Question

What is a monetary rule, as opposed to a monetary policy? What monetary rule would Milton Friedman have liked the Fed to follow? Why has support for a monetary rule of the kind Friedman advocated declined since \(1980 ?\)

Short answer

A monetary rule is a policy guideline venture that commits the monetary authority to a certain course of action based on set rules, unlike a monetary policy that adjusts according to economic conditions. Milton Friedman favored a constant growth rate rule, conducting monetary policy by increasing the money supply with a fixed percentage each year. The support for this monetary rule has declined since 1980 due to the advancement of technology affecting economic indicators and the prominence of the theory favoring discretionary monetary policies for stabilizing real economic variables.

Step-by-step solution

Understanding Monetary Rule and Monetary Policy

A monetary rule refers to a normative policy guideline venture to regulate the flow of money within a national or global economy. It functions under an established set of rules that commits the monetary authority towards a certain course of action. On the other hand, monetary policy refers to the actions undertaken by a monetary authority, like the Fed, to control the supply of money and interest rates. While the monetary policy may be adjusted regularly according to economic conditions and financial indicators, the monetary rule operates by strict regulations without modifications.

Milton Friedman's Monetary Rule

Milton Friedman was a strong supporter of monetary rule over discretionary monetary policy. His preferred rule was a constant growth rate rule, where the money supply would be increased by a fixed percentage annually. This rule was aimed to prevent erratic changes in the money supply, and to reduce unpredictability, enhancing economic stability and growth.

Declining Support post-1980 for Friedman's Monetary Rule

The decreasing support for Friedman's monetary rule post-1980 can be reasoned by two factors. Firstly, the advancement of technology and evolution of financial systems made monetary aggregates less reliable indicators of economic conditions. Secondly, increasing acceptance of the theory that monetary policy had a role to play in stabilizing real economic variables, such as unemployment rate and output, led many to favor discretionary monetary policies over hard rules.

Key concepts

Monetary Policy

Monetary policy is a set of actions that a country's central bank or monetary authority takes to manage the money supply and interest rates. Its goal is to achieve economic objectives like controlling inflation, consumption, growth, and liquidity. Central banks, such as the Federal Reserve in the United States, adjust monetary policies based on economic indicators to stabilize or stimulate the economy as needed. This flexible approach allows central banks to respond directly to current economic conditions, often employing tactics such as changing interest rates or altering the amount of money in circulation.
Monetary policy can be expansionary or contractionary:

• Expansionary policy: Aimed at increasing the money supply and decreasing interest rates to encourage economic growth.
• Contractionary policy: Targets reducing the money supply and increasing interest rates to control inflation.

By understanding and manipulating these facets, monetary authorities attempt to ensure that the economy remains stable and growing.

Milton Friedman

Milton Friedman was a highly influential economist, renowned for his advocacy of monetary rule over discretionary monetary policy. He believed that economic instability was often caused by erratic government interventions in the money supply. Friedman's solution was a monetary rule known as the "k-percent rule," where the central bank would expand the money supply at a constant rate every year, irrespective of the current economic conditions. This rule was intended to align with long-term economic stability by eliminating unexpected fluctuations in the money supply.
Friedman argued that a consistent growth rate in money supply would mitigate inflationary pressures and avoid boom-and-bust cycles. He emphasized predictability, suggesting that markets thrive better under conditions of certainty. Despite his dedication, the rise of flexible monetary policies and sophisticated financial systems have caused a shift away from strict adherence to such rules.

Federal Reserve

The Federal Reserve, commonly referred to as the Fed, is the central bank of the United States and plays a pivotal role in the country's monetary policy. Established in 1913, its primary objectives are to promote maximum employment, stabilize prices, and moderate long-term interest rates.
The Fed utilizes several tools to implement monetary policy:

• Open Market Operations: Buying or selling government securities to influence the money supply and interest rates.
• Discount Rate: The interest rate charged to commercial banks for borrowing funds, influencing the levels of banking activity and money supply.
• Reserve Requirements: Dictating the minimum reserves a bank must hold, affecting the amount of money banks can lend.

In recent decades, the Fed has been instrumental in managing economic crises and maintaining economic stability through adaptive monetary policies, which have sometimes diverged from rigid rules proposed by economists like Milton Friedman.

Economic Stability

Economic stability refers to a situation where an economy experiences constant growth, low inflation, and reduced unemployment levels. It is a desirable outcome for policymakers as it creates a conducive environment for economic growth and development. Stability is achieved through a balance of various economic factors, and monetary policy plays a crucial role in this process.
Several factors contribute to economic stability:

• Predictable Policies: When policies are predictable and consistent, it assures investors and consumers, fostering trust and engagement in the economy.
• Controlled Inflation: Keeping inflation at manageable levels ensures that the value of money is stable, preventing future economic disruptions.
• Employment Levels: High employment contributes to aggregate demand and production, maintaining the cycle of economic growth.

Achieving economic stability is challenging, and central banks, like the Federal Reserve, strive to adjust policies to meet this goal, which contrasts with the more rigid approach proposed by monetarists like Milton Friedman. His concept of a fixed monetary rule, aimed at enhancing stability, has seen declining support as newer economic theories highlight the benefits of adaptive policy measures.