What is the Fixed-Rule Policy

A fixed-rule policy is a fiscal or monetary policy which operates automatically, based on a predetermined set of rules. Advocates of fixed-rule policies argue that they eliminate the role of policymakers discretion in an attempt to avoid the problem of misaligned incentives between individual policymakers and the broader public.

BREAKING DOWN Fixed-Rule Policy

Fixed-rule policies derive from the public choice theory of political economy. This theory emphasizes the economic incentives of policymakers and the economic effects of those incentives. The Taylor Rule, invented by economist John Taylor, is the most famous example of the fixed-rule monetary policy. Calculation of the Taylor Rule results in what the targeted federal funds rate should be. The Rule's equation includes variables for the rate of inflation as measured by the GDP deflator, the real GDP growth,  and the potential output of the economy. 

Advocates of fixed rule policies, like the Taylor Rule, argue that setting and sticking to a predetermined plan creates certainty in the marketplace. This system will avoid subjecting policy decisions to the skewed incentives of individual policymakers or connected political party. These advocates argue that central bankers, for instance, have an incentive to keep interest rates low in the short term. Low-interest rates tend to stimulate economic growth which will gain public approval while the central banker is in office. However, such a policy would be bad for overall economic growth in the long run.

Examples of Fixed-Rule Policy

Fiscal policy is often subject to fixed rules as well as monetary policy. The European Union (EU), for instance, the Stability and Growth Pact. This Pact states that member countries shall not have structural budget deficits of more than 1%, and that total debt-to-GDP ratio should be more than 60%. 

The Pact has come under earnest pressure and criticism following the global financial crisis of 2008 and the subsequent European debt crisis. Critics of the pact argue that it is too rigid, and does not leave national governments with enough discretion to set fiscal policy at levels needed to restart economic growth. On the other hand, advocates of the fixed-rule policy contend that the EU pact is too weak as member states routinely avoid sanctions for structural budget deficits of more than 1%.

The U.S. Congress has also adopted fixed-rule fiscal policies to help restrain spending. The PAY-GO rule, passed in 1990, states that tax cuts, increases in entitlement, and mandatory spending, must pay for themselves through tax increases, or reductions in mandatory spending. However, Congress has waived the rule on several occasions, including the 2018 fiscal budget resolution and the passage of the Medicare Access and CHIP Reauthorization Act of 2015.