What is a Fixed-Rule Policy?

A fixed-rule policy is a fiscal or monetary policy which operates automatically, based on a predetermined set of criteria. 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.

Key Takeaways

  • Fixed-policy rules are predetermined policies that constrain policy makers’ actions based on objective criteria.
  • In economic terms, fixed-policy rules can apply to monetary or fiscal policy.
  • Fixed-policy rule may help direct policy makers toward decisions that better serve the public interest and improve economic outcomes.

Understanding a 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 general concept is that elected officials and other policymakers tend to overly focus on the short-term impact of policies and are easily influenced by special interests over the interests of the general population (both of which help determine their re-election or reappointment to office and their career prospects after leaving office). This often results in public policy choices that are not in the public interest.

Fixed-rule policies are binding rules that constrain officials' policy choices based on certain predetermined criteria to direct them toward serving the public interest. Because policymakers in general cannot bind their own future choices, fixed policy rules usually have to be enforced by some kind of higher authority in order to be binding, such as a constitutional amendment or high court ruling. The criteria used to limit policy choices generally include economic, fiscal, legal, or demographic factors beyond policymakers' control. These criteria set boundaries on the discretion of policymakers, which can make economic policy decisions more stable and predictable both for voters and market participants and can counterbalance the political incentives created by concentrated interests. Popular criteria for fixed-policy rules include things like inflation rates and population growth rates. 

Examples of Fixed-Rule Policies

Fixed-policy rules are common at many levels of government. In terms of economic policy, fixed-policy rules can apply to fiscal or monetary policy.   

Monetary Policy

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. 

Previously, the gold standard served as fixed-policy rule for monetary policy (and indirectly for fiscal policy as well). Because currencies were denominated in gold (or other metals), central banks' ability to print paper notes to circulate on the market (and governments’ ability to borrow money for deficit spending) was limited by their available gold reserves. 

Fiscal Policy

Fiscal policy is often subject to fixed rules as well as monetary policy. These can include basic constitutional requirements to maintain a balanced budget as well as more nuanced tax, expenditure, and debt limitations. 

The European Union (EU), for instance, has the Stability and Growth Pact. This pact states that member countries shall not have structural budget deficits of more than 1%, and that the 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. 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.

Pros and Cons of Fixed-Policy Rules

Advocates of fixed rule policies, such as 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 could be bad for overall economic growth in the long run if it contributes to boom-and-bust fluctuations in the economy.

Critics of the fixed-policy rules argue that they are too rigid and do not leave governments with enough discretion to deal with emergencies or set policy at levels needed to restart economic growth, and that they tie policymakers' hands precisely when bold action is called for. On the other hand, advocates of the fixed-rule policy contend that they can be and are often ignored or overridden in emergencies anyway. For example, despite the EU pact, member states routinely avoid sanctions for structural budget deficits of more than 1%.