Which of the following would be an example of running monetary policy by rules?
a) A 5%increase in money supply automatically leads to a 2% increase in real GDP
b)An increase in money supply automatically leads to an increase in inflation
c)The Fed will increase money growth to different levels, depending on the severity of the recession.
d)A 1% drop in real GDP will automatically elicit a 2% increase in money supply.
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Of these options, only D is a clear example of running monetary policy by rules.
When monetary policy is run by rules, it is not done on an ad hoc or discretionary basis. Instead, it is done based on objective rules. The point of this is that it is good (in the view of some economists) for monetary policy to be very predictable. If there are strong rules, businesses will know what will happen in monetary policy. They will then be able to plan for what they know is coming.
A and B are not rules for running monetary policy. Instead, they are statements about what effects various monetary policies will have. They do not say what monetary policy should be taken at what particular time. Instead, they say what would happen if a given policy were adopted.
C is a rule of sorts, but it is not a strong and objective rule. It just says that the Fed will base its responses on the severity of the recession. This does not tell us how severe the recession has to be in order for the Fed to adopt a particular policy.
D is a strong rule. It tells us exactly when the Fed will do a certain thing. Firms will know how much the money supply will increase in what circumstances.
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