The second is that the calculation of the rule – or policy reaction function – is extraordinarily complex. Moreover, these two problems interact, in that the complexity of the decision rule is increased enormously when the possibility of learning about the true model is introduced. So although policy rules offer important insights they do not provide a practical guide to decision-making, and it is useful to examine more deeply why that is the case. No economist can point to a particular model, and in honesty say “that is how the world works”. A crucial difference between economic and, say, meteorological analysis is that in economics there are no natural constants, not even for the natural rate of unemployment. Our understanding of the economy is incomplete and constantly evolving, sometimes in small steps, sometimes in big leaps. The stock of knowledge is not static. So any monetary policy rule that is judged to be optimal today is likely to be superseded by a new and improved version tomorrow. In other words, there is no time-invariant policy reaction function which could describe the policy intentions of a central bank. Rather, monetary policy in practice is characterised by a continuous process of learning embedded, in the case of the Bank of England, in the rounds of meetings and forecasts that are the daily life of the Monetary Policy Committee.
To describe monetary policy in terms of a constant rule derived from a known model of the economy is to ignore this process of learning. So how should central banks behave in the light of their ignorance? Two approaches have been suggested. Interestingly, at one end of the spectrum, both Milton Friedman and Robert Lucas argued that policy should be based on a simple rule precisely because of our ignorance. Central banks, in their view, should have limited ambitions and aim simply at steady growth of the money supply – the so-called k% rule under which the money stock rises at a fixed rate, k%, each year. As Friedman (1968) put it, “Steady monetary growth would provide a monetary climate favourable to the operation of those basic forces …… that are the true springs of economic growth. That is the most that we can ask of monetary policy at our present state of knowledge”.9 The principle of adopting a strategy that takes into account limits to our knowledge is a sound one. But advocates of a rigid k% rule argue that we should ignore all other sources of information (estimates of the output gap, for example) and allow any shocks to the velocity of money to feed through to activity or the price level. In practice, experience in both Europe and the US has shown that velocity shocks can be large and few economists now advocate the use of k% rules. So committing to a wholly inflexible rule is likely to be neither desirable nor credible.