9. Monetary Rules

• Friedman-rule: M.Friedman (1956), The quantity theory of money. A restatement.

Studies in Quantitity Theory, Chicago

• Quantity Equation (e.g. Deutsche Bundesbank, Monatsbericht April 1999)

• Taylor-Rule: John B. Taylor: Discretion versus policy rules in practice. In: Carnegie-Rochester

Conference Series on Public Policy. Band 39, 1993, S. 195-214.

1KuBU van Suntum, Lecture KuB 1

Friedman´s rule(s)

2KuB

• 2%-rule: monetary support of growth in factor supply only => stable factor prices, commodity prices decline => „neutral money“

• 5%-Rule: monetary support of growth both in factor supply (2%) and productivity (3%): factor prices rise, commodity prices stable => „stable money“

U van Suntum, Lecture KuB 2

3

Example (with v constant):

• production function Yreal = a N

productivity growth (3%) growth in factor supply (2%)

• quantity equation: M v = Y = Yreal p => p = v M/(aN)

• quantity equation: M v = Y = w N => w = v (M/N)

p = v M/(aN) => constant if M/(aN) is constant (5% rule) w = v (M/N) => constant, if (M/N) is constant (2% rule)

KuBU van Suntum, Lecture KuB 3

4

ECB follows idea of modified 5%-rule:

• commodity prices: inflation rate near to, but below 2% • factor prices (wages): productivity growth plus inflation rate

1. pillar:Monetary growth

2. pillar:Inflation targeting

ECB-double pillar strategy

KuBU van Suntum, Lecture KuB 4

5

1. pillar: monetary growth

ypMv

pYvM gggg

KuBU van Suntum, Lecture KuB 5

6

pvyM gggg

Upper bound: 5,5% = 2,5% - (-1,0%) + 2%

Lower bound: 4,5% = 2,0% - (-0,5%) + 2%

Target value: 4,5%

KuBU van Suntum, Lecture KuB 6

7

2. pillar: inflation targeting (multi-indicator concept)

Instruments (interest rates)

Inflation target(stable prices level)

monetaryforecast

monetaryindicators

time

KuBU van Suntum, Lecture KuB 7

Taylor-rule

)()(~

yybaii real

Short term prime rate

Long termReal interest rate

currentinflation

rate

targetinflations

rate

currentreal GDP

potential output

inflation gap

output-gap

disturbance term

8KuBU van Suntum, Lecture KuB 8

Interpretation of Taylor-Rule

Empirical description of central bank behavior

normative recommendation for central bank policy

Taylor-rate i = real equilibrium interest rate + expected inflation rate + a * inflation gap + b * output gap

i.e. rise in prime rate if inflation or real output are above standard value

9KuBU van Suntum, Lecture KuB 9

Taylor-rate and actual interest rate

Source: Deutsche Bundesbank, Monatsbericht April 1999

10KuBU van Suntum, Lecture KuB 10

Comparison of Taylor rule and quantity equation

(see Bundesbank, Monatsbericht März 1999)

)]()()[(i(4)i

0mit )()3(

)2(

)1(

***1-t

*1

****

vvyypp

dMdMiii

vypM

vypM

t

(actual monetary increase)

(target monetary increase)

(i.e. interest rate increases if actual above target monetary increase)

(* trend or target value

11KuBU van Suntum, Lecture KuB 11

Differences between quantity equation and Taylor:

• guided by growth rates instead of absolute target values• guided by interest rate of previous period instead of long term equilibrium rate• explicit recognition of changes in velocity of money circulation

)()(~

yybii real

Bundesbank:

Taylor:

12KuB

)]()()[(ii ***1-t vvyypp

U van Suntum, Lecture KuB 12

Lerning goals/questions

• What is the monetary strategy of ECB?

• Can you explain the Friedman rules (2% and 5%)?

• Can you explain the Taylor rule?

• What is the relationship between the Taylor rule and the quantity equation?

13KuBU van Suntum, Lecture KuB 13