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Is discretionary or rule based monetary policy better

when considering crisis avoidance?

Keiran Eagen

Senior Project Advisor: Kyle Edmondson

12th Grade Humanities


Animas High School
2/27/2017
Part I: Introduction
Take a moment to return to a world where the housing bubble has just popped,

unemployment was at extremely high numbers, and the global economy took a turn for the

worse. A low effective Federal Funds Rate (interest rates) allowed the economy to overheat, even

when there was evidence that things in the financial industry were getting out of control. The

government jumped to action right after the bubble burst, but for many it was already too late.

Lehman Brothers was the first financial institution to crumble, leading to more failures and

government bailouts, showing to the world that American financial industry really had become

too big to fail. Those interest rates were determined by the Federal Reserve, which is the central

bank in the United States.

Monetary policy is the process by which the monetary authority of a country, such as the

central bank, controls the supply of money, targeting an inflation or interest rate to ensure

stability and trust in currency. In the most general sense, monetary policy, when it functions

correctly, keeps the economy healthy, stable, and prosperous. The monetary authority, or central

bank, such as the Federal Reserve, use monetary policy to control how much money is available

for use. The monetary authority mainly focuses on indicators such as inflation and

unemployment which are influenced by expansionary and contractionary policies. The

importance of monetary policy is best understood by considering how it impacts consumers

through interest rates. During periods when the monetary authority would like to increase

employment, the Federal Reserve will lower interest rates making it is easier for businesses to

borrow money so they have more money to spend. Those businesses can then hire more

employees and more employees have an increased chance of getting a raise or a bonus. By

increasing employment rates and raising income, employees have more money to spend on

goods and services, which would, in theory, create growth in the economy. Lowering interest

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rates to create growth is an example of an expansionary model. The Federal Reserve also has the

opportunity to increase the Federal Funds Rate and would do this during times when the

economy was getting out of control, for example, the 2008 financial bubble. Raising interest

rates in order to calm or shrink the economy is contractionary policy. The Federal Reserve will

take these actions in order to sustain growth and stabilize the economy.

The goal of growth and stability, in order to promote full employment and low inflation,

is what has dominated the debate between rule-based monetary policy and discretionary

monetary policy. Rule-based monetary policy is often described as systematic policy reaction

functions, or a mathematical algorithm, that guides the monetary authority on how to address

inflation and unemployment. Rules are based around target goals and are generally chosen

because they will assist the Federal Reserve in reaching a desired interest rate or employment

rate. These rules can last for an indefinite number of decision cycles (periods), but can become

outdated or ineffective, in which case the monetary authority would need to adjust the rule or

find a new rule to replace it.

Discretionary policy assumes that there will be reoptimization every cycle on the part of

the authority. This means that the monetary authority is left to decide what the best ways to reach

its goals are, whether it be lowering unemployment or focusing on inflation. Optimization refers

to achieving the highest economic performance by maximizing desired factors and minimizing

undesired factors.

Ultimately, a healthy balance between rule-based policy and discretionary policy,

allowing flexibility while promoting commitment, is the strongest protocol for crisis avoidance.

Part II: Historical Context

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The definitions of rules and discretion have changed over time. Bennett McCallum, a

professor of economics at Carnegie Mellon University, says, discretion implies period-by-

period reoptimization on the part of the monetary authority whereas a rule calls for period-by-

period implementation of a contingency formula that has been selected to be generally applicable

for an indefinitely large number of decision periods (qtd. in Rivot 605). McCallum is describing

the basic difference between rules and discretion. Rules are a function that guides the Federal

Reserve which can be used for a long period of time, whereas discretion leaves the Federal

Reserve to take action when it has determined appropriate to do so. Rules are often described as

more reliable and consistent. Discretion is equally effective but often leaves the public guessing

what the Federal Reserve will do next.

Rules have been effectively used in the past. According to Allan Meltzer, professor of

Political Economy at Carnegie Mellon University, (260) and John Taylor, professor of

Economics at Stanford University, (qtd in Salter 444), from 1985 to 2003, the United States

informally followed the Taylor Rule, which was a popular model for monetary policy that

illustrates where the Federal Funds Rate should be set. This was in response to the Stagflation

that occurred during the 1970s and made the case for a rules-based policy more appealing. The

Federal Reserve has never formally chosen a rule but rather performed actions that are similar to

those that would have been taken had they been following a defined rule.

