Why Monetary Policy should be made by Rule Rather than Discretion
Introduction: Monetary policy involves the regulation of the money supply and of interest rates by a central bank. In the United States, monetary policy is determined by the Federal Reserve Board. The goals of the Federal Reserve Board (the Fed) are to encourage economic growth, control inflation, reduce unemployment to acceptable levels and stabilize the exchange rate between the U.S. dollar and foreign currencies in the foreign exchange marketplace. Monetary policy is one of the two ways the government can impact the economy. By regulating the amount of money in circulation the Federal Reserve can affect the amount of money that is spent by consumers and businesses.
Opinion: In an ideal world, monetary policy would be made by rule rather than by discretion. The key to using decision rules involves the identification of key relationships that, taken together, provide a useful approximation of the dynamics of the economy. Such an approximation would be the basis for statistical models that the Federal Reserve uses to assess the likely outcome of monetary policy decisions and determine the appropriate interventions by the Fed.
There are certain rules the Fed should accept according to Kenneth Kuttner writing in Review (Federal Reserve Bank of Saint Louis). One such rule involves inflation targeting. A non-contingent or unconditional rule represents an inflexible commitment to a stated rule such as this: Inflation shall not exceed 5 percent. Such a rule would require the central bank to focus on achieving this outcome to the exclusion of others. This type of inflexible rule has been criticized by the Fed as restricting it from doing its job effectively. Kuttner writes that rather than being rigid and unchanging most proposals for monetary policy rules assume that they would be used as guidelines for policymakers, recognizing the need for some discretion in u...