Monetary Policy Rule in Theory and Practice

Facing the Internal vs External Stability Dilemma

Nicolas Barbaroux

• Publisher: Routledge
• Year: 2013
• Print ISBN: 9780415501804
• eBook ISBN: 9781135067939
• Topic: Economics
• Subtopic: Banks & Banking
• Index: Economics

This new volume sheds new light on current monetary issues, in particular the debate on monetary policy making, by blending theoretical economic analysis, history of economics, and historical case studies.

A discretionary monetary policy refers to cases in which the central bank is free to change its policy actions or key instruments when the need arises, whilst a monetary policy rule can be defined as a commitment from (independent) central banks to reach one or several objective(s) by way of systematic policy actions. This book uses case studies from France and Sweden, and places them in the context of Keynes' argument from his 1923 'Tract on Monetary Reforms', to support the argument that the use of discretionary practices within a monetary policy rule (such as in the Gold Standard era) is the best approach. This book takes an innovative approach in combining a theoretical analysis (mainly the work of New Neoclassical Synthesis throughout Woodford's model) a history of economic thought analysis (based on the monetary works from Wicksell, Cassel and Keynes) and an historical study of central bank practices both in France (based on Bank of France archives materials) and in Sweden. The final section of the book explores the debate on monetary policy rule in light of the 2008 financial crisis. As such, the book provides a unique synthesis that will be of interest not only to scholars of history of economic thought and economic theory, but also to anyone with an interest in monetary economics and contemporary monetary policy.

Part I

Monetary policy in theory

The current financial crisis directed the spotlight onto monetary policy and policymakers. However, understanding monetary policy changes requires us to start at the onset of the monetary policy rule adventure. Without any doubt, policymakers became ‘rule minded’ in the gold standard era (Kydland and Bordo 1995). It introduced a quasi automatic behaviour for central banks – or official banks of issue beforehand – which took the form of a commitment mechanism preventing the monetary authorities from changing planned future policy. This first part will present two views on monetary policy rule making: the latest by way of New Neoclassical Synthesis theories and the oldest the Classical view of the gold standard era. Moreover, these two theoretical approaches are interesting because they dramatically differ in the way they face instability. While the former favoured internal stability – by way of internal price level targeting – the latter relied on external stability by way of its (gold) exchange rate anchoring.

Chapter 1 aims at providing an up to date definition of monetary policy according to the latest macroeconomic models. We present Woodford's Neo-Wicksellian approach in line with Wicksell's Paleo one since we consider that current macroeconomic theories are connected to Wicksell's legacy. The latter was known for having pioneered actual monetary policy guidance by way of his interest rate rule management under a pure credit system, meaning an economy free from gold anchoring and in which the monetary system is infinitely elastic. This new framework is in total opposition to the one of the nineteenth century where central banks were not politically independent. Nowadays, most major central banks conduct monetary policy under an inflation targeting strategy. We will focus on Woodford's Neo-Wicksellian model as it appeared in his masterpiece ‘Interest and Prices’ (2003) since we consider it to be the most complete form of monetary policy a thought of nowadays by academics. The chapter also discusses the Wicksellian inheritance in Woodford monetary policy theory.

By contrast, Chapter 2 presents the origin of monetary policy rule making according to classical theories and its implementation into the gold standard system. Monetary policy was thought to be as if central bankers followed a rigid rule of conduct which consisted in managing the discount rate according to gold reserve constraints. The case of the Bank of England at that time made clear that the money supply followed the famous Currency Principle, inducing an automatic fiduciary note issue to vary automatically with the level of gold reserve. The work done by Kydland and Bordo (1995) is quite enlightening in this way. However, the sharp criticism of Keynes and Cassel at that time obliges us to reconsider our position. As strong opponents to this official view on the gold standard order, they demonstrated that the supply of money is not gold dependent but rather the result of political ‘management’ under the central bank's complicity. The latter point is a major argument that we will use in order to set up the book's thesis. In fact, the main thesis defended by the book is that monetary policy rule is – and always has been – associated with more or less discretionary behaviours. The reason for this complementarity is to be found in the stability dilemma. Following Keynes’ Tract on Monetary Reform (1923), it became clear that discretionary behaviour from central bankers is indispensable in order to face the conflict between internal stability – mainly price level disturbances or economic growth – and external stability, that is exchange rate fluctuations. This unofficial reading of the gold standard's history accord with the book's main thesis.

