Discretion indicates that one or more policies can be taken flexibly by the monetary authority to achieve certain economic targets, according to its judgment of the current economic situation. While regularity indicates that the monetary authority should take currency supply as the only policy instrument, and decide the currency supply according to a single rule, not the monetary authority’s judgment.
When initiating and implementing monetary policies, whether discretionary policy or rule-based policy should be used by the government is always a subject of the controversy. This issue gets more attention after the financial crisis in 2008, when monetary policy became a major method for macro-economic control. According to Wang, Chinese financial market requires more policy transparency, and the government should make full use of the “stabilizer” (rule-based policy). Studying in the Eliot School, the George Washington University, Wang suggests that the regularity is a good method that can enable the public to know more about the policymaking bodies and the current trend of the market, which is very important to the social stability. And it is right for the present market in China. The rule-based monetary should be attached more importance and work as the major method of monetary policy.
Before the stagflation in the 1970s, Keynes’ theory, which supports the discretionary monetary policy, was widely accepted by the public. In his work The General Theory of Employment, Interest and Money (1936), Keynes pointed out that the economics itself is erratic. The long-term growth rate often deviates from the short-term growth rate, so the economic fluctuates and hard to maintain a balanced state (p. 13-23). Faster short-term growth rate gives rise to higher social effective demand. When the demand is greater than the supply, inflation takes place. Conversely, when the long-term growth rate exceeds the short-term one, social effective supply will be higher than effective demand. The economy will depress and employment rate will go down. Therefore, the government should interfere in the economy actively, to avoid the possible economic crisis and depress the unemployment rate, and to pursue the optimal equilibrium for the market. Government intervention always requires counter cyclical policy, so this kind of policy is also called discretionary policy.
The discretionary policy performed very well. Many central banks implemented monetary policy actively in that time and obtained good results. But in the 1970s, stagflation took place in many major economies. Both the unemployment rate and inflation rate went up, and this phenomenon cannot be explained by Keynes’ theory. Therefore, more and more queries were raised, and then the neoclassicism economics, which supports the rule-based monetary policy, was introduced.
Neoclassicism, one school of economic thought, claims the central bank can use only currency supply as the measure of monetary policy, to coordinate the growth of currency with the growth of economy. These monetarists attach high importance to the direct transmission mechanism and believe that policy transmits without the participation of interest rate, so currency supply can be set as the only intermediate target. In his article “Rules versus Authorities in Monetary Policy,” Simons (1936) stated that a stable monetary policy with legal effect is invaluable for the enterprises, and the optimal rule for monetary policy is to fix the money supply (p. 28-30). Based on their theory, currency supply will influent the commodity price level in the market, thus preventing the economy from overheated or depression. Neoclassicism also argues that there is intrinsic stability in the private economy, and it is the necessary condition for the government to take the rule-based policy.
One reason that neoclassicism argues against the discretion is it will lead to an undue influence on the market. Friedman (1948) studied the history of American monetary policy, and found that using discretionary policy cannot stabilize the economy, but aggravate economic turbulence instead. After discretionary policy is implemented, it takes a long time to let the policy to come into force. The lagging effect will let the central bank takes excess policy mistakenly and thus lead to economic instability and inflation (p. 247-250).
An analogy can be used in this case. An economy deviates from the optimal condition can be seen as a patient catch a cold. The patient may go to see a doctor and then get his medicine. This kind of medicine might enable him to recover in two weeks. The patient, however, wants to get rid of the cold quickly, so he decides to take more pills than he should take as is advised by his doctor. It is what the government does sometimes. But in more cases, the government cannot find the doctor, and even cannot know how long the medicine takes to come into effect. The only thing that the government can do is to look at the market reaction, so it is understandable that it always takes undue policy when using discretion.
Therefore, after 1970, the central bank always sets an explicit and direct target, especially when controlling the inflation. In order to build a stable nominal anchor, the central bank prefers policy base on a clear rules but not on discretion, since it is believed that the stable price is the prerequisite of growth. The central banks’ actions are also strong supports to the regularity. According to Li (2012), by studying the data between 1998 and 2011 in Chinese market, the Chinese central bank is following the McCallum rule (p. 31). Li concluded that the rule-based policy works well and the McCallum rule can be even used as an important reference index of current monetary condition in the market.
Another reason that neoclassicism argues is regularity can solve the time inconsistency. Compared to the uncertainty of the discretionary policy, the rule-based policy enables the market to form better future expectations and thus stabilizes the economy. Kydland and Prescott (1977) came up with the idea of inconsistency. In their study, they pointed out that the uniform solution derived from the optimizing control theory is a suboptimal solution. The cause of this problem is that the policymaker does not take into consideration that the future policy would affect the current expectation and action. Kydland and Prescott suggested that under discretionary, the central bank’s short-sighted and speculated actions will lead to the deviation of inflation and make the future market more unpredictable. In order to enhance the stability and credibility of policy, the government should implement specific and constant policy, which can be easy understood by the public and can help the public form homogeneous expectation. A better socially equilibria can be reached if the government makes a pre-commitment according to the rules (p. 475-490).
