Should India follow a rule based Monetary Policy

Monetary Policy is one of the important instruments of monetary authority of any country to

stabilize the economy and to control money supply of the country to adjust inflation and interest

rate in order to ensure price stability of the economy. The decision taken by monetary authority

may be of two type viz. rule-based monetary policy and discretionary monetary policy.

Rule based monetary policy is such type of monetary policy in which monetary authority

hardly diverges from their settled strategies. In discretionary monetary policy monetary

authority can impose and change their imposed strategy in accordance with current scenario.

There has been a debate among economists whether to follow rule based approach or

discretion policy approach. It is called time-inconsistency problem. Behavioral economist

argued that discretionary monetary policy creates economic instability by generating inflationary

pressure. In rule based monetary policy monetary authority takes their strategy based on some

pre-specific guideline which is very rigid in nature and puts restriction on the authority to take

further monetary decision. There is hardly a scope to adjust or deviate from the set policy. On the

other hand, under discretion policy central bank can alter its financial decision in accordance

with the situation. So it creates possibility for adjustment according to current scenario. But

supporters of rule-based monetary policy argue that discretionary policy is very inconsistent in

nature as authority can change the strategy over time. They said that rule based approach is

more appropriate for economic progress by making the economy more credible, while on the

other hand discretionary approach creates the possibility of inflation, which is unhealthy for an

economy. So under rule based approach an economy can achieve low inflation rate by

achieving higher employment easily compared with other.

 Both policies have their own advantages and disadvantages. Rule based policy is

beneficial as it directly restrict financial instruments by imposing strict limits. It actually lowers

the possibility of uncertainty by increasing economic efficiency, as under this strategy central

bank takes all its actions within a limit. It also helps the policy-makers to set the policy

independently instead of considering any special group. This approach creates more

transparency in government decisions and activities. It is also beneficial to solve the problem of

credibility. But it is beneficial only in short run.

For long run, discretion policy is advantageous as it offers the facility of flexibility.

Central bank always tries to limit inflation but there exist tradeoff between inflation and

unemployment. So it is difficult for them to follow a low inflation and high employment rate.

During 1920-1930s for the first time economists argued about this problem of time

inconsistency. In this respect economist Taylor had given a theory called Taylor Rule to

determine the nominal rate of interest set by central bank to alter the rate of inflation, output, and

employment etc. The rule presents that for one percent increase in inflation rate central bank

must have to increase nominal interest rate at more than one percent to manage the

inflationary pressure. Following this rule central bank has to take either rule based or

discretionary approach to set interest rate. In his original paper, Taylor had described that

nominal interest must force the actual inflation to diverge from targeted rate. Taylor equation-

= + + ( ) + ( )

Here, is SR nominal interest rate set by central bank, and are actual and targeted rate of

inflation respectively. and are real and potential rate of GDP respectively.

Before going to time inconsistency problem in Indian context, lets start with a brief

history of Indias financial system. During 1935-50 Indias main emphasis was to overcome the
problem of creditability through bank rate, open market operation and reserve requirements. In

1951-70 India had shifted its emphasis and controlling inflationary pressure was Indias priority

financial decision. During 1971-90 India had used SLR and CRR to stable financial condition

and inflationary pressure. During liberalization period, after 1990 India had relied on market

determined exchange rate and interest rate. In April, 1999 India had adopted Liquidity

Adjustment Facility (LAF) which worked through fixed repo and reverse repo. This mechanism

was helpful to establish interest rate as an important instrument of monetary policy.

In their article Kydland and Prescott (1977) had presented argument in favor of rule-

based approach. Indias interest rate was highly regulated. In reality it is a very difficult job for

RBI to understand which one is applicable. To solve such debate central bank follow empirical

evidences. In this respect economist Taylor had found out formula to determine appropriate

monetary policy in real world. Taylor recommended that in short run, interest rate should be set

according to the divergence of actual inflation from targeted level and divergence of real GDP

from potential level. Taylor had suggested process of pre-determination to calculate its

parameters. The combination of inflation and output can decide the appropriate policy and can

bring the economy into potential level. It is also statistically significant that there exist an inverse

relationship, greater the deviation from Taylor rule higher is the deviation of inflation from its

potential level. Finally, in conclusion it can be said that Taylor had suggested interest rate

should be set previously. This rule had provided an important tool to understand the relationship

among interest rate, inflation and output growth. So interest rate should be pre-determined

following rule based monetary policy.

In recent years India is passing through the phase of high inflation. Following Taylors

rule RBI has to set short run interest rate to achieve the goal of economic stability and potential
output and manageable rate of inflation. India, as a developing country must have to follow

rule based approach to set its SR interest rate. It is more appropriate in India as it directly

restrict inflation by imposing strict limits. It lowers the possibility of uncertainty by increasing

economic efficiency and transparency, as under this strategy central bank takes all its actions

within limits. To achieve targets, RBI to control current economic instability, rule based policy

is appropriate as it restricts the possibility to deviate.

References

Efficacy of Monetary Policy Rules in India, RBI speeches (Speech by Shri Deepak

Mohanty, Executive Director, at Delhi School of Economics, Delhi, 25th March 2013).

Kydland, Finn and E. Prescott (1977): Rules Rather than Discretion: The Inconsistency

of Optimal Plans, Journal of Political Economy, 85 (3), 473-492.

Patra, M. D. and M. Kapur (2012): Alternative Monetary Policy Rules for India, IMF

Working Paper, No.118, IMF.

Stanley, F. (1988) Rules versus Discretion in Monetary Policy, NBER Working Paper

No. 2518.

Michel, Norbert. (2015) Why Congress Should Institute Rules-Based Monetary Policy

The Heritage Foundation.

Calabria, A. M. (2015) Rules verses Discretion: Insights from Behavioral Economics

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