Models, Markets, and Monetary Policy: From Friedman to Taylor to Data dependent policy

Nice speech by Richard Clarida.

Let me set the scene with a very brief—and certainly selective—review of the evolution over the past several decades of professional thinking about monetary policy. I will begin with Milton Friedman’s landmark 1967 American Economic Association presidential address, “The Role of Monetary Policy.”2 This article is, of course, most famous for its message that there is no long-run, exploitable tradeoff between inflation and unemployment. And in this paper, Friedman introduced the concept of the “natural rate of unemployment,” which today we call u*.3 What is less widely appreciated is that Friedman’s article also contains a concise but insightful discussion of Wicksell’s “natural rate of interest”—r* in today’s terminology—the real interest rate consistent with price stability.

But while u* and r* provide key reference points in Friedman’s framework for assessing how far an economy may be from its long-run equilibrium in labor and financial markets, they play absolutely no role in the monetary policy rule he advocates: his well-known k-percent rule that central banks should aim for and deliver a constant rate of growth of a monetary aggregate. This simple rule, he believed, could deliver long-run price stability without requiring the central bank to take a stand on, model, or estimate either r* or u*. Although he acknowledged that shocks would push u away from u* (and, implicitly, r away from r*), Friedman felt the role of monetary policy was to operate with a simple quantity rule that did not itself introduce potential instability into the process by which an economy on its own would converge to u* and r*.4In Friedman’s policy framework, u* and r* are economic destinations, not policy rule inputs.

Of course, I do not need to elaborate for this audience that the history of k-percent rules is that they were rarely tried, and when they were tried in the 1970s and the 1980s, they were found to work much better in theory than in practice.


That vacuum, of course, was filled by John Taylor in his classic 1993 paper, “Discretion vs. Policy Rules in Practice.” Again, for this audience, I will not need to remind you of the enormous impact this single paper had not only on the field of monetary economics, but also—and more importantly—on the practice of monetary policy. For our purposes today, I will note that the crucial insight of John’s paper was that, whereas a central bank could pick the “k” in a “k-percent” rule on its own, without any reference to the underlying parameters of the economy (including r* and u*), a well-designed rule for setting a short-term interest rate as a policy instrument should, John argued, respect several requirements.




One Response to “Models, Markets, and Monetary Policy: From Friedman to Taylor to Data dependent policy”

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