Policy Implications
Following the contributions of Fischer (1977), Phelps and Taylor (1977), it
was clear that the new classical conclusion that government demand management
policy was ineffective did not depend on the assumption of rational
expectations but rather on the assumption of instantaneous market clearing.
In new Keynesian models which emphasize sticky prices, money is no longer
neutral and policy effectiveness is, at least in principle, re-established. Since
in the Greenwald–Stiglitz model greater price flexibility exacerbates the problems
of economic fluctuations, new Keynesians have also demonstrated the
potential role for corrective demand management policies even if prices are
flexible (but not instantaneously so). In a world where firms set prices and
wages in an uncoordinated way, and where they are uncertain of the consequences
of their actions, it is not surprising that considerable inertia with
respect to prices and wages results.
In a market economy endogenous forces can frequently amplify the disturbing
impact of exogenous shocks. While new Keynesians tend to be more
concerned with the way an economy responds to shocks than with the
source of the shocks, experience during the past quarter-century has confirmed
that economies can be disturbed from the supply side as well as the
demand side. Indeed, as Benjamin Friedman (1992) has observed, it is often
practically and conceptually difficult to draw a clear distinction between
what is and what is not the focal point of any disturbance. Because in new
Keynesian models fluctuations are irregular and unpredictable, new Keynesians
are not enthusiastic supporters of government attempts to ‘fine-tune’ the
macroeconomy. Many new Keynesians (such as Mankiw) accept the monetarist
criticisms relating to old-style Keynesianism as well as several of the
criticisms raised by new classical economists, such as those related to dynamic
consistency (see Chapter 5). There is no unified new Keynesian view
on the extent of discretionary fiscal and monetary action that a government
may take in response to aggregate fluctuations (see Solow and Taylor, 1998).
However, most new Keynesians do see a need for activist government action
of some form because of market failure, especially in the case of a deep
recession. For example, Taylor (2000a) argues that while fiscal policy should
normally be used to achieve long-term objectives such as economic growth,
there is a strong case for the explicit use of fiscal expansionary policy in
‘unusual situations such as when nominal interest rates hit a lower bound of
zero’.
Because of uncertainty with respect to the kinds of problems an economy
may confront in the future, new Keynesians do not support the fixed-rules
approach to monetary policy advocated by Friedman (1968a) and new classical
equilibrium theorists such as Lucas, Sargent, Wallace, Barro, Kydland
and Prescott during the 1970s. If the monetarists and new classicists successfully
undermined the case for fine-tuning, new Keynesians have certainly
championed the case for what Lindbeck (1992) has referred to as ‘coarsetuning’
– policies designed to offset or avoid serious macro-level problems.
Here it is interesting to recall Leijonhufvud’s (1973, 1981) idea that market
economies operate reasonably well within certain limits. Leijonhufvud argues
that
The system is likely to behave differently for large than for moderate displacements
from the ‘full coordination’ time path. Within some range from the path (referred
to as the corridor for brevity), the system’s homeostatic mechanisms work well,
and deviation counteracting tendencies increase in strength.
However, Leijonhufvud argues that outside ‘the corridor’ these equilibrating
tendencies are much weaker and the market system is increasingly vulnerable
to effective demand failures. More recently Krugman (1998, 1999) has also
reminded economists about the dangers of ‘Depression Economics’ and the
potential for a liquidity trap (see Buiter, 2003b).
Echoing this concern, new Keynesian analysis provides theoretical support
for policy intervention, especially in the case of huge shocks which lead to
persistence, because the adjustment process in market economies works too
slowly. An increasing consensus of economists now support the case for
some form of constrained discretion in the form of an activist rule. Indeed,
during the last decade of the twentieth century, macroeconomics began to
evolve into what Goodfriend and King (1997) have called a ‘New Neoclassical
Synthesis’. The central elements of this new synthesis involve:
The new Keynesian school 411
1. the need for macroeconomic models to take into account intertemporal
optimization;
2. the widespread use of the rational expectations hypothesis;
3. recognition of the importance of imperfect competition in goods, labour
and credit markets;
4. incorporating costly price adjustment into macroeconomic models.
Clearly this new consensus has a distinctly new Keynesian flavour. Indeed,
Gali (2002) refers to the new generation of small-scale monetary business
cycle models as either ‘new Keynesian’ or ‘new Neoclassical Synthesis’
models. This ‘new paradigm’ integrates Keynesian elements such as nominal
rigidities and imperfect competition into a real business cycle dynamic general
equilibrium framework.
According to Goodfriend and King, the ‘New Neoclassical Synthesis’ models
suggest four major conclusions about the role of monetary policy. First,
monetary policy has persistent effects on real variables due to gradual price
adjustment. Second, there is ‘little’ long-run trade-off between real and nominal
variables. Third, inflation has significant welfare costs due to its distorting
impact on economic performance. Fourth, in understanding the effects of
monetary policy, it is important to take into account the credibility of policy.
This implies that monetary policy is best conducted within a rules-based
framework, with central banks adopting a regime of inflation targeting
(Muscatelli and Trecroci, 2000). As Goodfriend and King note, these ideas
relating to monetary policy ‘are consistent with the public statements of
central bankers from a wide range of countries’ (see, for example Gordon
Brown, 1997, 2001, and the ‘core properties’ of the Bank of England’s
macroeconometric model, Bank of England, 1999; Treasury, 1999
Costs of inflation
An important element of the growing consensus in macroeconomics is that
low and stable inflation is conducive to growth, stability and the efficient
functioning of market economies (Fischer, 1993; Taylor, 1996, 1998a, 1998b).
The consensus view is that inflation has real economic costs, especially
unanticipated inflation. The costs of anticipated inflation include ‘shoe leather’
costs, menu costs and the costs created by distortions in a non-indexed tax
system. The costs of unanticipated inflation include distortions to the distribution
of income, distortions to the price mechanism causing efficiency losses,
and losses due to increased uncertainty which lowers investment and reduces
economic growth. Also important are the costs of disinflation (the ‘sacrifice
ratio’), especially if hysteresis effects are present (Ball, 1999; Cross, 2002).
Leijonhufvud also argues that during non-trivial inflation the principal–agent
problems in the economy, particularly in the government sector, become
impossible of solution. This is because nominal auditing and bookkeeping
are the only methods invented for principals to control agents in various
situations. For example, Leijonhufvud highlights the problems that arise
when the national budget for the coming year becomes meaningless when
‘money twelve months hence is of totally unknown purchasing power’. In
such situations government departments cannot be held responsible for not
adhering to their budgets since the government has lost overall control. ‘It is
not just a case of the private sector not being able to predict what the
monetary authorities are going to do, the monetary authorities themselves
have no idea what the rate of money creation will be next month because of
constantly shifting, intense political pressures’ (Snowdon, 2004a; see also
Heymann and Leijonhufvud, 1995). Other significant costs arise if governments
choose to suppress inflation, leading to distortions to the price
mechanism and further significant efficiency losses. Shiller (1997) has also
shown that inflation is extremely unpopular among the general public although
‘people have definite opinions about the mechanisms and consequences
of inflation and these opinions differ … strikingly between the general public
and economists’. To a large extent these differences seem to depend on the
finding of Diamond et al. (1997) that ‘money illusion seems to be widespread
among economic agents’.
While the impact of inflation rates of less than 20 per cent on the rate of
economic growth may be small, it is important to note that small variations in
growth rates have dramatic effects on living standards over relatively short
historical periods (see Chapter 11, and Fischer, 1993; Barro, 1995; Ghosh
and Phillips, 1998; Feldstein, 1999; Temple, 2000; Kirshner, 2001). Ramey
and Ramey (1995) also present evidence from a sample of 95 countries that
volatility and growth are related; that is, more stable economies normally
grow faster. Given that macroeconomic stability and economic growth are
positively related (Fischer, 1993), achieving low and stable inflation will be
conducive to sustained growth. For example, Taylor, in a series of papers,
argues that US growth since the early 1980s (the ‘Great Boom’) was sustained
due to lower volatility induced by improved monetary policy (Taylor,
1996, 1997a, 1997b, 1998a, 1998b, 1999).
