Fiscal and
Monetary Policy
Fiscal and Monetary Policy
The Nature of Fiscal
Policy
THE NATURE OF FISCAL POLICY

The purpose of fiscal policy
 correcting
 fine

a fundamental disequilibrium
tuning
Government finances
 budget
deficits and surpluses
 financing
 the
a deficit
PSNCR
UK public-sector deficits/surpluses: 1979–2001
Year
1979
1980
1981
1982
1983
1984
PSNCR (£bn)
% of GDP
12.5
6.3
11.4
5.0
10.6
4.2
5.3
1.9
11.1
3.7
10.3
3.2
Year
1985
1986
1987
1988
1989
1990
7.6
2.1
2.6
0.7
–1.2
–0.3
–11.5
–2.4
–9.1
–1.8
–1.3
–0.2
1991
1992
1993
1994
1995
1996
PSNCR (£bn)
7.0
28.6
43.2
39.4
35.4
24.8
% of GDP
1.2
4.7
6.7
5.8
4.9
3.3
Year
1997
1998
1999
2000
2001
PSNCR (£bn) (–ve = surplus)
% of GDP (–ve = surplus)
11.9
1.5
–6.4
–0.7
–1.8
–0.2
–37.3
–4.0
–2.7
–0.3
PSNCR (£bn) (–ve = surplus)
% of GDP (–ve = surplus)
Year
UK public-sector deficits/surpluses: 1979–2001
Year
1979
1980
1981
1982
1983
1984
PSNCR (£bn)
% of GDP
12.5
6.3
11.4
5.0
10.6
4.2
5.3
1.9
11.1
3.7
10.3
3.2
Year
1985
1986
1987
1988
1989
1990
7.6
2.1
2.6
0.7
–1.2
–0.3
–11.5
–2.4
–9.1
–1.8
–1.3
–0.2
1991
1992
1993
1994
1995
1996
PSNCR (£bn)
7.0
28.6
43.2
39.4
35.4
24.8
% of GDP
1.2
4.7
6.7
5.8
4.9
3.3
Year
1997
1998
1999
2000
2001
PSNCR (£bn) (–ve = surplus)
% of GDP (–ve = surplus)
11.9
1.5
–6.4
–0.7
–1.8
–0.2
–37.3
–4.0
–2.7
–0.3
PSNCR (£bn) (–ve = surplus)
% of GDP (–ve = surplus)
Year
UK public-sector deficits/surpluses: 1979–2001
Year
1979
1980
1981
1982
1983
1984
PSNCR (£bn)
% of GDP
12.5
6.3
11.4
5.0
10.6
4.2
5.3
1.9
11.1
3.7
10.3
3.2
Year
1985
1986
1987
1988
1989
1990
7.6
2.1
2.6
0.7
–1.2
–0.3
–11.5
–2.4
–9.1
–1.8
–1.3
–0.2
1991
1992
1993
1994
1995
1996
PSNCR (£bn)
7.0
28.6
43.2
39.4
35.4
24.8
% of GDP
1.2
4.7
6.7
5.8
4.9
3.3
Year
1997
1998
1999
2000
2001
PSNCR (£bn) (–ve = surplus)
% of GDP (–ve = surplus)
11.9
1.5
–6.4
–0.7
–1.8
–0.2
–37.3
–4.0
–2.7
–0.3
PSNCR (£bn) (–ve = surplus)
% of GDP (–ve = surplus)
Year
UK public-sector deficits/surpluses: 1979–2001
Year
1979
1980
1981
1982
1983
1984
PSNCR (£bn)
% of GDP
12.5
6.3
11.4
5.0
10.6
4.2
5.3
1.9
11.1
3.7
10.3
3.2
Year
1985
1986
1987
1988
1989
1990
7.6
2.1
2.6
0.7
–1.2
–0.3
–11.5
–2.4
–9.1
–1.8
–1.3
–0.2
1991
1992
1993
1994
1995
1996
PSNCR (£bn)
7.0
28.6
43.2
39.4
35.4
24.8
% of GDP
1.2
4.7
6.7
5.8
4.9
3.3
Year
1997
1998
1999
2000
2001
PSNCR (£bn) (–ve = surplus)
% of GDP (–ve = surplus)
