A contributors' "who's who" from the academic and policy communities explain and provide perspectives on John Taylor's revolutionary thinking about monetary policy. They explore some of the literature that Taylor inspired and help us understand how the new ways of thinking that he pioneered have influenced actual policy here and abroad.
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The Taylor Rule and the Transformation of Monetary Policy
By Evan F. Koenig, Robert Leeson, George A. Kahn
Hoover Institution PressCopyright © 2012 Board of Trustees of the Leland Stanford Junior University
All rights reserved.
MONETARY POLICY RULES: FROM ADAM SMITH TO JOHN TAYLOR
Pier Francesco Asso and Robert Leeson
This paper is based on a paper prepared for presentation at the Federal Reserve Bank of Dallas' conference on "John Taylor's Contribution to Monetary Theory and Policy." It has benefited from comments from Ray Fair, John Taylor, participants at the Dallas Fed conference, and seminar participants at the Federal Reserve Board of Governors and at the Federal Reserve Banks of Boston and New York. Pier Francesco Asso is Professor of History of Economics at the University of Palermo, Italy. Robert Leeson is a Visiting Professor of Economics at Stanford University and a Visiting Fellow at the Hoover Institution.
At the November 1992 Carnegie-Rochester Conference on Public Policy in Pittsburgh, John Taylor (1993a) suggested that the federal funds rate (r) should normatively (with qualifications) and could positively (at least in the previous five years) be explained by a simple equation:
r = p + 0.5 y + 0.5(p - 2) + 2,
where y is the percent deviation of real GDP from trend and p is the rate of inflation over the previous four quarters.
Within a few months of the publication of the Carnegie-Rochester volume, members of the Federal Open Market Committee (FOMC) were using the formula to inform their monetary policy deliberations. Governor Janet Yellen indicated that she used the Taylor rule to provide her "a rough sense of whether or not the funds rate is at a reasonable level" (FOMC minutes January 31–February 1, 1995). Taylor visited the Fed board staff in early 1995 and was then asked to discuss the rule with the chairman and other members of the Board of Governors (December 5, 1995).
Athanasios Orphanides (2003) used the Taylor rule to examine the post-World War II history of U.S. monetary policy decisions. The purpose of the current paper is different: it is to shed light on the intellectual history of monetary policy rules, with special emphasis on the Taylor rule. Section 2 introduces the fundamental debate of rules versus discretion and output stabilization versus inflation stabilization. Sections 3–5 examine the early history of policy rules: from Adam Smith to the Great War (section 3), from the Great War to the Great Crash (section 4), plus gold and commodity standard rules (section 5). Sections 6–7 examine three influential rules-based advocates: Henry C. Simons (section 6) plus A. W. H. Phillips and Milton Friedman (section 7). Sections 8–9 examine the evolution of Taylor's thinking between 1976 and 1991, during his two spells at the Council of Economic Advisers (section 8), and in the months immediately preceding the Carnegie-Rochester conference (section 9). Section 10 examines the influence of the Taylor rule on macroeconomic research. Concluding remarks are provided in section 11.
2. Cutting the Gordian Knot
Taylor chose his timing well. In 1946, the year in which he was born, the two competing intellectual leaders of the rules versus discretion debate died. They were Henry Simons (the leader of the Chicago "rules party," who advocated stabilizing "p" using a price level rule) and John Maynard Keynes (whose followers emphasized the importance of stabilizing "y"). The year 1946 was also important for two economists who were to exert seminal influences over Taylor's intellectual development: A. W. H. Phillips enrolled at the London School of Economics and Milton Friedman returned to Chicago, where shortly afterward he rediscovered the quantity theory as a tool for challenging his Keynesian opponents and developed the k-percent money growth rule as an alternative to Simons' price-level rule. The Taylor rule (with r, not M, on the left-hand side) replaced the Friedman rule with a lag.
