UCL ECON7003 Money and Banking Topic 6. Monetary policy and the two traditions in macroeconomics.

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UCL ECON7003 Money and BankingTopic 6.Monetary
policy and the two traditions in macroeconomics.

• Introduction to Part II of the module Money and
  monetary policy.
• Keynes versus the classics the debates take
  definitive shape.
• Classical economics market-clearing Says Law
  QTM. Circular flow classical view and Keyness
  challenge.
• Limited debate on monetary policy in post-war
  period.
• Post-war boom. Post-war consensus. Accommodating
  monetary policy. Balance of Payments and problems
  of stop-go.
• Return of macroeconomic turbulence the debate is
  revived.
• Financial deregulation, fiscal expansion, end of
  Bretton Woods system, inflationary pressures.
  Stagflation. Macro debate and macro turbulence.

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• From micro to macro
• Unemployment, inflation, economic growth, and the
  balance of payments.
• Inter-disciplinary economic history, politics,
  world affairs.
• Macroeconomic debates as a whole briefly
  surveyed.

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• The course of debate in outline
• Early modern times.
• Keynes-versus-classics
• 1979 to the present.
• Three targets
• Period Target
• Late 1970s to early 1980s Monetary aggregates
• Mid-1980s to 1992 Exchange rates
• 1992 to present Inflation
• i.e. thematic chronological.

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• The UK an open economy
• Targets and international factors
• exchange rate ? monetary aggregate targeting of
  Thatcher period unsustainable
• ER by definition open economy.
• inflation and international prices (oil, etc.)
  and international macroeconomic conditions
  generally.
• ? course will reverse standard procedure
• open-economy issues from beginning.

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Unemployment in the UK, 1880-2005.
Stagflation 1970s
Post-war Keynesianism
Classical revival
Note 3 successive dominant currents in post-war
macro
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Circular flow
Keynes Government may need to intervene to
increase AD / compensate if J lt W
INJECTIONS
Export expenditure (X)
Investment expenditure (I)
Government expenditure (G)
C
Y
BANKS, etc
GOV
ABROAD
T
M
S
WITHDRAWALS
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Classical view All aspects of market economy are
self-regulating.Only government intervention /
deficit financing, etc., can impede circular flow.
INJECTIONS
C
Y
Therefore, for W J to ensure unimpeded circular
flow, we must have T G !
WITHDRAWALS
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Bond prices and interest rates. Perpetuity Face
value 100 Coupon 10. Market interest rate 10.
? PB 100, i.e. remains at face value
Face value Coupon Market r Price of Bond
100 10
100 10 10
100 10
5 200
100
20 50
Fall in market interest rates to 5 ? 100
invested elsewhere would only return half as
much ? PB doubles. Rise in market interest rates
to 20 ? 100 invested elsewhere would return
twice as much ? PB is halved. i.e. Bond prices
are inversely related to market interest rates.
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15 perceived as higher than normal ? holders
of bonds expect r? ? PB? ? message to holders of
bonds is Hold onto bonds. Assumption Only two
assets, money and bonds. ? Hold onto bonds
Do not hold onto M ? MD is low.
Conversely, 5 perceived as low? expect r? ?
PB? ? message is Sell bonds Hold onto M ?
MD high.
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The Money Market
Vertical MS inelasticity with respect to
interest rates Assumption that MS is determined
exogenously by monetary authorities (e.g. for
political reasons, etc.). MD/P MS/P, where
MD/P L ( y , r- ). i.e. Money demand is
positively related to income and negatively
related to interest rates.
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MD/P L ( y , r- ) Assuming simple linear
relationships, we have MD/P ky lr ky
transactions demand ( precautionary). Assumed
constant / stable proportion of income. lr
speculative demand, demand for idle gt active
balances. Keyness new contribution to theory of
MD.
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y? ? MDAB?, but at r r0 there would be EDM, so
r? to choke off the ED.
LM curve represents all the combinations of r and
y where the money market is in equilibrium.
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Derivation of the IS curve
e
e' c i(rL) g
e c i(rH) g
c
c0
y0
y1
y
Note multiplier effect ?i ? more than
proportional ?y
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Derivation of the IS curve, contd
IS curve represents all the combinations of r and
y where the goods market is in equilibrium.
IS
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IS curve, contd
Vertical LM (Treasury View) would mean full
crowding out ?g -?I Fiscal policy
completely ineffective
Multiplier effect dampened. Partial crowding
out of i by rise in r needed to bring money
market into equilibrium
LM
IS
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• Keynesian tradition
• LM normally flattish
• ?Fiscal policy very effective.
• Monetary policy ineffective.
• Horizontal LM liquidity trap.
• Monetary policy totally ineffective (pushing on
  a string).
• May occur if r are
• too low for anyone to move into bonds
• AND too high to encourage i (investor pessimism,
  etc.).

