The Hayek-Taylor Rule

Abstract

Friedrich August von Hayek in his early papers criticized price-level stabilization as an optimal monetary policy. In the Hayek theory, attempts to stabilize the price level in an economy with increasing natural output may initiate business cycle. The trigger lies in monetary accommodation that is required to prevent the fall in prices, which would otherwise be a natural response of the economic system to the expanding long-run aggregate supply. Hayek proposed different monetary policy as a substitute: the central bank should target constant MV, which may deliver greater stability to the economy. John B. Taylor proposed a rule that prescribes interest-rate policy for the central bank. It contains some elements of the Wicksellian and Hayekian tradition, such as the natural rate of interest and emphasis on monetary conservatism. Compared with the Hayek theory, the Taylor rule (usually) sets a positive inflation target. This paper integrates the Hayek MV-rule into the traditional Taylor rule. The Hayek-Taylor rule (HTR) is constructed, which uses the interest rate as the monetary-policy instrument. It is demonstrated that the HTR is less expansionary than the original Taylor rule. Conditions under which the zero lower bound is hit in the HTR are discussed in detail. Finally, the paper shows that the HTR does not require information about the potential output or the output gap, if certain conditions are met.