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 KuB U 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 Y real = a N productivity growth (3%) growth in factor supply (2%) quantity equation: M v = Y = Y real 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) KuB U 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 KuB U van Suntum, Lecture KuB 4

5 1. pillar: monetary growth KuB U van Suntum, Lecture KuB 5

6 Upper bound: 5,5% = 2,5% - (-1,0%) + 2% Lower bound:4,5% = 2,0% - (-0,5%) + 2% Target value: 4,5% KuB U van Suntum, Lecture KuB 6

7 2. pillar: inflation targeting (multi-indicator concept) Instruments (interest rates) Inflation target (stable prices level) monetary forecast monetary indicators time KuB U van Suntum, Lecture KuB 7

Taylor-rule Short term prime rate Long term Real interest rate current inflation rate target inflations rate current real GDP potential output inflation gap output-gap disturbance term 8KuB U 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 9KuB U van Suntum, Lecture KuB 9

Taylor-rate and actual interest rate Source: Deutsche Bundesbank, Monatsbericht April KuB U van Suntum, Lecture KuB 10

Comparison of Taylor rule and quantity equation (see Bundesbank, Monatsbericht März 1999) (actual monetary increase) (target monetary increase) (i.e. interest rate increases if actual above target monetary increase) (* trend or target value 11KuB U 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 Bundesbank: Taylor: 12KuB 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? 13KuB U van Suntum, Lecture KuB 13