Monetary Policy — 2: Rules versus Discretion

Abstract

The disturbed conjuncture in the early 1970s, with a synchronous boom in many countries in 1972–3 leading on to a surge in raw material prices, the first oil shock and the breakdown in the Bretton Woods pegged exchange rate system, was conducive to the adoption of monetary targets, rather than interest rates, as the intermediate objectives of Central Banks. A brief history of these developments is contained in Section 1. Nevertheless, this step, undertaken in many major industrialised countries in 1975–6, failed to bring about a real break in the inflationary climate. It was widely argued that this was because monetary targetry was operated in too discretionary a manner without sufficient commitment by the authorities.

One of the puzzles of the 1970s was why the authorities had allowed inflation to take such hold when tight monetary policy should have been able to prevent that. The best answer was provided by Kydland and Prescott and elaborated by Barro and Gordon. This is described in a simplified way in Section 2. The argument is that any benevolent authority, sincerely seeking to maximise a social welfare function, which assumed that the private sector’s expectations of future inflation were fixed — irrespective of its own actions — would prefer to lower unemployment below the medium-term natural rate at the expense of somewhat higher unanticipated inflation. A rational public would come to expect that action from the authorities, however, thereby raising the base level of expected inflation until it rose to a point where the public’s (and the authorities’) dislike of any further inflation fully offset any benefit from a temporary reduction in unemployment. The key finding was that this expectational, consistent equilibrium involving discretion was inferior to a condition in which the authorities committed themselves in advance to a rule of holding prices constant and not trying to influence the level of output and employment. One limitation of this basic model is that the authorities are clearly themselves acting irrationally in treating the private sector’s expectations as fixed. Instead, the authorities will appreciate that they will be penalised by a loss of future credibility if and when they are tempted to renege on their commitment to price stability. This appreciation leads on to a consideration of reputational equilibria and the application of technically sophisticated game-theoretic analysis (not pursued here) to this subject.

The claim that more pre-commitment was required to provide credibility and to inspire confidence was sympathetically received by the authorities, notibly by the conservative governments coming into power in the USA and UK at the start of the 1980s. Nevertheless, the steps then taken to tighten the operation of targetry were subsequently relaxed and largely abandoned after a few years. This is described in Section 3. This was partly the result of the success of these policies in achieving a decisive break in inflation but more important was the increasing erosion of stability in the statistical relationships between monetary aggregates and nominal incomes.

With velocity thus proving increasingly unpredictable, monetary targets were dropped in a widening range of countries. The question then arises how monetary policy should be directed in this new situation. In Section 4, we concentrate on the problem that emerges for major, central currencies which do not, or choose not to, accept the choice of pegging their exchange rate (the latter is considered in Chapters 17 and 18). We consider the relative merits of targeting the monetary base, the aggregate upon whose velocity financial innovations have hitherto had the least apparent disturbing effect, or nominal incomes, and then finally turn to a short discussion of the possible adoption of ‘free banking’ with the total withdrawal of the authorities from monetary policy actions.