From 2003 to the present, American monetary policy has been largely discretionary. This

transition from rules to discretion has been described by John Taylor, the creator of the Taylor

Rule, as the Great Deviation which occurred from 2001 to 2006.

Part III: Research and Analysis

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Understanding Rules and Discretion

Understanding how rule-based monetary policy and discretionary monetary policy

function is fundamental when discussing the two major protocols. McCallum summarizes that a

rule calls for period-by-period implementation of a contingency formula that has been selected to

be generally applicable for an indefinitely large number of decision periods (qtd. in Rivot 605).

A rule uses information gathered from the economy, put into a formula, which provides the

Federal Reserve with a target rate. Rules, in their contemporary definition, refer to systematic

policy reaction functions, used by the Federal Reserve as an indicator of what actions should be

taken when addressing the federal funds rate. Alexander Salter, a research fellow with the Free

Market Institute says, a good rule simply specifies plans of action, depending on contingencies,

on which the central bank cannot later renege (444). Salter is explaining that all a good rule has

to do is hold the Federal Reserve to specific actions. Rules hold the monetary authority to

specific policy and goals, allowing both the public and the market to trust the actions of the

monetary authority. They can lead to stability as there is an anchor in the form of a rule that the

Federal Reserve cannot later reverse. In short, a good rule assures that the central bank will be

held to their word unless there are compelling circumstances to change. Rules are simply a

system that assists or guides the Federal Reserve in its decision making for as many periods as

possible.

A rule can last for many periods while discretion may continue indefinitely because of its

flexibility. Using McCallum as a benchmark again, discretion implies period-by-period

reoptimization on the part of the monetary authority (qtd. in Rivot 605). This means that all

policy decisions are made by the Federal Reserve. Gerald Dwyer, a professor of economics at

Clemson University says, Discretion means that the monetary authoritys future actions are not

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restricted (6). Rules bind the central bank to a specific action, whereas discretion leaves the

central bank to decide to commit or change their opinions whenever they deem necessary.

Discretionary policy can achieve the same outcome as rule-based policy. Dwyer used an example

saying if a constant growth rate of the money stock were desirable, as Friedman advocated, a

monetary authority exercising discretion could produce this outcome (5). Dwyer is describing

how discretion has the ability to reach the same goals as rules-based policy. The difference is that

discretion also allows the monetary authority to be flexible in its opinions and policy. This can

result in economic stability because of the central bank's ability to respond to unforeseen events.

Discretion simply means that the central bank's future decisions are unrestricted and all decisions

are left to the judgment of the central bank.

Rules Policy: Strengths

Rules major strength is that they hold the central bank to a plan. Time inconsistency,

according to Salter, is when an individual or organization displays inconsistency when its

preferences tomorrow are at a variance with its preferences today (445). This description

accurately illustrates what rules are good at avoiding. A rule holds the central bank to a plan of

action, which avoids issues of time inconsistency. In theory, if the central bank was able to

commit itself, without fail, to some sort of rule, then, social welfare would improve (Salter

445). According to Milton Friedman, a prominent economist and Nobel Memorial Prize winner,

Our economic system will work best when producers and consumers, employers and

employees, can proceed with full confidence that the average level of prices will behave in a

known way in the future - preferably that it will be highly stable (qtd. in Rivot 609). What

Friedman depicts is an economic system where the Federal Funds Rate is not affected by time

inconsistency. This is because rules lead to the Federal Reserve focusing on long term goals.

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With this focus comes consensus within the Federal Reserve about what these goals are, which

leads to a central bank that operates predictably. This predictability should lead to improved

social welfare and a more stable economy where steady growth is highly achievable.

Discretionary Policy: Strengths

Growth is also highly achievable through discretion, although it is reached through a

different pathway because discretion is generally less predictable. In theory discretion should be

stabilizing. The New Keynesians, followers of the economist John Maynard Keynes, see the

strengths of discretion as its flexibility to handle fluctuations in the market. According to Sylvie

Rivot, an economic historian at University of Straussberg, New Keynesians view monetary

policy as much more flexible and capable of moderating short-run fluctuations than fiscal policy

through manipulation of the overnight rate (618). Even though New Keynesians recognize

these strengths, they emphasize monetary policy as a long term issue rather than a short term

weapon (Rivot 618). Even if the Federal Reserve chooses discretion, a long term focus should

be maintained. Stephan Sauer, a professor at Ludwig-Maximilians University Munich, explains,

