Monetary and fiscal policies after the financial crisis

Monetary and fiscal Monetary and fiscal policies after the financial policies after the financial

crisiscrisis

Malcolm SawyerMalcolm Sawyer

Monetary and fiscal policies after Monetary and fiscal policies after the financial crisisthe financial crisis

Until recently, claims would generally be made for Until recently, claims would generally be made for the success of policies based on independent the success of policies based on independent Central Banks with some form of the targeting of Central Banks with some form of the targeting of inflation. inflation.

The experience of the past year or so has cast The experience of the past year or so has cast major doubts on the general IT framework.major doubts on the general IT framework.

Inflation has risen well above the target, widely Inflation has risen well above the target, widely seen to be cost inflation, and for which IT has no seen to be cost inflation, and for which IT has no response.response.

With the financial crisis interest rate policy is With the financial crisis interest rate policy is directed away from concern over inflation but more directed away from concern over inflation but more significantly the economy clearly does not resemble significantly the economy clearly does not resemble the stable one envisaged by the IT approach.the stable one envisaged by the IT approach.

New consensus in New consensus in macroeconomicsmacroeconomics

The ‘new consensus in macroeconomics’ The ‘new consensus in macroeconomics’ (NCM) framework which at least in the (NCM) framework which at least in the academic sphere (macroeconomic models at academic sphere (macroeconomic models at the Bank of England and some used within the Bank of England and some used within the ECB based on it) underpins Central Bank the ECB based on it) underpins Central Bank independence, inflation targeting and the independence, inflation targeting and the link is based notoriously on an absence of link is based notoriously on an absence of banks ; it is based on an essentially stable banks ; it is based on an essentially stable view of the economy which diminishes the view of the economy which diminishes the role for fiscal policy and for monetary policy role for fiscal policy and for monetary policy with respect to stabilisation. with respect to stabilisation.


The skeleton NCM model:The skeleton NCM model: Yg t = a0 + a1 Ygt-1 + a2 Et (Ygt+1) – a3 [Rt Yg t = a0 + a1 Ygt-1 + a2 Et (Ygt+1) – a3 [Rt

– Et (pt+1)] + s1– Et (pt+1)] + s1 pt = b1Ygt + b2pt-1 + b3Et (pt+1) + s2 pt = b1Ygt + b2pt-1 + b3Et (pt+1) + s2 Rt = RR* + Et (pt+1) + c1Ygt-1 + c2 (pt-1 – Rt = RR* + Et (pt+1) + c1Ygt-1 + c2 (pt-1 –

pT)] + s3pT)] + s3 with b2 + b3 = 1, where Yg is the output gap, R is with b2 + b3 = 1, where Yg is the output gap, R is

nominal rate of interest, p is rate of inflation, pT is nominal rate of interest, p is rate of inflation, pT is inflation rate target, RR* is the ‘equilibrium’ real inflation rate target, RR* is the ‘equilibrium’ real rate of interest, consistent with zero output gap rate of interest, consistent with zero output gap and constant rate of inflation, si (with i = 1, 2, 3) and constant rate of inflation, si (with i = 1, 2, 3) represents stochastic shocks, and Et refers to represents stochastic shocks, and Et refers to expectations held at time t. expectations held at time t.


Equation (1) is the aggregate Equation (1) is the aggregate demand equation with the current demand equation with the current output gap determined by past and output gap determined by past and expected future output gap and the expected future output gap and the real rate of interest.real rate of interest.

Equation (2) is a Phillips’ curve with Equation (2) is a Phillips’ curve with inflation based on current output gap inflation based on current output gap and past and future inflation. and past and future inflation.

Equation (3) is an interest rate policy Equation (3) is an interest rate policy rule often referred to as Taylor’s rule.rule often referred to as Taylor’s rule.


A key role in the NCM played by the A key role in the NCM played by the ‘equilibrium rate of interest’, RR* = - a0/a3, ‘equilibrium rate of interest’, RR* = - a0/a3, but which may not exist, difficult to estimate but which may not exist, difficult to estimate and in this framework depends on the and in this framework depends on the exogenous component of demand (including exogenous component of demand (including fiscal policy stance). fiscal policy stance).

Fiscal policy can be ruled out Fiscal policy can be ruled out ifif it is it is assumed that Ricardian equivalence ‘rules’, assumed that Ricardian equivalence ‘rules’, and hence in terms of these equations and hence in terms of these equations aa0 is 0 is constant no matter what the fiscal stance. constant no matter what the fiscal stance.

Inflation targeting Inflation targeting There are some significant problems with There are some significant problems with

inflation targeting (and also with dual mandates inflation targeting (and also with dual mandates which include inflation). These include:which include inflation). These include:

The one instrument – one objective approach.The one instrument – one objective approach. Ignoring the potential role of fiscal policy;Ignoring the potential role of fiscal policy; The inter-temporal budget constraint in the The inter-temporal budget constraint in the

development of this model in effect imposes development of this model in effect imposes lifetime expenditure equals lifetime income and lifetime expenditure equals lifetime income and in effect rules any inadequacy of private in effect rules any inadequacy of private aggregate demand. aggregate demand.

