Time Inconsistency Is Only One of Many Reasons to Favor Policy Rules

Advocates of purely discretionary monetary policy frequently list Kydland and Prescott’s time inconsistency argument as the only reason for policy rules, and then they try to shoot that down or say it is outweighed by arguments in favor of discretion.  This is the gist of Narayana Kocherlakota’s recent argument for pure discretion.

But there are a host of reasons why a monetary policy based more on rules and less on discretion is desirable, and time inconsistency is only one. I listed these seven in a Harry Johnson Lecture that I gave back when Fed policy was more rules-based:

(1)  Time inconsistency.  The time inconsistency problem calls for the use of a policy rule in order to reduce the chance that the monetary policy­ makers will change their policy after people in the private sector have taken their actions.

(2) Clearer explanations. If a policy rule is simple, it can make explaining monetary policy decisions to the public or to students of public policy much easier. It is very difficult to explain why a particular interest rate is being chosen at a particular date without reference to a method or procedure such as would be described by a policy rule. The use of a policy rule can mean a better educated public and a more effective democracy. It can help to take some of the mystique out of monetary policy.

(3) Less short-run political pressure. A policy rule is less subject to political pressure than discretionary policy. If monetary policy appears to be run in an ad hoc rather than a systematic way then politicians may argue that they can be just as ad hoc and interfere with monetary policy decisions. A monetary policy rule which shows how the instruments of policy must be set in a large number of circumstances is less subject to political pressure every time conditions change.

(4) Reduction in uncertainty.   Policy rules reduce uncertainty by describing future policy actions more clearly. The use of monetary policy rules by financial analysts as an aid in forecasting actual changes in the instruments would reduce uncertainty in the financial markets.

(5) Teaching the art and science of central banking.  Monetary policy rules are a good way to instruct new central bankers in the art and science of monetary policy.  In fact, it is for exactly this reason that new central bankers frequently find such policy rules useful for assessing  their decisions.

(6) Greater accountability. Policy rules for the instrument settings allow for more accountability by policy-makers. Because monetary policy works with a long and variable lag, it is difficult simply to look at inflation and determine if policy-makers are doing a good job. Today’s inflation rate depends on past decisions, but today’s settings for the instruments of policy—the monetary base or the short-term  nominal  interest  rate—depend on today’s decisions.

(7) A useful historical benchmark. Policy rules provide a useful baseline for historical comparisons. For example, if the interest rate was at a certain level at a time in the past with similar macroeconomic conditions to those of today, then that same level would be a good baseline from which to consider today’s policy actions.

This list still applies today and it does not even include a key technical reason (call it number (8)) that I still stress to my Ph.D. students: The Lucas econometric policy evaluation critique implies that in a forward-looking world policy rules are needed simply to evaluate monetary policy.

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