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BRITISH MACROECONOMIC POLICY Schools of thought (very broadly defined) in macroeconomics Keynesian - active approach.

. Left to itself, free market economy is unstable. No automatic tendency towards full employment equilibrium. Demand management policy should be used to regulate flows of expenditure, with direct effects on output and employment. Neoclassical passive approach. Free market economy is stable. When shocks occur, rapid price adjustments take place to restore equilibrium. Government action not required, and if attempted may make things worse. Government should adopt consistent policy rules, to create a stable environment for private sector economic activity.

Policy objectives 1. Full Employment

First became an objective following 1936 publication of J.M.Keynes General Theory. Keynes identified 2 types of unemployment: Frictional/structural (people changing jobs, people with wrong skills, chronically unemployable). Demand-deficient (due to lack of aggregate demand in the economy). Keynes argued that macroeconomic policy should aim to minimise demand-deficient unemployment. Beveridge Report (1944) specified 3% as an acceptable rate of unemployment. As the influence of Keynesian macro-economics has receded, so too has the emphasis given to full employment as a policy objective. Neoclassical economists place greater emphasis on microeconomic causes of unemployment - skills mismatch - labour market imperfections This places unemployment beyond the scope of macroeconomic policy (similar to pre-1930s view). 2. Price stability (or a low and stable rate of inflation)

Costs of inflation perhaps less obvious than the costs of unemployment. Costs tend to be less if inflation is anticipated than if unanticipated stability is important. Unanticipated inflation imposes costs of adjusting prices/collecting information about prices. Errors occur; trade takes place on the basis of false information.

Unanticipated inflation discriminates against those on fixed incomes, and redistributes wealth from creditors to debtors. If government is a net debtor, inflation is a hidden tax. (With anticipated inflation these effects can be taken into account when contracts are drawn up).


Unanticipated inflation creates uncertainty, which may deter investment or foreign trade. Under a fixed exchange rate, inflation causes loss of competitiveness, and may create pressure for exchange rate devaluation. Economic growth

Growth in gross domestic product (GDP) or in GDP per capita is the most commonly used measure of improvement in living standards. Growth also makes other objectives easier to achieve, e.g. - allows non-inflationary increases in wages, - offsets loss of employment due to technical change. R.A.Butler (Conservative, 1954) suggested there should be a doubling of living standards every 25 years ( annual growth rate just below 3%). 4. Balance of payments equilibrium Value of exports minus Value of imports = BALANCE OF TRADE plus Net income to/from abroad = CURRENT ACCOUNT Net capital flows to/from abroad = CAPITAL ACCOUNT Current account + capital account = BALANCE OF PAYMENTS Is balance of payments equilibrium really an objective, or a constraint? Unlike 1-3, it is not really desirable for its own sake. Effects of balance of payments disequilibrium depend whether the exchange rate is fixed or flexible:



Receipts for UK exports + capital inflows

Foreign exchange market $s


Payments for UK imports + capital outflows

Central bank

Figure 1

UK balance of payments surplus: fixed exchange rate regime



Receipts for UK exports + capital inflows

Figure 2

Foreign exchange market $s


Payments for UK imports + capital outflows

Central bank

UK balance of payments deficit: fixed exchange rate regime

Fixed: Surpluses or deficits are financed by building up or running down reserves of foreign currency. Surplus increase in reserves inflationary. Deficit depletion of reserves deflationary, and not sustainable indefinitely.

Flexible: Exchange rate adjusts to equalise the demand and supply for currencies, eliminating surpluses and deficits. Model of exchange rate determination Consider effects of changes in the /$ exchange rate on prices and demand for: an exported good, worth 1 when it leaves the UK factory; an imported good, worth $1.50 when it leaves the US factory.