In particular, if an economy is characterised by rigid prices, a low discount factor, a high

preference for output stabilisation or a sufficiently large deviation from its steady state, it should

prefer discretionary monetary policy over the timeless perspective (24). Discretion will be

better equipped to deal with these deviations because rules lack the ability to address

fluctuations. Those who follow the New Keynesian model have also argued that discretion can

actually lead to fewer long run losses than a traditional rules-based policy. Discretions strength is

its ability to be flexible and respond to unforeseen events, especially in economies where there

are large deviations from steady state.

Rules Policy: Weaknesses

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Rules have the ability to limit decisions that could be made by the central bank, even if

those decisions are necessary. Using Friedmans K-Percent Rule as an example, Friedman

recommended that the money supply be increased by a fixed percentage every time period. That

rate should be chosen to achieve, on average, no change in moneys purchasing power, meaning,

a constant price level. (Salter 449). Friedmans rule, as described above, is dependent on an

extremely stable economy, where the rules only goal is to keep the worth of the dollar the same.

The rule relies on velocity--which is the rate at which money is exchanged from one transaction

to another--to stay consistent and stable in order for the correct percentage to be decided. Rules

are created in order to keep control on the market so that there is relative stability. This is a noble

goal but can be detrimental as rules dont have the ability to address all circumstances. This is

because, according to McCallums definition, a rule calls for period-by-period implementation

of a contingency formula (Rivot 605). Although this is good for stability it leaves the central

bank at a loss if something occurs that was not foreseen. Rules are designed to last for an

indefinite number of decision periods, but can also become obsolete over time as rules

implemented in a stable economy do not allow for flexibility when the economy becomes

unstable. This raises serious questions about how and when rules can be used in the United

States. If America were to fall out of economic stability again what action would be taken by the

Federal Reserve if they were committed to rules? Would the Federal Reserve switch to discretion

and risk the possibility of losing credibility? While this is a prospect, these statements are made

hypothetically as rules have never been formally implemented in the United States.

Discretionary Policy: Weaknesses

A weakness of discretion is time inconsistency, which is essentially an issue of

predictability. Even if the central bank and the public are well informed there will still be time

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inconsistency, because of the evolving opinions and decision process of the Federal Reserve.

Time inconsistency can also occur because of the lag between observation, evaluation, and

implementation. There are examples of time inconsistency throughout history, especially during

2003 to 2005, according to Taylor who says,

The Fed also returned to and expanded its forward guidance procedures. Rather

than simply saying that the interest rate would remain low for a considerable

period or increase at a measured pace, the Fed began saying that it would keep

the federal funds rate near zero until a certain date, such as 2015. It then changed

the policy, saying it would keep the rate at zero at least until the unemployment

rate hit 6.5%. (US Cong. House Committee on Financial Services).

Taylor describes a Federal Reserve that lacked predictability and consensus about the

consequences of its actions. He concludes that this deviation from plan by the Federal Reserve

exacerbated the Great Recession, as well as cost the Federal Reserve credibility. In early 2012

Allan Meltzer said Also, they show the very short-term focus that dominates Federal Reserve

activity (257). Taylor and Meltzer illustrate a Federal Reserve that used discretion heavily. The

discipline required to lead a discretion based monetary policy was not displayed and because of

that, the Federal Reserve received criticism. When following discretion based policy discipline

means that the central bank needs to announce its positions ahead of time, show commitment to

its actions and have consensus. These three key elements characterize a central bank that may not

be the most predictable, but can be trusted and is credible. If the Federal Reserve announces they

will keep interest rates low for a period of time the economy can trust that the Federal Reserve

will do so.

Rules and Discretion During Crisis

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Rules

Maintaining a healthy economy is important, as is doing everything possible to avoid

major economic downturn. Some have suggested that rules could have lessened the effects of the

of the Great Recession. The reasons for this are: 1) the Federal Reserve may have misread

economic indicators, 2) rules would have allowed faster action from the Federal Reserve, and 3)

rules could have increased market stability because of general knowledge of the monetary

authorities chosen rule as well as their commitment to that rule. According to David Beckworth,

a former economist for the U.S. Department of Treasury,

the U.S. Federal Reserve misread crucial economic signals and engaged in overly

expansionary policy in the years leading up to the crisis, then the judgement of

monetary policy makers-the predominant guiding force in the ad hoc period

identified by Taylor, Meltzer, as well as Nikolsko-Rzhevskyy, Papell, and Prodan-

resulted in significant economic harm, which in turn suggests that rules-based

policy might have spared us the economic calamity that followed (qtd. in Salter

445).

