UCL ECON7003 Money and Banking Lecture 16. TARGETING MONETARY AGGREGATES

1. UCL ECON7003 Money and BankingLecture 16.TARGETING MONETARY AGGREGATES Historical background to critique of Keynesian DMP – review. Monetarist theory and monetarist argument for rules – review. Goals of monetary policy and indirect targeting. Inflationary pressures in the 1970s – demand-pull and cost-push. Monetarism and party politics in the 1970s. Public perception: monetarism identified with ‘cuts’. Monetarist policies, 1979-82: from doctrinaire to pragmatic.

2. Historical background to critique of Keynesian DMP – review. • Monetary policy in post-war boom. • Post-war consensus on DMP • Keynesian DMP and ‘accommodating’ MP • Balance of payments / conflict of goals • Late 1960s: developing macro instability. • Inflationary pressures, early 1970s. • Heath government reverts to interventionist counter-measures. • Labour government of 1974-9: stagflation. • 1976-7: IMF loan.

3. Monetarist theory and monetarist argument for rules – review. • Money demand, QTM, factor of proportionality (k). • Friedman: Permanent Income Hypothesis. • Adaptive Expectations Hypothesis, ‘fooling’. • Neutrality of money – LR / SR distinction. • ‘Natural rate’. • Optimum MS rule. • Problems of CB in controlling MS: other actors – review. • Money market disequilibrium. • ‘Long and variable lags’.

4. Rules versus discretion: Discretionary MP thus seen as the principle cause of both: The cycle. Inflation: “Always and everywhere a monetary phenomenon” (Friedman).

5. Discretionary MP and generation of cycle: monetarist view. Monetary expansion → r↓ → economy moves down IS. Monetary contraction is then implemented as a counter-measure. BUT overshoots ye.

6. Monetarists hold that MS has stable relation to PY. Friedman and Schwartz on US monetary history: Volatility / policy swings in monetary aggregates were principal cause of cycle. Shaded areas represent recessions:

7. It is a matter of record that periods of relative stability in the rate of monetary growth have also been periods of relative stability in economic activity, both in the United States and other countries.

8. LR economic growth → ΔMS is necessary • BUT MS should be set in way that minimises inflationary expectations. • Governments cannot be trusted with discretion to do this: • they have other motives, e.g. electoral. • → Monetary policy should be set by rules that are • clearly-identifiable • publicly-announced • credibly enforceable • e.g. in step with the trend rate of growth. • Preferably: should be administered by a monetary authority independent of government.

9. My own prescription is still that the monetary authority go all the way in avoiding such swings by adopting publicly the policy of achieving a steady rate of growth in a specified monetary total. The precise rate of growth, like the precise monetary total, is less important than the adoption of some stated and known rate… Steady monetary growth would provide a monetary climate favorable to the effective operation of those basic forces of enterprise, ingenuity, invention, hard work, and thrift that are the true springs of economic growth.

10. Non-inflationary increase in MS: • Money market: ye to ye′ determined on S-side. • → MD increases from MD(ye) to MD(ye′). • CB follows its MS growth rule • → MS = MD, i.e. superimposed. • → no upward or downward pressure on r.

11. Non-inflationary increase in MS by CB following MS rule in low-π conditions – preview.

12. r not determined in M Market, but by 3-way interaction between: D-side influences (represented by IS curve); S-side constraints (represented by Phillips Curve); CB preferences w.r.t. trade-off between u and π(see WS6).

13. i.e. no upward or downward pressure on r from money market. • → LM curve ceases to act as constraint. • r determined by 3-way interaction from elsewhere.

14. Direct and indirect targets: • MP and direct targeting of Y and P. • Goals of MP = goals of macro policy as a whole: • Low u and π, high and steady growth, BOP, etc. • So why not target the goals directly? • Particularly: • (1) Target Y? • (2) Target P? • Monetarist critique of Keynesian DMP in post-war decades. • → Remain the basis of current arguments against this.

