I need help determining a debate discussion about, I included the pro/con readings from the textbook.

3. Should monetary policy be made by rule or discretion?

Throughout this course, you have learned about economic models and principles and how they apply to the macroeconomic issues a country faces. Take this time to share what you have learned.

In your initial post, choose one of the six debates of macroeconomic policy discussed in the textbook. Explain why this macroeconomic issue is relevant to you. Support your choice with economic concepts you have learned during the course.

There are six debates of macroeconomic policy that were outlined in the book. They are:

1. Should policymakers try to stabilize the economy?

2. Should government fight recessions with spending hikes or tax cuts?

3. Should monetary policy be made by rule or discretion?

4. Should the Central Bank aim for zero inflation?

5. Should the government balance its budget?

6. Should the tax laws be reformed to encourage saving?

Pro: Monetary Policy Should Be Made by Rule

Discretion in the conduct of monetary policy has two problems. The first is that it does not limit incompetence and abuse of power. When the government sends police into a community to maintain civic order, it gives them strict guidelines about how to carry out their job. Because police have great power, allowing them to exercise that power however they wanted would be dangerous. Yet when the government gives central bankers the authority to maintain economic order, it gives them few guidelines. Monetary policymakers are allowed undisciplined discretion.

One example of the abuse of power is that central bankers are sometimes tempted to use monetary policy to affect the outcome of elections. Suppose that the vote for the incumbent president is based on economic conditions at the time he is up for reelection. A central banker sympathetic to the incumbent might be tempted to pursue expansionary policies just before the election to stimulate production and employment, knowing that the resulting inflation will not show up until after the election. Thus, to the extent that central bankers ally themselves with politicians, discretionary policy can lead to economic fluctuations that reflect the electoral calendar. Economists call such fluctuations the political business cycle. Prior to the election of 1972, for instance, President Richard Nixon pressured Fed Chair Arthur Burns to pursue a more expansionary monetary policy, presumably to bolster Nixon's reelection chances.

The second and subtler problem with discretionary monetary policy is that it might lead to higher inflation than is desirable. Central bankers, knowing that there is no long-run trade-off between inflation and unemployment, often announce that their goal is zero inflation. Yet they rarely achieve price stability. Why? Perhaps it is because, once the public forms expectations of inflation, policymakers face a short-run trade-off between inflation and unemployment. They are tempted to renege on their announcement of price stability to achieve lower unemployment. This discrepancy between announcements (what policymakers say they are going to do) and actions (what they subsequently in fact do) is called the time inconsistency of policy. Because policymakers can be time inconsistent, people are skeptical when central bankers announce their intentions to reduce inflation. As a result, people often expect higher inflation than monetary policymakers claim they are trying to achieve. Higher expectations of inflation, in turn, shift the short-run Phillips curve upward, making the short-run trade-off between inflation and unemployment less favorable than it otherwise might be.

One way to avoid these two problems with discretionary policy is to commit the central bank to a policy rule. For example, suppose that Congress passed a law requiring the Fed to increase the money supply by exactly percent per year. (Why percent? Because real GDP grows on average about 3 percent per year, and because money demand grows with real GDP, percent growth in the money supply is roughly the rate necessary to produce long-run price stability.) Such a law would eliminate incompetence and abuse of power on the part of the Fed, and it would make the political business cycle impossible. In addition, policy could no longer be time inconsistent. People would now believe the Fed's announcement of low inflation because the Fed would be legally required to pursue a low-inflation monetary policy. With low expected inflation, the economy would face a more favorable short-run trade-off between inflation and unemployment.

Other rules for monetary policy are also possible. A more active rule might allow some feedback from the state of the economy to changes in monetary policy. For example, a more active rule might require the Fed to increase monetary growth by percentage point for every percentage point that unemployment rises above its natural rate. Regardless of the precise form of the rule, committing the Fed to some rule would yield advantages by limiting incompetence, abuse of power, and time inconsistency in the conduct of monetary policy.

Con: Monetary Policy Should Not Be Made by Rule

There may be pitfalls with discretionary monetary policy, but there is also an important advantage to it: flexibility. The Fed has to confront various circumstances, not all of which can be foreseen. In the 1930s, banks failed in record numbers. In the 1970s, the price of oil skyrocketed around the world. In October 1987, the stock market fell by percent in a single day. From 2007 to 2009, house prices dropped, home foreclosures soared, and the financial system experienced significant problems. The Fed must decide how to respond to these shocks to the economy. A designer of a policy rule could not possibly consider all the contingencies and specify in advance the right policy response. It is better to appoint good people to conduct monetary policy and then give them the freedom to do the best they can.

Moreover, the alleged problems with discretion are largely hypothetical. The practical importance of the political business cycle, for instance, is far from clear. While it is true that Nixon tried to pressure Burns in 1972, it is not clear that he succeeded: Interest rates rose significantly during the election year. Moreover, in some cases, just the opposite seems to occur. President Jimmy Carter appointed Paul Volcker to head the Federal Reserve in 1979. Nonetheless, in October of that year, Volcker switched to a contractionary monetary policy to combat the high inflation that he had inherited from his predecessor. The predictable result of Volcker's decision was a recession, and the predictable result of the recession was a decline in Carter's popularity. Rather than using monetary policy to help the president who had appointed him, Volcker took actions he thought were in the national interest, even though they contributed to Carter's defeat by Ronald Reagan in the November 1980 election.

The practical importance of time inconsistency is also far from clear. Although most people are skeptical of central-bank announcements, central bankers can achieve credibility over time by backing up their words with actions. In the 1990s and 2000s, the Fed achieved and maintained a low rate of inflation, despite the ever-present temptation to take advantage of the short-run trade-off between inflation and unemployment. This experience shows that low inflation does not require that the Fed be committed to a policy rule.

Any attempt to replace discretion with a rule must confront the difficult task of specifying a precise rule. Despite much research examining the costs and benefits of alternative rules, economists have not reached consensus about what a good rule would be. Until there is consensus, society has little choice but to give central bankers discretion to conduct monetary policy as they see fit.