Recently, Romer and Romer (1999) and Easterly and Fischer (2001) have
presented evidence showing that inflation damages the well-being of the
poorest groups in society. The Romers find that high inflation and macroeconomic
instability are ‘correlated with less rapid growth of average income
and lower equality’. They therefore conclude that a low-inflation economic
environment is likely to result in higher income for the poor over time due to
its favourable effects on long-run growth and income equality, both of which
are adversely affected by high and variable inflation. Although expansionary
monetary policies can induce a boom and thus reduce poverty, these effects
are only temporary. As Friedman (1968a) and Phelps (1968) demonstrated
many years ago, expansionary monetary policy cannot create a permanent
boom. Thus ‘the typical package of reforms that brings about low inflation
and macroeconomic stability will also generate improved conditions for the
poor and more rapid growth for all’ (Romer and Romer, 1999).
Monetary regimes and inflation targeting
If a consensus of economists agree that inflation is damaging to economic
welfare, it remains to be decided how best to control inflation. Since it is now
widely accepted that the primary long-run goal of monetary policy is to
control inflation and create reasonable price stability, the clear task for economists
is to decide on the exact form of monetary regime to adopt in order to
achieve this goal. Monetary regimes are characterized by the use of a specific
nominal anchor. Mishkin (1999) defines a nominal anchor as ‘a constraint on
the value of domestic money’ or more broadly as ‘a constraint on discretionary
policy that helps weaken the time-inconsistency problem’. This helps to
solve the inflation bias problem inherent with the use of discretionary demand
management policies (Kydland and Prescott, 1977). In practice, during
the last 50 years, we can distinguish four types of monetary regime that have
operated in market economies; first, exchange rate targeting, for example the
UK, 1990–92; second, monetary targeting, for example the UK, 1976–87;
third, explicit inflation targeting, for example the UK, 1992 to date; fourth,
implicit inflation targeting, for example the USA, in recent years (see Mishkin,
1999; Goodfriend, 2004). While each of these monetary regimes has advantages
and disadvantages, in recent years an increasing number of countries
have begun to adopt inflation targeting in various forms, combined with an
accountable and more transparent independent central bank (see Alesina and
Summers, 1993; Fischer, 1995a, 1995b, 1996b; Green, 1996; Bernanke and
Mishkin, 1992, 1997; Bernanke and Woodford, 1997; Bernanke et al., 1999;
King, 1997a, 1997b; Snowdon, 1997; Svensson, 1997a, 1997b, 1999, 2000;
Artis et al., 1998; Haldane, 1998; Vickers, 1998; Mishkin, 1999, 2000a,
2000b, 2002; Gartner, 2000; Muscatelli and Trecroci, 2000; Piga, 2000;
Britton, 2002; Geraats, 2002; Bernanke and Woodford, 2004; see also the
interview with Bernanke in Snowdon, 2002a, 2002b).
Following Svensson (1997a, 1997b) and Mishkin (2002), we can view
inflation targeting as a monetary regime that encompasses six main elements:
1. the public announcement of medium-term numerical targets for inflation;
2. a firm institutional commitment to price stability (usually a low and
stable rate of inflation around 2–3 per cent) as the primary goal of
monetary policy; the government, representing society, assigns a loss
function to the central bank;
3. an ‘information-inclusive strategy’ where many variables are used for
deciding the setting of policy variables;
4. greater transparency and openness in the implementation of monetary
policy so as to facilitate better communication with the public; inflation
targets are much easier to understand than exchange rate or monetary
targets;
5. increased accountability of the central bank with respect to achieving its
inflation objectives; the inflation target provides an ex post indicator of
monetary policy performance; also, by estimating inflationary expectations
relative to the inflation target, it is possible to get a measure of the
credibility of the policy;
6. because the use of inflation targeting as a nominal anchor involves comparing
the announced target for inflation with the inflation forecast as the
basis for making monetary policy decisions, Svensson (1997b) has pointed
out that ‘inflation targeting implies inflation forecast targeting’ and ‘the
central bank’s inflation forecast becomes the intermediate target’.
The successful adoption of an inflation targeting regime also has certain
other key prerequisites. The credibility of inflation targeting as a strategy will
obviously be greatly enhanced by having a sound financial system where the
central bank has complete instrument independence in order to meet its
inflation objectives (see Berger et al., 2001; Piga, 2000). To this end the Bank
of England was granted operational independence in May, 1997 (Brown,
1997). It is also crucial that central banks in inflation targeting countries
should be free of fiscal dominance. It is highly unlikely that countries with
persistent and large fiscal deficits will be able to credibly implement a
successful inflation targeting strategy. This may be a particular problem for
many developing and transition economies (Mishkin, 2000a). Successful inflation
targeting also requires the adoption of a floating exchange rate regime
to ensure that the country adopting this strategy maintains independence for
its monetary policy. The well-known open economy policy trilemma shows
that a country cannot simultaneously maintain open capital markets + fixed
exchange rates + an independent monetary policy oriented towards domestic
objectives. A government can choose any two of these but not all three
simultaneously! If a government wants to target monetary policy towards
domestic considerations such as an inflation target, either capital mobility or
the exchange rate target will have to be abandoned (see Obstfeld, 1998;
Obstfeld and Taylor, 1998; Snowdon, 2004b).
As we noted in Chapter 5, Svensson (1997a) has shown how inflation
targeting has emerged as a strategy designed to eliminate the inflation bias
inherent in discretionary monetary policies. While Friedman and Kuttner
(1996) interpret inflation targeting as a form of monetary rule, Bernanke and
Mishkin (1997) prefer to view it as a monetary regime that subjects the
central bank to a form of ‘constrained discretion’. Bernanke and Mishkin see
inflation targeting as a framework for monetary policy rather than a rigid
policy rule. In practice all countries that have adopted inflation targeting have
also built an element of flexibility into the target. This flexible approach is
supported by Mervyn King (2004), who was appointed Governor of the Bank
of England following the retirement of Eddie George in June 2003. King
identifies the ‘core of the monetary policy problem’ as being ‘uncertainty
about future social decisions resulting from the impossibility and the undesirability
of committing successors to any given monetary policy strategy’.
These problems make any form of fixed rule undesirable even if it were
possible to commit to one because, as King (2004) argues,
The exercise of some discretion is desirable in order that we may learn. The most
cogent argument against the adoption of a fixed monetary policy rule is that no
rule is likely to remain optimal for long … So we would not want to embed any
rule deeply into our decision making structure … Instead, we delegate the power
of decision to an institution that will implement policy period by period exercising
constrained discretion.
The need for flexibility due to uncertainty is also emphasized by Alan
Greenspan, who became Chaiman of the US Federal Reserve in August 1987
(he is due to retire in June 2008). The Federal Reserve’s experiences over the
post-war era make it clear that ‘uncertainty is not just a pervasive feature of
the monetary policy landscape; it is the defining characteristic of that landscape’
(Greenspan, 2004). Furthermore:
Given our inevitably incomplete knowledge about key structural aspects of an everchanging
economy and the sometimes symmetric costs or benefits of particular
outcomes, a central bank needs to consider not only the most likely future path for
the economy but also the distribution of possible outcomes about that path. The
decision-makers then need to reach a judgement about the probabilities, costs, and
benefits of the various possible outcomes under alternative choices for policy.
Clearly the setting of interest rates is as much ‘art as science’ (Cecchetti,
2000). The need for flexibility can in part be illustrated by considering a
conventional form of the loss function (Lt) assigned to central bankers given
by equation (7.16).
