Rules versus Discretion: A Reconsideration ABSTRACT In this paper, I evaluate the relative merits of rules versus dis- cretion in making monetary policy, from both empirical and theoretical perspec- Poole, William. © 2020 by the Board of Trustees of Leland Stanford Junior University | Privacy Policy, Reducing Carbon Emissions with Nuclear Power, "John Taylor on Wages, U.S. Economy and the Taylor Rule" on Bloomberg, “Central Bank Models: A Key to Future Monetary Policy” by John Taylor, “A New Opportunity for Monetary Reform” by John Taylor, “Unconventional Monetary Policy, Normalization, and Reform” by John Taylor, "Rules for International Monetary Stability: Past, Present, and Future" by Michael D. Bordo and John B. Taylor, "The Taylor Rule and the Transformation of Monetary Policy" edited by Evan F. Koenig, Robert Leeson, George A. Kahn, “National and International Monetary Reform,” chapter by John B. Taylor in Blueprint for America. Until 1977 the general argument for monetary rules suffered from the apparent dominance of discretion: if a particular monetary policy was desirable, it could always 09 adopted by discretion. Two case studies—German unification and the 1990 oil-price shock—that had a bearing on the operation of monetary policy in recent years are used to illustrate how such a policy rule might work in practice. The conclusions deal explicitly with the rules versus discretion issue. Rules, Discretion, and Reputation in a Model of Monetary Policy. Rules-based monetary policy gives a central bank a strict set of guidelines that dictate its future actions. International Encyclopedia of the Social Sciences. 1993. ... Let's start with the monetarist and new classical arguments in support of policy rules for the conduct of monetary policy and balancing the budget. Comment. Tn the context of monetary policy, a rule is a restriction on the monetary authority’s discre-tion. American Economic Review 38 (3): 245–264. Chp16 6 Rules vs Discretion Brad Kells. If wage and price rigidities are only slight, then a rule might work, but it would require the absence of substitutes such as equity or bonds; it would also require that loans be held for long periods so that repayment on principal is not required. 1983a. Milton Friedman believed that the Federal Reserve did not use its discretion to act when the money supply declined by a third during the 1929–1933 period, turning a garden-variety recession into the Great Depression. The central bankers and policy makers have always been mystified by … Arrow, Kenneth. Economists are divided over whether rules or discretion is the best policy for managing the economy., "Rules Versus Discretion A Monetary and Fiscal Framework for Economic Stabilization. A decision maker such as the Federal Reserve analyzes the problem at hand, and decides on the best policy action to take. "Rules Versus Discretion A rule involves the exercise of control over the monetary authority in a way that restricts the monetary authority’s actions. 1948. Rules versus Authorities in Monetary Policy. (October 16, 2020). The 5 percent rule, however, runs up against rigidities and lag effects in the economy, which are short run in nature. The purpose of such rules is to prevent government from trying to manage aggregate demand. Sound monetary policy is essential for strong economic growth and stability. The debate between rules and discretion in economic policy was first introduced in 1936 by Henry Simons in a paper titled Rules Versus Authorities In Monetary Policy. The most debatable topic in the conduct of monetary policy in recent times is the Rules versus Discretion controversy. ." To cover the international scene as well, Friedman complemented the 5 percent rule with a flexible exchange rate. The introduction of the notion of dynamic inconsistency made a stronger case for rules, the final sections analyze tine case for rules rather than discretion in the light of recent game theoretic approaches to policy analysis. Later, Milton Friedman extended the argument, noting that real-world policy-makers have imperfect information and imperfect tools; so, even the best-intentioned attempts to combat fluctuations could end up destabilizing the economy. 