Beckworth explains how rules may have guided the Federal Reserve to act differently. With rules

in place there is no need to meticulously comb through information gathered in order to make

informed decisions to stabilize the economy because the rule acts as a guide for the Federal

Reserve.

Secondly, because rules outline the actions that the central bank will follow in specific

situations, there is no time lost when implementing these actions. A criticism that is often heard

is that the government did not act swiftly enough during the beginning of the recession and

quicker action could have lead to a crisis that was much smaller in size. According to John

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Connaughton, a professor of financial economics at University of North Carolina Charlotte, In

August of 2007 the Fed began lowering interest rates in response to sluggish economic

conditions brought about by $3.00 a gallon gasoline prices during the summer of 2007 (1).

Connaughton describes how the Federal Reserve was trying to take action in order to help

stabilize the economy. These actions were made in order to try and stimulate spending, as

consumers had less discretionary income with the hike in gas prices. Another concern is that the

Federal Reserve had already kept interest rates low, around 1% for a long time, which may have

hindered them from lowering them more. Along with this, during 2007 the tourist industry also

took a large hit as as gas prices continued to rise during the summer and even spiked to $4.00 by

June of 2008 (Connaughton 1). This combination of low interest rates, high gas prices, and then

the housing market crash led to a full on crisis. Quicker action from the Federal Reserve could

have had the ability to lessen the crisis.

Finally, rules could have lessened panic with the knowledge that the Federal Reserve

would be transparent and would commit to the rule. According to Richard Kovacevich, a former

Wells Fargo CEO, the Federal Reserve and the Treasury contributed to an unnecessary panic in

the marketplace and required an unprecedented $29 trillion dollars of market intervention...

(Kovacevich 544). Kovacevich emphasizes the need for predictability and the role it plays in the

economy. The panic that Kovacevich mentions stems from before the market intervention. The

economy was entering recession and financial institutions were not sure of what the Federal

Reserve or the Treasury were going to do next. Theoretically rules would have promoted an

environment that was less panicked as the future and current actions of the Federal Reserve

would have been well known and understood because of the Federal Reserve's transparency and

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commitment to the rule. This predictability could have lead to an extremely less panicked

situation.

While all of these things could have lessened the effects of the Great Recession there is

still debate as to how much rules-based policy actually could have helped. It does need to be

taken into consideration that rules-based policy may not have guided the Federal Reserve in a

different direction. The Federal Reserve's commitment to the rule would have hindered them

from adapting.

Discretion vs. Rules

Commitment to a rule does in theory lead to greater market stability because the central

bank is more predictable, but, as mentioned before, commitment to a rules-based policy will not

always yield the best results. If the Federal Reserve were to set an incorrect interest rate

perhaps based on flawed information, one of the most important prices in the economy--the price

of time--will not accurately reflect the real scarcity of capital and can result in costly resource

misallocations (Salter 452). This is because a rule lacks flexibility to respond to things such as a

crisis, which is where discretion shines. If a rule, such as the Taylor Rule, is utilized then how

would the Federal Reserve be able to respond to major changes in inflation rates and interest

rates, seeing as the Taylor Rule is relatively backward looking. This is a situation of a rule

becoming inapplicable. In the case that the rule that central bank chooses does become

inapplicable Meltzer suggests that No rule can be correct all the time. Rule-like behavior calls

on the Fed to announce a rule, like the Taylor Rule. If it believes there is reason to depart from

the rule, it should announce its decision. If its decision turns out wrong, it should offer an

explanation... (262). While Meltzer's proposition is reasonable, discretion based policy would

not encounter this issue at all. When utilizing discretion the Federal Reserve's future actions are

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not restricted so if the economy has a sudden change the Federal Reserve can adjust to this

change in the appropriate manner. In the long run this process of discretion could leave the

economy in a better state as there is no time wasted if a rule becomes obsolete. Along with this a

crisis could be considered an unforeseen contingency which rules struggle to respond to as they

are fixed. The housing crash in 2008 was not expected and the next crisis will most likely be

unexpected as well. Discretion allows the Federal Reserve to be flexible in their decision making

and respond to unforeseen contingencies which could lessen the effects of a crisis.