Lt = Pt − P∗ + Yt − Y∗ > 1
2
[ ˙ ˙ )2 φ( )2 ], φ 0 (7.16)
In this quadratic social loss function ˙Pt is the rate of inflation at time period
t, P˙ * is the inflation target, Yt is aggregate output at time t, and Y* represents
the natural rate or target rate of output. The parameter φ is the relative weight
given to stabilizing the output gap. For strict inflation targeting φ = 0, whereas
with flexible inflation targeting φ > 0. As Svenssson (1997a) notes, ‘no
central bank with an explicit inflation target seems to behave as if it wishes to
achieve the target at all cost’. Setting φ = 0 would be the policy stance
adopted by those who Mervyn King (1997b) describes as ‘inflation nutters’.
Thus all countries that have introduced inflation targeting have built an element
of flexibility into the target (Allsopp and Vines, 2000).
What should be the numerical value of the inflation target? Alan
Greenspan, currently the most powerful monetary policy maker in the world,
has reputedly defined price stability as a situation where people cease to
take inflation into account in their decisions. More specifically, Bernanke et
al. (1999) come down in favour of a positive value for the inflation target in
the range 1–3 per cent. This is supported by Summers (1991b, 1996),
Akerlof et al. (1996), and Fischer (1996b). One of the main lessons of the
Great Depression, and one that has been repeated in much milder form in
Japan during the last decade, is that it is of paramount importance that
policy makers ensure that economies avoid deflation (Buiter, 2003b;
Eggertsson and Woodford, 2003; Svensson, 2003a). Because the nominal
interest rate has a lower bound of zero, any general deflation of prices will
cause an extremely damaging increase in real interest rates. Cechetti (1998)
argues that the message for inflation targeting strategies is clear, ‘be wary
of targets that imply a significant chance of deflation’. It would therefore
seem unwise to follow Feldstein’s (1999) recommendation to set a zero
inflation target. Akerlof et al. (1996) also support a positive inflation target
to allow for relative price changes. If nominal wages are rigid downwards,
then an alternative way of engineering a fall in real wages in order to
stimulate employment is to raise the general price level via inflation relative
to sticky nominal wages. With a flexible and positive inflation target this
option is available for the central bank.
Following the UK’s departure from the ERM in September 1992 it became
imperative to put in place a new nominal anchor to control inflation. During
the post-1945 period we can identify five monetary regimes adopted by the
UK monetary authorities, namely, a fixed (adjustable peg) exchange rate
regime, 1948–71; a floating exchange rate regime with no nominal anchor,
1971–6; monetary targets, 1976–87; exchange rate targeting (‘shadowing the
Deutchmark’ followed by membership of the ERM), 1987–92; and finally
inflation targeting, 1992 to date (Balls and O’Donnell, 2002). The credibility
of the inflation targeting regime was substantially improved in May 1997
when the Bank of England was given operational independence. This decision,
taken by the ‘New Labour’ government, was designed to enhance the
administration’s anti-inflation credibility by removing the suspicion that ideoThe
logical or short-term electoral considerations would in future influence the
conduct of stabilization policy (see Chapter 10).
The current UK monetary policy framework encompasses the following
main features:
1. A symmetrical inflation target. The targets or goals of policy are set by
the Chancellor of the Exchequer.
2. Monthly monetary policy meetings by a nine-member Monetary Policy
Committee (MPC) of ‘experts’. To date, current and past membership of
the MPC has included many distinguished economists, including Mervyn
King, Charles Bean, Steven Nickell, Charles Goodhart, Willem Buiter,
Alan Budd, John Vickers, Sushil Wadhami, DeAnne Julius, Christopher
Allsopp, Kate Barker and Eddie George.
3. Instrument independence for the central bank. The MPC has responsibility
for setting interest rates with the central objective of publication of
MPC minutes.
4. Publication of a quarterly Inflation Report which sets forth the Bank of
England’s inflation and GDP forecasts. The Bank of England’s inflation
forecast is published in the form of a probability distribution presented in
the form of a ‘fan chart’ (see Figure 7.13). The Bank’s current objective
is to achieve an inflation target of 2 per cent, as measured by the 12-
month increase in the consumer prices index (CPI). This target was
announced on 10 December 2003. Previously the inflation target was 2.5
per cent based on RPIX inflation (the retail prices index excluding mortgage
interest payments).
5. An open letter system. Should inflation deviate from target by more than
1 per cent in either direction, the Governor of the Bank of England, on
behalf of the MPC, must write an open letter to the Chancellor explaining
the reasons for the deviation of inflation from target, an accommodative
approach when confronted by large supply shocks to ease the adverse
output and employment consequences in such circumstances (Budd, 1998;
Bean, 1998; Treasury, 1999; Eijffinger, 2002b).
Since 1992 the inflation performance of the UK economy has been very
impressive, especially when compared to earlier periods such as the 1970s
Note: a Implied average expectations from 5 to 10 years ahead, derived from index-linked gilts.
Source: Bank of England, www.bankofengland.co.uk.
Figure 7.14 UK inflation and inflation expectations, October 1991–
October 2003
7
6
5
4
3
2
1
0
%
Oct. 91 Oct. 93 Oct. 95 Oct. 97 Oct. 99 Oct. 01 Oct. 03
Implied inflation
from IGsa
RPIX inflation rate
Inflation
target
announced
Bank
independence
and 1980s when inflation was high and volatile. Figure 7.14 clearly illustrates
the dramatic improvement in the UK’s inflation performance since 1992,
especially compared to earlier periods (see King, 2004).
While it is too early to tell if this monetary arrangement can deliver lower
inflation and greater economic stability over the longer term, especially in a
more turbulent world than that witnessed during the 1990s, the evidence from
recent years at least gives some cause for optimism, a case of ‘so far so good’
(see Treasury, 1999; Balls and O’Donnell, 2002). However, Ball and Sheridan
(2003) argue that there is no evidence that inflation targeting has improved
economic performance as measured by inflation, output growth and interest
rates. They present evidence that non-inflation-targeting countries have also
experienced a decline in inflation during the same period as the inflation
targeters, suggesting perhaps that better inflation performance may have been
the result of other factors. For example, Rogoff (2003), in noting the fall in
global inflation since the early 1980s, identifies the interaction of globalization,
privatization and deregulation as important factors, along with better
policies and institutions, as major factors contributing to disinflation.
A new Keynesian approach to monetary policy
In two influential papers, Clarida et al. (1999, 2000) set out what they consider
to be some important lessons that economists have learned about the
conduct of monetary policy. Economists’ research in this field points towards
some useful general principles about optimal policy. They identify their
approach as new Keynesian because in their model nominal price rigidities
allow monetary policy to have non-neutral effects on real variables in the
short run, there is a positive short-run relationship between output and inflation
(that is, a Phillips curve), and the ex ante real interest rate is negatively
related to output (that is, an IS function).
In their analysis of US monetary policy in the period 1960–96 Clarida et
al. (2000) show that there is a ‘significant difference in the way that monetary
policy was conducted pre-and post-1979’, being relatively well managed
after 1979 compared to the earlier period. The key difference between the
two periods is the magnitude and speed of response of the Federal Reserve to
expected inflation. Under the respective chairmanships of William M. Martin,
G.William Miller and Arthur Burns, the Fed was ‘highly accommodative’. In
contrast, in the years of Paul Volcker and Alan Greenspan, the Fed was much
more ‘proactive toward controlling inflation’ (see Romer and Romer, 2002,
2004).