11.9
1.5
–6.4
–0.7
–1.8
–0.2
–37.3
–4.0
–2.7
–0.3
PSNCR (£bn) (–ve = surplus)
% of GDP (–ve = surplus)
Year
UK general government expenditure as % of GDP
50
Annual growth rate (%)
48
46
44
42
40
38
36
34
1970
1975
1980
1985
1990
1995
2000
UK general government expenditure as % of GDP
50
Annual growth rate (%)
48
46
44
42
40
38
36
34
1970
1975
1980
1985
1990
1995
2000
UK general government expenditure by function (%)
H
I
J
K
General public services 4.4%
K
Housing, etc 3.6%
Recreation, etc 1.7%
Environment 0.9%
J
Public order
5.1%
H
K
J
I
H
H
I
J
K
General public services 5.1%
Housing, etc 1.5%
Recreation, etc 1.0%
Environment 0.7%
I
Public order 5.6%
Social protection Economic affairs
36%
6.4%
conomic Affairs
7.7%
Social protection
39.0%
Defence 7.3%
Defence 10.1%
Other 14.2%
Other 7.3%
Education 10.9%
1991
Health 12.3%
Education 11.5 %
Health 14.2%
1999
UK general government expenditure by function (%)
H
I
J
K
General public services 4.4%
K
Housing, etc 3.6%
Recreation, etc 1.7%
Environment 0.9%
J
Public order
5.1%
H
K
J
I
H
H
I
J
K
General public services 5.1%
Housing, etc 1.5%
Recreation, etc 1.0%
Environment 0.7%
I
Public order 5.6%
Social protection Economic affairs
36%
6.4%
conomic Affairs
7.7%
Social protection
39.0%
Defence 7.3%
Defence 10.1%
Other 14.2%
Other 7.3%
Education 10.9%
1991
Health 12.3%
Education 11.5 %
Health 14.2%
1999
General government deficits/surpluses
and debt as % of GDP
General government deficits (–)
or surpluses (+)
General government debt
Average
1990–95
Average
1996–2001
Average
1990–95
Average
1996–2001
Belgium
–6.4
–1.8
128.9
117.3
France
–4.3
–2.4
48.5
64.3
Ireland
–2.6
+2.2
84.2
52.4
–10.2
–2.7
115.4
115.5
Japan
–0.8
–5.7
68.8
108.7
Netherlands
–4.2
0.0
75.8
64.2
Sweden
–6.1
+1.2
65.3
67.8
UK
–5.3
–0.4
52.1
57.4
USA
–4.5
+0.1
72.9
66.0
Euro area
–5.1
–1.9
66.8
75.7
Italy
General government deficits/surpluses
and debt as % of GDP
General government deficits (–)
or surpluses (+)
General government debt
Average
1990–95
Average
1996–2001
Average
1990–95
Average
1996–2001
Belgium
–6.4
–1.8
128.9
117.3
France
–4.3
–2.4
48.5
64.3
Ireland
–2.6
+2.2
84.2
52.4
–10.2
–2.7
115.4
115.5
Japan
–0.8
–5.7
68.8
108.7
Netherlands
–4.2
0.0
75.8
64.2
Sweden
–6.1
+1.2
65.3
67.8
UK
–5.3
–0.4
52.1
57.4
USA
–4.5
+0.1
72.9
66.0
Euro area
–5.1
–1.9
66.8
75.7
Italy
THE NATURE OF FISCAL POLICY