1990. The idea of ‘rule-based’ monetary policy is actually relatively old. The discussions raised a huge number of interesting ideas, among which was the question of rules vs. discretion in monetary policy. Macroeconomic Policy in a World Economy: From Econometric Design to Practical Operation. Loading... Unsubscribe from Brad Kells? Journal of Economic Perspectives 20 (4): 3–28. The debate of rules versus discretion in economic policy has its origin in the writings of Henry Simons at the University of Chicago. People have expectations about the tax policies of different administrations. The issue became more complicated in the short run when interest rates, a mostly Keynesian variable, turned up significant. Poole, William. For Simon, such a systemic policy appears paradoxical, as it would require an intelligent monetary system on the one hand, and credibility of rules on the other. Friedman, a student of Simon, moved the research forward by articulating two rules on the money supply, the k-percent rule, and a Friedman rule, which he later referred to as the “5 percent and the 2 percent rules,” respectively (Friedman 1969, p. 48). stagflation A combination of a weak economy (stagnation) and inflation. In the 5 percent rule, “the aggregate quantity of money is automatically determined by the requirements of domestic stability” (Friedman 1948, p. 252). He likens a rule to the choice of using rules to fly a plane rather than letting the pilot have his or her way of navigating. The debate of rules versus discretion in economic policy has its origin in the writings of Henry Simons at the University of Chicago. Rules Versus Discretion . Journal of Political Economy 44 (1): 1–30. Statistics and Economic Policy. Then, copy and paste the text into your bibliography or works cited list. As more sophisticated models evolved, policy rules became hard to eliminate, and according to Finn Kydland and Edward Prescott, they could improve social optimum. View Lecture 10. Featured Publication Section VI examines some of the international implications of anti-inflationary monetary policies. 8 thoughts on “ Rules versus discretion in monetary policy ” James I. Hymas October 19, 2007 at 7:48 pm. ." A decision improves with time and experience, which requires information that is available only sequentially. Academics and policymakers debate whether central banks should follow a predetermined, fixed rule or should have discretion in monetary policy. Discretion A rules-based monetary policy is more effective in promoting economic growth and stability than a discretionary monetary policy. One of the most important contributions to this … 1957. De Marchi. Once people have some knowledge of such changes, they adjust their expectations and set into motion a series of iterative changes that may or may not converge to an equilibrium given the current state of the economy. "Rules Versus Discretion About the author Rules Rather Than Discretion: The Inconsistency of Optimal Plans. Taylor extended his policy rule to price and nominal income rules for the open economy under fixed versus flexible exchange rates. International Encyclopedia of the Social Sciences. Modern Macroeconomics in Practice: How Theory Is Shaping Policy. Monetarism is an economic school of thought that emphasizes minimal government intervention into the marketplace and the importance of the money supp…, rule / roōl/ • n. 1. one of a set of explicit or understood regulations or principles governing conduct within a particular activity or sphere: the r…, Pocket calculators only came into common use in the 1970s. Pick a style below, and copy the text for your bibliography. gives you the ability to cite reference entries and articles according to common styles from the Modern Language Association (MLA), The Chicago Manual of Style, and the American Psychological Association (APA). The danger with rules is the tendency to substitute administrative authority for rules, which tends to impair competition and expand government activities. Ann Arbor: University of Michigan Press. SEE ALSO Arrow, Kenneth J.; Central Banks; Economics, Keynesian; Exchange Rates; Friedman, Milton; Great Depression; Macroeconomics; Modigliani, Franco; Monetarism; Policy, Monetary; Taylor Rule. Rules vs discretion_d25aa00fdff38521b84d47dc746d9956.pdf from ECO 305 at The Chinese University of Hong Kong. Simons, Henry C. 1936. The monetarist’s preferred habitat is the long run, managing the economy through simple rules of the money supply. Monetary policy refers to the Federal Reserve's work with the money supply to influence the economy. William Poole lauds a Taylor Rule that can be refined, much like a scientist would refine a constant. Monetary policy is often only noticeable when the Federal Reserve gets it wrong, as it has several times in recent history. Within the “Cite this article” tool, pick a style to see how all available information looks when formatted according to that style. Henry Simons (1936) first raised this issue as a choice between rules and authorities, terms little different than those used in recent discussions. ." A currency plus demand-deposit definition is not sufficient for rules to work because people hoard and dishoard money, many “near money” substitutes may exist, or wages and prices may be rigid. Just as default rules may be useful in minimizing consumer errors, monetary rules can serve to minimize errors of monetary policy. Econometrica 25 (4): 523–531. 