Clarida et al. (2000) conduct their investigation by specifying a baseline
policy reaction function of the form given by (7.17):
rt r E Pt k t P E yt q t
∗ = ∗ +β[ ( ˙ | ) − ˙∗]+ γ [ | ] , Ω , Ω (7.1)
Here rt
* represents the target rate for the Federal Funds (FF) nominal interest
rate; ˙
Pt,k is the rate of inflation between time periods t and t + k; P˙ * is the
inflation target; yt,q measures the average deviation between actual GDP and
the target level of GDP (the output gap) between time periods t and t + q; E is
the expectations operator; Ωt is the information set available to the policy
maker at the time the interest rate is set; and r* is the ‘desired’ nominal FF
rate when both ˙P and y are at their target levels. For a central bank with a
quadratic loss function, such as the one given by equation (7.16), this form of
policy reaction function (rule) is appropriate in a new Keynesian setting. The
policy rule given by (7.17) differs from the well-known ‘Taylor rule’ in that it
is forward-looking (see Taylor, 1993, 1998a). Taylor proposed a rule where
the Fed reacts to lagged output and inflation whereas (7.17) suggests that the
Fed set the FF rate according to their expectation of the future values of
inflation and output gap. The Taylor rule is equivalent to a ‘special case’ of
equation (7.17) where lagged values of inflation and the output gap provide
sufficient information for forecasting future inflation. First recommended at
the 1992 Carnegie-Rochester Conference, Taylor’s (1993) policy formula is
given by (7.18):
r = P˙ + g(y) + h(P˙ − P˙ * ) + r* (7.18)
where y is real GDP measured as the percentage deviation from potential GDP;
r is the short-term nominal rate of interest in percentage points; ˙P is the rate
of inflation and P˙ * the target rate of inflation; r* is the ‘implicit real interest
rate in the central bank’s reaction function’; and the parameters g, h, ˙P * and
r* all have a positive value. With this rule short-term nominal interest rates
will rise if output and/or inflation are above their target values and nominal
rates will fall when either is below their target value. For a critique of Taylor
rules see Svensson (2003b).
In the case of (7.17) the policy maker is able to take into account a broad
selection of information about the future path of the economy. In standard
macroeconomic models aggregate demand responds negatively to the real
rate of interest; that is, higher real rates dampen economic activity and lower
real rates stimulate economic activity. From equation (7.17) we can derive
the ‘implied rule’ for the target (ex ante) real rate of interest, rrt
∗. This is
given by equation (7.19):
rrt rr E Pt k t P E yt q t
∗ = * + − − +
,
*
, ( )[ (˙ β 1 |Ω ) ˙ ] γ [ |Ω ] (7.19)
Here, rrt rt E Pt k t P
∗ ≡ −[ ( ˙ | ) − ˙ ], ,
Ω * and rr* ≡ r* − P˙ * is the long-run equilibrium
real rate of interest. According to (7.19) the real rate target will respond
to changes in the Fed’s expectations about future output and inflation
ever, as Clarida et al. point out, the sign of the response of rrt
∗ to expected
changes in output and inflation will depend on the respective values of the
coefficients β and γ. Providing that β > 1 and γ > 0, then the interest rate rule
will tend be stabilizing. If β ≤ 1 and γ ≤ 0, then interest rate rules ‘are likely
to be destabilising, or, at best, accommodative of shocks’. With β < 1, an
increase in expected inflation leads to a decline in the real interest rate, which
in turn stimulates aggregate demand thereby exacerbating inflation. During
the mid-1970s, the real interest rate in the USA was negative even though
inflation was above 10 per cent.
By building on this basic framework, Clarida et al. (2000), in their examination
of the conduct of monetary policy in the period 1960–96, find that
the Federal reserve was highly accommodative in the pre-Volcker years: on average,
it let the real short-term interest rate decline as anticipated inflation rose. While it
raised the nominal rate, it did so by less than the increase in expected inflation. On
the other hand, during the Volcker–Greenspan era the Federal Reserve adopted a
proactive stance toward controlling inflation: it systematically raised real as well as
nominal short-term interest rates in response to higher expected inflation.
During the 1970s, despite accelerating inflation, the FF nominal rate tracked
the rate of inflation but for much of the period this led to a zero or negative ex
post real rate. There was a visible change in the conduct of monetary policy
after 1979 when, following the Volcker disinflation via tight monetary policy,
the real rate for most of the 1980s became positive. In recognition of the lag
in monetary policy’s impact on economic activity, the new monetary regime
involved a pre-emptive response to the build-up of inflationary pressures. As
a result of this marked change in the Fed’s policy, inflation was successfully
reduced although as a consequence of the disinflation the USA suffered its
worst recession since the Great Depression. Unemployment rose from 5.7 per
cent in the second quarter of 1979 to 10.7 per cent in the fourth quarter of
1982 (Gordon, 2003).
In their analysis of the change of policy regime at the Fed, Clarida et al.
compare the FF rate with the estimated target forward (FWD) value for the
interest rate under the ‘Volcker–Greenspan’ rule for the whole period. According
to Clarida et al. the estimated rule ‘does a good job’ of capturing the
broad movements of the FF rate for the post-1979 sample period.
There seems little doubt that the lower inflation experienced during the past
two decades owes a great deal to the more anti-inflationary monetary stance
taken by the Fed and other central banks around the world. DeLong (1997)
suggests that the inferior monetary policy regime of the pre-Volcker period
may have been due to the Fed believing that the natural rate of unemployment
was lower than it actually was during the 1970s. Clarida et al. (2000) suggest
another possibility. At that time ‘neither the Fed nor the economics profession
understood the dynamics of inflation very well. Indeed it was not until the midto-
late 1970s that intermediate textbooks began emphasising the absence of a
long-run trade-off between inflation and output. The ideas that expectations
matter in generating inflation and that credibility is important in policymaking
were simply not well established during that era’ (see also Taylor, 1997a;
Mayer, 1999; Romer and Romer, 2004). To understand the historical performance
of an economy over time it would seem imperative to have an understanding
of the policy maker’s knowledge during the time period under investigation.
Since a great deal of policy makers’ knowledge is derived from the research
findings of economists, the state of economists’ knowledge at each point in
history must always be taken into consideration when assessing economic
performance (Romer and Romer, 2002). Although it is a very important task of
economists to analyse and be critical of past policy errors, we should remember
that, as with all things, it is easy to be wise after the event.
While a consensus among new Keynesian economists would support the
new Keynesian style of monetary policy outlined above, there remain doubters.
For example, Stiglitz (1993, pp. 1069–70) prefers a more flexible approach
to policy making and argues:
Changing economic circumstances require changes in economic policy, and it is
impossible to prescribe ahead of time what policies would be appropriate … The
reality is that no government can stand idly by as 10, 15, or 20 percent of its
workers face unemployment … new Keynesian economists also believe that it is
virtually impossible to design rules that are appropriate in the face of a rapidly
changing econ
Other policy implications
For those new Keynesians who have been developing various explanations of
real wage rigidity, a number of policy conclusions emerge which are aimed
specifically at reducing highly persistent unemployment (Manning, 1995;
Nickell, 1997, 1998). The work of Lindbeck and Snower (1988b) suggests
that institutional reforms are necessary in order to reduce the power of the
insiders and make outsiders more attractive to employers. Theoretically conceivable
power-reducing policies include:
1. a softening of job security legislation in order to reduce the hiring and
firing (turnover) costs of labour; and
2. reform of industrial relations in order to lessen the likelihood of strikes.
Policies that would help to ‘enfranchise’ the outsiders would include:
1. retraining outsiders in order to improve their human capital and marginal
product;
2. policies which improve labour mobility; for example, a better-functioning
housing market;
3. profit-sharing arrangements which bring greater flexibility to wages;
4. redesigning of the unemployment compensation system so as to encourage
job search.
Weitzman (1985) has forcefully argued the case for profit-sharing schemes
on the basis that they offer a decentralized, automatic and market incentive
approach to encourage wage flexibility, which would lessen the impact of
macroeconomic shocks. Weitzman points to the experience of Japan, Korea
and Taiwan with their flexible payment systems which have enabled these
economies in the past to ride out the business cycle with relatively high
output and employment levels (see Layard et al., 1991, for a critique).
The distorting impact of the unemployment compensation system on unemployment
is recognized by many new Keynesian economists. A system
which provides compensation for an indefinite duration without any obligation
for unemployed workers to accept jobs offered seems most likely to
disenfranchise the outsiders and raise efficiency wages in order to reduce
shirking (Shapiro and Stiglitz, 1984). In the shirking model the equilibrium
level of involuntary unemployment will be increased if the amount of unemployment
benefit is raised. Layard et al. (1991) also favour reform of the
unemployment compensation system (see Atkinson and Micklewright, 1991,
for a survey of the literature).