The purpose of fiscal policy
 correcting
 fine

a fundamental disequilibrium
tuning
Government finances
 budget
deficits and surpluses
 financing
a deficit
 the
PSNCR
 the
national debt and public-sector debt
Getting budget deficits down?
Budget deficits as a % of GDP
9
7
5
3
1
-11992
-3
1993
1994
1995
1996
1997
1998
1999
2000
2001
Getting budget deficits down?
Budget deficits as a % of GDP
9
7
5
3
France
1
-11992
-3
1993
1994
1995
1996
1997
1998
1999
2000
2001
Getting budget deficits down?
Budget deficits as a % of GDP
9
7
5
3
Germany
France
1
-11992
-3
1993
1994
1995
1996
1997
1998
1999
2000
2001
Getting budget deficits down?
Budget deficits as a % of GDP
9
7
Italy
5
3
Germany
France
1
-11992
-3
1993
1994
1995
1996
1997
1998
1999
2000
2001
Getting budget deficits down?
Budget deficits as a % of GDP
9
7
Spain
Italy
5
3
Germany
France
1
-11992
-3
1993
1994
1995
1996
1997
1998
1999
2000
2001
Getting budget deficits down?
Budget deficits as a % of GDP
9
Belgium
7
Spain
Italy
5
3
Germany
France
1
-11992
-3
1993
1994
1995
1996
1997
1998
1999
2000
2001
Getting budget deficits down?
Budget deficits as a % of GDP
9
Belgium
7
Spain
Italy
5
3
Germany
Netherlands
1
-11992
-3
France
1993
1994
1995
1996
1997
1998
1999
2000
2001
National Debt
(as % of GDP)
National Debt
80
75
70
65
60
55
50
45
40
35
30
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
National Debt
(as % of GDP)
National Debt
80
75
70
65
60
55
50
45
UK
40
35
30
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
National Debt
(as % of GDP)
National Debt
80
75
70
65
USA
60
55
50
45
UK
40
35
30
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
National Debt
(as % of GDP)
National Debt
80
Euro
area
75
70
65
USA
60
55
50
45
UK
40
35
30
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
THE NATURE OF FISCAL POLICY

Public-sector deficits or surpluses and
the government’s fiscal stance
 fiscal
stance and the state of the economy
 the structural balance

Automatic fiscal stabilisers
 tax
stabilisers
 benefits stabilisers
National income and the size of the public-sector deficit or surplus
G, T
Tax revenue
SURPLUS
DEFICIT
O
Gov. expenditure
(incl. benefits)
Y1
Y
THE NATURE OF FISCAL POLICY

Public-sector deficits or surpluses and
the government’s fiscal stance
 fiscal
stance and the state of the economy
 the structural balance

Automatic fiscal stabilisers
 tax
stabilisers
 benefits stabilisers

Discretionary fiscal policy
THE NATURE OF FISCAL POLICY

Public-sector deficits or surpluses and
the government’s fiscal stance
 fiscal
stance and the state of the economy
 the structural balance

Automatic fiscal stabilisers
 tax
stabilisers
 benefits stabilisers

Discretionary fiscal policy
 changing
government expenditure
THE NATURE OF FISCAL POLICY

Public-sector deficits or surpluses and
the government’s fiscal stance
 fiscal
stance and the state of the economy
 the structural balance

Automatic fiscal stabilisers
 tax
stabilisers
 benefits stabilisers

Discretionary fiscal policy
 changing
government expenditure
 changing taxes
A cut in taxes: (a) lump-sum taxes
W, J
W1
O
Y
A cut in taxes: (a) lump-sum taxes
W, J
W1
W2
O
Y
A cut in taxes: (a) lump-sum taxes
W, J
W1
W2
DT x mpcd
O
Y
A cut in taxes: (b) cut in tax rates
W, J
W1
O
Y
A cut in taxes: (b) cut in tax rates
W, J
W1
W2
O
Y
A cut in taxes: (b) cut in tax rates
W, J
W1
W2
DT x mpcd
O
Y
Fiscal and Monetary Policy
The Effectiveness of
Fiscal Policy
EFFECTIVENESS OF FISCAL POLICY

