Study Of Monetary Policy Rules

For a long time, there has been debate on rules versus discretion in monetarypolicy-making. After the great depression in the thirties of the 20th century,economists in foreign countries reconsidered the role of monetary policy.Economists leaded by Keynes thought that there was limited role for monetarypolicy to improve employment and real economy, so they advocated usingfinancial policy and discretional monetary policy to bring economy toequilibrium of full employment. At the same time, the school of Chicagoadvocating economic liberalism believed in that the economic system could reachequilibrium automatically, so they opposed using discretional monetary policy tostimulate economy and advocated using rule to restrict the monetary authority.By means of analyzing the monetary history of the United States, Friedmanfound that there had been long and variable time lag before monetary policytaking effect and therefore it was unlikely for discretional monetary policy toreduce economic circles. On the contrary, it aggravated the economy frequentlyand even became the source of economic fluctuation sometimes. However,discretion seems excel rules logically: if a rule can reach the objective ofstabilizing the economy, then discretional monetary policy can use it too, andreserve the right to abandon it if necessary.The dispute of rules versus discretion was concluded by the appearance of timeinconsistent issue. According to the viewpoint of the school of rationalexpectation, the anticipation of the public is not fixed but affected by centralbank' s policy. So if the monetary authority employs discretional policy, thepublic can gradually realize this cheating behavior, and when he signs wage orprice contracts the public will make decision based on his own expectation tofuture monetary policy not on the cheating policy of currency authorities. As aresult, discretional policy can only bring about high inflation and highexpectation of inflation with no profits on employment or output. So fromtheoretical point of view, central bank should bide by rule rather than discretion.Some scholars put forward schemes to mitigate or solve the issue of timeinconsistency under discretional system, such as Barro and Gordon's scheme ofreputation equilibrium, Rogoff's scheme of conservative central banker, Walsh'sscheme of optimal contracts for central bankers. But every of the schemes has itslimitations and cannot resolve the issue of time inconsistency radically. By far,the viewpoints which advocate using rules win the advantage.With regard to how to use rule, there still are different opinions amongeconomic academia. One of which thinks that rule should only prescribe thetarget that the central bank must achieve, and there is no need to restrict theinstrument adopted by the central bank and the operational manner of theinstrument. This kind of rule is called targeting rule, including the rules ofexchange rate targeting, interest rate targeting, monetary targeting, inflationtargeting, nominal income targeting and price-level targeting. The otherviewpoint claimed that rule should prescribe not only the targets but theinstrument and its reaction manners. This kind of rule is called instrument rule,including Friedman rule, McCallum rule, and Taylor rule.Practically, targeting rule was more favored by the monetary authorities thaninstrument rule. The gold standard beginning at the end of 19th century and thesubsequent gold exchange standard, the Bretton Woods and European monetarysystem can all be regard as exchange rate targeting rule. However, due to itsdefects per se, especially when it cannot obtain the objective of stabilizingeconomy, exchange rate targeting rule was discarded at once. Before the BrettonWoods system took effect, the United States and so on adopted interest ratetargeting at one time. But the interest rate targeting did not achieve the objectiveof stabilizing output and employment. So its practice was ended unsuccessfullyunder the criticism of monetarists. After the seventies of 20th century, most of thedeveloped countries turned to the rule of monetary targeting. As a result of thefinancial innovation in the eighties of the 20th century, the demand for moneybecame instable so that the money supply became uncontrollable. Therefore,using monetary targeting rule could not realize the objective of stabilizingeconomy, and many countries turned to inflation targeting rule one after another.Inflation targeting rule did not need the monetary authorities target on somenominal variable. It could use the information provided by all nominal variablesincluding interest rate, exchange rate, money supply and all real variableincluding real output, employment, real economic increase rate, etc. to estimatefuture inflation and take corresponding action to make it in the targeting range.The difference between price-level targeting and inflation targeting is that thetarget of price-level targeting is not the growth rate of price but medium-term orlong-term price. Thus after suffered from economic disturbance, the currencyauthorities have to make the price level back into the targeting range. Unlikeinflation targeting, the target pined by nominal income targeting is the sum ofinflation and the growth rate of real output. Therefore, if the growth rate of realoutput is stable, nominal income targeting is similar to inflation targeting.However, because the effect of monetary policy to nominal income is morevolatile than to inflation, nominal income targeting is more difficult to controlthan inflation targeting.The studies on instrument rule began from Milton Friedman. Through makingparticular study on the monetary history of the United States for almost a century,Friedman thought that the