Some new Keynesians (particularly the European branch) favour some
form of incomes policy to modify the adverse impact of an uncoordinated
wage bargaining system; for example, Layard et al. (1991) argue that ‘if
unemployment is above the long-run NAIRU and there is hysteresis, a temporary
incomes policy is an excellent way of helping unemployment return to
the NAIRU more quickly’ (see also Galbraith, 1997). However, such policies
remain extremely contentious and most new Keynesians (for example,
Mankiw) do not feel that incomes policies have a useful role to play.
Following the contributions of Fischer (1977), Phelps and Taylor (1977), it
was clear that the new classical conclusion that government demand management
policy was ineffective did not depend on the assumption of rational
expectations but rather on the assumption of instantaneous market clearing.
In new Keynesian models which emphasize sticky prices, money is no longer
neutral and policy effectiveness is, at least in principle, re-established. Since
in the Greenwald–Stiglitz model greater price flexibility exacerbates the problems
of economic fluctuations, new Keynesians have also demonstrated the
potential role for corrective demand management policies even if prices are
flexible (but not instantaneously so). In a world where firms set prices and
wages in an uncoordinated way, and where they are uncertain of the consequences
of their actions, it is not surprising that considerable inertia with
respect to prices and wages results.
In a market economy endogenous forces can frequently amplify the disturbing
impact of exogenous shocks. While new Keynesians tend to be more
concerned with the way an economy responds to shocks than with the
source of the shocks, experience during the past quarter-century has confirmed
that economies can be disturbed from the supply side as well as the
demand side. Indeed, as Benjamin Friedman (1992) has observed, it is often
practically and conceptually difficult to draw a clear distinction between
what is and what is not the focal point of any disturbance. Because in new
Keynesian models fluctuations are irregular and unpredictable, new Keynesians
are not enthusiastic supporters of government attempts to ‘fine-tune’ the
macroeconomy. Many new Keynesians (such as Mankiw) accept the monetarist
criticisms relating to old-style Keynesianism as well as several of the
criticisms raised by new classical economists, such as those related to dynamic
consistency (see Chapter 5). There is no unified new Keynesian view
on the extent of discretionary fiscal and monetary action that a government
may take in response to aggregate fluctuations (see Solow and Taylor, 1998).
However, most new Keynesians do see a need for activist government action
of some form because of market failure, especially in the case of a deep
recession. For example, Taylor (2000a) argues that while fiscal policy should
normally be used to achieve long-term objectives such as economic growth,
there is a strong case for the explicit use of fiscal expansionary policy in
‘unusual situations such as when nominal interest rates hit a lower bound of
zero’.
Because of uncertainty with respect to the kinds of problems an economy
may confront in the future, new Keynesians do not support the fixed-rules
approach to monetary policy advocated by Friedman (1968a) and new classical
equilibrium theorists such as Lucas, Sargent, Wallace, Barro, Kydland
and Prescott during the 1970s. If the monetarists and new classicists successfully
undermined the case for fine-tuning, new Keynesians have certainly
championed the case for what Lindbeck (1992) has referred to as ‘coarsetuning’
– policies designed to offset or avoid serious macro-level problems.
Here it is interesting to recall Leijonhufvud’s (1973, 1981) idea that market
economies operate reasonably well within certain limits. Leijonhufvud argues
that
The system is likely to behave differently for large than for moderate displacements
from the ‘full coordination’ time path. Within some range from the path (referred
to as the corridor for brevity), the system’s homeostatic mechanisms work well,
and deviation counteracting tendencies increase in strength.
However, Leijonhufvud argues that outside ‘the corridor’ these equilibrating
tendencies are much weaker and the market system is increasingly vulnerable
to effective demand failures. More recently Krugman (1998, 1999) has also
reminded economists about the dangers of ‘Depression Economics’ and the
potential for a liquidity trap (see Buiter, 2003b).
Echoing this concern, new Keynesian analysis provides theoretical support
for policy intervention, especially in the case of huge shocks which lead to
persistence, because the adjustment process in market economies works too
slowly. An increasing consensus of economists now support the case for
some form of constrained discretion in the form of an activist rule. Indeed,
during the last decade of the twentieth century, macroeconomics began to
evolve into what Goodfriend and King (1997) have called a ‘New Neoclassical
Synthesis’. The central elements of this new synthesis involve:
The new Keynesian school 411
1. the need for macroeconomic models to take into account intertemporal
optimization;
2. the widespread use of the rational expectations hypothesis;
3. recognition of the importance of imperfect competition in goods, labour
and credit markets;
4. incorporating costly price adjustment into macroeconomic models.
Clearly this new consensus has a distinctly new Keynesian flavour. Indeed,
Gali (2002) refers to the new generation of small-scale monetary business
cycle models as either ‘new Keynesian’ or ‘new Neoclassical Synthesis’
models. This ‘new paradigm’ integrates Keynesian elements such as nominal
rigidities and imperfect competition into a real business cycle dynamic general
equilibrium framework.
According to Goodfriend and King, the ‘New Neoclassical Synthesis’ models
suggest four major conclusions about the role of monetary policy. First,
monetary policy has persistent effects on real variables due to gradual price
adjustment. Second, there is ‘little’ long-run trade-off between real and nominal
variables. Third, inflation has significant welfare costs due to its distorting
impact on economic performance. Fourth, in understanding the effects of
monetary policy, it is important to take into account the credibility of policy.
This implies that monetary policy is best conducted within a rules-based
framework, with central banks adopting a regime of inflation targeting
(Muscatelli and Trecroci, 2000). As Goodfriend and King note, these ideas
relating to monetary policy ‘are consistent with the public statements of
central bankers from a wide range of countries’ (see, for example Gordon
Brown, 1997, 2001, and the ‘core properties’ of the Bank of England’s
macroeconometric model, Bank of England, 1999; Treasury, 1999
Costs of inflation
An important element of the growing consensus in macroeconomics is that
low and stable inflation is conducive to growth, stability and the efficient
functioning of market economies (Fischer, 1993; Taylor, 1996, 1998a, 1998b).
The consensus view is that inflation has real economic costs, especially
unanticipated inflation. The costs of anticipated inflation include ‘shoe leather’
costs, menu costs and the costs created by distortions in a non-indexed tax
system. The costs of unanticipated inflation include distortions to the distribution
of income, distortions to the price mechanism causing efficiency losses,
and losses due to increased uncertainty which lowers investment and reduces
economic growth. Also important are the costs of disinflation (the ‘sacrifice
ratio’), especially if hysteresis effects are present (Ball, 1999; Cross, 2002).
Leijonhufvud also argues that during non-trivial inflation the principal–agent
problems in the economy, particularly in the government sector, become
impossible of solution. This is because nominal auditing and bookkeeping
are the only methods invented for principals to control agents in various
situations. For example, Leijonhufvud highlights the problems that arise
when the national budget for the coming year becomes meaningless when
‘money twelve months hence is of totally unknown purchasing power’. In
such situations government departments cannot be held responsible for not
adhering to their budgets since the government has lost overall control. ‘It is
not just a case of the private sector not being able to predict what the
monetary authorities are going to do, the monetary authorities themselves
have no idea what the rate of money creation will be next month because of
constantly shifting, intense political pressures’ (Snowdon, 2004a; see also
Heymann and Leijonhufvud, 1995). Other significant costs arise if governments
choose to suppress inflation, leading to distortions to the price
mechanism and further significant efficiency losses. Shiller (1997) has also
shown that inflation is extremely unpopular among the general public although
‘people have definite opinions about the mechanisms and consequences
of inflation and these opinions differ … strikingly between the general public
and economists’. To a large extent these differences seem to depend on the
finding of Diamond et al. (1997) that ‘money illusion seems to be widespread
among economic agents’.
