Monetary Policy: Rules Versus Discretion

Under a classical gold standard, there is little need for a central bank other than to provide coordination to the payments system. The value of money is determined by the supply of and the demand for gold. Thus the classical gold standard is the ultimate form of a policy rule. By contrast, in a system of fiat money, the value of money in the long run is determined by the rate at which the central bank allows the supply of money to grow. The debate over rules versus discretion is concerned with the question of what constraints should be placed on the central bank when determining monetary policy. Those in favor of policy rules seek to limit the scope of central bank actions and pursue long-run price stability alone. Advocates of discretion argue that central banks must be flexible and respond to short-run fluctuations in both prices and output.

Advocacy for monetary policy rules is rooted in the classical liberal thought of the “Chicago School.” Just two decades after the founding of the Federal Reserve System, and just three years after the United States left the gold standard, University of Chicago economist Henry Simons voiced reservations about handing over control of the money supply to a discretionary central bank. Less than three decades later, the advocacy of rules found its strongest proponent, Milton Friedman. Friedman frequently argued for a fixed growth rate for the money supply, contending that policy makers do not have enough knowledge about the way the economy works to be able to fine-tune it effectively. Faced with long and variable lags between the implementation of policy and its final effect, Friedman called for a focus on long-run price stability, which is achieved through stable money growth.

Economic Theory

Theoretical justification for the rules-based approach came from advances in economics in the 1970s when Finn Kydland and Edward Prescott published their seminal work on the “time consistency problem.” Kydland and Prescott showed that if the central bank does not have the ability to commit to the optimal long-run policy (low inflation), they will sacrifice price stability for a short-run increase in output. Policy rules give the central bank the ability to commit to a course of action ahead of time and then follow it, even if future policy makers may want to deviate from it. Without rules, future policy makers will deviate from any previously announced path when it suits their short-run objectives. The resulting discretionary outcome is suboptimal. Kydland and Prescott's theoretical work has spawned a vast literature on the time consistency problem as applied to monetary policy and central bank independence. The hypothesis being that central banks that are more independent from the political process are more able to commit to long-run objectives and are more likely to foster low-inflation environments.

In the years that followed, John Taylor developed the notion of “feedback rules.” Feedback rules allow for a more activist monetary policy than Friedman's constant money growth rule. The “Taylor Rule,” as it is known, allows the policy maker's choice of interest rate to be influenced by the departure of inflation from its target and the departure of output from its natural rate. Though named a rule, it incorporates discretion in the form of the choice of inflation target and sensitivity to output deviations.

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