A Simpler Monetary Policy Rule Than The Taylor Rule

A Brief Exposition Of The Taylor Rule

According to a 1993 paper by John B. Taylor, the Taylor Rule is defined as follows:

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 (trend real GDP)

2 is an assumed target rate of inflation

This rule is dominated by ambiguous concepts, i.e. target inflation rate and trend or potential growth of GDP, and by its focus on inflation. Another objective of this rule appears to be to smooth the business cycle and to make the business cycle more predictable. It is aimed at reducing discretionary monetary policies.

Professor Taylor also concludes his article in diminishing the value of his own rule by saying “This paper has endeavored to study the role of policy rules in a world where simple, algebraic formulations of such rules cannot and should not be mechanically followed by policymakers.” (Emphasis added) So what is it then a rule or a rubber band at the discretion of Fed chairmen like the irresponsible Ben Bernanke. If I were a cynic, I would say economists always leave a door open for them to come in as advisors for if there were simple hard rules what would be left for economists to do.

What Taylor seems not to have explicitly taken into account is the time value of money or the principle that money (cash or borrowed money) should never be cheap, because cheap money leads to overinvestment, higher government and private sector indebtedness and overspeculation.

Taylor also appears to be more concerned whether his rule fits historical macroeconomic data and therefore can be perceived to have explanatory power or so.

I am also not quite sure whether Taylor’s Rule always sets interest rate above the current inflation rate since he uses target inflation and trend GDP.

A Simpler Rule

Thus, a much simpler monetary policy rule would be to prohibit central banks to set their key short-term interest rates below inflation plus some factor (e.g. trend rate of GDP growth). This rule is easy to observe for the markets and for anyone.

I previously introduced this simpler rule in two other blogs (http://bingelt.blogspot.com/2012/01/us-fed-continues-to-be-reckless.html & http://bingelt.blogspot.com/2012/07/great-recession-caused-by-reckless.html).