1Modern views on monetary policymaking

At the onset of the twenty-first century, most commentators on the history of macroeconomics highlight the idea of consensus or convergence concerning the modern state of macroeconomics (Woodford 2009, Goodhart 2005, Lavoie and Seccareccia 2004, Woodford 2003). Several labels were attached to the new tendency that featured monetary macro-models such as ‘Post-Modern Monetary Theory’ (Warin 2006) or ‘New Consensus on Monetary Policy’ (Fontana 2006). According to Woodford (1999) or Blanchard (2000) macroeconomics made much progress over the last twenty years by proposing a new framework for monetary policy. These improvements were not only due to increasing collaborations between academics and policymakers but also to the quantitative progress in macroeconomics. For instance, Woodford (1999) saw this new macro-approach as one ‘that can be estimated using macroeconomic time series and have optimizing foundations that allow an explicit evaluation of outcomes in terms of individual welfare’ (Woodford 2006: 1). In other words, the ‘modern’ state of macroeconomics refers to intertemporal equilibrium models (DSGE) with endogenous private sector expectations including the 1976 Lucasian ‘New Classical’ critique of traditional policy-evaluation exercises. Whatever the name given, the main features in this modern stage of macroeconomics rely on five components: intertemporal household optimizers with an endogenous determinacy on money via interest rate settings by independent central banks with a commitment to a monetary policy rule so as to reach perfect price stability.

This chapter considers the way monetary policy is theoretically viewed over the last ten to fifteen years. This context designs explicitly the framework inherited from Goodfriend and King (1997)’s publication on the ‘New Neoclassical Synthesis’.¹ In order to have a clear understanding of monetary policy, we will first briefly analyze the new context in which modern macroeconomic policies are elaborated while underscoring the monetary policy implications of this New Neoclassical Synthesis. In this enterprise, we will pay attention to Woodford's model such as it appeared in his masterpiece ‘Interest and Prices’ (2003) since we consider it to be the most complete form of the way monetary policy is viewed nowadays by academics. In the revolutionary part of macroeconomic development, one of the key stages that we will retain lies in the superiority of ‘rules’ over ‘discretion’ which allows Woodford to legitimize his own Wicksellian flavour. This inheritance will be discussed both in the spirit of the history of economic thought and in line with its policy implications.

Modern monetary policymaking

Economic research has expanded rapidly over the past twenty years. Recently major developments have been possible owing to technical innovations and progress, mainly in the fields of econometrics or games theory. According to Woodford (2009) the major disagreement that has been solved concerns the division between models that focus on short-term fluctuations and others that target long-term growth. This convergence is materialized through the emergence of a New Neoclassical Synthesis (NNS) that seems to reconcile both Keynesian and Real Business Cycle theorists. But technique alone cannot explain everything. Indeed, some progress in macroeconomics, and some modifications in the macro-research agenda were simply the outcome of crisis situations.

This first section aims to prove that the proper context explains why we model monetary policy in this way. The new context emerging from structural changes in economic functioning opened the doors to a new monetary policymaking frame-work – i.e. a New Neoclassical Synthesis. The latter seems to have a Wicksellian flavour.

A post-monetary world context

This idea of a ‘post-monetary world’ refers explicitly to the new context which has surrounded monetary policy over the last three decades (Woodford 1997). More precisely, if the world has reached a post monetary stage, it is a few changes, notably the development of new forms of money, which have forced policymakers to move on. In fact, since financial globalization, the frontier between money and liquid assets has dwindled while reducing the usefulness of monetary aggregates for monetary policy. Warin (2006) refers to a ‘post-modern’ universe in order to take into account those monetary transformations. The importance of the context is not a waste of time if we want to have a thorough understanding of how monetary policy is designed nowadays. As advised by Hicks (1967) monetary theory, more than any other field in Economics, should maintain a close relationship with reality. Looking over the last three decades, we discern the following four main features of the new monetary era:

