14/07/2022
Rules for Monetary Policy
Even if we are convinced that policy rules are superior to discretion, the debate over macroeconomic policy is not over. If the Central Bank were to commit to a rule for monetary policy, what rule should it choose? Let’s discuss briefly three policy rules that various economists advocate.
Some economists, called monetarists, advocate that the Central Bank keep the money supply growing at a steady rate. Monetarists believe that fluctuations in the money supply are responsible for most large fluctuations in the economy. They argue that slow and steady growth in the money supply would yield stable output, employment, and prices. But, most economists believe that it is not the best possible policy rule. Steady growth in the money supply stabilizes aggregate demand only if the velocity of money is stable. But sometimes the economy experiences shocks, such as shifts in money demand that cause velocity to be unstable. Most economists believe that a policy rule needs to allow the money supply to adjust to various shocks to the economy.
A second policy rule that economists widely advocate is nominal GDP targeting. Under this rule, the Central Bank announces a planned path for nominal GDP. If nominal GDP rises above the target, the Central Bank reduces money growth to dampen aggregate demand. If it falls below the target, the Central Bank raises money growth to stimulate aggregate demand. Because a nominal GDP target allows monetary policy to adjust to changes in the velocity of money, most economists believe it would lead to greater stability in output and prices than a monetarist policy rule.
A third policy rule that is often advocated is inflation targeting. Under this knows exactly what the natural rate of unemployment is. If the Central Bank chose a target for the unemployment rate below the natural rate, the result would be accelerating inflation. Conversely, if the national bank chose a target for the unemployment rate above the natural rate,