Ultra fine tuning: the frequent adjustment of Ultra fine tuning: the frequent adjustment of interest rate runs into most of the problems interest rate runs into most of the problems which were raised against fiscal fine tuning. which were raised against fiscal fine tuning.

Inflation targetingInflation targeting

Lack of link from interest rate to inflation Lack of link from interest rate to inflation (theory)(theory)

The Phillips’ curve type analysis has failed to The Phillips’ curve type analysis has failed to establish the theoretical basis. A higher level of establish the theoretical basis. A higher level of output/demand may lead to a higher price output/demand may lead to a higher price (relative to cost) – that would be the standard (relative to cost) – that would be the standard micro-economic position. It can, of course, be micro-economic position. It can, of course, be argued that unit costs and mark-up are roughly argued that unit costs and mark-up are roughly constant with respect to output over wide constant with respect to output over wide range. Higher demand may then lead to higher range. Higher demand may then lead to higher price, but that does not mean higher inflation price, but that does not mean higher inflation (= persistent price increases). (= persistent price increases).


Two situations where this could lead to Two situations where this could lead to inflation : (i) a higher price level in the inflation : (i) a higher price level in the period in which it occurs provides a period in which it occurs provides a measure rate of inflation for that period; if measure rate of inflation for that period; if expectations on inflation jump in line with expectations on inflation jump in line with that experience, then inflation may that experience, then inflation may continue; (ii) wages (or similar) come into continue; (ii) wages (or similar) come into the picture and higher output involves both the picture and higher output involves both higher prices and higher wages ; the higher prices and higher wages ; the intended increase in at least one of intended increase in at least one of price/wage or wage/price cannot occur.price/wage or wage/price cannot occur.

Inflation targetingInflation targeting The argument presented by Wicksell rested The argument presented by Wicksell rested

on the effect of interest rate changes on on the effect of interest rate changes on asset prices. Lower interest rate raised asset prices. Lower interest rate raised asset prices, and stimulated acquisition of asset prices, and stimulated acquisition of assets concerned and specifically assets concerned and specifically production of those capital assets. This production of those capital assets. This could be seen as changing relative price of could be seen as changing relative price of interest-sensitive products. It can also fed interest-sensitive products. It can also fed into development of speculative bubbles in into development of speculative bubbles in asset prices. It can though again be argued asset prices. It can though again be argued that the level of interest rates influences that the level of interest rates influences the level of prices, rather than the rate of the level of prices, rather than the rate of increase of prices (inflation). increase of prices (inflation).


Lack of link from interest rate to inflation : Lack of link from interest rate to inflation : empiricsempirics

There seems to be a consensus from the There seems to be a consensus from the econometrics; and these are typically econometrics; and these are typically econometric estimation undertaken within econometric estimation undertaken within Central Banks or by those closely Central Banks or by those closely associated with them. A 1 per cent hike in associated with them. A 1 per cent hike in policy interest rate leads to a significant policy interest rate leads to a significant drop in output but reduction in inflation of drop in output but reduction in inflation of the order of 0.1 to 0.2 per cent. the order of 0.1 to 0.2 per cent.


Two words of caution : the interest rate Two words of caution : the interest rate change is applied for a year, but this may change is applied for a year, but this may be because the nature of the model is such be because the nature of the model is such that a departure from the equilibrium that a departure from the equilibrium interest rate within the model would interest rate within the model would eventually cause the model to explore eventually cause the model to explore

Inflation in these models is tied down by Inflation in these models is tied down by expectations, and with assumption of some expectations, and with assumption of some form of forward-looking ‘rational form of forward-looking ‘rational expectations’ and that the inflation target is expectations’ and that the inflation target is met. met.

What should monetary policy do ?What should monetary policy do ?

Is there any role for activist monetary policy ?Is there any role for activist monetary policy ? Other uses of the interest rate Other uses of the interest rate Towards the rule: real interest rate equal to Towards the rule: real interest rate equal to

rate of growth.rate of growth. In present approach all attention is paid to 25 In present approach all attention is paid to 25

basis point variations in the interest rate on a basis point variations in the interest rate on a monthly basis; little attention is paid to the monthly basis; little attention is paid to the average/equilibrium/natural rate. average/equilibrium/natural rate.

A number of arguments point to the average A number of arguments point to the average rate being around the rate of growth. rate being around the rate of growth.

What should monetary policy do ?What should monetary policy do ?

‘‘The 2-percent “equilibrium” real rate The 2-percent “equilibrium” real rate is close to the assumed steady-state is close to the assumed steady-state growth rate of 2.2 percent’, Taylor, growth rate of 2.2 percent’, Taylor, 1993, p. 202). 1993, p. 202).

