Rules Versus Discretion

BIBLIOGRAPHY

The debate of rules versus discretion in economic policy has its origin in the writings of Henry Simons at the University of Chicago. A policy rule can be specific as fixing the quantity of currency and demand deposits, or general as when the Federal Reserve announces to the public the course of action it will take for various states of the economy, putting its reputation behind it. Although rules can be set up in an equation form, such as the Taylor Rule, they require variables such as the natural level of output and expected prices that are only approximate. A rule can be active, as when it requires increasing the money supply when the economy is on a downswing, or passive when the money supply is increased by a fixed percent annually. By definition rules are normative, but some rules are descriptive, meaning that they predict values close to what the authorities actually allow. The danger with rules is the tendency to substitute administrative authority for rules, which tends to impair competition and expand government activities. In 1990, President George H. W. Bush replaced the term “policy rule” with “systematic policy” or “policy system” in his message to Congress.

Discretion requires delegating responsibilities to economic institutions such as the Federal Reserve to decide macroeconomic goals and policies as they see appropriate. According to Kenneth Arrow, the world of uncertainty necessitates discretionary policies. A decision improves with time and experience, which requires information that is available only sequentially. A decision maker such as the Federal Reserve analyzes the problem at hand, and decides on the best policy action to take. Discretionary policy may be inconsistent when it does not change the initial conditions that create a disturbance, or shortsighted when a policy requires lags to materialize.

Economists are divided over whether rules or discretion is the best policy for managing the economy. In the short run, monetary and fiscal policies can affect income, but in the long run, they do not have permanent effects on real income. The monetarist’s preferred habitat is the long run, managing the economy through simple rules of the money supply. Milton Friedman believed that the Federal Reserve did not use its discretion to act when the money supply declined by a third during the 1929–1933 period, turning a garden-variety recession into the Great Depression. However, Keynesians find that output, unemployment, and prices can be stabilized in the short run by autonomous expenditures, including those by the government. Franco Modigliani believed that the deep business cycle in 1974 was a consequence of following monetary rules that did not allow the money supply to adapt adequately in both the up and down swings of the cycle.

The debate over rules versus discretion is not settled empirically. If a rule is placed on the money supply, the monetarists look for a causal link between money and prices. The definition of money and a stable velocity-of-circulation function are necessary for empirical investigation. A currency plus demand-deposit definition is not sufficient for rules to work because people hoard and dishoard money, many “near money” substitutes may exist, or wages and prices may be rigid. If wage and price rigidities are only slight, then a rule might work, but it would require the absence of substitutes such as equity or bonds; it would also require that loans be held for long periods so that repayment on principal is not required. For Simon, such a systemic policy appears paradoxical, as it would require an intelligent monetary system on the one hand, and credibility of rules on the other. Friedman, a student of Simon, moved the research forward by articulating two rules on the money supply, the k-percent rule, and a Friedman rule, which he later referred to as the “5 percent and the 2 percent rules,” respectively (Friedman 1969, p. 48). In the 5 percent rule, “the aggregate quantity of money is automatically determined by the requirements of domestic stability” (Friedman 1948, p. 252). To cover the international scene as well, Friedman complemented the 5 percent rule with a flexible exchange rate. The 5 percent rule, however, runs up against rigidities and lag effects in the economy, which are short run in nature. The long-run 2 percent rule requires nominal interest rates to equal the opportunity cost of producing money for the interest rate to be approximately zero.

The test for a stable velocity-of-money function was indirect. Because the velocity function was variable in the short run, Friedman turned to more general evidences, including the use of his permanent-income concept for further empirical analysis. Regression analysis on demand for the money function between money and prices was significant but did not assign causal agency to money alone. The issue became more complicated in the short run when interest rates, a mostly Keynesian variable, turned up significant. Abraham Hirsch and Neil De Marchi examined ruling out common elements in a variety of results tested in order to help identify money as the cause of price changes. Such method of difference testing, coined by John Stuart Mill, cannot be exhaustive.

