debates over monetary policy as well as some that are more radical and hence less frequently discussed. I also discuss whether a given rule may have helped to contain the negative effects of the recent financial crisis. My political economy perspective, to be discussed in much more depth in subsequent sections, evaluates political-economic proposals by taking into account both incentive and knowledge problems. I focus on how such rules function, the conditions under which they can be expected to achieve macroeconomic stability, and the plausibility of implementing them should the desire to do so arise.

The importance of securing an institutional environment conducive to effective and responsible monetary policy has been made apparent by the 2008-2009 financial crisis. There is disagreement over what role monetary policy played in the crisis, however. Some contend that overly loose monetary policy helped fuel an unsustainable boom that would inevitably result in a painful recession (e.g., Horwitz and Luther 2011; Beckworth 2012; White 2012). Others argue that monetary policy was not responsible for creating an unsustainable boom, but it was responsible for the ensuing bust through a failure to act decisively once it became obvious that financial markets were distressed (e.g., Sumner 2011, 2012; Hetzel 2012). The consensus is that monetary policy bears some of the blame for the recession and lingering economic malaise. To prevent such calamities in the future, policy makers must have the tools to determine which policies and institutions constitute sound monetary policy. This paper provides these tools.

I begin by presenting the case for rules-based monetary policy. After discussing some recent empirical studies suggesting that the financial crisis occurred during an era of ad hoc monetary policy (thus supporting the superiority' of rules), I present the theory behind the desirability of rules-based monetary policy. The second section covers four monetary-policy rules that could be implemented without significant changes to current monetary institutions--namely, central banks: Milton Friedman's k-percent growth rule, John Taylor's interest-rate rule, Bennett McCallum's monetary base rule, and inflation targeting. Whereas these four rules may be seen as commandments passed down to the monetary authority', the more radical rules I consider in the third section--nominal income targeting and free banking--would fundamentally change the nature of the monetary authority itself. The paper concludes by summarizing the results and calling for a reorientation of modern macroeconomic and monetary debate to emphasize the rule of law rather than economic control.

Rules versus Discretion in the Monetary Authority

In the vast majority of advanced economies, the institution responsible for conducting monetary policy is the central bank. (1) Ideally, the central bank adjusts the supply of money in the economy whenever necessary to act as a stabilizing force against the possibility of monetary disequilibrium. However, it is an open question what means a central bank ought to employ in order to achieve the desired stability in the monetary economy. The most important issue is whether the central bank should be given a firm rule that dictates what actions it can take to stabilize the economy or should be allowed discretion to perform monetary policy as it sees fit. It should be noted that a binding rule does not need to be a precise mathematical formula. A good monetary-policy rule specifies plans of action, depending on contingencies, on which the central bank cannot later renege.

The empirical literature on rules versus discretion in monetary policy is enormous. Rather than conduct an exhaustive literature review, I discuss briefly some recent arguments to provide a frame for the theoretical discussion to follow. …

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