3 Rules vs. International Encyclopedia of the Social Sciences. Robert J. Barro and David Gordon argued that people would adjust their expectation of inflation to eliminate surprise inflation, creating a potential for higher money supply and inflations in equilibrium. A rules-based monetary policy is more effective in promoting economic growth and stability than a discretionary monetary policy. Robert M. Solow and John B. Taylor, 78–88. monetary policy the latter is typically used to refer to the clarity with which the private ... "Rules vs. In addition to the MLA, Chicago, and APA styles, your school, university, publication, or institution may have its own requirements for citations. Journal of Political Economy 91 (4): 589–610. 1969. Abraham Hirsch and Neil De Marchi examined ruling out common elements in a variety of results tested in order to help identify money as the cause of price changes. The debate over rules versus discretion is not settled empirically. Journal of Political Economy 85 (3): 473–492. Cambridge, MA: MIT Press. 1999. V. V. Chari and Patrick Kehoe found that as of 2002, approximately twenty-two countries use some form of rule-based policy. By definition rules are normative, but some rules are descriptive, meaning that they predict values close to what the authorities actually allow. Discretion requires delegating responsibilities to economic institutions such as the Federal Reserve to decide macroeconomic goals and policies as they see appropriate. Kydland, Finn E., and Edward C. Prescott. New York: Norton. In monetary policy, discretion is essential to offset output fluctuations in Keynesian frameworks. Such method of difference testing, coined by John Stuart Mill, cannot be exhaustive. Journal of Monetary Economics 12: 101–121. A change in administration leads people to change their expectations and their current decisions. Therefore, that information is unavailable for most content. We all agreed that a rule-based system would be a major improvement on the existing system. Discretion" after Twenty-five Years - 13 strument there exist equilibria in which the threat of reversion disciplines central-bank behavior, but no reversions actually occur along the equilib- rium path. The current monetary regime in the UK, and many other major economies, is known as flexible inflation targeting. Quarterly Journal of Economics 84 (2): 197–216. ECO305 Lecture 10. The Optimum Quantity of Money. Friedman, Milton 1912-2006 Rules may help to anchor inflation expectations, while discretion may be useful when there are unforeseen circumstances. | Lucas M. Engelhardt - Duration: 45:31. Cite this article Pick a style below, and copy the text for your bibliography. monetary policy the latter is typically used to refer to the clarity with which the private ... "Rules vs. He found that the nominal income rule outperformed the price rule. © 2019 | All rights reserved. Sound monetary policy is essential for strong economic growth and stability. If policy rules are implemented, such expectations-driven inflation would not occur, but policy makers would have an incentive to break the rule—cheating—because higher inflation means less unemployment and more growth, according to the Phillips curve. In The Optimum Quantity of Money and Other Essays. A policy rule can be specific as fixing the quantity of currency and demand deposits, or general as when the Federal Reserve announces to the public the course of action it will take for various states of the economy, putting its reputation behind it. Discretion" after Twenty-five Years * 13 strument there exist equilibria in which the threat of reversion disciplines central-bank behavior, but no reversions actually occur along the equilib- rium path. Over time more ideas for monetary policy rules have been suggested and the design of rules has improved greatly. the statesmen, and The time-(in)consistency literature, launched bu Kydland and Prescott (1977), shows that discretion-based solutions would be the first-best in terms of agents’ utility, but they are not time-consistent. What would cause the Federal Reserve to adopt a discretionary policy? versus discretion” as explained in Taylor and Williams (2011); it was “rules versus chaotic monetary policy” whether the chaos was