During the years between the Lucas critique and the Taylor rule (1976–1992), Taylor had a foot in academia and an almost equally sized foot in the policy apparatus (CEA 1976–77, Research Adviser at the Philadelphia Fed 1981–84, CEA 1989–91). By placing almost equal career coefficients on government service and academia, Taylor acquired an invaluable understanding of policy constraints and communication issues. The 1946 Employment Act created the CEA and initiated the Economic Report of the President. The act did not specify priorities about p and y: this dual mandate sought to "promote maximum employment, production, and purchasing power." But by the 1960s many economists saw an irreconcilable conflict between promoting maximum employment and production, on the one hand, and promoting stable prices (maximum purchasing power). Keynesians tended to favor a Phillips curve discretionary trade-off as an expression of the emphasis attached to y.
The Taylor rule synthesized (and provided a compromise between) competing schools of thought in a language devoid of rhetorical passion. The Great Depression created a constituency which tended to emphasize the importance of minimizing y (and hence tended to increase the weight attached to y). Inflation was accommodated as a necessary cost of keeping debt servicing low (pre-1951), tolerated, or "controlled away" by wage and price controls. The Great Inflation (circa 1965–79) and the costs associated with the Great Disinflation (post-1979) created a constituency that sought to minimize p (and hence tended to increase the weight attached to p).
Keynes intentionally divided economists into (obsolete) "classics" and (modern) Keynesians; Friedman divided the profession into (destabilizing) fiscalists and (stabilizing) monetarists. Taylor (1989a) heretically suggested that different schools of thought should be open to alternative perspectives; his Evaluating Policy Regimes commentary suggested that "some of the differences among models do not represent strong ideological differences" (1993b, 428). The Taylor rule with its equal weights has the advantage of offering a compromise solution between y-hawks and p-hawks.
The rules-versus-discretion debate has often been broadcast at high decibels. Part of the Keynesian-Monetarist econometric debate was described as the battle of the radio stations: FM (Friedman and [David] Meiselman) versus AM ([Albert] Ando and [Franco] Modigliani). Around the time of Taylor's first publication (1968), the macroeconomic conversation came to be dominated by what some regarded as the NPR "radio of the right" ("Natural" rate of unemployment, "Perfectly" flexible prices and wages or "Perfect" competition, and "Rational" expectations).
Robert Solow (1978, 203) detected in the rational expectations revolutionaries "a polemical vocabulary reminiscent of Spiro Agnew"; but the revolutionaries doubted that "softening our rhetoric will help matters" (Lucas and Sargent 1978, 82, 60). In a review of Tom Sargent's Macroeconomic Theory, Taylor (1981a) commented on Sargent's "frequently rousing style" of adversely contrasting new classical macro with the "Keynesian-activist" view. The Taylor rule embraced "R" (and, in the background though it is not required, "N"), replaced "P" with contracts, and provided a policy framework minus the inflammatory rhetoric.
When new rational expectations methods led to real business cycle models without a stabilization role for monetary policy, Taylor (2007c) recalled that it was a tough time: the dark ages for monetary policy rules research. Academic interests appeared to become decoupled from the needs of policymakers. A small group of monetary economists saw themselves as "toiling in the vineyards" (McCallum 1999).
A revival (at least in policy circles) began in the later 1980s. In 1985, the Brookings Institution and the Center for Economic Policy Research (later in association with the International Monetary Fund) launched a research project to investigate international macroeconomic interactions and policy. At the December 1988 Macroeconomic Policies in an Interdependent World conference, several papers investigated policy rules. At this conference, Taylor (1989b, 125, 138) had the short-run interest rate as the primary operating instrument of monetary policy: "placing some weight on real output in the interest rate reaction function is likely to be better than a pure price rule."
But the impressive body of rules-based academic literature appeared not to be leading to a consensus. In March 1990, Taylor (1993b, 426–9) noted that significant progress had been made, but "the results vary from model to model. No particular policy rule with particular parameters emerges as optimal for any single country, let alone all countries. Because of the differences among the models and the methodology, I would have been surprised if a clear winner had presented itself." However, policy rules which focused "on the sum of real output and inflation" outperform other types: "a consensus is emerging about a functional form." Yet there was no consensus about the size of coefficients. Shortly afterward Taylor cut this Gordian knot with his simple but persuasive equation: a compromise between academic complexity and policy-influencing simplicity.