Effectiveness of automatic stabilisers
 adverse
 the

supply-side effects
problem of fiscal drag
Discretionary policy: problems of
forecasting the magnitude of the effect
 effects
on other injections and withdrawals
 crowding
out
The monetary effects of fiscal policy
W, J
W
J1
O
Y1
(a) The goods market
Y
The monetary effects of fiscal policy
Rate of
interest
W, J
MS
W
r1
L1
J1
O
Y1
(a) The goods market
Y
O
Money
(b) The money market
The monetary effects of fiscal policy
Rate of
interest
W, J
MS
An expansionary
fiscal policy
W
J2
J1
O
Y1
Y2
(a) The goods market
Y
r1
L1
O
Money
(b) The money market
The monetary effects of fiscal policy
Rate of
interest
W, J
MS
An expansionary
fiscal policy
r2
W
J2
J1
O
Y1
Y2
(a) The goods market
Y
Effect on the
demand for money
r1
L2
L1
O
Money
(b) The money market
The monetary effects of fiscal policy
Rate of
interest
W, J
MS MS2
An expansionary
fiscal policy
r2
W
J2
J1
O
Y1
Y2
(a) The goods market
Y
Accommodating
increase in the
money supply
r1
L2
L1
O
Money
(b) The money market
EFFECTIVENESS OF FISCAL POLICY

Effectiveness of automatic stabilisers
 adverse
 the

supply-side effects
problem of fiscal drag
Discretionary policy: problems of
forecasting the magnitude of the effect
 effects
on other injections and withdrawals
 crowding
 size
out
of the multiplier and accelerator
effects
EFFECTIVENESS OF FISCAL POLICY

Discretionary fiscal policy: problems of
timing and time lags
 various
 policy
time lags
may be destabilising
Fiscal policy: stabilising or destabilising?
Real national income
Path (a): no intervention
3
4
3
2
4
2
1
1
O
Time
Fiscal policy: stabilising or destabilising?
Real national income
Path (a): no intervention
Path (b): policy stabilises
3
4
3
2
4
2
1
1
O
Time
Fiscal policy: stabilising or destabilising?
Real national income
Path (a): no intervention
Path (b): policy stabilises
Path (c): policy destabilises
3
4
3
2
4
2
1
1
O
Time
EFFECTIVENESS OF FISCAL POLICY

Discretionary fiscal policy: problems of
timing and time lags
 various
 policy

time lags
may be destabilising
Side-effects of discretionary fiscal
policy
EFFECTIVENESS OF FISCAL POLICY

Discretionary fiscal policy: problems of
timing and time lags
 various
 policy
time lags
may be destabilising

Side-effects of discretionary fiscal
policy

Changing government expenditure
versus changing taxes
Fiscal and Monetary Policy
Varieties of Monetary
Policy
VARIETIES OF MONETARY POLICY

The policy setting
 historical
 current

approaches to monetary policy
approach to monetary policy
Control of money supply over medium
and long term
 control
of banks’ liquidity ratio
 restricting

size of PSNCR
Short-term monetary control: the
alternatives
The demand for and supply of money
Rate of interest
MS
r1
L
O
Q1
Money
The demand for and supply of money
Rate of interest
M S'
MS
r2
r1
L
O
Q2
Q1
Money
VARIETIES OF MONETARY POLICY

Techniques to control money supply
 preliminary
decisions:
 statutory
or prudent ratios?
 what to control: monetary base or broad
money?
 open-market
operations
 funding
 variable
minimum reserve ratios
Effect of raising the minimum reserve ratio
from 10% to 20%
Initial position: 10% reserve ratio
Liabilities
Deposits
£100bn
Assets
Reserve assets
Advances, etc.
Total
£100bn
Total
£10bn
£90bn
£100bn
Effect of raising the minimum reserve ratio
from 10% to 20%
Initial position: 10% reserve ratio
Liabilities
Deposits
£100bn
Assets
Reserve assets
Advances, etc.
Total
£100bn
Total
£10bn
£90bn
£100bn
New position: 20% reserve ratio
Liabilities
Deposits
Total
£50bn
Assets
Reserve assets
Advances, etc.
£10bn
£40bn
£50bn
Total
£50bn
VARIETIES OF MONETARY POLICY

Techniques to control money supply
 preliminary
decisions:
 statutory
or prudent ratios?
 what to control: monetary base or broad
money?
 open-market
operations
 funding
 variable

minimum reserve ratios
Techniques to control interest rates
VARIETIES OF MONETARY POLICY