The ‘golden rule’ of accumulation.The ‘golden rule’ of accumulation. The distributional argument (real rate The distributional argument (real rate

of interest = growth rate preserves of interest = growth rate preserves relative position of savings)relative position of savings)

Sustainable debtSustainable debt

The sustainable debt position is The sustainable debt position is given by given by b b = = dd//g g where where gg is nominal is nominal growth rate, growth rate, bb is debt/bonds, is debt/bonds,

dd is total deficit = primary deficit is total deficit = primary deficit d’d’ + interest payments + interest payments b.ib.i

Hence Hence bb..gg = = dd = = dd’’ + ’’ + i.bi.b, and hence , and hence dd’’ = 0 when ’’ = 0 when ii = = gg and deficit = and deficit = interest payments. interest payments.

Setting the interest rateSetting the interest rate

Proposal coming from this is to set nominal Proposal coming from this is to set nominal rate at beginning of year, given expected rate at beginning of year, given expected inflation; and sit back for the rest of the inflation; and sit back for the rest of the yearyear

Some issues : the arguments above relate Some issues : the arguments above relate to ‘the’ rate of interest ; the relevant one is to ‘the’ rate of interest ; the relevant one is not necessarily the policy rate, e.g. post-tax not necessarily the policy rate, e.g. post-tax rate on bonds relevant for the sustainable rate on bonds relevant for the sustainable deficit argument: does policy rate in the end deficit argument: does policy rate in the end set all the relevant interest rates ?set all the relevant interest rates ?

Exchange rate considerations ?Exchange rate considerations ?

What should then be the role and What should then be the role and objectives of monetary policy ?objectives of monetary policy ?

Objective of monetary policy shifts Objective of monetary policy shifts away from inflation more towards away from inflation more towards financial stabilityfinancial stability

Development of monetary policy Development of monetary policy away from solely interest rates away from solely interest rates

What about inflation ? What about inflation ?

Fiscal policyFiscal policy

‘‘Functional finance’ approach sets a clear Functional finance’ approach sets a clear rule : set budget deficit to support rule : set budget deficit to support aggregate demand at target level aggregate demand at target level

Fiscal policy : some form of ‘functional Fiscal policy : some form of ‘functional finance’ over the long haul with enhanced finance’ over the long haul with enhanced automatic stabilisers. automatic stabilisers.

The need to avoid arbitrary budget deficit The need to avoid arbitrary budget deficit rules – whether balanced budget in a year, rules – whether balanced budget in a year, over a cycle, or current budget balanced over a cycle, or current budget balanced over the cycle.over the cycle.


In ‘functional finance’ approach limit In ‘functional finance’ approach limit on budget deficit is the size of net on budget deficit is the size of net private savings at target level of private savings at target level of economic activity.economic activity.

Any total budget deficit is Any total budget deficit is sustainable through the relationship sustainable through the relationship b=d/gb=d/g

Fiscal policyFiscal policy The need to deal with government’s capital The need to deal with government’s capital

account with assets and liabilities : implications account with assets and liabilities : implications for ‘bail-out’, and also for public-private for ‘bail-out’, and also for public-private partnerships, private finance initiative. partnerships, private finance initiative.

The arguments for inter-temporal budget The arguments for inter-temporal budget constraint etc. have idea that the limit of the constraint etc. have idea that the limit of the discounted outstanding government debt as time discounted outstanding government debt as time tends to infinity is zero, alternatively expressed tends to infinity is zero, alternatively expressed as sum of debt at time 0 plus discounted future as sum of debt at time 0 plus discounted future budget deficits equals zero ; hence since debt at budget deficits equals zero ; hence since debt at time 0 is positive, discounted future budget time 0 is positive, discounted future budget deficits negative. Is the outstanding debt the deficits negative. Is the outstanding debt the relevant figure ?relevant figure ?


Debt targets (or concerns) are set in Debt targets (or concerns) are set in liability terms : relevance of bail outs liability terms : relevance of bail outs

The role of the PPPs and PFIs akin to The role of the PPPs and PFIs akin to off-balance sheet activities. off-balance sheet activities.

It could lead to the budget deficit It could lead to the budget deficit being calculated in real terms rather being calculated in real terms rather than the nominal terms.than the nominal terms.

Concluding commentsConcluding comments

The financial crisis and the inflation The financial crisis and the inflation ‘surge’ undermines current monetary ‘surge’ undermines current monetary policy arrangements. Drop focus of policy arrangements. Drop focus of monetary policy on inflationmonetary policy on inflation

Have argued here for setting interest Have argued here for setting interest rate = growth raterate = growth rate

Monetary policy more broadly Monetary policy more broadly defined to focus on financial stabilitydefined to focus on financial stability

Concluding commentsConcluding comments

Reinstatement of fiscal policy for Reinstatement of fiscal policy for stabilisation purposes and reassert stabilisation purposes and reassert ‘functional finance’.‘functional finance’.

As long as budget position set in As long as budget position set in accordance with ‘functional finance’ accordance with ‘functional finance’ principles it can always be funded, principles it can always be funded, does not place pressure on interest does not place pressure on interest rates and is not undermined by rates and is not undermined by unsustainable debts. unsustainable debts.

Monetary and fiscal policies after the financial crisis

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