3. From 1776 to the Great War
The problem of designing rational rules to preserve monetary stability or to achieve other policy objectives has long occupied the minds of monetary authorities and thinkers. Some historians have traced the early seeds of the modern "rules versus discretion" dichotomy as far back as the Roman Empire or the Middle Ages (Volckart 2007). However, it was in the age of David Ricardo, Henry Thornton, Lord Overstone, and Walter Bagehot that, for the first time, the importance of monetary policy being rule-guided acquired a great practical and institutional importance.
Major historical events provided economists with the ideal environment for writing and conceiving new rules of conduct in monetary policy. In fact, it was in coincidence with the rise of nation-states and with the general introduction of paper money and its progressive dematerialization that the economic implications of alternative money rules produced some first results both analytically and for practical action. The recurring crises which affected the British economy after the Napoleonic Wars also provided new rationales for discussion of the objectives and instruments of monetary policy. Furthermore, it was in the aftermath of World War I that economists began to reconsider monetary stability and monetary management as a crucial factor for promoting economic stability and growth.
Most of the nineteenth-century controversies on the functioning of alternative monetary systems or on the nature and importance of money in generating cyclical fluctuation can be read through the lenses of the "rules versus discretion" dichotomy. After the financial chaos generated by the Napoleonic Wars, the importance of rules of conduct in monetary affairs began to attract the attention of bankers, professional associations, and political parties. As payments technologies evolved and became more complex, an explicit commitment to abide by rules of conduct was conceived as part of an enforcing mechanism to avoid abuses, maintain or restore confidence in the value of money and in the legitimacy of the new financial instruments, and establish on firmer grounds the relationships between banks of issue and commercial banks.
Some early perceptions of our story can be found in Adam Smith's The Wealth of Nations. Despite the many financial crashes which had accompanied the introduction of paper money, Smith did not assume a dogmatic approach on behalf of metal standards. On the contrary, he clearly anticipated the possibility that metal shortages would check the prospects of growth and that economic systems would inevitably move beyond the adoption of commodity moneys. At that time, "a well-regulated paper-money" will substitute for metals "not only without any inconveniency, but, in some cases, with some advantages" (Smith 1776, b. iv, c. i). Among the latter, Smith suggested a greater degree of flexibility but also a possible increase in the overall stock of capital.
However, it was the British suspension of the gold standard in 1797 and the publication of the Bullion Report in 1810 which originated a wave of new reflections and writings. Economists and pamphleteers opened a profound discussion on the nature of money, the causes of wartime inflation, and the role of the banking system which went on until the passage of the 1844 Peel Act. The field was split between the adherents of the Currency School — who explained inflation in terms of the monetary abuses primarily caused by excessive government expenditure — and the Banking School, which gave a more complex interpretation of the reasons for monetary instability and liquidity creation. It could be argued that both the Currency School and the Banking School provided cases for subjecting the Bank of England to some preconceived rules of conduct.
Inspired by the writings of Ricardo and of Robert Torrens, the Currency School firmly stood in favor of legislated rules to govern the money supply and set the guidelines for the country's monetary policy. Rules of conduct were also required to enforce the capacity of the Bank of England to protect confidence in new payments technologies and as a consequence of the spread of new financial instruments.
The Banking School proposed a "softer" rule which the national banks of issue ought to follow in governing their issuing operations. This rule, which went under the name of "the real bills doctrine," had also received intellectual recognition in several passages of Smith's Wealth of Nations. Under the real bills doctrine, new liquidity could be created only for those invoices whose object was to finance real goods in the course of production and distribution. Following Smith, Thomas Tooke, James Fullarton, John Stuart Mill, and other Banking School economists suggested that banks of issue should not be constrained by a rigid, quantitative rule: in fact, the optimum quantity of money would be forthcoming automatically if the banks themselves regulated their notes and other liabilities by responding to "the needs of trade." It followed that, so long as outright convertibility in commodity moneys persisted, over-issue was a very unlikely event. However, as has been suggested by David Laidler (2002), it was the ultimate fallacy of the real bills doctrine as a guiding principle of monetary policy and as a sound explanation of general price alterations that may help to explain the search for more specific, quantitatively determined price rules.