Techniques to control money supply
 preliminary
decisions:
 statutory
or prudent ratios?
 what to control: monetary base or broad
money?
 open-market
operations
 funding
 variable

minimum reserve ratios
Techniques to control interest rates
 statutory
base rates
VARIETIES OF MONETARY POLICY

Techniques to control money supply
 preliminary
decisions:
 statutory
or prudent ratios?
 what to control: monetary base or broad
money?
 open-market
operations
 funding
 variable

minimum reserve ratios
Techniques to control interest rates
 statutory
base rates
 operations in discount and repo markets
Bank of England operations in the bill and
gilt repo markets to raise interest rates
D by banks
Rate of discount
S1 by B. of E.
r1
O
Bills
(a) Bank of England sells more bills
Bank of England operations in the bill and
gilt repo markets to raise interest rates
Rate of discount
S1 by B. of E.
S2 by B. of E. D by banks
r2
r1
O
Bills
(a) Bank of England sells more bills
Bank of England operations in the bill and
gilt repo markets to raise interest rates
Rate of discount / gilt repo rate
D1 by B. of E.
r1
S by banks
O
Bills and gilts
(b) Bank of England buys fewer bills / gilts
Rate of discount / gilt repo rate
Bank of England operations in the bill and
gilt repo markets to raise interest rates
D2 by B. of E.
D1 by B. of E.
r2
r1
S by banks
O
Bills and gilts
(b) Bank of England buys fewer bills / gilts
VARIETIES OF MONETARY POLICY

Techniques to control money supply
 preliminary
decisions:
 statutory
or prudent ratios?
 what to control: monetary base or broad money?
 open-market
operations
 funding
 variable

minimum reserve ratios
Techniques to control interest rates
 statutory
base rates
 operations in discount and repo markets

Credit rationing
Fiscal and Monetary Policy
Problems of
Monetary Policy
PROBLEMS OF MONETARY POLICY

Medium and long-term control over the
money supply: reducing PSNCR
 automatic
 the
fiscal stabilisers
desire to cut taxes
 difficulty
in cutting government
expenditure
PROBLEMS OF MONETARY POLICY

Practical difficulties in short-run
control of the money supply
 problems
 with
statutory cash ratios
 without
statutory cash ratios
 problems
 with
with controlling broad liquidity
statutory reserve ratios
 without
 the
with monetary base control
statutory reserve ratios
effect on interest rates
The effect on interest rates of a change in demand for money:
money supply kept at fixed level by the authorities
Rate of interest
MS
r1
r
L'
L
O
Money
PROBLEMS OF MONETARY POLICY

Problems with credit rationing
 Goodhart's
law
 bank
resistance
 stifles competition
 distortionary

effects on economy
Problems with controlling interest rates
 inelastic
demand for loans
An inelastic demand for loans
Rate of interest
Assume that the authorities
want to reduce the
demand for money to Q2
r1
Demand for loans
O
Q2
Q1
Loans
Rate of interest
An inelastic demand for loans
A large rise in the
rate of interest (to r2)
will be necessary
r2
r1
Demand for loans
O
Q2
Q1
Loans
PROBLEMS OF MONETARY POLICY

Problems with credit rationing
 Goodhart's
law
 bank
resistance
 stifles competition
 distortionary

effects on economy
Problems with controlling interest rates
 inelastic
demand for loans
 unstable demand for money
PROBLEMS OF MONETARY POLICY

Problems with credit rationing
 Goodhart's
law
 bank
resistance
 stifles competition
 distortionary

effects on economy
Problems with controlling interest rates
 inelastic
demand for loans
 unstable demand for money
 possible
conflict between domestic goals
and exchange-rate goals
PROBLEMS OF MONETARY POLICY

Using monetary policy
 problems
of using it to manage aggregate
demand
 using
it to keep to a target
 inflation
 exchange
 money
rate
supply
Fiscal and Monetary Policy
ISLM Analysis of
Fiscal and Monetary
Policy
Equilibrium in both the goods and money markets
Rate of interest
LM
re
IS
O
Ye
National income
ISLM ANALYSIS OF FISCAL AND MONETARY POLICY

