Dynamic Macroeconomics

20.1 Rules versus Discretion in Monetary Policy
Disagreements over the appropriate design of monetary policy have existed
at least since the nineteenth-century controversy between the 
currency
and
banking
schools in the United Kingdom. Although both schools supported
convertibility of paper currency to gold, the currency school argued that the
quantity of money should vary exogenously, as if all money were gold,
whereas the banking school argued for a more flexible approach to the
determination of monetary policy. In many ways, the currency school was in
favor of strict rules, whereas the banking school favored more discretion.
Although the British Bank Act of 1844 adopted the views of the currency
school, the actual operation of monetary policy during the pre-1914 gold
standard era entailed significant elements of discretion in the setting of
interest rates. This orthodoxy was analyzed in successive editions of Mill
[1848] and in Jevons [1875]. In addition, it was gradually recognized that, in
periods of financial crisis, central banks should operate as 
lenders of last
resort
(Bagehot [1873]).
However, the orthodoxy was also challenged, in view of the trend decline
of the price level during the gold standard period. Alternative academic
proposals for monetary policy emerged toward the end of the nineteenth
century, none of which questioned the convertibility of banknotes into
precious metals, such as gold or silver. Jevons [1875] favored supplementing
gold with indexation to prices, as did Marshall [1871, 1887]. Both Marshall
and Edgeworth [1895] advocated symmetallism over the gold standard.
Fisher [1896, 1911] put forward a radical academic proposal for the
stabilization of the price level, rather than the gold price, as the main rule for
monetary policy. Another such proposal was the Wicksell [1898] interest
rate rule for changes in the nominal interest rate in accordance with
deviations of the price level from a target price level. It is clear that the
operation of the gold standard was not considered to be ideal by its
contemporaries, and many alternative monetary policy rules were put
forward.

---

Renewed arguments concerning the conduct of monetary policy emerged
in the United States, during the operation of the prewar classical gold
standard, but especially during and after the Great Depression. Fisher [1936]
backed up his earlier proposal for a constant price level objective with a
rule for 100% reserves behind bank deposits, and so did Simons [1936].
Simons argued forcefully for rules as opposed to discretion, and favored a
fixed money supply rule, although he worried about shocks to the velocity of
money. The Simons proposal was later updated by Friedman [1960], who
argued for a fixed rate of growth of the money supply as the optimal rule for
monetary policy.
After World War II, the dominant Keynesian approach favored a more
discretionary monetary policy as discussed in chapter 15. However, the
instability of the Phillips curve eventually tilted the discussion again in favor
of rules, especially following the important contributions of Friedman [1968]
and Kydland and Prescott [1977].
Another argument in favor of rules is the virtual impossibility of perfect
knowledge about key parameters of economic models, the difficulties of
estimating and forecasting the state of the economy, and the need for
robustness. Discretion requires much more knowledge about the workings of
the economy than we actually possess, in contrast to abiding by simple rules,
as forcefully suggested by Meltzer [1987]. Among others, Orphanides
[2003a] has formally investigated the implications of imperfect knowledge
for monetary policy.
Very little disagreement exists today about the view that monetary policy
should be determined on the basis of rules. Yet there is still a very lively
debate about the appropriate design of such rules.
2
Should rules be contingent on the state of the economy, as, for example,
suggested by the Wicksell [1898] rule? Or should they be noncontingent, like
the Fisher [1896] price level stabilization rule, or the Simons [1936]–
Friedman [1960] rule for the money supply? Contingent rules allow for some
flexibility in addressing shocks that affect aggregate fluctuations, whereas
noncontingent rules do not.
Another longstanding debate has concerned the appropriate instrument of
monetary policy. Should central banks control the money supply or nominal
interest rates? In recent years, the debate has tilted in favor of interest rate
rather than money supply rules, in view of the practice long followed by most

---

central banks that have to deal with the practical difficulties in controlling
(or even defining) the appropriate measure of the money supply.
3
The literature on interest rate rules in the past 20 years has focused on the
analysis of one particular such rule, the Taylor [1993, 1999] rule. This rule
has been shown to describe the monetary policy of the United States and
other advanced economies relatively well since at least the early 1980s, if
not earlier. The Taylor rule, which is a generalized version of the contingent
rule proposed more than a century ago by Wicksell [1898], is usually
analyzed in the context of new Keynesian models of aggregate fluctuations,
such as the models discussed in chapters 16 and 17. It has been compared to
optimal monetary policy, and proposals have been put forward for
improvements in the choice of parameters and other characteristics of this