Essay: Monetary Policy – Rules or Discretion?

In a economy recently plagued with housing market crashes and financial crisis, we can easily see the vital functions that a monetary policy has on anticipating and preventing instability in our economy. Understanding how monetary policy works and how it can be affected, by either rules or discretion, is crucial and all possibilities must be taken into account to establish the most effective outcome for our economy.
Monetary policy is an extremely valuable guideline for our economy. Small changes in the money supply can affect the price level, interest rates and almost all aspects of the macroeconomic world. When looking at monetary policy, understanding the variables of each argument can help us determine a more extensive view of each policy.
Using the Rule approach in monetary policy infers that, ‘the policy instruments of the central bank would be set according to some simple and publicly announced formula, with little or no scope for modification or discretionary action on the part of policymakers’ (Bernanke). Therefore in the context of describing a rule, it’s merely a restriction that is placed in such a way that it limits the authorities discretion of monetary actions. The ‘K-Percent Rule’, a famous proposal by the most prominent advocate of using rules in monetary policy states, ‘the central bank would be charged with ensuring that some specified measure of the nation money supply increase by a fixed percentage each year, irrespective of broader economic conditions’ (Bernanke). Although this rule never came into effect, it’s a great example to show a rule-based policy that would be put into place, which could not be altered by discretion. Therefore, in addition to restricting discretion, ‘Friedman argued, a rule of this type would have the advantages of simplicity, predictability, and credibility, and would help insulate monetary policy” (Bernanke). These rules are used therefore, to restrict judgment and create set guidelines.
Under Discretion, however, ‘a monetary authority is free to act in accordance with its own judgment’ (Dwyer). A discretional approach to monetary policy is simply giving the central bank, or monetary authority the ability to act upon monetary policies based on current circumstances and situations. In the eyes of discretional advocates, the use of strict rule based policies is too inflexible and restrictive to have an effect in a real world setting. Proponents of discretion, ‘have firmly rejected the use of strict rules for policy, arguing that central bankers must be left free to set monetary policy as they see fit, based on their best judgment and the use of all relevant information’ (Bernanke). Opposed to using a strict rule based monetary policy, using discretion has many advantages of its own. Discretion was described, as giving a monetary authority the power to act in accordance with its own judgment. This policy helps to create flexibility and allows for creation of adjustments as situations occur. This particular monetary policy has more power when it comes to unforeseen circumstances and scenarios that have not been planned nor accounted for. Buol states example of this monetary policy in effect as such, ‘Under a discretionary regime, policy-makes would have the flexibility to bail out innocent victims’under a ‘no bailout, period’ rule, all flood victims would be on their own’ (Buol). Discretion is able to analyze the current market situation and take into account many factors that could come into play, and utilize current market tactics to help stabilize monetary markets.
As with all things, each policy has its own advantages and disadvantages. Rule based policies must account for many possible scenarios with procedures and formulas that can be used to calculate each as they occur. Because rules are strictly based, meaning no discretion, they lack the possibility of human error, but make up for it in the inadequate response of disastrous or unprepared events. This rule-based policy is effective because, ‘Rules can directly limit the actions taken by a monetary authority’ (Dwyer). Discretion, however, is not limited by formulas or specific guidelines and can therefore adapt to circumstances that are unseen and create procedures or take the steps necessary to restore balance to the economy.
And so, while each of these policies has their pros and cons, I believe there should be a stronger merge between these two policies for our economy. Each is effective, yet they both lack a strong foundation that should exist at the core of our monetary policy. Ultimately, discretion should play a key role in determining the advancement of our monetary policies. We live in a day where the unpredictability outweighs the predictability. Accounting for these improbable scenarios is something that a strict rule based monetary policy cannot attest to. In the past, the rule-based policy has been beneficial, but as our world increases forward I am becoming more of an advocate towards discretional monetary policies.
Bernanke, Ben S. “FRB Speech: Bernanke–Constrained Discretion and Monetary Policy–February 3, 2003.” FRB Speech: Bernanke–Constrained Discretion and Monetary Policy–February 3, 2003. N.p., 03 Feb. 2003. Web. 10 Apr. 2014.
Dwyer, Gerald P., Jr. “Rules and Discretion in Monetary Policy.” Http://research.stlouisfed.org/. N.p., May-June 1993. Web. 07 Apr. 2014.
Buol, Jason J., and Mark D. Vaughan. “Publications.” Rules vs. Discretion: The Wrong Choice Could Open the Floodgates. The Regional Economist, Jan. 2003. Web. 10 Apr. 2014.