Policy of Discretion Versus Policy Rule in Monetary Policy - Essay Example

POLICY OF DISCRETION VERSES RULE IN MONETARY POLICY By al Affiliation Policy of Discretion Verses Policy Rule in Monetary Policy The examination of this project paper description research is to show how the discretion policy of econometric evaluation on the monetary policy rule can be of an application in the policymaking environment. According to the research of this paper, it is argued that a good discretion policy and a policy rule should typically call for changes in the funds rate of the federal state in order to respond to both price level and real income changes. The discretion policy rule in a monetary policy environment is to preserve the policy concept. Especially where it is impossible to follow any mechanical algebraic formula that is describing the policy rule (Fischer, 2008, p.39). The econometric discretion policy evaluate on fiscal and monetary policy by using the new rational expectation method of macroeconomics. This has been the substantial subject cause for increased recent year’s research. A number of factors have provided a motivation for the research. The critique of Lucas showed that traditional discretion econometric policy was flawed in its evaluation. This was supported by the fact that recognition of rational expectation is not an implication of monetary policy effectiveness as was being potted by the discretion policy. On the other hand, the finding that credibility has significant benefits which are empirical and the demonstration of time inconsistency is a blatant proof that policy rule are superior to discretion policy (Baumol & Blinder, 2011, p.41). Although it is possible to find precursors of the new policy rule research, the recent analyses have been made possible by estimation and solution techniques which are new in the wide economy equilibrium model. The empirical model development of consistent expectation of prices and wages dynamic is another key proof factor of policy rule applicability. Also, the multi-country empirical framework abilities to efficiently handle the international cash flows in the world market as a factor of occurrence has been a proof too for policy rule’s effectiveness than discretion. However, the policy rules preferred in this research description paper have generally not involved fixed settings for the monetary policy instruments. The instruments not involved are such as the phenomenon of constant growth rate for the supply of money. In this context, the rules have been proved to be responsive by calling for the changes in the supply of money, monetary base and the short term interest rates these callings are to provide a response to the changes in the levels of price and real income. In a discussion, some of the researches have been quite precise about this response of policy rule. The research explains that the coefficients policy rule algebraic formulas provide instructions which are exact on how much should be adjusted by the Fed. The instruments of policy rule responds to increases in real GDP and price levels as well due to these Fed adjustments. The functional forms and signs though they have differing form study to study, there has been some recently developed signs and forms which have been agreed into a consensus about (Lippi, 2009, p.71). One policy rule that captures the consensus spirit of the recent research and is agreeably considered to be quite straightforward is as follows: r = p + 5y+ .5(p-2) + 2 where r is the federal funds rate, p is the rate of inflation over the previous four quarters, y is the percent deviation of real GDP from a target. That is y = 100 (Y – Y*) / Y* where Y is real GDP Y* is trend real GDP (equals to 2.2% per year) However, these modifications would make it difficult and more complex to understand the policy rule. Even in equations and models with many modifications as such illustrated above, it is still difficult to see how such algebraic rules of policy could sufficiently be encompassing. For instance, the interpretation of whether a rise in the level of price is permanent or temporary has a likelihood of requiring that several measures of prices be looked at. Such prices measures can include producers’ price index, consumers’ price index and the employment price index. Another useful practice of policy rule is looking at the expectations of future market measure inflation, interest rate term structure, forecasts form other analysts and surveys. The interpretation of the growth rate and level of potential output of the economy is frequently a factor of policy rules. It involves the predictions of labor force participation, productivity and the natural rate if unemployment changes. The analysis of these economical and monetary is capable to be aided by the quantitative methods it is quite difficult to make their formulation into an algebraic precise formula. This is because there will be episodes in the economy where monetary policies will be needed to conducted an adjustment on in order to deal with factors which are special. A good example was the case when the Federal Reserve issued additional reserve to the banking system after the break of the stock market in 1987, October 19. The issued reserves consequently helped to prevent liquidity contraction and therefore restoring confidence in back to the banking sector. In such cases, the Fed would need more than just a mere simple policy to be as a guide (Baliño & Cottarelli, 2014, pp.56-7). Therefore, does this all mean that the policy rule must be all given up and that a return to description is to be made? Yes, in fact there are arguments which sound like the ones used by advocated rules in the past system