Academic journal article Review - Federal Reserve Bank of St. Louis

Targeting versus Instrument Rules for Monetary Policy: What Is Wrong with McCallum and Nelson?/Commentary

Academic journal article Review - Federal Reserve Bank of St. Louis

Targeting versus Instrument Rules for Monetary Policy: What Is Wrong with McCallum and Nelson?/Commentary

Article excerpt

In their paper "Targeting versus Instrument Rules for Monetary Policy," McCallum and Nelson critique targeting rules for the analysis of monetary policy. Their arguments are rebutted here. First, McCallum and Nelson's preference to study the robustness of simple monetary policy rules is no reason at all to limit attention to simple instrument rules; simple targeting rules may have more desirable properties. Second, optimal targeting rules are a compact, robust, and structural description of goal-directed monetary policy, analogous to the compact, robust, and structural consumption Euler conditions in the theory of consumption. They express the very robust condition of equality of the marginal rates of substitution and transformation between the central bank's target variables. Indeed, they provide desirable micro foundations of monetary policy. Third, under realistic information assumptions, the instrument rule analog to any targeting rule that McCallum and Nelson have proposed results in very large instrument rate volatility and is also, for other reasons, inferior to a targeting rule.

Federal Reserve Bank of St. Louis Review, September/October 2005, 87(5), pp. 613-25.


My good friends Ben McCallum and Ed Nelson have written a paper, McCallum and Nelson (2005), with arguably a somewhat destructive purpose. They attempt to contradict the arguments in favor of targeting rules, rather than instrument rules, in positive and normative analysis of monetary policy that I have presented in Svensson (2003b) and previous papers (for instance, Svensson, 1997 and 1999). In their concluding section, they suggest that Svensson (2003b) "does not develop any compelling reasons for preferring targeting rules over instrument rules." They seem to believe that the concept of targeting rules is unnecessary and that instrument rules are all that is needed in monetary policy analysis.

In their struggle against targeting rules, however, McCallum and Nelson seem to face an uphill battle. There is now a rapidly growing literature by many authors that successfully applies targeting rules to monetary policy analysis. This literature includes recent contributions by Benigno and Benigno (2003), Benigno and Woodford (2004a,b), Cecchetti (1998, 2000), Cecchetti and Kim (2004), Evans and Honkapohja (2004), Giannoni and Woodford (2003a,b and 2004), Kuttner (2004), Mishkin (2002), Onatski and Williams (2004), Preston (2004), Walsh (2003 and 2004a,b), Woodford (2004), and others. In the first drafts of Woodford's (2003) book, there were no targeting rules; in the final, published version, targeting rules are prominent. In 1998, at a distinguished National Bureau of Economic Research (NBER) conference on monetary policy rules (Taylor, 1999), Rudebusch and Svensson (1999) was the only paper to use targeting rules; in 2003, at an equally distinguished NBER conference on inflation targeting (Bernanke and Woodford, 2004), several papers used targeting rules and no paper used a simple instrument rule as a model of inflation targeting. A Google search with the string '"targeting rules" AND monetary' gave about 1,700 results in April 2004, about 2,100 in August 2004, and about 5,700 in June 2005. There are, hence, more papers than mine-indeed, some books-that McCallum and Nelson may want to take issue with.1

To be clear: An instrument rule is a formula for setting the central bank's instrument rate as a given function of observable variables. A simple instrument rule makes the instrument rate a simple function of a few observable variables. The best-known example of a simple instrument rule is the Taylor rule, where the instrument rate is a linear function of the inflation gap (between inflation and an inflation target) and the output gap (between output and potential output). Another example is a formula for adjusting the monetary base proposed by McCallum (1988) and Meltzer (1987).2

A (specific) targeting rule specifies a condition to be fulfilled by the central bank's target variables (or forecasts thereof). …

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