discretional monetary policy is a crucial source toinduce unstable economy. So he advocated a rule that the money supplyincreased in accordance with fixed growth rate. This rule is called Friedman rule.Because it limited the central bank's flexibility completely, Friedman rule hadlittle feasibility in practice. Bennett T. McCallum improved Friedman's rule offixed growth rate by using more controllable money base as instrument andadjusting its growth rate according to the change of nominal income and velocityof money. This rule is called McCallum rule. However, because most developedcountries use interest rate as instrument of monetary policy and output andinflation as targets, John B. Taylor recomposed the instrument and objectives ofMcCallum rule and established a rule which uses short-term interest rate asinstrument and real output and inflation as objectives. This is the famous Taylorrule. Taylor rule has been widely concerned because it simulated actual policy ofFederal Reserve in principle and could judge whether monetary policy wassuitable or not. The appearance of Taylor rule made people reconsider themeaning and role of instrument rule.Since our central bank published the targets of money supply in 1994 officially,monetary targeting rule has been introduced to our country since then. However,monetary targeting in our country has been being the problem of controllabilityin practice. Investigating the reasons, there are design problems of the monetarytargeting per se and problems of environment to implement monetary policy.Among which the fixed exchange rate system pegging on US dollar is one reasonthat leads to deficient controllability of monetary targeting. This dissertationanalyzes the applicability of other targeting rules and the illumination of inflationtargeting rule to the monetary policy of our country. Besides, this paper reviewsthe domestic research on Taylor rule, and carries through a demonstrativeresearch on McCallum rule, and then analyzes the instructive meanings of Taylorrule and McCallum rule to our country.The main conclusions of this dissertation are as follows.First, monetary policy rules can provide definite nominal anchor for theoperation of monetary policy, and can stabilize the inflationary expectation of thepublic and then avoid the time inconsistent problem of the monetary policy.Therefore, Central Bankers should not use discretion but follow certain rule ofmonetary policy when they operate monetary policy.Second, all of the instrument rules and targeting rules are the resorts to restrictthe discretion of the currency authorities. The purpose of rules is to realize thefinal goal of monetary policy: stabilizing output and inflation. Accordingly, thetool used by monetary rule must have controllability and have close relation withthe final goal of monetary policy. For reflecting the operational results of policytool quickly, it must be monitored easily too.Third, because any rule has its characteristics and applicable bounds so thatthere is no monetary policy rule that can by applied to any country and anycircumstance, central bankers should take the native situation and thecharacteristics of different rules into consideration when choosing monetarypolicy rule.Fourthly, monetary targeting in our country has been being the issue of lack ofcontrollability. There are various reasons resulting in this problem includinginstitutional arrangement of monetary targeting as well as the exteriorenvironment in which monetary policy put into practice. Thus we should startfrom these two aspects to resolve this problem. For the other targeting rules, ourcountry has no condition or necessity to adopt them now.Fifthly, McCallum rule is more coincident with the situation of our countrythan Taylor rule. Because it uses money base as instrument and nominal incomeas target, McCallum rule is more consistent with the operation of the central bankof our country. Besides, nominal GDP targeting can keep away from the problemof measurement of output gap and inflation gap which embarrassing Taylor rule.Sixthly, although it is not proper to publicly enounce to set down our country'smonetary policy according to the Taylor rule or McCallum rule, these rules canprovide an effective guidance for our central bank to operate monetary policy. Inaddition, Taylor rule and McCallum rule can still provide a frame reference toevaluate the degree of tightness of our monetary policy.The innovations of this dissertation are as follows.First, this dissertation carries through a systematical and comprehensive studyon monetary policy rules, and analyzes the inheriting and developing relation ofevery kind of rule, and carries through dialectic comparison and evaluationamong monetary rules.Second, this dissertation combines the research on monetary policy rules withthe practice of our country's monetary policy, and investigates problem ofcontrollability of monetary targeting in our country and puts forwardcorresponding countermeasures, and analyzes the applicability of other targetingrules, and studies the use for reference of inflation targeting for the currencypolicy of our country.Thirdly, this dissertation carries out a positive research on McCallum rule, andsimulates the practice of monetary policy of our central bank since 1994, andreaches the conclusion that the operation of monetary policy in our countrypresents obvious character of pro-periodicity.Fourthly, this dissertation deduces the response function of money base inopen economy and unveils the meanings of the parameters of McCallum rule.Fifthly, this dissertation discusses the applicable foreground of Taylor rule andMcCallum rule for our country's monetary policy in detail, and analyzes their usefor reference to the monetary policy in our country.