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Reexamining the monetarist critique of interest rate rules

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  • Robert G. King
  • Mau-Ting Lin

Abstract

Monetarist economists argued long ago that central bank interest rate rules exacerbate macroeconomic fluctuations, essentially by not allowing the interest rate to respond promptly to shifts in the supply and demand for loans. To support this critique, they pointed to the procyclicality of the money stock. Yet, when there are real shocks and a real business cycle, modern macroeconomic models imply that some procyclicality of money is desirable, to stabilize the price level. A simple interest rate rule illustrates that the monetarist critique can be valid within this model, since the rule exacerbates the response of real activity to real shocks. Other interest rate rules instead limit the macro economy's response to real shocks. But, while these interest rate rules have diverse effects on real activity, there is an important common implication: By smoothing the nominal interest rate in the short run, the rules all lead to increases in the longer-run variability in inflation and nominal interest rates.

Suggested Citation

  • Robert G. King & Mau-Ting Lin, 2005. "Reexamining the monetarist critique of interest rate rules," Review, Federal Reserve Bank of St. Louis, vol. 87(Jul), pages 513-530.
    • Handle: RePEc:fip:fedlrv:y:2005:i:jul:p:513-530:n:v.87no.4
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    Cited by:

    1. Andrés, Javier & David López-Salido, J. & Nelson, Edward, 2009. "Money and the natural rate of interest: Structural estimates for the United States and the euro area," Journal of Economic Dynamics and Control, Elsevier, vol. 33(3), pages 758-776, March.
    2. Elmar Mertens, 2005. "Puzzling Comovements between Output and Interest Rates? Multiple Shocks are the Answer," Working Papers 05.05, Swiss National Bank, Study Center Gerzensee.
    3. Bhattacharya, B.B. & Bhanumurthy, N.R. & Mallick, Hrushikesh, 2008. "Modeling interest rate cycles in India," Journal of Policy Modeling, Elsevier, vol. 30(5), pages 899-915.
    4. Woon Gyu Choi & Yi Wen, 2010. "Dissecting Taylor Rules in a Structural VAR," IMF Working Papers 2010/020, International Monetary Fund.

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