To explain the idea of inconsistency, imagine a game between private sector and monetary authority. The private sector knows that, a rational and farsighted government has the motive to change its policy, if it can increase social welfare. Besides, a government takes discretionary policy can change its policy after announcement legally. So it seems reasonable that the central bank will create a short-term inflation after declaring a low inflation target, in order to stimulate the economy. When understanding the facts above, the public will not follow the central bank’s expectation. The public will make questions on the central bank’s reliability and thus act contrary to policy based on the rational expectation. The private sector, therefore, will adjust its expectation and future action to increase its own welfare, which would affect the inflation level and result in an inflation bias. In this case, the policy will become invalid. In short, the discretionary policy encourages speculation in the market and thus increases the cost of policy implement and depress the social welfare.
An example is, even though knowing it is dangerous to live in the places vulnerable to flooding, people would like to build their houses there, since the land prices are very low. Discouraging people from living by the river, the government might announce that, when floods occur, doles will not be provided to the people who build housed in these areas. However, it might be noticed that the government will not sit by and do nothing if floods occur. Therefore, they will adjust their expectations and actions to increase its own welfare – they will ignore the policy and build houses by the river. In this case, the policy fails. Since more and more people live in these places, the government has to give up what it has said, and pay more money for the prevention and control measures. This kind of game between the public and the government will surely increase the policy cost and lower the social welfare.
In order to avoid this kind of problem, rule-based policy is needed. Regularity can enhance the money authority’s credibility. Only when everyone believes the policy will be executed determinedly, the policy can come into force.
Empirical evidences also provide supporting evidences. Fang (2011) collected seventeen-year monthly financial data from January 1992 to June 2009, and examined the volatility effect by setting up a vector autoregressive model. Studying the relationship between GDP, fixed asset investment, fiscal expenditure and taxes, Fang reached a conclusion that rule-based is better than discretionary. Fang suggests that the fiscal policy is supposed to work as a stabilizer first. It means the policy should focus on enhancing the policy certainty and predictability, and reducing the distortion in the market (p. 42-43).
Some people still claim that a discretionary approach is necessary for macro-economic control, so discretion should be used as a major method in monetary policy. According to Keynesianism, with an imperfect market mechanism, prices and wages are viscous all the time. When prices and wages deviate from the full-employment equilibrium, it takes a long time for the economy to return to. Therefore, to accelerate the recovery of economy, a simulation of aggregate demand is indispensable. There are three major methods to interfere with the market, one of them is the macro-economic control. The macro-economic control refers to counter the economic cycle, minimize the economic volatility and stabilize the market. It means that the government is supposed to make policy according to the present economic condition. When the economy is overheated, deflation policy should be taken to manage the high inflation; when the economy is recessionary, expansionary policy should be adopted to increase the low employment rate. To realize these results, discretion is indispensable. This kind of Keynesian stimulus, however, will fail in the long term according to the rational expectations theory. The discretionary monetary policy is subjective and random, thus hard to attain this goal. As is stated above, a policy will fail without limitation of rules. The loss of credibility will destroy a central bank.
Some people further assert that the macro-economic control method is aimed at adjustment in the short term. No macroeconomic control is constant in the long term, so the discussion of the failure of Keynesian stimulus is meaningless. But the macro-economic control, virtually, is obliged to focus on both short term and long term. The “long-term” macroeconomic control does not mean constant, this is referring to the considerations of the effect and result of the policy. The neglect of long-term effect will result in economic fluctuation as is discussed above.
Furthermore, regularity is a requirement of a democratic society. Since the 1990s, more and more countries in the world pursue policy transparency and even set it as a major target of the monetary policy. One of the reasons is the limited rationality of government. Even though the government wants to do its best, it cannot always make the right decisions. Therefore, a set of rules is necessary. Another reason is that monetary and fiscal policy determines the resources distribution. The policy will affect everyone’s interest in the society, so it must reflect everyone’s appeal. However, it cannot work well without a set of rules and regulations. According to Simons (1936), “A democratic, free-enterprise system implies, and requires for its effective functioning and survival, a stable framework of definite rules, laid down in legislation and subject to change only gradually and with careful regard for the vested interests of participants in the economic game” (p. 29). So even though discretionary should be taken sometimes, the major instrument of the central bank must be the rules.
In conclusion, since rule-based policy will decrease the error as well as the uncertainty of policy making, increase the transparency and monetary authority’s credibility, there is no doubt that regularity should be taken as the major method of monetary policy the central bank.