Friday, March 14, 2008

Phelps on Uncertainty

Ned Phelps, Nobel laureate in economics, has some wise words about the nature of uncertainty in economic thinking and about rule-based monetary policy. "The claim for rule-based monetary policy is weak on its face," he argues, because it is based on concepts such as the natural rates of interest and inflation--concepts that Phelps invented--that "are anything but certain." And yet the European Central Bank relies on rule-based monetary policy--relying largely on a variant of the so-called Taylor rule (named for John Taylor), according to which the bank sets its basic rate by computing a "reaction function" in which the key independent variables are the deviation of output and inflation from their natural rates.

The virtue of rule-based monetary policy is supposed to be that it removes the policy process from undue political influence and therefore makes the central bank's commitment to controlling inflation more credible by making its response more mechanical, even if the result is a "politically unpalatable" level of unemployment.

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