Fiscal policy and ISLM analysis
 shifting
 effect
the IS curve
on interest rates and national
income
ISLM analysis of fiscal and monetary policy
Rate of interest
LM
r1
IS
O
Y1
National income
ISLM analysis of fiscal and monetary policy
LM
Rate of interest
Expansionary
fiscal policy
r2
r1
IS2
IS1
O
Y1
Y2
National income
ISLM ANALYSIS OF FISCAL AND MONETARY POLICY

Fiscal policy and ISLM analysis
 shifting
the IS curve
 effect
on interest rates and national
income

Monetary policy and ISLM analysis
 shifting
 effect
the LM curve
on interest rates and national
income
ISLM analysis of fiscal and monetary policy
LM1
LM2
Rate of interest
Expansionary
monetary policy
r1
r3
IS
O
Y1
Y3
National income
ISLM ANALYSIS OF FISCAL AND MONETARY POLICY

Fiscal policy and ISLM analysis
 shifting
the IS curve
 effect
on interest rates and national
income

Monetary policy and ISLM analysis
 shifting
the LM curve
 effect
on interest rates and national
income

Fiscal and monetary policy together
ISLM analysis of fiscal and monetary policy
LM1
Rate of interest
Expansionary
fiscal and
monetary policy
LM2
r1
IS2
IS1
O
Y1
National income
Y4
ISLM ANALYSIS OF FISCAL AND MONETARY POLICY

Analysis under Keynesian assumptions
 effectiveness
of fiscal policy
Rate of interest
Keynesian analysis of fiscal and monetary policy
LM
Expansionary
fiscal policy
IS2
IS1
O
Y1
Y2
National income
ISLM ANALYSIS OF FISCAL AND MONETARY POLICY

Analysis under Keynesian assumptions
 effectiveness
of fiscal policy
 ineffectiveness
of monetary policy
Keynesian analysis of fiscal and monetary policy
Rate of interest
Expansionary
monetary policy
LM1
LM2
IS
O
Y1Y2
National income
ISLM ANALYSIS OF FISCAL AND MONETARY POLICY

Analysis under Keynesian assumptions
 effectiveness
of fiscal policy
 ineffectiveness

of monetary policy
Analysis under monetarist
assumptions
ISLM ANALYSIS OF FISCAL AND MONETARY POLICY

Analysis under Keynesian assumptions
 effectiveness
of fiscal policy
 ineffectiveness

of monetary policy
Analysis under monetarist
assumptions
 ineffectiveness
of fiscal policy
Monetarist analysis of fiscal and monetary policy
LM
Rate of interest
Expansionary
fiscal policy
IS2
IS1
O
Y1Y2
National income
ISLM ANALYSIS OF FISCAL AND MONETARY POLICY

Analysis under Keynesian assumptions
 effectiveness
of fiscal policy
 ineffectiveness