While the impact of inflation rates of less than 20 per cent on the rate of
economic growth may be small, it is important to note that small variations in
growth rates have dramatic effects on living standards over relatively short
historical periods (see Chapter 11, and Fischer, 1993; Barro, 1995; Ghosh
and Phillips, 1998; Feldstein, 1999; Temple, 2000; Kirshner, 2001). Ramey
and Ramey (1995) also present evidence from a sample of 95 countries that
volatility and growth are related; that is, more stable economies normally
grow faster. Given that macroeconomic stability and economic growth are
positively related (Fischer, 1993), achieving low and stable inflation will be
conducive to sustained growth. For example, Taylor, in a series of papers,
argues that US growth since the early 1980s (the ‘Great Boom’) was sustained
due to lower volatility induced by improved monetary policy (Taylor,
1996, 1997a, 1997b, 1998a, 1998b, 1999).
Recently, Romer and Romer (1999) and Easterly and Fischer (2001) have
presented evidence showing that inflation damages the well-being of the
poorest groups in society. The Romers find that high inflation and macroeconomic
instability are ‘correlated with less rapid growth of average income
and lower equality’. They therefore conclude that a low-inflation economic
environment is likely to result in higher income for the poor over time due to
its favourable effects on long-run growth and income equality, both of which
are adversely affected by high and variable inflation. Although expansionary
monetary policies can induce a boom and thus reduce poverty, these effects
are only temporary. As Friedman (1968a) and Phelps (1968) demonstrated
many years ago, expansionary monetary policy cannot create a permanent
boom. Thus ‘the typical package of reforms that brings about low inflation
and macroeconomic stability will also generate improved conditions for the
poor and more rapid growth for all’ (Romer and Romer, 1999).
Monetary regimes and inflation targeting
If a consensus of economists agree that inflation is damaging to economic
welfare, it remains to be decided how best to control inflation. Since it is now
widely accepted that the primary long-run goal of monetary policy is to
control inflation and create reasonable price stability, the clear task for economists
is to decide on the exact form of monetary regime to adopt in order to
achieve this goal. Monetary regimes are characterized by the use of a specific
nominal anchor. Mishkin (1999) defines a nominal anchor as ‘a constraint on
the value of domestic money’ or more broadly as ‘a constraint on discretionary
policy that helps weaken the time-inconsistency problem’. This helps to
solve the inflation bias problem inherent with the use of discretionary demand
management policies (Kydland and Prescott, 1977). In practice, during
the last 50 years, we can distinguish four types of monetary regime that have
operated in market economies; first, exchange rate targeting, for example the
UK, 1990–92; second, monetary targeting, for example the UK, 1976–87;
third, explicit inflation targeting, for example the UK, 1992 to date; fourth,
implicit inflation targeting, for example the USA, in recent years (see Mishkin,
1999; Goodfriend, 2004). While each of these monetary regimes has advantages
and disadvantages, in recent years an increasing number of countries
have begun to adopt inflation targeting in various forms, combined with an
accountable and more transparent independent central bank (see Alesina and
Summers, 1993; Fischer, 1995a, 1995b, 1996b; Green, 1996; Bernanke and
Mishkin, 1992, 1997; Bernanke and Woodford, 1997; Bernanke et al., 1999;
King, 1997a, 1997b; Snowdon, 1997; Svensson, 1997a, 1997b, 1999, 2000;
Artis et al., 1998; Haldane, 1998; Vickers, 1998; Mishkin, 1999, 2000a,
2000b, 2002; Gartner, 2000; Muscatelli and Trecroci, 2000; Piga, 2000;
Britton, 2002; Geraats, 2002; Bernanke and Woodford, 2004; see also the
interview with Bernanke in Snowdon, 2002a, 2002b).
Following Svensson (1997a, 1997b) and Mishkin (2002), we can view
inflation targeting as a monetary regime that encompasses six main elements:
1. the public announcement of medium-term numerical targets for inflation;
2. a firm institutional commitment to price stability (usually a low and
stable rate of inflation around 2–3 per cent) as the primary goal of
monetary policy; the government, representing society, assigns a loss
function to the central bank;
3. an ‘information-inclusive strategy’ where many variables are used for
deciding the setting of policy variables;
4. greater transparency and openness in the implementation of monetary
policy so as to facilitate better communication with the public; inflation
targets are much easier to understand than exchange rate or monetary
targets;
5. increased accountability of the central bank with respect to achieving its
inflation objectives; the inflation target provides an ex post indicator of
monetary policy performance; also, by estimating inflationary expectations
relative to the inflation target, it is possible to get a measure of the
credibility of the policy;
6. because the use of inflation targeting as a nominal anchor involves comparing
the announced target for inflation with the inflation forecast as the
basis for making monetary policy decisions, Svensson (1997b) has pointed
out that ‘inflation targeting implies inflation forecast targeting’ and ‘the
central bank’s inflation forecast becomes the intermediate target’.
The successful adoption of an inflation targeting regime also has certain
other key prerequisites. The credibility of inflation targeting as a strategy will
obviously be greatly enhanced by having a sound financial system where the
central bank has complete instrument independence in order to meet its
inflation objectives (see Berger et al., 2001; Piga, 2000). To this end the Bank
of England was granted operational independence in May, 1997 (Brown,
1997). It is also crucial that central banks in inflation targeting countries
should be free of fiscal dominance. It is highly unlikely that countries with
persistent and large fiscal deficits will be able to credibly implement a
successful inflation targeting strategy. This may be a particular problem for
many developing and transition economies (Mishkin, 2000a). Successful inflation
targeting also requires the adoption of a floating exchange rate regime
to ensure that the country adopting this strategy maintains independence for
its monetary policy. The well-known open economy policy trilemma shows
that a country cannot simultaneously maintain open capital markets + fixed
exchange rates + an independent monetary policy oriented towards domestic
objectives. A government can choose any two of these but not all three
simultaneously! If a government wants to target monetary policy towards
domestic considerations such as an inflation target, either capital mobility or
the exchange rate target will have to be abandoned (see Obstfeld, 1998;
Obstfeld and Taylor, 1998; Snowdon, 2004b).
As we noted in Chapter 5, Svensson (1997a) has shown how inflation
targeting has emerged as a strategy designed to eliminate the inflation bias
inherent in discretionary monetary policies. While Friedman and Kuttner
(1996) interpret inflation targeting as a form of monetary rule, Bernanke and
Mishkin (1997) prefer to view it as a monetary regime that subjects the
central bank to a form of ‘constrained discretion’. Bernanke and Mishkin see
inflation targeting as a framework for monetary policy rather than a rigid
policy rule. In practice all countries that have adopted inflation targeting have
also built an element of flexibility into the target. This flexible approach is
supported by Mervyn King (2004), who was appointed Governor of the Bank
of England following the retirement of Eddie George in June 2003. King
identifies the ‘core of the monetary policy problem’ as being ‘uncertainty
about future social decisions resulting from the impossibility and the undesirability
of committing successors to any given monetary policy strategy’.
These problems make any form of fixed rule undesirable even if it were
possible to commit to one because, as King (2004) argues,
The exercise of some discretion is desirable in order that we may learn. The most
cogent argument against the adoption of a fixed monetary policy rule is that no
rule is likely to remain optimal for long … So we would not want to embed any
rule deeply into our decision making structure … Instead, we delegate the power
of decision to an institution that will implement policy period by period exercising
constrained discretion.
The need for flexibility due to uncertainty is also emphasized by Alan
Greenspan, who became Chaiman of the US Federal Reserve in August 1987
(he is due to retire in June 2008). The Federal Reserve’s experiences over the
post-war era make it clear that ‘uncertainty is not just a pervasive feature of
the monetary policy landscape; it is the defining characteristic of that landscape’
(Greenspan, 2004). Furthermore:
Given our inevitably incomplete knowledge about key structural aspects of an everchanging
economy and the sometimes symmetric costs or benefits of particular
outcomes, a central bank needs to consider not only the most likely future path for
the economy but also the distribution of possible outcomes about that path. The
decision-makers then need to reach a judgement about the probabilities, costs, and
benefits of the various possible outcomes under alternative choices for policy.
Clearly the setting of interest rates is as much ‘art as science’ (Cecchetti,
2000). The need for flexibility can in part be illustrated by considering a
conventional form of the loss function (Lt) assigned to central bankers given
by equation (7.16).