As more sophisticated models evolved, policy rules became hard to eliminate, and according to Finn Kydland and Edward Prescott, they could improve social optimum. A change in administration leads people to change their expectations and their current decisions. People have expectations about the tax policies of different administrations. Once people have some knowledge of such changes, they adjust their expectations and set into motion a series of iterative changes that may or may not converge to an equilibrium given the current state of the economy. Some policy rules are suboptimal in the sense that their feedback mechanisms depend on initial conditions, and to continue initial policy in subsequent periods is not optimal.

The discretion to print more money can create unexpected inflation. Robert J. Barro and David Gordon argued that people would adjust their expectation of inflation to eliminate surprise inflation, creating a potential for higher money supply and inflations in equilibrium. If policy rules are implemented, such expectations-driven inflation would not occur, but policy makers would have an incentive to break the rule—cheating—because higher inflation means less unemployment and more growth, according to the Phillips curve. These gaming situations between policy makers and the public can be avoided if policy makers are concerned about their “reputation” or “credibility.” The incentive to be credible is based on a substitution of short-term benefits for higher level benefits from lower inflation in the long run.

Other research focuses on ways to pinpoint a rule and extend it into more research areas. William Poole lauds a Taylor Rule that can be refined, much like a scientist would refine a constant. He likens a rule to the choice of using rules to fly a plane rather than letting the pilot have his or her way of navigating. Taylor extended his policy rule to price and nominal income rules for the open economy under fixed versus flexible exchange rates. He found that the nominal income rule outperformed the price rule. Considering the effect of exchange rates on aggregate supply, Richard Froyen and Alfred Guender show that the nominal income rule is weak. V. V. Chari and Patrick Kehoe found that as of 2002, approximately twenty-two countries use some form of rule-based policy.

SEE ALSO Arrow, Kenneth J.; Central Banks; Economics, Keynesian; Exchange Rates; Friedman, Milton; Great Depression; Macroeconomics; Modigliani, Franco; Monetarism; Policy, Monetary; Taylor Rule

BIBLIOGRAPHY

Arrow, Kenneth. 1957. Statistics and Economic Policy. Econometrica 25 (4): 523–531.

Barro, Robert J., and David B. Gordon. 1983a. A Positive Theory of Monetary Policy in a Natural-Rate Model. Journal of Political Economy 91 (4): 589–610.

Barro, Robert J., and David B. Gordon. 1983b. Rules, Discretion, and Reputation in a Model of Monetary Policy. Journal of Monetary Economics 12: 101–121.

Chari, V. V., and Patrick J. Kehoe. 2006. Modern Macroeconomics in Practice: How Theory Is Shaping Policy. Journal of Economic Perspectives 20 (4): 3–28.

Friedman, Milton. 1948. A Monetary and Fiscal Framework for Economic Stabilization. American Economic Review 38 (3): 245–264.

Friedman, Milton. 1969. The Optimum Quantity of Money. In The Optimum Quantity of Money and Other Essays. Chicago: Aldine.

Froyen, Richard T., and Alfred Guender. 2000. Alternative Monetary Policy Rules for Small Open Economies. Review of International Economics 8 (4): 721–740.

Hirsch, Abraham, and Neil B. De Marchi. 1990. Milton Friedman: Economics in Theory and Practice. Ann Arbor: University of Michigan Press.

Kydland, Finn E., and Edward C. Prescott. 1977. Rules Rather Than Discretion: The Inconsistency of Optimal Plans. Journal of Political Economy 85 (3): 473–492.

Modigliani, Franco. 1986. The Debate Over Stabilization Policy. New York: Cambridge University Press.

Poole, William. 1970. Optimal Choice of Monetary Policy Instruments in a Simple Stochastic Macro Model. Quarterly Journal of Economics 84 (2): 197–216.

Poole, William. 1999. Comment. In Inflation, Unemployment, and Monetary Policy, eds. Robert M. Solow and John B. Taylor, 78–88. Cambridge, MA: MIT Press.

Simons, Henry C. 1936. Rules versus Authorities in Monetary Policy. Journal of Political Economy 44 (1): 1–30.

Taylor, John B. 1993. Macroeconomic Policy in a World Economy: From Econometric Design to Practical Operation. New York: Norton.

Lall Ramrattan

Michael Szenberg