Reexamining the monetarist critique of interest rate rules

Robert King () and Mau-Ting Lin

Review, 2005, vol. 87, issue Jul, 513-530

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.

Keywords: Interest rates; Macroeconomics (search for similar items in EconPapers)
Date: 2005
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Citations: View citations in EconPapers (7)

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