Title: UCL ECON7003 Money and Banking Topic 6. Monetary policy and the two traditions in macroeconomics.
1UCL 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.
2- 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.
3- 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.
4- 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.
5Unemployment in the UK, 1880-2005.
Stagflation 1970s
Post-war Keynesianism
Classical revival
Note 3 successive dominant currents in post-war
macro
6(No Transcript)
7Circular 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
8Classical 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
9Bond 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.
1015 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.
11The 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.
12 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.
13y? ? 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.
14Derivation 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
15Derivation of the IS curve, contd
IS curve represents all the combinations of r and
y where the goods market is in equilibrium.
IS
16IS 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
17- 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.).
18- 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.
19- 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.
20- 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??
21- 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.
22Keynesian 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?
23- 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.
24- 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 .
25- 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.
26- 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.
27- 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.
28- 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.
29- 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.
30- 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.