15. Path (b) – aim of intervention Path (c) – undesired outcome of intervention • (1) MP to target Y, i.e. as element of Keynesian DMP / ‘fine tuning’: ‘Long and unpredictable lags’ – review. → liable to come at wrong time and aggravate fluctuations: Path (a) – without intervention Y The intervention has increased the amplitude of the fluctuations! O Time

16. Friedman on over-reaction / swings in monetary policy: In the past, monetary authorities have on occasion moved in the wrong direction… More frequently, they have moved in the right direction, albeit often too late, but have erred by moving too far. Too late and too much as been the general practice. … The reason for the propensity to overreact seems clear: the failure of monetary authorities to allow for the delay between their actions and the subsequent effects on the economy. They tend to determine their actions by today’s conditions – but their actions will affect the economy only six or nine or twelve or fifteen months later. Hence they feel impelled to step on the brake, or the accelerator, as the case may be, too hard.

17. (2) Targeting P: 1960s-70s: P&I policies of UK governments But monetary authorities today (usually CB) not in position to intervene in this way. Monetarists are against intervention anyway. • Monetarist alternative: • MP should focus instead on ‘intermediate targets’. • i.e. Targets which affect Y and P, etc. Target which has affect over shorter and more predictable period > ‘long and unpredictable lags’. Usual intermediate target: a monetary aggregate.

18. Friedman for intermediate targets (MS aggregates / ‘totals’) > targeting P/ the ‘long way around’: The link between the policy actions of the monetary authority and the price level, while unquestionably present, is more indirect than the link between the policy actions of the authority and any of the several monetary totals. Monetary action takes a longer time to affect the price level than to affect the monetary totals and both the time lag and the magnitude of effect vary with circumstances. As a result, we cannot predict at all accurately just what effect a particular monetary action will have on the price level and, equally important, just when it will have that effect. …At the present stage of our understanding, the long way around seems the surer way to our objective.

19. Monetarism from theory to party politics in UK. P&I policies: Heath government's ‘U-Turn’, 1973-4. Labour government, 1974-9. • Some success against π. • But £continued to depreciate. 1976-7: monetarist conditions for IMF loan: • MS targets. • Market-oriented S-side measures. ‘Monetarism’ thus associated with: Fiscal contraction (‘cuts’). S-side measures > monetary issues as such.

20. Inflation – ‘Cost-Push’ from oil prices: • 1973-4 – Arab-Israeli war October 1973; Arab oil boycott. • 1979-80 – Iranian revolution. • Much comment on 1970s π emphasises these ‘oil shocks’: • i.e. emphasis on π from external‘Cost-Push’. • BUT: • UK πexceptionally severe > other industrialised countries • → Domestic factors also need emphasis: • Cost-Push from wage inflation as well as oil. • Demand-Pull from expansionary MP.

21. Inflation – demand-pull from DMP? • Monetarist view: π is a monetary phenomenon only. • i.e. ultimately QTM holds. • π just ademand-pull effect of expansionary MP. • Might fit early 1970s: • Recession → reflationary measures 1972. • → ‘Barber boom’ 1972-3 • Overtaken by global boom during 1973. • → Already severe inflationary pressure summer 1973. • Then‘oil shock’, October 1973 – i.e. just a catalyst for an underlying D-pull π problem.

22. Inflation – Cost-Push from wage inflation? (i) early 1970s • From late 1960s: attempts to curb union power through legislation. • But largely unsuccessful • This issue dominated much of political debate of 1970s: • Miners’ strike 1971-2 / State of Emergency / 3-Day Week. • 1973-4: another miners’ strike / another State of Emergency. • Coincided with first ‘oil shock’ • π peaked 1975 / exceptionally high in UK: • Many blamed W increases conceded in face of union actions.

23. Inflation – Cost-Push from wage inflation? (ii) late 1970s. • 1978-9: ‘Winter of Discontent’: • Third miners’ strike • Spread to other sections of labour movement • 10% wage rise in first half of 1979. • Then second ‘oil shock’ of 1979-80. • Thatcher government to power May 1979 • Declared intention to curb union power.

24. Monetarist policies and party politics: • From IMF loan to election of Thatcher: • Late 1970s: Labour Government already adopting monetarist policies. • Under IMF pressure / loan condition / reluctant. • But Thatcher → leader of Conservatives 1975 • → Accorded with their ideology / took monetarism up with conviction. • → Central feature of Thatcher government policy.

25. Phase 1: Doctrinaire monetarism • DMP policies of ‘Stop-Go’ era were declared abandoned: • Priorities reversed: • from u / countering cycle • to reducing π – ‘Public Enemy No. 1’ • → All MP to focus on πe • Aim: reduce inflationary expectations • πe↓ → workers reduce wage demands → reduce π. • ‘Medium-Term Financial Strategy’ (MTFS): • Tighten control on MS / modest growth only. • Well-publicised targets. • Loudly-proclaimed determination to maintain targets.

