RDP 8605: On Some Recent Developments in Monetary Economics 5. Policy Rules

The notion of a stable money demand function lead obviously and directly to the idea that monetary policy should be implemented with the aid of a target for growth of (some measure of) the supply of money.

The high inflation of the 1970s gave impetus to the introduction of monetary “targets”. It was argued that steady reductions in growth of money supply would eventually lead to the elimination of inflation. Announcement of this plan in advance would, it was hoped, reduce the disruption to real activity that would otherwise be expected to accompany an anti-inflationary tightening of monetary policy. Some also saw monetary targets as a way of imposing discipline on the monetary authorities. This approach was reinforced, in some minds at least, by research into so-called “rational expectations”. In some versions of this literature the (very strong) argument was made that an announced (and credible) reduction of monetary growth would produce a parallel reduction of inflation with virtually no disruption to real activity.

The strong version of the argument was tested with the sharp tightening of U.S. monetary in the early 1980s. Although there are those who question whether the test was sufficiently “clean”, most economists accept that the episode showed that anti-inflationary monetary policy will involve real costs in the short-term. Of course, the main message of the experience is that sufficiently determined monetary policy can get rid of inflation. This was achieved notwithstanding a very large fiscal deficit. Although there was a major initial check to economic activity, subsequent developments included a major economic recovery with inflation still declining.

The strong form of the rational expectations argument is now believed to be a special case; it is now commonplace to find rational expectations models with essentially Keynesian features.[15] However, the debate on the proposition did focus attention on an important issue: the interrelationships between economic policy and private responses to policy changes.

All of the rational expectations macromodels (like their predecessors) are based on aggregate relationships, which are as subject to problems as Friedman's money-income equation. These relationships therefore cannot be a solid basis for the actual conduct of policy using rigid rules when economic relationships are changing, because of changes in the regulatory framework, innovation by the private sector, or for whatever reason.

It might be noted that this point also applies to those models which attempt to model policy decisions in a choice-theoretic manner, or as the outcomes of strategic games between policymakers and private agents.[16] While the macroeconomic relationships which represent the economy remain based on the relatively simple, aggregated “stylised facts” of present day macroeconomics, such models will remain of limited value. Judgements have to be made about the practical relevance of changes in economic relationships.


Begg (1982) and Gale (1983) survey this area. [15]

Van der Ploeg (1984) is an example of the first type of model; Barro and Gordon (1983) and Canzoneri (1983) of the latter. [16]