The Quest for rules

Author:Prakash Loungani
Position:Division Chief in the IMF's External Relations Department

From discretion to rules. Taylor rules!. Cooperation amid chaos. New rules for the IMF. Between Stanford and Washington.


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HAVING a concept named after you is as much a mark of honor in economics as it is in other sciences. By this standard, Stanford's John taylor is among the most honored macroeconomists of his generation. Indeed, concepts bearing his name have become so pervasive that U.S. Federal Reserve Board Chairman Ben Bernanke joked that "with our appetites whetted by the taylor rule, the [taylor] principle, and the [taylor] curve, we now look forward to the taylor dictum, the taylor hyperbola, and maybe even the taylor conundrum." The best known of these concepts, the taylor rule, is a simple equation that taylor propounded in 1992 to describe the response of the Fed's interest rate target to inflation and business cycles. The equation succeeded as both description and prescription: it described how the Fed had been setting its interest rate target and prescribed what the Fed ought to-and might-do next. The equation quickly gained wide acceptance among central banks as a useful guide for policy.

Those who know John taylor well are not surprised at this success. At a conference held in Dallas last year to honor taylor's work, the IMF's First Deputy Managing Director, John Lipsky, a graduate school classmate of taylor's, said: "If there had been a yearbook of our Ph.D. cohort at Stanford, the caption beneath John's picture might well have stated: 'Most Likely to Develop a Successful Monetary Policy Rule.' his interests and training surely pointed toward such a contribution." the academic work laid the foundation, taylor agrees, but what "made it all gel" was his policy experience in Washington during two stints at the U.S. Council of Economic Advisers (CEA), he tells F&D. "I doubt I would have had that idea without the CEA experience." Indeed, taylor's career has been marked by an easy back-and-forth between academia and policymaking, most recently as the U.S. treasury's top official for international affairs. When in academia, he jumps into teaching and research with an abandon that seems uncharacteristic of a Washington policymaker: to grab students' attention in a class on agricultural supply and demand, he once pranced around the classroom in a California raisin costume to the tune of Marvin Gaye's "I heard It through the Grapevine."

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From discretion to rules

Until the 1970s, the workings of the Fed and other central banks were shrouded in mystery. Monetary policy was considered an esoteric topic best left to the discretion of technicians. The problem was that this use of discretion often led to costly mistakes: for example, during the Great Depression, when the Fed sent the economy into a tailspin by stepping on the brakes instead of the accelerator, or during the Great Inflation of the 1970s, when the Fed let inflation ratchet up to double digits.

The solution, according to conservative economists such as the late Milton Friedman, was to bind the Fed into following fairly rigid rules. In fact, Friedman had for decades been calling for a rule under which the Fed would keep the money supply growing at a fixed rate of about 3-5 percent a year-essentially turning over the conduct of monetary policy to a computer. However, when the Fed tried such money supply-based rules in the early 1980s, it was unsuccessful-the short-run relationship between the money supply and the economy was too unstable for the rules to be a good guide to monetary policy.

Sympathetic to Friedman's advocacy of rules over discretion, taylor was one of a younger generation of conservative macroeconomists interested in devising a monetary policy rule that would fare better. He brought remarkable skills and training that positioned him as the front-runner in the quest to formulate a practical monetary rule. As an undergraduate at Princeton in the mid-1960s, he wrote an award-winning senior thesis that simulated the economy's response under different types of economic policies. He built on this foundation during his graduate work at Stanford, where he studied with famous statisticians such as T.W. (ted) Anderson on so-called joint estimation and control problems-sophisticated statistical methods of simultaneously modeling the behavior of the economy and the choice of optimal economic policies.

At Columbia University, his first position after graduate school, he worked with Edmund (Ned) Phelps-who won the Nobel Prize in 2006-on models that incorporated sticky, or sluggish, behavior of prices and wages. By...

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