What is the McCallum Rule
The McCallum Rule is a monetary policy development guideline which was developed by economist Bennett T. McCallum at the end of the 20th century. The McCallum Rule uses a formula to describe the way a country's inflation and the total amount of their monetary base interact. The Rule explains how those numbers should be kept in balance.
The McCallum Rule is often contrasted with another economic targeting rule, the Taylor Rule.
BREAKING DOWN McCallum Rule
The McCallum Rule is a specifically a type of nominal Gross Domestic Product targeting rule (NGDP targeting rule). A targeting rule is a formula designed to help a country’s central bank know when to intervene in their currency. A central bank may intervene by changing interest rates through the use of a variety of mechanisms to hit a specific target.
Most economic targeting rules are designed not to allow rampant inflation and a currency explosion which could destabilize the country’s economy, leading to panic and recession. These rules are usually designed to achieve measured, sustainable growth. Some types of economic targeting rules rely on controlling one measure of growth or inflation. Others, such as NGDP targeting rules, look at the interaction of several areas as a way to balance them and achieve controlled growth.
Bennett T. McCallum developed the McCallum Rule in a series of papers written between 1987 and 1990. He worked to attempt to capture the way the monetary base of a country interacted with the inflation rate. Through these indicators, he hoped to predict what would happen in an economy and to designate possible corrective measures which could be taken by the Federal Reserve Bank or other central banks. This rule differs from many NGDP targeting rules because it places fundamental importance on the existing monetary base and what changes will occur in that base.
Essential inputs to the McCallum Rule model are the target inflation rate and the long-term average rate of growth in the actual gross domestic product (GDP).
Strengths and Weaknesses of the McCallum Rule
In theory, the McCallum Rule would provide for greater stability and less dangerous inflation, although critics argue that it would cause too much stability. When the economic measures of the 1970s are used to back-test the McCallum rule, they show that at least part of the effect that contributed to that decade’s economic downturn was that the economy grew too rapidly, which ultimately lead to high levels of inflation.
However, the McCallum rule only describes one part of the problem. Other economic models show that interest rates set by the Federal Reserve were also too low. Because the cost of borrowing was not high enough, individuals would simply borrow to spend instead of saving.
McCallum Rule vs Taylor Rule
The Taylor Rule is another economic targeting rule designed to help central banks control growth and inflation, created in 1993 by John B. Taylor, and also Dale W. Henderson and Warwick McKibbin. It describes the effect of inflation on pricing and growth.
The McCallum Rule and the Taylor Rule are often considered rival measures to explain economic behavior, but the two rules do not describe or explain the same relationships at all. The Taylor Rule is primarily concerned with the Federal funds rate, while the McCallum Rule describes relationships involving the monetary base.