Setting Interest Rates According to a Fixed Formula Essay (Critical Writing)

Introduction

In the article under discussion, the investigation of the contradiction between rules and discretion is applied to the problem of setting interest rates. The author describes major aspects of financial policymaking, employing Taylor’s model as an example of a strict and determined approach to fixing the interest rate. However, the disadvantages of this model are also discussed since they tend to have a considerable impact on the development of a successful financial strategy. The purpose of this paper is to critically evaluate the assumptions which are made in the article under consideration.

The Article’s Analysis

Overview of the Problem

The article begins with a discussion of the current trends in financial policymaking. It is stated that some Republicans in the Congress, namely Jeb Hensarling, tend to develop an idea that central banks have to set interest rates based on a relatively simple formula¹. According to their opinion, applying this approach would result in the better predictability of banks’ performance since it would provide a stable monetary policy².

However, it is also stated that the controversy between rules and discretion tends to have a significant impact on economic policymaking. The article mentions two principal factors which influence inflation: the wage rate expected by workers and the interest rate³. When wage growth is moderate, the policymakers will tend to cut rates if they prefer the unemployment level to be lower than natural (in other words, the one that causes inflation)⁴. Further, the article states that making central banks independent helps to solve this problem, but it is suggested that a simple algorithm could be even more beneficial. The model, which was proposed by John Taylor of Stanford University in 1993, is exemplified as a considerable approach to implement.

Benefits of Taylor’s Model

This subsection will discuss the principal advantages of the model under consideration. It is possible to observe that the primary aspect, which appears to be beneficial, is the transparency of financial policymaking provided by Taylor’s method. In general, it could be considered to be the main argument in favor of following the rules.

Taylor provides the following scheme for calculating the interest rate. First of all, the real interest rate, which is considered by 2% by Taylor, serves as the basis of the calculations⁵. Further, the inflation is added, and then, after establishing the economic goals, it is needed to raise or cut rates by 0.5% for every 1% that inflation is above the target or it falls short of its potential, respectively⁶. This formula is simple, and it allows us to predict the economic behavior of the Feds as well as the transparency of financial decision-making.

Disadvantages of Taylor’s Model

One of the factors, which could be considered as the primary flaw of the model under discussion (and, in general, applying a strict set of rules to the economy), is the short-run fluctuations’ influence⁷. It could be hardly predicted, and thus various alterations should be made when the economic circumstances are changing. For example, the contemporary labor market is evolving since labor force participation rates, and unemployment rates significantly vary with demand. This situation creates a distinct level of uncertainty for financial policymakers and central banks. Also, it is possible to mention that the estimated natural interest rate has significantly decreased since the beginning of the Great Recession, and there are no signs of improvement⁸.

Critical Evaluations

Since the primary aspects of the article were analyzed, it is essential to critically evaluate the significance of its arguments in the context of choosing between strict rules and discretion. First of all, it is suggested that the transparency which is provided by the employment of Taylor’s model, considerably benefits the simplification of individuals’ decision-making and central banks’ operating. It is evident that when interest rates are on the rise, people tend to save, and when the rates are declining, people tend to borrow.

Therefore, it is possible to assume that the more stable and predictable the central banks’ policy is, the more decisive and predictable individuals tend to behave, and thus a relatively successful functioning of the economy in the long-run is expected⁹. However, the article also mentions several disadvantages of the model, which are were discussed previously.

Despite the possible problems, which are created by the uncertainty of the current economic circumstances, it is possible to mention a very important aspect that can encourage central banks to follow a more plain and predictable policy. It is suggested that the stability of interest rates is one of the most appealing factors for investors. Therefore, the article, being critical enough to recognize the possible disadvantages of Taylor’s model for the contemporary economy, provides a highly applicable framework.

Conclusion

Numerous areas of the public policy are subject to the contradiction between following the rigid set of rules and acting based on one’s discretion. This issue is highly controversial, and it is not likely that it is possible to decisively tell which policy is better since each of them has its benefits as well as disadvantages. However, Taylor’s model, despite its several disadvantages, can be successfully implemented in the current financial circumstances if reasonable adjustments are made.

Bibliography

Bloom, Nicholas. “Fluctuations in Uncertainty.” Journal of Economic Perspectives 28, no. 2 (2014): 153-176.

Laubach, Thomas, and John C. Williams. Measuring the Natural Rate of Interest Redux. PDF. Federal Reserve Bank of San Francisco Working Paper, 2015.

McLeay, Michael, Amar Radia, and Ryland Thomas. Money Creation in the Modern Economy. PDF. Quarterly Bulletin of the Bank of England, 2014.

Romer, Christina D., and David H. Romer. “The NBER Monetary Economics Program.” NBER Reporter 1, (2014): 1-7.

“Rule It Out.” The Economist, 2015. Web.

Footnotes

1. Michael McLeay, Amar Radia, and Ryland Thomas, Money Creation in the Modern Economy, PDF, Quarterly Bulletin of the Bank of England, 2014.
2. “Rule It Out,” The Economist, 2015. Web.
3. Ibid.
4. Ibid.
5. Ibid.
6. Ibid.
7. Nicholas Bloom, “Fluctuations in Uncertainty,” Journal of Economic Perspectives 28, no. 2 (2014): 153.
8. Thomas Laubach and John C. Williams, Measuring the Natural Rate of Interest Redux, PDF, Federal Reserve Bank of San Francisco Working Paper, 2015.
9. Christina D. Romer and David H. Romer, “The NBER Monetary Economics Program,” NBER Reporter 1, (2014): 2.