caused by policy makers’ discretion or simply exogenous shocks like gold discoveries or shortages. Optimal Choice of Monetary Policy Instruments in a Simple Stochastic Macro Model. Discretion may better serve the public interest when the environment is uncertain and policy- … The definition of money and a stable velocity-of-circulation function are necessary for empirical investigation. . International Encyclopedia of the Social Sciences. Keywords: Rules vs. discretion, time inconsistency, optimal monetary policy, inflation targets, inflation caps JEL Classification: E5, E6, E52, E58, E61 Suppose that society can credibly impose on the monetary authority rules governing the conduct of monetary policy. In Inflation, Unemployment, and Monetary Policy, eds. DISCRETION. Some macroeconomists thus have argued in recent years that monetary policy should be ‘rule-based’ rather than discretionary, that is, Central Bankers strictly would have to follow some kind of monetary policy rule without the authority to deviate from it. Although rules can be set up in an equation form, such as the Taylor Rule, they require variables such as the natural level of output and expected prices that are only approximate. Chari, V. V., and Patrick J. Kehoe. This rule closely approximates Federal Reserve policy during the past several years. The long-run 2 percent rule requires nominal interest rates to equal the opportunity cost of producing money for the interest rate to be approximately zero. Implications for rules and discretion • Mechanical rules, as an external constraint imposed on the central bank by society, are not an option. In the short run, monetary and fiscal policies can affect income, but in the long run, they do not have permanent effects on real income. 1986. Monetary Policy: Rules vs. Read John Taylor’s chapter “National and International Monetary Reform” in. Discretionary monetary policy is a more flexible approach whereby central bankers at the Fed can quickly react to changing factors to tweak the economy, especially in an unusual situation. The Debate Over Stabilization Policy. When this is the case, there is value for rules over discretion, for constitutional constraints on the conduct of monetary (and fiscal) policies, or for other ways to tie the government’s hands. Modigliani, Franco. Refer to each style’s convention regarding the best way to format page numbers and retrieval dates. Considering the effect of exchange rates on aggregate supply, Richard Froyen and Alfred Guender show that the nominal income rule is weak. The debate over “rules vs. discretion” was a centerpiece of disputes over monetary policy during the 1960s-1980s. 1977. • There is no good alternative to leaving monetary policy to the discretion of policy makers – must be free to move in a crisis Franco Modigliani believed that the deep business cycle in 1974 was a consequence of following monetary rules that did not allow the money supply to adapt adequately in both the up and down swings of the cycle. Most online reference entries and articles do not have page numbers. Alternative Monetary Policy Rules for Small Open Economies. In fact, strategic responses of rational, utility-maximising agents lead to an ex-post sub-optimal arrangement; rules ensure that – ex-po… Chicago: Aldine. Retrieved October 16, 2020 from New York: Cambridge University Press. Discretionary policy may be inconsistent when it does not change the initial conditions that create a disturbance, or shortsighted when a policy requires lags to materialize. In 1990, President George H. W. Bush replaced the term “policy rule” with “systematic policy” or “policy system” in his message to Congress. 16 Oct. 2020 . 1970. Review of International Economics 8 (4): 721–740. A Positive Theory of Monetary Policy in a Natural-Rate Model. Barro, Robert J., and David B. Gordon. . . Barro, Robert J., and David B. Gordon. A policy rule can be specific as fixing the quantity of currency and demand deposits, or general as when the Federal Reserve announces to the public the course of action it will take for various states of the economy, putting its reputation behind it. ... Monetary Policy: Discretion, Rules, or Markets? Friedman, Milton. Policy can be conducted by rules or discretion. The discretion to print more money can create unexpected inflation. Other research focuses on ways to pinpoint a rule and extend it into more research areas. Discretion . The test for a stable velocity-of-money function was indirect. Proponents of central bank discretion argue that a simple monetary policy rule is incompatible with … Hirsch, Abraham, and Neil B. Rules vs. discretion in monetary