LOS 27d Describe alternative monetary policy strategies and explain why they have been rejected by the

There are lour alternative rules to the Taylor rule and the policy of targeting the federal funds rate as the key policy variable.

1. A rule called the McCallum ride focuses on the rate of growth of the monetary base, based on the quantity theory of money (MV=PY). The rule essentially matches the growth rate of the monetary base to the long-term growth rate of real GDP, adds the target inflation rate, and adjusts for changes in the velocity of money over time. The main drawback of this policy is that fluctuations in the demand for money can cause variations in interest rates that lead to fluctuations in aggregate demand.

2. A rule targeting the rate of growth of the money supply is closely associated with the work of Nobel Laureate Milton Friedman and the quantity theory of money. Friedman's well-known prescription for monetary policy is to grow the money supply at the rate of increase of potential real GDP. The drawbacks of targeting monetary aggregates, which was followed to a large degree in the 1970s when the Fed targeted the growth rates of Ml and M2, are that fluctuations in both the velocity of money and the demand for money can lead to interest rate swings and consequent variability in aggregate demand for goods and services.

3. A rule targeting the exchange rate suggests that money supply growth should be adjusted so that the exchange rate between a country's currency and some basket or index of the currencies of other countries remains stable. In this case the resulting inflation rate would be that of the other countries in the long term and the monetary authorities would have little control over it.

4. The final alternative is inflation targeting and this is practiced by many central banks with the notable exceptions of Japan and the United States. Under this rule, the central bank makes its inflation expectations explicit and uses open market operations and manages the overnight rate in such a way as to bring expected inflation into line with the target rate, typically 2% with an acceptable range of 1% to 3%. The advantage of this policy rule is predictability and transparency along with the stable expectations for future inflation that result from a centra! bank's credible commitment to stable prices (the target rate of inflation). Whether inflation targeting would have produced better results m terms of stable prices and economic growth than the targeting based on some variant of the laylor rule is still an open question and subject to ongoing debate.

Professor's Note: Inflation targeting is also discussed in the next topic re/new on central hanks. Note that even in the face of the slowdown in economic activity associated with the collapse of the U.S. housing market, the problems with sub-prime mortgage securities defaults in 2007-08 and the consequent risk of slowing economic growth and possible recession, the European Central Bank continued to make monetary policy decisions based only on data on current and expected inflation. Time will tell whether inflation targeting produces a better result than the U.S. policy, which has leaned more toward economic stimulus to reduce the probability and/or magnitude of a recession.

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