Assume unit price elasticities, so total revenue from each market (expressed in domestic currency units) is constant. Exchange rate: US price of UK export: Units sold in US: value of UK exports: UK price of US import: Units sold in UK: value of UK imports: Balance of trade: 1=$2 $2 75 75 0.75 133 100 -25 1=$1.50 $1.50 100 100 1 100 100 0 1=$1 $1 150 150 1.50 67 100 +50

So, a reduction in the exchange rate improves the balance of trade/payments. An increase in the exchange rate worsens the balance of trade/payments. More generally, exports and capital inflows generate demand for sterling at the foreign exchanges. Imports and capital outflows generate supply of sterling at the foreign exchanges. If the price elasticity of demand for imports is greater than one, we get a conventional demand and supply diagram. It is also argued that movements in the exchange rate tend to be destabilising: an increase in the exchange rate tends to erode competitiveness loss of output and employment; a decrease in the exchange rate tends to make imports dearer inflation.

Exchange rate $s per 2


1.5 1 Exports

75 Figure 3



value of exports and imports

Supply and demand for s, assuming unit elasticities and no capital flows

Exchange rate $s per s3 b of p deficit Imports + capital outflows

s2 s1 Exports + capital inflows b of p surplus value of exports and imports Figure 4 Supply and demand for s, assuming price elasticity of demand for imports > 1, and capital flows

Instruments and targets A policy instrument is a variable directly under the control of government. Governments may also choose to specify targets, which are not under direct control but which are influenced by relevant instruments. Examples Instrument Monetary Policy Fiscal Policy Notes and coins Income tax rate Target Broad money supply Income tax revenue

Monetary policy: the mechanics Is the money supply controllable? There is no single definition of the money supply. The narrowest measure currently published in the UK is M0 (base or high poweredmoney), here denoted B: B=C+R where C = notes & coins in circulation outside the banking system, R = banks reserves of cash and liquid assets. The standard broad money supply measure is M4, here denoted M: M=C+D where D = a broad range of (both current and deposit account) bank deposits. What determines the ratio of narrow to broad money? M =C+D = c+1 M= c+1B B C+R c+r c+r where c = C = publics ratio of cash to bank deposits, D r = R = banks ratio of reserves to bank deposits. D Control over M therefore rests on: (i) the stability of c and r; and (ii) the controllability of B.

(i) Stability of c and r Stability of r is not too problematic. Government can legislate to require banks to maintain a minimum ratio of liquid assets to total assets. Stability of c is more controversial (depends on what determines the publics demand for money). Neoclassical/Monetarists emphasise demand for money as a means of exchange c (and therefore M) are stable and controllable optimistic about effectiveness of monetary policy. Keynesians emphasise demand for money as a store of wealth (one of a number of competing types of asset) c is volatile and unpredictable; M is not controllable pessimistic about effectiveness of monetary policy.

(ii) Controllability of B Hinges on the links between monetary, fiscal and exchange rate policy, expressed by the government budget constraint: B = PSBR + B of P Net sales of government debt where B = change in the monetary base, PSBR = public sector borrowing requirement = difference between government expenditures and tax receipts, B of P = balance of payments, Net sales of government debt = the difference between new government borrowing, and repayment of debt which has matured. There are two important implications: 1. Link between fiscal & monetary policy

An increase in the PSBR will lead to an increase in the money supply, unless it is matched by an increase in sales of debt (i.e. government borrowing). Keynesians assume that through borrowing, it is possible to increase PSBR without increasing the money supply. On this view, it is possible to run fiscal policy independently of monetary policy. Neoclassical/Monetarist economists argue that its difficult to fund a positive PSBR by borrowing, because debt cant be accumulated indefinitely (if it is, the interest rate will start to rise).

Increase in PSBR increase in money supply. Conversely, to control the money supply you have to control the PSBR. On this view, fiscal policy is subservient to monetary policy. 2. Link between exchange rate & monetary policy Variations in the balance of payments lead directly to changes in the money supply. With a fixed exchange rate, this seems inevitable (due to variations in demand for exports and imports, and unpredictable capital flows). With a flexible exchange rate, however, variations in the balance of payments are averted through exchange rate adjustment. Tendency toward surplus exchange rate rises surplus eliminated. Tendency toward deficit exchange rate falls deficit eliminated. Conclusions To retain control of the domestic money supply, the government must run a flexible exchange rate regime. Fixing the exchange rate implies loss of control of the domestic money supply. Active exchange rate and monetary policy are mutually exclusive alternatives.