policies Many economists have argued whether using preset rules in framing monetary policies is better than the discretion of the policy maker or not. 2000. public observes policy-makers and forms expectations of their likely actions Keywords: rules versus discretion, price-specie-flow mechanism, monetary policy, Bank Charter Act, Chicago Plan, 100-percent-reserve banking, Currency School, Banking School, Bullionist debates, gold standard, Lucas Critique, Goodhart's Law In order to get it right, it helps to follow a rules-based policy instead of one based on discretion. would have a discretionary monetary policy. According to Kenneth Arrow, the world of uncertainty necessitates discretionary policies. Rules offer time consistency— the outcome demanded by the public in the short run is consistent with the out- come desired in the long run. Discretion Revisited: A Proposal to Make the Strategy of Monetary Policy Transparent Robert L. Hetzel Knut Wicksell (1978, 3) said a hundred years ago in his Lectures on Political Economy, “With regard to money, everything is determined by human beings themselves, i.e. Taylor, John B. Because each style has its own formatting nuances that evolve over time and not all information is available for every reference entry or article, cannot guarantee each citation it generates. Milton Friedman is best known for his influential contributions to monetary macroeconomics and for his st…, Rulers of the Byzantine Empire ( (table)),, Wittgenstein: Rule-following Paradox, Forms of Life and Education. Discretion versus policy rules in practice John B. Taylor* Stanford University, Stanford, CA 94905 Abstract This paper examines how recent econometric policy evaluation research on monetary policy rules can be applied in a practical policymaking environment. Milton Friedman: Economics in Theory and Practice. These gaming situations between policy makers and the public can be avoided if policy makers are concerned about their “reputation” or “credibility.” The incentive to be credible is based on a substitution of short-term benefits for higher level benefits from lower inflation in the long run. Therefore, be sure to refer to those guidelines when editing your bibliography or works cited list. Rules can directly limit the actions taken by a monetary authority. Conversely, monetarists propose a tight, fixed rule to ensure price stability. In particular, the forecasts explain why the Fed chose to cut interest rates a little sooner in the early phases of the recessions of 1990 and 2001, as the Fed (correctly) anticipated the downturn. A rule can be active, as when it requires increasing the money supply when the economy is on a downswing, or passive when the money supply is increased by a fixed percent annually. Regression analysis on demand for the money function between money and prices was significant but did not assign causal agency to money alone. If a rule is placed on the money supply, the monetarists look for a causal link between money and prices. However, the date of retrieval is often important. Therefore, it’s best to use citations as a starting point before checking the style against your school or publication’s requirements and the most-recent information available at these sites: Froyen, Richard T., and Alfred Guender. Why has discretionary monetary policy replaced rules-based monetary policy at various points in our history? Digital computers first appeared in the 1940s, but were not in widespread use by the gener…, Queensberry Rules the standard rules of boxing, originally drawn up in 1867 to govern the sport in Britain, named after John Sholto Douglas (1844–190…, Friedman, Milton 1983b. HOULD MONETARY POLICY be determined by a legislated rule or by a monetary authority’s discretion? Some policy rules are suboptimal in the sense that their feedback mechanisms depend on initial conditions, and to continue initial policy in subsequent periods is not optimal. However, Keynesians find that output, unemployment, and prices can be stabilized in the short run by autonomous expenditures, including those by the government. Rules vs. _____ [1] For an overview of earlier debates see Robert Hetzel, "The Rules versus Discretion Debate Over Monetary Policy in the 1920s. 2006. Because the velocity function was variable in the short run, Friedman turned to more general evidences, including the use of his permanent-income concept for further empirical analysis. ifthegovernmenthasfull“discretion” (freedomtochooseˇ)andlittle“internalcommitment”,then the economy ends up in a high-inflation trap. Friedman, Milton. RULES VS.
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