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• Monetary theory and policy before the Great
  Depression.
• Debates over Bank of England Charter 1844
• Currency school
• Bank credit to behave as if metallic money.
• Tight restrictions / rules for issue of bank
  notes.
• Took lead from Ricardo.
• Banking school
• Bank of England should have discretion / act
  according to market conditions.

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• Currency school won out ? Bank of England divided
  into
• banking department
• issue department
• In practice, considerable discretion.
• i.e. already prefigures debates over
• rules versus discretion
• hawks versus doves on the MPC, etc.

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• Keynes versus the classics the debates take
  definitive shape.
• Keynes termed established approach
• classical
• Treasury View
• Market forces work OK.
• Says law supply creates its own demand.
• ? will ensure smooth circular flow
• Economy self-stabilising at full employment.
• i.e. Y YFE is unique point of equilibrium in
  the economy.
• IF government minimizes intervention / balances
  budget.
• Subsequent macro mostly a re-play of this debate??

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• Post-war consensus
• Keynesianism / old Keynesianism as orthodoxy!
• Both Labour and Conservative governments
  (post-war consensus)
• Demand management
• i.e. both expansionary and contractionary fiscal
  and monetary policy.
• to minimize amplitude of cyclical fluctuations.
• Continued Keyness view
• fiscal policy (usually ?T gt ?G) effective
• monetary policy ineffective.

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Keynesian argument for an accommodating
MP Classical ?G - ?I ? ?Y 0 BUT
composition of Y has changed private sector
crowded out Keynesian Use MP in conjunction
with FP G? ? r? BUT ALSO M? ? r? ? net
effect r unchanged ? no C/O of I through r path
/ r effect neutralised. G? is accommodated by
M?
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• Practical problems with post-war UK macro policy
• Balance of Payments / conflict of goals.
• fixed against at rate unchanged for 18 years
  (2.80 / ).
• This constrained MP
• Expansion ? BOP deficit.
• ? response deflation, with goal of
• Imports ?
• p? ? export competitiveness?
• When BOP back to surplus, government would
  reflate.
• Critics called this stop-go.

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• 1960s increasing conflict of goals
• if both BOP deficit and domestic recession,
  stop or go??
• Underlying problem UKs exports increasingly
  uncompetitive.
• ? LR tendency was towards deflationary policy.
• downward pressure on .
• 1967 UK forced to devluae .

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• Post-war consensus always uneasy.
• e.g. Conservative cabinet split in 1957-8.
• Meanwhile, monetarism of Friedman / Chicago
  school laying theoretical base
• monetary policy should be taken seriously
• not for any good it might do
• but for harm if misguidedly adopted as tool for
  DMP.

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• Late 1960s developing macro instability
• Persistent BOT deficit
• Inflation edging up
• BOP crisis and devaluation 1967.
• Response of Heath government of 1970-4
• Free market policies
• But these backfired.
• In particular, inflationary pressures.

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• Inflationary pressures, early 1970s
• Sweeping deregulation Competition and Credit
  Control. ? Dramatic increase in credit and MS.
• 1972-3 Last fling of loose monetary and fiscal
  policy from a Conservative government (Barber
  boom).
• Breakdown of Bretton Woods ? ER no longer
  restraint on MS.
• Strong pressure for W increases.
• p already soaring when overtaken by oil price
  rise late 1973.

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• Heath government reverted to interventionist
  counter-measures
• Prices and income policies.
• Seen as unsuccessful.
• Conservative government fell 1974.
• ? Split in Conservative Party and adoption of
  Thatcher as Party leader in 1975.
• Monetarism -- influential advocates
• In press writers / editors in Financial Times,
  Times.
• In right wing of Tory Party (Powell, Joseph).
• Thatcher became figurehead during late 1970s.

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• Labour government of 1974-9 faced
• Stagflation
• i.e. breakdown of Phillips curve relationship.
• Reintroduced PI policies.
• Some success against p, but continued to fall
• 1976-7 forced to accept monetarist conditions
  for IMF loan
• Money supply targets.
• Market oriented supply-side measures
• tax reform
• union reform
• abandonment of minimum W
• reduction in UB
• cuts in public services.

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• Monetarist policies in UK thus associated with
  market-oriented / S-side approach
• Conservatives more ideologically in tune than
  Labour.
• Won election of May 1979 on monetarist
  platform.
• ? Next topic first of three targets, particular
  from May 1979.