26. Minimising intervention • Minimise intervention (i.e. on cycle / u, etc.) through MP. • Also minimise intervention all-round. • Intervention only to ensure effective functioning of markets: • Free play to market incentives. • Encourage free enterprise, etc. • Seen as means to shift AS (i.e. vertical LRAS) rightwards.

27. Fiscal policy: ‘Cuts’ • Use of FP for DMP totally abandoned. • FP now centred on reducing G G/Y↓: Integral part of monetarist policy. Inseparable from MS↓. • → Monetarism identified by public with deflationary FP / ‘cuts’.

28. G↓ → IS inwards → r↓ → I (i.e. private sector I)↑. • Standard classical c/o arguments on effects of borrowing to finance PSBR (now PSNCR): • Borrow from CB: • → CB’s balance sheet expands. i.e. R↑ → credit creation by commercial banking system. i.e. MS↑ → π↑. Borrow from NBP: → just re-allocates existing LF. More D pressure on existing LF → r↑ → crowding out of private I.

29. Thus PSBR↓ essential to counter-inflationary strategy: • Prevent crowding out of private sector I. Accorded with government’s pro-private policy platform / ideology. Inefficiency effects of P&I policy: Would contribute to breakdown of PC.

30. US (and UK??): ‘Monetarism’ really just a red herring / designed to obscure true motives of Fed (and UK government??): Mishkin 18: 425-6 on Volker 1979-82 unpopular i hikes: “Monetary aggregate targets may have been a smokescreen to keep the Fed from being blamed for the high interest rates… Interest rate decisions reflected π, e.g. “With inflationary psychology apparently broken, interest rates were allowed to fall.” Fed strategy “was neither intended nor likely to produce smooth growth in the monetary aggregates. Indeed, the large fluctuations in interest rates… helped generate volatile money growth.”

31. Inflationary pressures when Thatcher government to power, May 1979: Financial deregulation and innovation – CCC, etc. Loose MP and FP (‘Barber boom’). Breakdown of BW fixed (‘adjustable peg’) ER system. W π; industrial actions – miners, etc.; 1978-9 ‘winter of discontent’. Continuing high oil price since 1973-4 ‘shock’. Petro-$ markets.

32. ‘Public enemy no. 1’ wins the first round: UK inflation spirals: • Government abandoned incomes policy: • Monetary contraction supposed to reduce W on its own. • End of ‘tripartite’ wage negotiating machinery. • Income tax cut from 33 to 30%. • VAT ↑ from 7 to 15%. • Note: Net effect on tax revenue of income tax and VAT changes was ΔT = 0, but with redistribution of tax burden from high earnings to necessities. • High pay settlement to Civil Service – an election promise. • End 1979 Iran revolution → ‘second oil shock’.

33. Early 1980s recession • Tight MP and FP against the π pressure → • Interest rates 17% by end 1979 • £ soared → hit exports • North Sea oil on stream → ER↑ even further. • All FE controls lifted end 1979. • → BOTHinflationANDrecession worse in UK than elsewhere.

34. Phase 2: ‘Pragmatic monetarism’ • By 1982: • Thatcher government’s commitment to monetarist policies beginning to waver: • u > 3m • π easing • → Tacit reversion to DMP / expansionary MP • By mid-1980s: • Monetarist policy / targeting MS effectively abandoned. • Shift towards ER targeting.

35. Continuing ‘supply-side’ policies to free up market forces • Continued to reduce G – ‘cuts’ • Increase incentive to work through T↓ • Reduce power of labour – miners’ strike 1984-5, etc. • Reduce UB • Encourage competition: • Privatisation • Deregulation • Equivalent set of policies in US: ‘Reaganomics’.

36. UCL ECON7003 Money and BankingLecture 17 – preview • TARGETING MONETARY AGGREGATES, concluded. • The Thatcher monetarist policy: balance of pain and gain. • Gradualism – assessment. • Problems of M aggregate targeting: • Controllability • Predictability • Direction of causation. • Defining Money. • Goodhart’s Law in action. • TARGETING EXCHANGE RATES.