Controversy over Rules and Discretion of Monetary Policy

In this article we will discuss about the controversy over the issue whether the central bank should conduct policy in accordance with a set of fixed rules or it should follow a discretionary monetary policy.

Friedman argues that the lag between the initiation of a monetary policy and the time at which the policy is effective is so long and variable that discretionary countercyclical policy aimed at economic stabilisation may be destabilising.

When a discretionary monetary policy is adopted, the central bank follows an easy monetary policy in a recession and a tight monetary policy in a boom. Given the long length of the lags and their variability, the effect of an easy monetary policy in order to control a recession may lead to inflationary pressures.

Similarly, a tight monetary policy to control a boom may lead to recessionary conditions on account of time lags and delayed effects. Due to unpredictability in forecasting booms and recessions and the length, variability and uncertainty of the time lags, countercyclical discretionary monetary policy is destabilising rather than stabilising. Friedman, therefore, calls for an end to discretionary monetary policy.

Instead of leaving monetary policy to the judgement of the monetary authority, Friedman proposes that it should follow a fixed long-run rule that the money supply should grow at a constant rate year after year. There should be no deviation from this rule under any circumstances.

Suppose the rule is 3 per cent growth rate of money supply which closely approximates the economy’s past average annual growth rate in real output. Such a stable growth rate of money supply will keep prices stable and allow the aggregate demand to grow with the growth in productive capacity of the economy.

It will thus increase employment and income. Any inflationary situation will be temporary because it will not receive an impetus by any increase in the money supply. Similarly, any recessionary tendency will be short-lived because the liquidity provided by the constant money supply will cause aggregate demand to expand.

Thus the fixed rule for monetary policy suggested by Friedman would remove the uncertainties associated with discretionary countercyclical monetary policy.

Another variant of the rule is that suppose the money supply grows at 2 per cent per year for every 1 per cent unemployment in excess of, say, 5 per cent. Algebraically such a rule would be expressed as ΔM/M = 3.0+2(U – 4.0) where, ΔM / M is the annual percentage growth rate of money and U is the percentage unemployment rate.

This is illustrated in Fig. 2 where the unemployment rate is shown on the horizontal axis and the growth rate of money supply on the vertical axis. At 4 per cent unemployment, the growth rate of money supply is 3 per cent.

If the unemployment rate rises above 4 per cent, the growth rate of the money supply is increased automatically. Thus with 5 per cent unemployment, the growth rate of money supply would be 5 per cent = 3.0 +2(5 – 4).

Conversely, if unemployment dropped below 4 per cent, the growth of money supply would be lowered below 3 per cent. By linking the growth of money supply to the unemployment rate, countercyclical monetary policy is achieved without any discretion. This is called the activist monetary rule because it expands money supply when unemployment is high and reduces it when it is low. It does not allow any policy discretion and is thus a rule.

Many economists do not agree with Friedman and also object to the ‘activist monetary rule’. According to them, rules lead to rigidity upon the behaviour of instrument variables, thereby destabilising target variables. As a matter of fact, there should be flexibility of instruments for maintaining stability of targets. Money supply is an instrument that affects such targets of monetary policy as prices, output, income and employment.

Suppose the monetary authority has the fixed interest rate target and follows the fixed money supply rule. Their effects on income are explained in terms of Fig. 3 where the national income is measured along the horizontal axis and the interest rate on the vertical axis. OY_F is the initial full employment equilibrium at R interest rate. When, say, due to tall in business expectations, liquidity preference rises, this causes the LM curve to shift to the left to LM₁.

As the monetary authority follows the fixed money supply rule, it will take no action so that the national income falls to OY₁ when the LM₁ curve intersects the IS curve at E₁. Thus the fixed money supply rule is a bad rule for the monetary authority to follow when it follows the fixed interest rate target.

In general, rules directed at such targets as the rate of interest or the money supply are “second best”, and may even destabilize the economy. Therefore, no rule is a substitute for appropriate monetary policy designed to maintain full employment in the economy.