Policy Rules

The dispute about how monetary policy should be measured eventually led to a new way of approaching policy that neither side to the dispute originally saw. Policy need not be viewed as something outside the system, but can be seen as something inside it.

We have already assumed that businessmen, employees, and consumers are inside the system and react to the environment of that system. Consumers, for example, make spending decisions on the basis of their expected permanent income and businessmen invest on the basis of expected profitability, which depends on the expected future course of the economy and interest rates. In these and in other cases of people making decisions that are important for macroeconomics, people look at their environment and calculate what course of action will best serve them.

Sometime after 1970 economists began to look at policy making in a similar way. Policy is made by people who have goals and who must calculate how best to achieve those goals given the environment they face. As long as the goals and the understanding of the environment are constant, the policy makers should make decisions that have a pattern to them. They should be predictable to someone who understands the goals of the policy makers and their understanding of the environment. This predictable pattern in policy is a policy rule.

A great many rules are possible. The gold standard is a monetary policy rule. The Federal Reserve can try to maintain interest rates or levels of the money stock, two very different policy rules. During the Great Depression the Federal Reserve did not offset the monetary effects of bank runs, and has been criticized for this policy rule. During the Great Inflation in Germany, the central bank tried to keep up with the rising level of prices by issuing more money, a profoundly stupid policy rule.

Policy rules are not exotic items that only affect macroeconomics. We all react to policy rules constantly. For example, suppose two professors of economics have written in their syllabi that any student who misses three classes will fail the course. It would appear that they have identical policy rules, but suppose that one is known to be sympathetic to students with hard-luck stories while the other never grants exceptions. Would you expect the number of students cutting class the day before a major vacation to be the same for each? Do expectations matter?

These class-attendance policies seem to be imposed from the outside, but they may be in flux, being shaped by student behavior. Perhaps at one time the no-exceptions professor was sympathetic to student excuses, but found that this policy had bad effects—perhaps it encouraged students to invent excuses or gave a message that his class was not as important as a class with allowed no excuses. Policy rules not only affect behavior, but behavior in turn can shape policy rules.

Emphasis on policy rules leads to concerns about expectations and credibility that did not exist when economists focused on policy. They are worth a short exploration.

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Copyright Robert Schenk