What it means
Central banks have to decide how much money to supply to the economy. Rule-based approaches try to replace discretion with a clear formula, so that policy is predictable and less open to short-term pressures.
The McCallum Rule is one of the best-known examples of this thinking. The rule aims at a target path for nominal gross domestic product, which is the total value of everything produced in the economy at current prices.
Nominal output grows through a mix of real growth and inflation, so targeting it covers both. If the target is set at a sensible figure, inflation stays low and the economy is supported.
The rule has three parts. It starts with the target growth rate for nominal output, subtracts the recent average growth in velocity (how many times a unit of money is used in transactions over a period), and then adds a correction for past misses.
In the original version, velocity growth is averaged over the previous four years and the correction takes back half of last period's shortfall. The velocity adjustment is the clever part, because velocity can drift when banking, payments technology or confidence change.
If money is circulating more slowly, the central bank needs to supply more of it to reach the same nominal output. A rule that ignores velocity would miss the target whenever that relationship shifts.
Critics point out that the link between the monetary base and the economy has been unstable, particularly after financial innovation and in periods when interest rates were close to zero. Most central banks now set interest rates instead, often guided by the Taylor Rule.
The McCallum Rule remains important as a benchmark for judging whether policy has been too loose or too tight.
In practice
Real-world examples.
Example
An economist at a commercial bank compares the actual growth of the monetary base with the figure the McCallum Rule would have suggested over the past decade. The rule would have called for slower growth than the central bank delivered in one stretch. She uses the gap in a research note about inflation risk.
Example
A university lecturer in macroeconomics gives students the data and asks them to calculate the rule's recommended money growth for next year. The class sees that a fall in velocity raises the required growth in money. The exercise shows why a fixed growth rate for money can fail.
Example
A treasurer at a multinational reads that her country's central bank is considering a rules-based framework. She asks the finance team to model how interest rates and exchange rates might behave if money growth followed a formula instead of discretion. The model feeds into the company's borrowing plans.
Formula
Calculation
Base growth = Target nominal output growth - Average velocity growth + 0.5 x (Target growth last period - Actual nominal output growth last period)
Suppose the target for nominal output growth is 4.0% a year, velocity has grown at an average of 1.0% a year over the last four years, and nominal output grew 3.0% last year against the same 4.0% target. Base growth = 4.0 - 1.0 + 0.5 x (4.0 - 3.0). Working through the brackets, 0.5 x 1.0 = 0.5, so base growth = 4.0 - 1.0 + 0.5 = 3.5% a year. If the base was $4,000,000,000,000, it should grow by 4,000,000,000,000 x 0.035 = $140,000,000,000.Case study
Seen in the real world.
Northland Reserve is an illustrative, fictional central bank in a small economy that had struggled with swings in inflation. The governor asked her staff to run a historical test of the McCallum Rule against the bank's actual policy over 20 years. The staff found that, in three episodes, actual money growth had been well above the rule's suggestion in the year before inflation spiked.
In the most recent episode the rule called for 3.5% growth in the monetary base, and the bank had delivered 7.0%. The extra 3.5 percentage points on a base of $200,000,000,000 amounted to about $7,000,000,000 of surplus money creation. That was followed by an inflation rate well above the target.
The board did not adopt the rule as binding, but it began publishing the rule's figure alongside its own decisions. The illustrative lesson is that a simple formula can act as a useful cross-check on judgement even when it is not followed mechanically.
Watch out
Common mistakes.
- Confusing the McCallum Rule with the Taylor Rule, when the first sets the growth of the monetary base and the second sets the interest rate.
- Assuming the rule targets inflation alone, when it targets nominal output, which combines real growth and inflation.
- Treating the formula as a forecast of what the central bank will do, when it is a benchmark for what a rule-based policy would suggest.
Questions
People also ask.
What is the monetary base?
It is the central bank's own liabilities, mainly physical currency and the reserves that commercial banks hold at the central bank, and it is the money the bank controls most directly.
Why does velocity matter in the rule?
Velocity links the amount of money to total spending, so if it falls, more money is needed to support the same spending and the rule raises the recommended growth.
Do central banks use the McCallum Rule today?
Most do not follow it as a binding rule, but economists use it as a reference point when assessing whether policy has been too loose or too tight.
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