Fixed-Rule Policy

Posted in Finance, Accounting and Economics Terms, Total Reads: 567

Definition: Fixed-Rule Policy

As the name suggests, it is a fiscal or monetary policy target designed by the government to be a long term target for the economy. Thus no matter what the short term disturbances caused in the economy, the government/monetary authority will take any step that compromises on the target.

For example, fixed rule policy for a government can be to keep inflation below 4% every year. So, no matter what happens it is determined to stick to that policy. Even though business investments are subdued and monetarists demand to lower interest rates to increase business activity if the monetary authority believe that it might push the inflation beyond 4%, then it will not do so. By focusing on a fixed rule policy, a government/monetary authority can focus on working towards a long term sustainable goal without yielding to market pressures.

Another variation of fixed rule policy is having a fixed monetary policy rule whose aim is to keep the rate of money supply grow at a fixed rate without keeping in mind the economic situation. Milton Friedman opined that discretionary policies have only a short run effect on output. He argued that growing inflation was because of the attempt to maintain unemployment level which is below the natural level of unemployment. While he believed that a discretionary policy can have an effect on the economy, he said that the realized effect was often the opposite of the desired because of the lags that exist in recognizing need of change of policy, implementation lag, and effect on economy to be realized. Thus he argued that government should implement fixed policy rules.

Also, New-Classical economists believe in the concept of “Rational Expectations” and advocated a fixed growth rule and argue that low level of inflation will result only if Fed announces and maintains such a policy.



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