Another rationale for money rules rose from the need to enhance the autonomy and the independence of the national banks of issue and rescue them from the greed of the political powers. Full monetary autonomy was an essential prerequisite for achieving different policy objectives: the absorption of external shocks; the protection of confidence in a paper-money system; the smooth transition toward the restoration of full and automatic convertibility; and the indispensable "gradualism" in the adjustment process of external disequilibria. Here, the leading authority was Henry Thornton who, in his 1802 essay, clearly established a set of rules which the banks of issue ought to follow for an optimal regulation of the money supply. In the final pages of his book, Thornton elaborated a series of "restrictive principles of a practical order." The most relevant were: 1. "in no case, however, materially to diminish the sum in circulation, but to let it vibrate only within certain limits"; 2. "to afford a slow and cautious extension of it, as the general trade of the Kingdom enlarges itself"; 3. "to allow of some special, though temporary, encrease in the event of any extraordinary alarm or difficulty"; 4. "to lean to the side of diminution in the case of gold going abroad, and of the general exchanges continuing long unfavourable" (Thornton 1802, 295). According to Thornton, this was the "true policy" which the Bank of England ought to follow, without ever "suffering the solicitation of merchants, or the wishes of Government, to determine the measure of the bank issues."
The usefulness of money rules went beyond the necessity to halt inflation or avoid political abuses in the management of the money supply. In fact, as the market economy became more complex throughout the nineteenth century, economists began to realize the existence of dilemmas or conflicts among different policy objectives. This turned out to be a rather unpleasant discovery and it suggested that some external constraints should be placed upon the actions of policymakers. In the age of Thornton and Ricardo, several economists noted that different varieties of economic and financial crisis tended to occur at the same time and seemed to require contrasting economic policy remedies. The most common experience took the shape of a sudden instability in the foreign exchange market which coincided with widespread episodes of depositors' runs. In these occurrences the dilemma took the shape of the alternative between financial stringency on one hand and the injection of more liquidity into the system on the other. Therefore, as Bagehot observed, sticking to a set of pre-announced or preconceived rules may become a good, second-best solution for these dilemmas. Also, the contrast between external and internal stability or the one between national autonomy and international coordination were often emphasized by political economists. Particularly after World War I, it was noted that money rules could become optimal instruments in this respect.
Excerpted from The Taylor Rule and the Transformation of Monetary Policy by Evan F. Koenig, Robert Leeson, George A. Kahn. Copyright © 2012 Board of Trustees of the Leland Stanford Junior University. Excerpted by permission of Hoover Institution Press.
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Table of Contents
Preface by Richard W. Fisher
Introduction by Evan F. Koenig, Robert Leeson, and George A. Kahn
I. TAYLOR’S APPROACH TO MONETARY THEORY AND POLICY
1. Monetary Policy Rules: from Adam Smith to John Taylor
by Pier Francesco Asso, Robert Leeson
2. The Taylor Rule and the Practice of Central Banking
by George A. Kahn
3. A Comparison with Milton Friedman
by Edward Nelson
4. Two Basic Principles
by Robert E. Lucas
II. FROM THE GREAT MODERATION TO THE GREAT DEVIATION
5. The Great Moderation
by Ben S. Bernanke
6. The Great Deviation
by John B. Taylor
7. It’s Not So Simple
by Donald L. Kohn
III. NEW CHALLENGES IN THE DECADE AHEAD
8. Forecast Targeting as a Monetary Policy Strategy: Policy Rules in Practice
by Michael Woodford
9. The Dual Nature of Forecast Targeting and Instrument Rules
by John B. Taylor
10. Evaluating Monetary Policy
by Lars E. O. Svensson
IV. TAYLOR’S INFLUENCE ON POLICYMAKING: FIRSTHAND ACCOUNTS
by Ben S. Bernanke
12. The View from Inside the Fed
by Janet Yellen
13. The View from Inside the European Central Bank
by Otmar Issing
14. The View from Central Banks in Emerging Markets
by Guillermo Ortiz
15. A View from the Financial Markets
by John P. Lipsky
The Pursuit of Policy Rules: A Conversation between Robert Leeson and John B. Taylor
About the Contributing Authors