Lt = Pt − P∗ + Yt − Y∗ > 1
2
[ ˙ ˙ )2 φ( )2 ], φ 0 (7.16)
In this quadratic social loss function ˙Pt is the rate of inflation at time period
t, P˙ * is the inflation target, Yt is aggregate output at time t, and Y* represents
the natural rate or target rate of output. The parameter φ is the relative weight
given to stabilizing the output gap. For strict inflation targeting φ = 0, whereas
with flexible inflation targeting φ > 0. As Svenssson (1997a) notes, ‘no
central bank with an explicit inflation target seems to behave as if it wishes to
achieve the target at all cost’. Setting φ = 0 would be the policy stance
adopted by those who Mervyn King (1997b) describes as ‘inflation nutters’.
Thus all countries that have introduced inflation targeting have built an element
of flexibility into the target (Allsopp and Vines, 2000).
What should be the numerical value of the inflation target? Alan
Greenspan, currently the most powerful monetary policy maker in the world,
has reputedly defined price stability as a situation where people cease to
take inflation into account in their decisions. More specifically, Bernanke et
al. (1999) come down in favour of a positive value for the inflation target in
the range 1–3 per cent. This is supported by Summers (1991b, 1996),
Akerlof et al. (1996), and Fischer (1996b). One of the main lessons of the
Great Depression, and one that has been repeated in much milder form in
Japan during the last decade, is that it is of paramount importance that
policy makers ensure that economies avoid deflation (Buiter, 2003b;
Eggertsson and Woodford, 2003; Svensson, 2003a). Because the nominal
interest rate has a lower bound of zero, any general deflation of prices will
cause an extremely damaging increase in real interest rates. Cechetti (1998)
argues that the message for inflation targeting strategies is clear, ‘be wary
of targets that imply a significant chance of deflation’. It would therefore
seem unwise to follow Feldstein’s (1999) recommendation to set a zero
inflation target. Akerlof et al. (1996) also support a positive inflation target
to allow for relative price changes. If nominal wages are rigid downwards,
then an alternative way of engineering a fall in real wages in order to
stimulate employment is to raise the general price level via inflation relative
to sticky nominal wages. With a flexible and positive inflation target this
option is available for the central bank.
Following the UK’s departure from the ERM in September 1992 it became
imperative to put in place a new nominal anchor to control inflation. During
the post-1945 period we can identify five monetary regimes adopted by the
UK monetary authorities, namely, a fixed (adjustable peg) exchange rate
regime, 1948–71; a floating exchange rate regime with no nominal anchor,
1971–6; monetary targets, 1976–87; exchange rate targeting (‘shadowing the
Deutchmark’ followed by membership of the ERM), 1987–92; and finally
inflation targeting, 1992 to date (Balls and O’Donnell, 2002). The credibility
of the inflation targeting regime was substantially improved in May 1997
when the Bank of England was given operational independence. This decision,
taken by the ‘New Labour’ government, was designed to enhance the
administration’s anti-inflation credibility by removing the suspicion that ideoThe
logical or short-term electoral considerations would in future influence the
conduct of stabilization policy (see Chapter 10).
The current UK monetary policy framework encompasses the following
main features:
1. A symmetrical inflation target. The targets or goals of policy are set by
the Chancellor of the Exchequer.
2. Monthly monetary policy meetings by a nine-member Monetary Policy
Committee (MPC) of ‘experts’. To date, current and past membership of
the MPC has included many distinguished economists, including Mervyn
King, Charles Bean, Steven Nickell, Charles Goodhart, Willem Buiter,
Alan Budd, John Vickers, Sushil Wadhami, DeAnne Julius, Christopher
Allsopp, Kate Barker and Eddie George.
3. Instrument independence for the central bank. The MPC has responsibility
for setting interest rates with the central objective of publication of
MPC minutes.
4. Publication of a quarterly Inflation Report which sets forth the Bank of
England’s inflation and GDP forecasts. The Bank of England’s inflation
forecast is published in the form of a probability distribution presented in
the form of a ‘fan chart’ (see Figure 7.13). The Bank’s current objective
is to achieve an inflation target of 2 per cent, as measured by the 12-
month increase in the consumer prices index (CPI). This target was
announced on 10 December 2003. Previously the inflation target was 2.5
per cent based on RPIX inflation (the retail prices index excluding mortgage
interest payments).
5. An open letter system. Should inflation deviate from target by more than
1 per cent in either direction, the Governor of the Bank of England, on
behalf of the MPC, must write an open letter to the Chancellor explaining
the reasons for the deviation of inflation from target, an accommodative
approach when confronted by large supply shocks to ease the adverse
output and employment consequences in such circumstances (Budd, 1998;
Bean, 1998; Treasury, 1999; Eijffinger, 2002b).
Since 1992 the inflation performance of the UK economy has been very
impressive, especially when compared to earlier periods such as the 1970s
Note: a Implied average expectations from 5 to 10 years ahead, derived from index-linked gilts.
Source: Bank of England, www.bankofengland.co.uk.
Figure 7.14 UK inflation and inflation expectations, October 1991–
October 2003
7
6
5
4
3
2
1
0
%
Oct. 91 Oct. 93 Oct. 95 Oct. 97 Oct. 99 Oct. 01 Oct. 03
Implied inflation
from IGsa
RPIX inflation rate
Inflation
target
announced
Bank
independence
and 1980s when inflation was high and volatile. Figure 7.14 clearly illustrates
the dramatic improvement in the UK’s inflation performance since 1992,
especially compared to earlier periods (see King, 2004).
While it is too early to tell if this monetary arrangement can deliver lower
inflation and greater economic stability over the longer term, especially in a
more turbulent world than that witnessed during the 1990s, the evidence from
recent years at least gives some cause for optimism, a case of ‘so far so good’
(see Treasury, 1999; Balls and O’Donnell, 2002). However, Ball and Sheridan
(2003) argue that there is no evidence that inflation targeting has improved
economic performance as measured by inflation, output growth and interest
rates. They present evidence that non-inflation-targeting countries have also
experienced a decline in inflation during the same period as the inflation
targeters, suggesting perhaps that better inflation performance may have been
the result of other factors. For example, Rogoff (2003), in noting the fall in
global inflation since the early 1980s, identifies the interaction of globalization,
privatization and deregulation as important factors, along with better
policies and institutions, as major factors contributing to disinflation.
A new Keynesian approach to monetary policy
In two influential papers, Clarida et al. (1999, 2000) set out what they consider
to be some important lessons that economists have learned about the
conduct of monetary policy. Economists’ research in this field points towards
some useful general principles about optimal policy. They identify their
approach as new Keynesian because in their model nominal price rigidities
allow monetary policy to have non-neutral effects on real variables in the
short run, there is a positive short-run relationship between output and inflation
(that is, a Phillips curve), and the ex ante real interest rate is negatively
related to output (that is, an IS function).
In their analysis of US monetary policy in the period 1960–96 Clarida et
al. (2000) show that there is a ‘significant difference in the way that monetary
policy was conducted pre-and post-1979’, being relatively well managed
after 1979 compared to the earlier period. The key difference between the
two periods is the magnitude and speed of response of the Federal Reserve to
expected inflation. Under the respective chairmanships of William M. Martin,
G.William Miller and Arthur Burns, the Fed was ‘highly accommodative’. In
contrast, in the years of Paul Volcker and Alan Greenspan, the Fed was much
more ‘proactive toward controlling inflation’ (see Romer and Romer, 2002,
2004).
