A policy rule is a formula that tells the Fed how to set monetary policy. For example, in 1959 Milton Friedman argued that the Fed should increase the money supply a constant 4 percent each year to eliminate inflation and avoid destabilizing the economy. More recently, other economists have identified an additional benefit: A rule can eliminate inflationary bias that could occur when discretionary monetary policy is used. Under a discretionary policy, decision are made on a case-by-case basis.
But economists don't agree on how the economy works or on how monetary policy affects the economy. This lack of consensus makes the construction of a policy rule very difficult. A rule that works well in one model of the economy may not work well in others. But do different beliefs about the economy necessarily imply that no rule worked in all reasonable models of the economy? Or is it possible to find a rule to guide monetary policy that works fairly well for many different models?
This article appeared in the January/February 1995 edition of Business Review.
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