Discretion versus policy rules in practice

This paper examines how recent econometric policy evaluation research on monetary policy rules can be applied in a practical policymaking environment. According to this research, good policy rules typically call for changes in the federal funds rate in response to changes in the price level or changes in real income. An objective of the paper is to preserve the concept of such a policy rule in a policy environment where it is practically impossible to follow mechanically any particular algebraic formula that describes the policy rule. The discussion centers around a hypothetical but representative policy rule much like that advocated in recent research. This rule closely approximates Federal Reserve policy during the past several years. Two case studies-German unification and the 1990 oil-price shock-that had a bearing on the operation of monetary policy in recent years are used to illustrate how such a policy rule might work in practice. The econometric evaluation of monetary and fiscal policy rules using new methods of “rational expectations” macroeconomics has been the subject of substantially increased research in recent years.l A number of factors *Research was supported by a grant from the National Science Foundation at the National Bureau of Economic Research and by the Stanford Center for Economic Policy Research. I am grateful to Craig Furfine, Ben McCallum, Volker Wieland, and John Williams for helpful comments and assistance. ‘The forthcoming volume by Bryant, Hooper, and Mann (1993) summarizes much of the empirical research with large multicountry models. A recent Federal Reserve System conference summarized in Taylor (1992) was largely devoted to the analysis of policy rules. A prototype empirical analysis was provided by Taylor (1979) with a full multicountry analysis described in Taylor (1993). F&search by McCallum (1988) has also generated considerable interest in econometric evaluation of policy rules. Much of the material in this paper is drawn from Taylor (1993). 0167-2231/93/$06.00