Ever since the important contributions of new classical economists Finn E. Kydland and Edward C. Prescott during the 1970s and 80s, modern macroeconomics seeks optimal rules for monetary policy. Indeed, Milton Friedman had previously emphasized the importance of a binding rule for monetary policy. He recommended a constant but moderate expansion of the money stock over time as well as the abolition of fractional reserve banking in order to improve the central bank’s control over the money stock. Neither of these two measures has ever been implemented over an extended period of time.
Creating Rules for Monetary Policy
Many modern macroeconomists have come to reject the idea of a constant growth rule in favor of a more complex rule that incorporates feedback effects from other macroeconomic aggregates. According to their rationale, political discretion in the form of unexpected accelerations of the money growth rate may lead to short-term benefits. Yet, the latter would come at long-term costs of either permanently too high price inflation or a consecutive readjustment to lower money growth rates that goes hand in hand with real economic losses in output and employment. This is what economists would refer to as the sacrifice ratio. Optimal monetary policy thus requires abstention from reaping some of the potential short-term benefits for the sake of long-term financial and economic stability.
The most famous monetary policy rules that have been deemed optimal are named after John B. Taylor. According to such Taylor rules the central rate of interest should be set in response to changes of actual price inflation, the natural rate of interest, as well as the output gap. There is one obvious practical problem, namely, that the output gap and the natural rate of interest are non-observable theoretical concepts that have to be estimated or replaced by more or less arbitrary empirical proxies.
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