What Are The Monetary Rules For The Federal Reserve?

In our discussion of monetarism we laid out the case for fixed policy rules. The traditional argument for fixed rules is that the private economy is relatively stable and active policymaking is likely to destabilize rather than stabilize the economy. Moreover, to the extent that the central bank may be tempted to expand the economy before elections and to create a political business cycle, fixed rules will tie its hands. In addition modern macroeconomists point to the value of being able to commit to action in advance. If the central bank can commit to follow a no inflationary rule, people's expectations will adapt to this rule and inflationary expectations may be damped.

Until recently advocates of fixed monetary rules recommended a fixed nominal growth of say 4 percent per year in the money supply. With a constant velocity and output growing at 3 percent a year, this would lead to steady annual inflation of 1 percent. But as the data on velocity show, velocity was never terribly stable and it has become much more unstable in the last decade. Given the apparent instability of velocity, it would be hard to claim that a fixed monetary rule could have actually stabilized output during this period.