of monetary policy
Analysis under monetarist
assumptions
 ineffectiveness
 effectiveness
of fiscal policy
of monetary policy
Monetarist analysis of fiscal and monetary policy
LM1
LM2
Rate of interest
Expansionary
monetary policy
IS
O
Y1
Y2
National income
Fiscal and Monetary Policy
Fiscal and Monetary
Policy in the UK
UK growth, unemployment and inflation: 1920-2002
%
Growth
10
30
25
20
5
15
10
0
5
-5
0
-5
-10
1920 1925 1930 1935 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
-10
UK growth, unemployment and inflation: 1920-2002
%
Growth
10
30
25
20
5
15
10
0
5
-5
0
-5
-10
1920 1925 1930 1935 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
-10
UK growth, unemployment and inflation: 1920-2002
%
10
Growth
Unemployment
%
30
25
20
5
15
10
0
5
-5
0
-5
-10
1920 1925 1930 1935 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
-10
UK growth, unemployment and inflation: 1920-2002
%
10
Growth
Unemployment
Inflation
%
30
25
20
5
15
10
0
5
-5
0
-5
-10
1920 1925 1930 1935 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
-10
UK Macroeconomic performance: 1921 – 99
Unemployment
(% of labour
force)
Inflation
(% increase in
RPI)
Growth
(% increase in
real GDP)
1921–38
13.4
–1.5
2.1
1950–69
1.6
4.0
2.8
1970–99
7.6
8.0
2.0
UK Macroeconomic performance: 1921 – 99
Unemployment
(% of labour
force)
Inflation
(% increase in
RPI)
Growth
(% increase in
real GDP)
1921–38
13.4
–1.5
2.1
1950–69
1.6
4.0
2.8
1970–99
7.6
8.0
2.0
UK Macroeconomic performance: 1921 – 99
Unemployment
(% of labour
force)
Inflation
(% increase in
RPI)
Growth
(% increase in
real GDP)
1921–38
13.4
–1.5
2.1
1950–69
1.6
4.0
2.8
1970–99
7.6
8.0
2.0
FISCAL AND MONETARY POLICY IN THE UK

Attitudes towards demand
management

Keynesian demand management in the
1950s and 1960s
 stop–go
policies
 monetarist criticisms

Demise of fine tuning in the 1970s
 the
causes of stagflation
 demand
management policies in the 1970s
 the rise of monetarism
Selected monetary indicators: 1969–2001
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
Change
in M4 (%)
(1)
5.1
11.5
16.0
23.7
22.3
11.1
12.4
11.2
14.7
15.0
14.1
17.2
20.9
12.1
12.7
13.2
13.0
15.6
16.7
17.3
18.0
11.8
5.8
3.6
4.6
4.7
9.9
9.5
11.9
8.3
4.2
8.3
6.7
PSNCR
(£m)
(2)
–527
–219
1 196
1 829
4 121
6 447
10 167
8 923
5 474
8 416
12 502
11 432
10 573
5 547
11 070
10 342
7 625
2 630
–1 172
–11 426
–9 131
–1 288
7 003
28 623
43 168
39 425
35 446
24 778
11 851
–6 395
–1 781
–37 316
–2 665
Inflation
(%)
(3)
5.4
6.3
9.4
7.3
9.1
16.0
24.2
16.5
15.9
8.3
13.4
18.0
11.9
8.6
4.6
5.0
6.1
3.4
4.2
4.9
7.8
9.5
5.9
3.7
1.6
2.4
3.5
2.4
3.1
3.4
1.6
2.9
1.8
Interest rate:
20-year bonds
(4)
9.1
9.2
8.9
9.0
10.7
14.8
14.4
14.4
12.7
12.5
13.0
13.8
14.7
12.9
10.8
10.7
10.6
9.9
9.5
9.4
9.6
11.1
9.9
9.1
7.9
8.1
8.3
8.1
7.1
5.5
4.7
4.7
4.8
Real interest
rate
(5)
3.7
2.9
–0.5
1.7
1.6
–1.2
–9.8
–2.1
–3.2
4.2
–0.4
–4.2
2.8
4.3
6.2
5.7
4.5
6.5
5.3
4.5
1.8
1.6
4.0
5.4
6.3
5.7
4.8
5.7
4.0
2.1
3.1
1.8
2.0
FISCAL AND MONETARY POLICY IN THE UK

Monetarism in the early 1980s
 medium-term
financial strategy
 the
recession of the early 1980s
 assessment of the monetarist experiment
 return

to discretion in mid 1980s
Targeting the exchange rate
 its
advantages and disadvantages
 shadowing the German mark
 membership
of the ERM (1990–2)
 exit from the ERM
FISCAL AND MONETARY POLICY IN THE UK

Return to domestic-orientated policies
 targeting

inflation: 1993–7
Policies of the Labour government
1997
 fiscal
policy
 the
'Golden Rule'
 Comparison with EU Stability and Growth Pact
 monetary
policy
 Bank
of England inflation target
 ECB targets
 effectiveness
policies
of recent monetary and fiscal
Fiscal and Monetary Policy
Rules versus
Discretion
RULES VERSUS DISCRETION

