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Monetary Rules and Their Application in Times of Economic Crisis and in the Euro Area

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Monetary Rules and Their Application in Times of Economic Crisis and in the Euro Area EKONOMIE MONETARY RULES AND THEIR APPLICATION IN TIMES OF ECONOMIC CRISIS AND IN THE EURO AREA Marianna Siničáková, Viera Pavličková Introduction to the rate of growth of real GDP in economy. This rule was used in a certain form in the year Nowadays, the strategy of monetary policy 1935 already, when statistician Snyder [21] esti- application has become one of the most discu- mated a 4% growth rate of trade in the USA and ssed topics. World economic crisis helps experts stable velocity of money. Taking this information to realize that no existing tool is perfectly efficient. into account, he assumed that a 4% expansion of Therefore, they try to analyse which kind of mone- money per year will lead to the economic stabili- tary policy rules would be most appropriate. Both ty. Later, in the 1960s and the 1970s, Friedman, politicians and economists defend their opinions; himself, advocated the rate of growth of money either they support the discretionary policy or the supply of 4 %, which was equal to the level of eco- policy of the rule. nomic growth at that time. Discretionary policy means that the central Even more significant increase in the number bank does not follow any pre-determined steps of monetary rule followers came in the 1970s how to proceed under certain macroeconomic and the 1980s. It was the case of Kydland and circumstances. The greatest advantage is the fre- Prescott [5] for instance. They pointed out the edom in the process of choosing reactions to the problem of time inconsistency. A time inconsis- economic actions. tent policy can make the public happy, but only On the contrary, monetary rule policy can be in a short run. In achieving long-run policy goals, guided by some specific rule that must be follo- only time consistent policy can be successful. wed by the central bank. This leads to the confi- They offered the explanation by using the example dence within the relationship between the mone- of floods. Long term goal of the government is to tary authority and other economic subjects. prevent houses in areas threatened by floods. Po- liticians will inform people that they will not help 1. Rule vs. Discretion Discussion them financially in the case of floods. However, Until the 19th century, the discretionary strate- in a short run, if the disaster really happens, they gy was preferred by most of the countries of the will still support those who have suffered losses. world. No precise monetary rules were applied by Therefore, in any future case, people will not con- monetary authorities except the “gold standard” sider the government’s threat credible, if it did not and the exchange rate stability [15]. However, du- act according to its commitments. It will be more ring the last 100 years, monetary rules have found difficult for the government to influence people’s their followers. Good example of such a rule was behaviour if any problem occurs. In general, by the “gold standard”, where the unit of account is using the rules, the problem of time inconsistency a standard amount of gold. will be eliminated. Wicksell [21] brought a very simple rule, but Monetary policy rules defenders were also Bu- still, it was not widely spread. Paradox is that it’s chanan and Brennan [5]. They were convinced the most important disadvantage was its simplici- that discretionary policy enables a central bank ty. Many experts criticized the fact that the interest to generate inflation above its optimal level. Barro rate in the economy is only influenced by one pa- and Gordon [28] expanded this theory in the rameter – price stability. 1980s and claimed that monetary authority will al- Friedman’s k-percent rule is world known. The ways have propensity to lower the unemployment rule is also referred to as the „golden rule of mo- at the expense of higher inflation. ney stock growth“ [17]. Friedman claimed that the At that time, McCallum invented the so-called rate of growth of money supply should be equal McCallum rule [21]. The author focused on strana 16 3 / 2011 E + M EKONOMIE A MANAGEMENT EKONOMIE monetary base as a central bank’s target. This In case that actual inflation rate exceeds the parameter is influenced by inflation rate, real target value, monetary authority should raise the GDP growth and growth of velocity of money. interest rate above its neutral value. Increase in McCallum claims the US economy would have interest rate will slow down the economic growth, achieved better results if it had followed his rule, raise the unemployment and inflation will get especially in 1930s and 1970s. back to its target. The