A k - percent rule for monetary policy in West Germany

The concept of rules for monetary policy has been more and more critized in recent years. The Deutsche Bundesbank is also urged to give up monetary targeting. The idea is that the economic performance could be improved if monetary policy became more pragmatic and was more concerned about slow growth and high unemployment. In reality, however, monetary policy in the past decades has been highly unstable and has thus contributed to business cycle fluctuations and inflation. The intended policy oriented at the production potential has not been followed in West Germany. In this paper, a simple model is used to analyze what could have been expected from a rule similar to the one the Bundesbank has intended to pursue since 1974. The simulations for the period 1972-1987 show that strict application of a k-percent rule would have implied less pronounced cyclical fluctuations of domestic demand and a stable price level on average. This result contradicts the view that rules for monetary policy are useless or even counterproductive. A K-PERCENT RULE FOR MONETARY POLICY IN WEST GERMANY I. The Recent Debate on Rules for Monetary Policy The controversy on whether monetary policy should follow rules or react in a discretionary manner has been around for a long time. In recent years, the discussion has become more controversial for several reasons. Some argue that, after monetary policy has fulfilled the task of reducing the high inflation rates which had built up in the seventies, the most pressing problem is now unemployment, particularly in Western Europe. But there is not only this shift in priorities. Many would go even further and say that monetary targeting has altogether failed, and that this has become most obvious in the eighties. These critics, too, point at the stubbornly high unemployment reflecting supposedly the cost of reducing inflation -, but in particular at the large changes in velocity in the United States and some other countries. The decline in velocity in the United States implied that inflation was cut drastically in spite of relatively strong money growth . Had monetary policy followed a fixed rule of, say, keeping monetary expansion at six percent per year -, the United States would have experienced a recession much more severe than the actual one in 1980/82. Therefore, the argument goes, the US-Fed was right in overshooting pre-announced targets and in following 2 a more pragmatic strategy . More recently it was pointed out, in particular by Meltzer [19 87] and McCallum [1987], that the alternatives are not fixed rules and discretionary policies. In their view, monetary policy can be adjusted to contingencies like "financial turmoils" which occurred in the United States during the period of financial deregulation and innovations in the early eighties and which had probably contributed to the fall in velocity. This reaction can The rapid expansion of monetary aggregates starting in the summer of 1982 led many observers to forecast a resurgence of inflation at that time. Blinder [1987] criticizes the concept of rules because it supposedly implies fixing a rudder in a stormy sea.