Case against discretion
 time
lags
 over-correction
 government
may ignore long-term
consequences

Case for rules
 help
to reduce inflationary expectations
 create
a stable environment for investment
and economic growth
RULES VERSUS DISCRETION

Case against rules
 can
cause severe fluctuations in interest
rates and can cause greater instability
 which

rule to choose?
 rules
may conflict
 rules
may become unsuitable
Case for discretion
 fine
tuning can be improved by better
forecasting and quicker-action
RULES VERSUS DISCRETION

Inflation targeting
 use
of inflation targets around the world
Who sets explicit targets and monitoring ranges for
the exchange rate, money and inflation
Source: The Use of Explicit Targets for Monetary Policy: Practical Experiences
of 91 economies in the 1990s, (Bank of England, August 1999)
Who sets explicit targets and monitoring ranges for
the exchange rate, money and inflation
Source: The Use of Explicit Targets for Monetary Policy: Practical Experiences
of 91 economies in the 1990s, (Bank of England, August 1999)
Who sets explicit targets and monitoring ranges for
the exchange rate, money and inflation
Source: The Use of Explicit Targets for Monetary Policy: Practical Experiences
of 91 economies in the 1990s, (Bank of England, August 1999)
Who sets explicit targets and monitoring ranges for
the exchange rate, money and inflation
Source: The Use of Explicit Targets for Monetary Policy: Practical Experiences
of 91 economies in the 1990s, (Bank of England, August 1999)
Source: Bank of England
RULES VERSUS DISCRETION

Inflation targeting
 use
of inflation targets around the world
 weaknesses
of money supply targets
RULES VERSUS DISCRETION

Inflation targeting
 use
of inflation targets around the world
 weaknesses
of money supply targets
 weaknesses
of exchange rate targets
RULES VERSUS DISCRETION

Inflation targeting
 use
of inflation targets around the world
 weaknesses
of money supply targets
 weaknesses
of exchange rate targets
 relative
strength of inflation targets
RULES VERSUS DISCRETION

Inflation targeting
 use
of inflation targets around the world
 weaknesses
of money supply targets
 weaknesses
of exchange rate targets
 relative

strength of inflation targets
Issues with inflation targets
RULES VERSUS DISCRETION

Inflation targeting
 use
of inflation targets around the world
 weaknesses
of money supply targets
 weaknesses
of exchange rate targets
 relative

strength of inflation targets
Issues with inflation targets
 choice
 what
of the target
level?
 central
point or ceiling?
RULES VERSUS DISCRETION

Issues with inflation targets (cont.)
 who
sets the target?
 changing
 multiple
a
the target
targets
Taylor rule for setting interest rates
ADI curves based on different Taylor rules
Curve ADI1: based on Taylor rule giving
relatively high weight to stable inflation
Rate of inflation (P)
.
.P
b
1
.P
a
targe
t
ADI1
O
Y1
Y
0
National income
ADI curves based on different Taylor rules
Curve ADI1: based on Taylor rule giving
relatively high weight to stable inflation
Curve ADI2: based on Taylor rule giving relatively
high weight to stable real national income
Rate of inflation (P)
.
.P
b
1
c
.P
a
targe
t
ADI1
ADI2
O
Y1
Y2
Y
0
National income
RULES VERSUS DISCRETION

Issues with inflation targets (cont.)
 who
sets the target?
 changing
 multiple
a
the target
targets
Taylor rule for setting interest rates
 targeting
inflation and the money supply
RULES VERSUS DISCRETION

Issues with inflation targets (cont.)
 who
sets the target?
 changing
 multiple
a
the target
targets
Taylor rule for setting interest rates
 targeting
 basing
inflation and the money supply
interest rates on forecasts of
inflation
RULES VERSUS DISCRETION

Issues with inflation targets (cont.)
 who
sets the target?
 changing
 multiple
a
the target
targets
Taylor rule for setting interest rates
 targeting
inflation and the money supply
 basing
interest rates on forecasts of
inflation
 the
problem of deflation