UCL ECON7003 Money and Banking Lecture 16. TARGETING MONETARY AGGREGATES

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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.
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• 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.

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• 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.

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

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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.
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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
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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.
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• LR economic growth ? ?MS 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.

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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.
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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.
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Non-inflationary increase in MS by CB following
MS rule in low-p conditions preview.
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• 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 p
  (see WS6).

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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.
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• 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 p, 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.

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• (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
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• 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 todays
  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.

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• (2) Targeting P
• 1960s-70s PI 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 gt long and unpredictable
  lags.
• Usual intermediate target a monetary aggregate.

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• Friedman for intermediate targets (MS aggregates
  / totals) gt 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.

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• Monetarism from theory to party politics in UK.
• PI policies
• Heath government's U-Turn, 1973-4.
• Labour government, 1974-9.
• Some success against p.
• 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
• gt monetary issues as such.

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• Inflation Cost-Push from oil prices
• 1973-4 Arab-Israeli war October 1973 Arab oil
  boycott.
• 1979-80 Iranian revolution.
• Much comment on 1970s p emphasises these oil
  shocks
• i.e. emphasis on p from external Cost-Push.
• BUT
• UK p exceptionally severe gt other industrialised
  countries
• ? Domestic factors also need emphasis
• Cost-Push from wage inflation as well as oil.
• Demand-Pull from expansionary MP.

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• Inflation demand-pull from DMP?
• Monetarist view p is a monetary phenomenon only.
• i.e. ultimately QTM holds.
• p just a demand-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 p problem.

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• 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
• p peaked 1975 / exceptionally high in UK
• Many blamed W increases conceded in face of
  union actions.

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• 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.

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

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• 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.

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• 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.

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• 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
• ? CBs balance sheet expands.
• i.e. R? ? credit creation by commercial banking
  system.
• i.e. MS? ? p?.
• Borrow from NBP
• ? just re-allocates existing LF.
• More D pressure on existing LF ? r?
• ? crowding out of private I.

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• Thus PSBR? essential to counter-inflationary
  strategy
• Prevent crowding out of private sector I.
• Accorded with governments pro-private policy
  platform / ideology.
• Inefficiency effects of PI policy
• Would contribute to breakdown of PC.

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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 p, 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.
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• 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 p industrial actions miners, etc. 1978-9
  winter of discontent.
• Continuing high oil price since 1973-4 shock.
• Petro- markets.

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• 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 ?T 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.

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Early 1980s recession

• Tight MP and FP against the p pressure ?
• Interest rates 17 by end 1979
• soared ? hit exports
• North Sea oil on stream ? ER? even further.
• All FE controls lifted end 1979.
• ? BOTH inflation AND recession worse in UK than
  elsewhere.

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Phase 2 Pragmatic monetarism

• By 1982
• Thatcher governments commitment to monetarist
  policies beginning to waver
• u gt 3m
• p easing
• ? Tacit reversion to DMP / expansionary MP
• By mid-1980s
• Monetarist policy / targeting MS effectively
  abandoned.
• Shift towards ER targeting.

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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.

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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 Predictabili
ty Direction of causation. Defining
Money. Goodharts Law in action. TARGETING
EXCHANGE RATES.