1. Emergence of fiat money: this is the first corner stone of monetary macroeconomics – and also the international monetary system – dating back to the collapse of the Bretton-Woods system in 1973. Since this breakdown, the world functions with a pure fiat money system disconnected from any metallic anchoring. This new independence given – or obtained – by central banks has totally changed the way money is managed. From that time the value of the monetary unit has depended on the central bank's management through their monetary policies. The revolution that occurred is that the gold market and its vagaries no longer have any influence over the purchasing power of money. This proposition is totally in agreement with Wicksell's monetary works.² However, this new freedom for central banks is also synonymous with an increase in their responsibility due to the greater complexity of monetary management when compared to a gold convertibility system. All of that created new considerations and challenges for policymakers. As summarized by Woodford (2003: 2), the prevailing question appeared: ‘how should the bank's new freedom best be used?’. The new central bank's freedom was synonymous with a greater risk for inflation performance. In fact, since money value depended on the central bank's discretionary actions, there was a risk of a runon prices. The idea that monetary policy should target stability of prices quickly appeared. Thus, it seems that monetary policy rule was the best way to box the new ‘freedom’ of the major central banks, and by doing so, the purchasing power of the major currencies. Following this debate the existence of an inflationary bias had given birth to a wide literature on rule and the credibility issue in monetary policy. In fact, credibility is fundamental to the modern monetary system since it affects monetary policy performance. Central banks should inspire confidence regarding their ability to reach their goals. By focusing on monetary rule, it seems that central banks found a means to anchor confidence and expectations (Taylor 1993, 1999, 2000, Woodford 2003).
2. Financial markets development: the 1980s started a period of deregulation, often called financial globalization, that has brought about an increasing development of monetary and financial markets (mainly futures or derivatives markets). Those financial innovations have changed households’ behaviour in terms of saving and firms’ strategies in terms of investment. For central banks, the conduct of monetary policy became tricky for two reasons: first, the traditional demand for money became unstable; and second, traditional monetary aggregates became unable to reflect the evolution of the quantity of money in circulation due to complexity and the difficulty of distinguishing liquid assets from money. This financial globalization implied a change in the way monetary policy is managed. Since then, open-market operations have become of greater importance in order to control short-term liquidity and financial markets agents’ expectations.
3. Superiority of rule over discretion: inherited from both theoretical struggles and from changes in the monetary system, the superiority of rules over discretionary actions is a landmark of the modern monetary world. In fact, under the earlier fixed-exchange-rate systems, i.e. Bretton-Woods system and gold anchoring system beforehand, national currencies were rather fiduciary issues of notes and coins based on metallic reserves. Nowadays, the system involves flexible regime with purely fiat money. Thus, monetary policy rule became a fashion way to think and to speak about monetary policy. As soon as the monetary system contains fiduciary elements of credit, then the literature on the way monetary policy should be conducted expanded, mainly assuming monetary policy rule (Friedman 1968, Taylor 1993). The moving toward rule – rather than discretion – appeared from the ‘time (in)consistency’ literature inherited from the 2004 Nobel laureates Kydland and Prescott (1977). To them, monetary policy is defined as a commitment mechanism that prevents government – or central banks-from setting sub-optimal policies over time. From that, monetary policy is preferable to discretionary policy because future policy is expected to have substantial effects on today's economy. As claimed by Blanchard and Fisher (1989):

A policy is dynamically inconsistent when a future policy decision that forms part of an optimal plan formulated at an initial date is no longer optimal from the viewpoint of a later date, even though no relevant new information has appeared in the meantime.

(Ibid.: 592)

The approach taken by Woodford is in agreement with this analysis. Woodford's framework proposed a monetary policy rule approach with the objective of minimizing welfare losses inherited from different types of gaps with their respective ‘natural’ values. In fact, monetary policy is often thought to minimize welfare loss via reduction of inflationary bias. Theoretically, the superiority of rules over discretion is rooted in Lucas's famous criticisms of policy evaluations as well. Following the New Classical school and the rational expectations hypothesis, Lucas (1976) revolutionized policy analysis by demonstrating that no one can predict the effect of any policy action at a point in t...

Table of contents

• Cover
• Title Information
• Title Page
• Copyright Page
• Table of Contents
• List of Figures
• List of Tables
• Preface
• Acknowledgements
• Introduction: the history of the ‘rule vs discretion’ debatein monetary policymaking
• Part I Monetary Policy in Theory
• Part II Monetary Policy in Practice
• Part III The 2008 Financial Crisis: Implications for Monetary Policy Rule Making
• Conclusion
• Notes
• Bibliography
• Author Index
• Index