What are the advantages and disadvantages of using rules versus discretion in macroeconomic policy making?

The Taylor rule, a monetary policy rule set by US economist John B Taylor in 1993 as a simple equation to guide policymakers when setting the federal funds rate is a good example. It ties the policy rate to levels of inflation and growth. There have been discussions since then on the place of rules like the Taylor rule in future monetary policy. See Ben Bernanke's 2015 paper: "The Taylor Rule: A benchmark for Monetary Policy"? These include whether monetary policy rules should be prescriptive or backed by legislation, with central banks having to explain any deviation. At a time when central bankers face criticism on their policy stance, it will be interesting to see if there are renewed calls to constrain their policymaking discretion.

Economist Milton Friedman proposed having Central Bank monetary policy be replaced with a computer that grew the currency supply at a fixed rate. Other economists and schools of thought have instead opted for discretion by policy makers and central bankers to change macroeconomic conditions. All current major macroeconomic policies are guided by pollical influence and discretion. While some central banks have been tasked with macroeconomic mandates like low inflation or low unemployment, other central banks offer a range of discretion and rule following. Some empirical evidence has shown that central banks that are less politically threatened and more independent have delivered better macroeconomic outcomes.

In macroeconomic policy-making, "rules" refer to fixed guidelines or formulas that policymakers follow consistently, like a set path. For example, a central bank might follow a rule to adjust interest rates based on a specific formula tied to inflation and economic output. "Discretion," on the other hand, allows policymakers the flexibility to make decisions based on current economic conditions. It’s more about judgment and less about sticking to a pre-defined path. Using rules can provide stability and predictability, making it easier for businesses and consumers to plan for the future. Discretion offers the flexibility to respond to unexpected changes or crises in the economy.

Discretionary monetary policy has a built-in positive inflationary bias and the cost of this bias if not measured properly can seriously harm long term growth of the economy. If central banks adopt such a policy it will hurt its credibility as the monetary authority is least likely to achieve its target of say inflation anchoring. On the other hand, rule based monetary policy strictly achieves its objective and has no bias at all. Thus, rule based monetary policy enhances the credibility of the central bank and is beneficial for overall growth of the economy.

Using rules in macroeconomic policy-making has several advantages. First, rules provide consistency and predictability. When businesses and consumers know what to expect from policy changes, they can plan better, which can lead to more stable economic growth. Rules also help prevent policymakers from making decisions based on short-term political pressures. By sticking to a set framework, policies are more likely to focus on long-term economic health rather than immediate gains.Clear, rule-based policies make it easier for the public to understand and trust economic decisions. This can enhance the credibility of institutions like central banks, leading to more effective policies and stronger economic outcomes.

Before 2016, India's Reserve Bank did not have an inflation target for its monetary policy. After 2016, the inflation mandate became part of the law. Post that, the RBI is entirely focussed on the consumer price index (CPI) for its monetary policy. We have seen the benefits of an inflation target in India. Whenever the inflation crosses 6% (upper limit), the RBI intervenes. Also, if RBI fails to bring inflation down within a considerable period, then it has to report the reasons to the Parliament. So, in one way, RBI's credibility in control of inflation is enhanced. Plus, rules have made RBI (the authority that should control inflation) accountable to the public.

One major disadvantage is the lack of flexibility. Fixed rules can’t adapt to unexpected economic changes or crises, which can lead to ineffective or even harmful policies during unusual situations. Another issue is the potential for rigidity. Rules might not account for all variables or new economic insights, making it difficult to address unique or evolving challenges effectively. Rules can also be too simplistic. Economic conditions are often complex and multifaceted, and a one-size-fits-all approach might not capture the nuances needed for optimal decision-making.

Podemos numerar algumas desvantagens do uso de regras fixas. Primeiro, as regras podem ser inflexíveis e não responderem com a devida efetividade às mudanças nas condições econômicas. Segundo, as regras podem ser difíceis de implementar, principalmente devido à distância entre aqueles que formularam a regra e aqueles que irão aplicá-la. Há também que se considerar as distorções entre a finalidade pretendida originalmente e o uso prático de determinada regra. Terceiro, as regras podem ser capturadas por grupos de interesse.

Flexibility is a major benefit. Policymakers can respond quickly to unexpected economic changes or crises, such as financial downturns or sudden inflation spikes, making timely adjustments as needed. Discretion allows for a more nuanced approach. Unlike rigid rules, discretionary policies can be tailored to the specific circumstances of the moment, addressing unique challenges with more precision. It also enables innovation and adaptation. As new economic theories and data emerge, policymakers can incorporate the latest insights into their decisions, potentially leading to more effective and relevant policies.

An entirely different approach from the rules or discretion paradigm is to ask whether there should be macroeconomic policy decided by centralized sources like central banks at all. One alternative is individuals transacting in alternative currencies such as crypto currencies which have no central issuer or policy maker. Another alternative is for individuals to choose their interest rate policy by transacting with institutions that offer private market interest rates paid in gold or silver that are unaffected by government interest rates. As interest rate policy becomes more discretionary and political it is possible that individuals and institutions will seek more stable and lucrative interest rate policies from alternative sources.