rate of increase of interest In 1990s, monetary rules based on regulation rate is expressed by coefficient h, or a. of interest rate gained in importance. In 1993 J. On the contrary, a negative output gap (the B. Taylor presented a very easy monetary rule case when unemployment is higher than its na- which has become very popular immediately. Sin- tural value), the central bank should apply the ex- ce then, many countries all over the world have pansionary monetary policy and lower the interest applied this rule as a tool for monetary policy de- rate. This reaction will be followed by the rise of cision making process. the total product in the economy until it reaches its potential value. It will be connected with the 1.1 The Taylor Rule decrease of unemployment to the natural rate of unemployment. The author, J. B. Taylor, professor at the Stan- ford University, wanted to provide a very simple guideline for the monetary policy [25]. He fo- 1.2 Opinions of the Taylor Rule cused his research on the situation of the USA In general, the Taylor rule is considered to be and brought the equation that is now known and a supplement monetary tool to inflation targeting. applied by many countries all over the world. Eve- The rule focuses on achieving the inflation target rybody emphasizes its simplicity. The form of this in a middle-run. Moreover, it reacts to the GDP equation is: evolution that is closely connected to the inflation. i = Sgy + h (SS* r f (1) The Taylor rule is perceived very positively thanks to its intuitiveness, lifelikeness and simpli- i represents short-term nominal interest rate in city. In order to get the result, only data of actual percentage set by a central bank, S stands for the inflation and output gap are necessary. It descri- rate of inflation in percentage, S* means the infla- bes the policy applied in the past, as well as it pro- tion target in the economy, y is the output gap and vides certain guide how to proceed in the future. rf is neutral real interest rate that corresponds to The critics of this rule point out insufficient fle- zero inflation gap and zero output gap. Coeffici- xibility that ties banks´ hands. But, Taylor [1] him- ents h and g express the weights of both of these self defends his rule. He claims it is not determi- gaps. S*, r f, g and h are all positive values. ned absolutely and does not set the interest rate Other literature brings a slightly different equa- blindly. On the contrary, it reacts to the macroeco- tion [4]: nomic changes. One of the critics is Svensson [1]. He finds restrictive a very small number – 2 it = i* +a(StS* - b (utun (2) of parameters determining the monetary policy. It f where S plus r are replaced by one parameter, leaves no room for considering other information. that is i*. It expresses the target nominal interest Another important problem arises when we try to rate. The weights are a and b. The most important determine the exact level of neutral interest rate change here is the unemployment gap, which is and output gap or to choose the right set of data. used instead of output gap. As we know, higher During the past 20 years, practice has brought output is connected with lower unemployment some specifications of the Taylor rule in order to and vice versa. Therefore, the sign in front of this minimize the drawbacks. In general, we recogni- component is negative. se forward-looking and backward-looking Taylor Both equations claim, that if actual inflation rate rules. The former one uses predicted (ex-post) is equal to the target value and actual product rate values, while the latter one prefers actual data. has also reached the value of potential product The difference is visible on the example of the (output gap, or unemployment gap are zero), nomi- USA from 1997 [3]. Backward-looking rule su- nal interest rate set by the central bank should be ggested no change of the interest rate, but the equal to the target nominal interest rate (i , or + r f). t S forecasts-based one leads to increase in interest E + M EKONOMIE A MANAGEMENT 3 / 2011 strana 17 EKONOMIE rate. Detailed analysis showed higher costs in the interest rate should reach the values of about case of keeping interest rate stable. Therefore, -5 % in these months. It is, of course, impossible the Americans [3] claimed forward looking rule to to implement in practice. As current federal funds be more convenient and efficient. This fact is also interest rate is 0 %, the difference between calcu- supported by the main goal of monetary policy, lated and real value is significant, i.e. 5 %. Fig. 1 which is to influence the future evolution, not the provides the review of this situation: present one. Taylor said, his rule showed that the FED´s However, Taylor himself vindicates monetary policy is appropriate [26].
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