Part IV: Conclusion

In short rules-based policy is neither better nor worse than discretionary policy when

considering crisis avoidance. What is best is a combination of the two, a policy that allows

flexibility while still promoting commitment. Following a rule can be beneficial, but when the

rule is no longer applicable to the economic climate then discretion must be used in order to keep

the economy functioning in an optimal state. Rules-based policy is not better in all situations

because in times of crisis a rule may not be flexible enough or may not foresee future events,

which will limit the monetary authoritys ability to respond to a crisis or major fluctuation in

ways that are beneficial to the economy. On the other hand, discretion is not necessarily better

than rules-based policy because, as observed in the 2008-2009 recession, there was much panic

and confusion, in part because there was a lack of predictability surrounding future actions of the

Federal Reserve. Discretion poses issues of time inconsistency, which would lead to a loss of

credibility and trust in the eyes of the public, as well as financial institutions. These are

weaknesses of discretion but discretions strengths must not be ignored for overall long term

benefit.

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This means that in times of relative economic stability rules are better for optimal

performance of the economy, along with reaching goals of lowering inflation and full

employment. In times when rules become obsolete for an indefinite number of decision periods,

discretion is the better option. Discretion is the better option because it would allow for faster

action to lessen or avoid a crisis. In the case that a rule becomes obsolete the Federal Reserve

will need to announce that it is departing from that rule, as Meltzer suggests, and explain why, in

order to be transparent, retain credibility, and hold itself accountable.

Most importantly there needs to be serious thought about three questions. Where are

we? Where do we want to get? How do we get there most efficiently from where we are?

(Meltzer 263). These questions, if not considered, could lead to decision making that is not in the

best interests of the economy. General consensus on these goals will lead to monetary policy that

is successful in targeting inflation or employment, focused on the long run and consistently

assists in having a stable and healthy economy.

Further research and analysis should include consideration of specific rules and how they

may be implemented in conjunction with discretionary policy. An in depth understanding of

these rules and the different options in how the central bank conducts monetary policy under

them would also allow for a far more conclusive analysis of what rule may be best for the United

States. With an understanding of how different rules work and how they could be implemented in

conjunction with discretion would lead to taking the first steps to a new way of conducting

monetary policy.

Ultimately, a healthy balance between rule-based policy and discretionary policy,

allowing flexibility while promoting commitment, is the strongest protocol for crisis avoidance.

This balance will allow the Federal Reserve to keep the economy stable, with continued growth,

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while being able to respond to unforeseen events. This will allow for the Federal Reserve to

remain relatively predictable but, would also allow it to lessen the financial burden of the United

States if another crisis were to happen.

Glossary
Ad hoc: formed, arranged, or done for a particular purpose only.

Aggregate demand: an economic measurement of the sum of all final goods and services
produced in an economy, expressed as the total amount of money exchanged for those goods and
services.

Aggregate supply: the total supply of goods and services available to a particular market from
producers.

Dynamic inconsistency: as defined in game theory, refers to a disagreement between your earlier
self and your later self about what your later self should do. Informally, it is a failure to act (or
prefer) according to plan.

Economic indicator: a statistic used to gauge future trends in a nation's economy.

Ex ante: based on forecasts rather than actual results.

Ex post: based on actual results rather than forecasts.

Market discipline: Market discipline is found in prices. This is because buyers dont want to buy
things that are priced too high, which would send them into bankruptcy and sellers dont want to
sell things that are priced to low for fear of the same fate.

Monetary policy: the process by which the monetary authority of a country, such as the central
bank, controls the supply of money, targeting an inflation or interest rate to ensure stability and
trust in currency.

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Optimization: finding an alternative with the most cost effective or highest achievable
performance under the given constraints, by maximizing desired factors and minimizing
undesired ones.

Procyclic: Procyclic is a condition of positive correlation between the value of a good, a service
or an economic indicator and the overall state of the economy.

Promulgate: promote or make widely known.

Renege: to go back on a promise, undertaking or contract

Rule: a systematic policy reaction function.

Supply shock: an event that suddenly increases or decreases supply of a commodity.

Velocity: the rate at which money is exchanged from one transaction to another.

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