which a conclusion that the discretion policy is just but only an answer. Macroeconomic is clear of one thing concerning the modern concepts in the monetary policies, that is, policy rules are of major advantages and benefits in improving the performance of the economy. This is indeed a provision that has a substantial consensus. Hence, this creates the provision that it is important to ensure the preservation of the policy rule concept. This is to be done so even in an environment where it is practically impossible to mechanically follow the algebraic formulas written down. Since the formulas are always used by economists when describing their policy rule preferred. In the semantic issues, there is a considerable consensus among almost all economists that there is need for the policy rule need to be interpreted narrowly. This is to provide a view that policy need is entailing settings which are fixed nature fir the policy instruments. Although the discretion debate versus classic rules was carried on in a manner that depicted policy rule as being a constant rule of growth rate for money supply. Policy rule was also regarded as a feedback rule in which money was responding to changes in inflation and unemployment. In the area of fiscal policy in a policy rule, there exist automatic stabilizers of transfer payments. The transfer payments of the stabilizers rise with taxation revenue and the rate of unemployment. In the area of exchange rate policy, a fixed exchange system is clearly a policy rule but is a crawling peg since they are adjustable (Kennedy, 2011, p.76). Transitional Representation between the Discretion Policies verses Policy Rules There have been questions on how to make a transition from one policy to another, that is, either a transition from discretion policy to policy rules and vice versa. This explains that economists have just been good at determining the system that works best but rather not how transition of the systems. Transition is effected and needed in a situation when it becomes clear that a policy is performing poorly and that a new system of policy is regarded that it would work much better. This is the phenomenon that leads to transition. For example, suppose that the target rate of inflation in the policy rule is identified to be too high. Rather than aiming at a 5% inflation rate per year, it is recognized much more targeting a 2% inflation rate per year would be much better in long run economic performance. In the transition process, only the intercept term is changed since the problem of transition is none other than the disinflation problem. The transition between the discretion policy and policy rule is therefore diagrammatically represented as below during analogous monetary policy intercept budget recognition. A policy rule needs not to be a mechanical formula but this is where disagreements among economists arise. A policy rule according to the economists can be more informally operated and implemented by monetary policy makers who recognize the responses of general instruments. The monetary policy makers must also recognize that the operating rules require judgment and hence cannot be done by computers. This broadens the policy rule definition significantly and permits the issues considerations that could have rather been exclude under narrower definition. A policy rule by definition would include a rule of nominal income in which the Central Bank takes action upon in order to keep the income on nominal target. But this process would not include pure policies of discretion. Under pure discretion policies, the instruments settings of a policy are determined from scratch in each period and there is no attempt in following a reasonable contingency which is well defined. The contingency normally contain the future plans within the monetary environment. A distinctive precise difference between the policy of discretion and the policy rule is drawn from the consistency of time literature. A policy rule is basically referred to as an optimal rule or as the precommitted solution specifically to the dynamic problem optimization. Discretionary policy is referred to as the shortsighted, cheating, or inconsistent solution. This literature description provides a demonstration that the advantages of rules over discretion are comparable to the advantage of cooperative over noncooperative game theory solution (Dadkhah, 2009, p.75). This presents the reason why may researchers have focused on the rules of policy than discretion in the recent policy normative research. As argued above the term policy necessarily needs not to mean either a fixed policy setting for the mechanical formula or policy instruments. For the monetary policy makers, policy rule term is a connotation of either simplistic mechanical procedures or policy fixed setting instruments. Bibliography Baliño, J. T., & Cottarelli, C. 2014. Frameworks for monetary stability policy issues and country experiences: papers presented at the sixth seminar on central banking. Washington, D.C., March 1-10, 1994. Baumol, W. J., & Blinder, A. S. 2011. Macroeconomics: Principles and policy. Australia, South-Western: Cengage Learning. Dadkhah, K. 2009. The evolution of macroeconomic theory and policy. Dordrecht, Springer. Fischer, S. 2008. Rational Expectations and Economic Policy. Chicago: University of Chicago Press. http://public.eblib.com/choice/publicfullrecord.aspx?p=408428. Kennedy, M. M. J., & Kennedy, M. M. J. (2011). Macroeconomic theory. New Delhi: PHI Learning Pvt. Ltd. Lippi, F. 2009. Central bank independence, targets, and credibility: political and economic aspects of delegation arrangements for monetary policy. Cheltenham, UK: Edward Elgar. Read More