Some economists have proposed that the Federal Reserve follow a rigid rule for conducting monetary policy. A policy rule is a formula that tells the Fed how to set monetary policy. For example, in 1959 Milton Friedman argued that the Fed should increase the money supply a constant 4 percent each year to eliminate inflation and avoid destabilizing the economy. More recently, other economists have identified an additional benefit: a rule can eliminate the inflationary bias that could occur when discretionary monetary policy is used. Under a discretionary policy, decisions are made on a case-by-case basis.

But economists don't agree on how the economy works or on how monetary policy affects the economy. This lack of consensus makes the construction of a policy rule very difficult. A rule that works well in one model of the economy may not work well in others. But do different beliefs about the economy necessarily imply that no rule works in all reasonable models of the economy? Or is it possible to find a rule to guide monetary policy that works fairly well for many different models?

In a series of recent papers, Bennett McCallum of Carnegie-Mellon University proposed a rule that seems to work well in a variety of models. McCallum's rule targets nominal GDP (the dollar value of output in the economy) by setting the growth rate of the money supply (more precisely, the monetary base, which consists of bank reserves plus currency in circulation). The rule would allow the economy to expand at its normal pace and also eliminate inflation.

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Copyright © 1995 Federal Reserve Bank of Philadelphia. This article first appeared in Business Review - Federal Reserve Bank of Philadelphia 1 (January/February 1995): 3-14.

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