Clarida et al. (2000) conduct their investigation by specifying a baseline
policy reaction function of the form given by (7.17):
rt r E Pt k t P E yt q t
∗ = ∗ +β[ ( ˙ | ) − ˙∗]+ γ [ | ] , Ω , Ω (7.1)
Here rt
* represents the target rate for the Federal Funds (FF) nominal interest
rate; ˙
Pt,k is the rate of inflation between time periods t and t + k; P˙ * is the
inflation target; yt,q measures the average deviation between actual GDP and
the target level of GDP (the output gap) between time periods t and t + q; E is
the expectations operator; Ωt is the information set available to the policy
maker at the time the interest rate is set; and r* is the ‘desired’ nominal FF
rate when both ˙P and y are at their target levels. For a central bank with a
quadratic loss function, such as the one given by equation (7.16), this form of
policy reaction function (rule) is appropriate in a new Keynesian setting. The
policy rule given by (7.17) differs from the well-known ‘Taylor rule’ in that it
is forward-looking (see Taylor, 1993, 1998a). Taylor proposed a rule where
the Fed reacts to lagged output and inflation whereas (7.17) suggests that the
Fed set the FF rate according to their expectation of the future values of
inflation and output gap. The Taylor rule is equivalent to a ‘special case’ of
equation (7.17) where lagged values of inflation and the output gap provide
sufficient information for forecasting future inflation. First recommended at
the 1992 Carnegie-Rochester Conference, Taylor’s (1993) policy formula is
given by (7.18):
r = P˙ + g(y) + h(P˙ − P˙ * ) + r* (7.18)
where y is real GDP measured as the percentage deviation from potential GDP;
r is the short-term nominal rate of interest in percentage points; ˙P is the rate
of inflation and P˙ * the target rate of inflation; r* is the ‘implicit real interest
rate in the central bank’s reaction function’; and the parameters g, h, ˙P * and
r* all have a positive value. With this rule short-term nominal interest rates
will rise if output and/or inflation are above their target values and nominal
rates will fall when either is below their target value. For a critique of Taylor
rules see Svensson (2003b).
In the case of (7.17) the policy maker is able to take into account a broad
selection of information about the future path of the economy. In standard
macroeconomic models aggregate demand responds negatively to the real
rate of interest; that is, higher real rates dampen economic activity and lower
real rates stimulate economic activity. From equation (7.17) we can derive
the ‘implied rule’ for the target (ex ante) real rate of interest, rrt
∗. This is
given by equation (7.19):
rrt rr E Pt k t P E yt q t
∗ = * + − − +
,
*
, ( )[ (˙ β 1 |Ω ) ˙ ] γ [ |Ω ] (7.19)
Here, rrt rt E Pt k t P
∗ ≡ −[ ( ˙ | ) − ˙ ], ,
Ω * and rr* ≡ r* − P˙ * is the long-run equilibrium
real rate of interest. According to (7.19) the real rate target will respond
to changes in the Fed’s expectations about future output and inflation
ever, as Clarida et al. point out, the sign of the response of rrt
∗ to expected
changes in output and inflation will depend on the respective values of the
coefficients β and γ. Providing that β > 1 and γ > 0, then the interest rate rule
will tend be stabilizing. If β ≤ 1 and γ ≤ 0, then interest rate rules ‘are likely
to be destabilising, or, at best, accommodative of shocks’. With β < 1, an
increase in expected inflation leads to a decline in the real interest rate, which
in turn stimulates aggregate demand thereby exacerbating inflation. During
the mid-1970s, the real interest rate in the USA was negative even though
inflation was above 10 per cent.
By building on this basic framework, Clarida et al. (2000), in their examination
of the conduct of monetary policy in the period 1960–96, find that
the Federal reserve was highly accommodative in the pre-Volcker years: on average,
it let the real short-term interest rate decline as anticipated inflation rose. While it
raised the nominal rate, it did so by less than the increase in expected inflation. On
the other hand, during the Volcker–Greenspan era the Federal Reserve adopted a
proactive stance toward controlling inflation: it systematically raised real as well as
nominal short-term interest rates in response to higher expected inflation.
During the 1970s, despite accelerating inflation, the FF nominal rate tracked
the rate of inflation but for much of the period this led to a zero or negative ex
post real rate. There was a visible change in the conduct of monetary policy
after 1979 when, following the Volcker disinflation via tight monetary policy,
the real rate for most of the 1980s became positive. In recognition of the lag
in monetary policy’s impact on economic activity, the new monetary regime
involved a pre-emptive response to the build-up of inflationary pressures. As
a result of this marked change in the Fed’s policy, inflation was successfully
reduced although as a consequence of the disinflation the USA suffered its
worst recession since the Great Depression. Unemployment rose from 5.7 per
cent in the second quarter of 1979 to 10.7 per cent in the fourth quarter of
1982 (Gordon, 2003).
In their analysis of the change of policy regime at the Fed, Clarida et al.
compare the FF rate with the estimated target forward (FWD) value for the
interest rate under the ‘Volcker–Greenspan’ rule for the whole period. According
to Clarida et al. the estimated rule ‘does a good job’ of capturing the
broad movements of the FF rate for the post-1979 sample period.
There seems little doubt that the lower inflation experienced during the past
two decades owes a great deal to the more anti-inflationary monetary stance
taken by the Fed and other central banks around the world. DeLong (1997)
suggests that the inferior monetary policy regime of the pre-Volcker period
may have been due to the Fed believing that the natural rate of unemployment
was lower than it actually was during the 1970s. Clarida et al. (2000) suggest
another possibility. At that time ‘neither the Fed nor the economics profession
understood the dynamics of inflation very well. Indeed it was not until the midto-
late 1970s that intermediate textbooks began emphasising the absence of a
long-run trade-off between inflation and output. The ideas that expectations
matter in generating inflation and that credibility is important in policymaking
were simply not well established during that era’ (see also Taylor, 1997a;
Mayer, 1999; Romer and Romer, 2004). To understand the historical performance
of an economy over time it would seem imperative to have an understanding
of the policy maker’s knowledge during the time period under investigation.
Since a great deal of policy makers’ knowledge is derived from the research
findings of economists, the state of economists’ knowledge at each point in
history must always be taken into consideration when assessing economic
performance (Romer and Romer, 2002). Although it is a very important task of
economists to analyse and be critical of past policy errors, we should remember
that, as with all things, it is easy to be wise after the event.
While a consensus among new Keynesian economists would support the
new Keynesian style of monetary policy outlined above, there remain doubters.
For example, Stiglitz (1993, pp. 1069–70) prefers a more flexible approach
to policy making and argues:
Changing economic circumstances require changes in economic policy, and it is
impossible to prescribe ahead of time what policies would be appropriate … The
reality is that no government can stand idly by as 10, 15, or 20 percent of its
workers face unemployment … new Keynesian economists also believe that it is
virtually impossible to design rules that are appropriate in the face of a rapidly
changing econ
Other policy implications
For those new Keynesians who have been developing various explanations of
real wage rigidity, a number of policy conclusions emerge which are aimed
specifically at reducing highly persistent unemployment (Manning, 1995;
Nickell, 1997, 1998). The work of Lindbeck and Snower (1988b) suggests
that institutional reforms are necessary in order to reduce the power of the
insiders and make outsiders more attractive to employers. Theoretically conceivable
power-reducing policies include:
1. a softening of job security legislation in order to reduce the hiring and
firing (turnover) costs of labour; and
2. reform of industrial relations in order to lessen the likelihood of strikes.
Policies that would help to ‘enfranchise’ the outsiders would include:
1. retraining outsiders in order to improve their human capital and marginal
product;
2. policies which improve labour mobility; for example, a better-functioning
housing market;
3. profit-sharing arrangements which bring greater flexibility to wages;
4. redesigning of the unemployment compensation system so as to encourage
job search.
Weitzman (1985) has forcefully argued the case for profit-sharing schemes
on the basis that they offer a decentralized, automatic and market incentive
approach to encourage wage flexibility, which would lessen the impact of
macroeconomic shocks. Weitzman points to the experience of Japan, Korea
and Taiwan with their flexible payment systems which have enabled these
economies in the past to ride out the business cycle with relatively high
output and employment levels (see Layard et al., 1991, for a critique).
The distorting impact of the unemployment compensation system on unemployment
is recognized by many new Keynesian economists. A system
which provides compensation for an indefinite duration without any obligation
for unemployed workers to accept jobs offered seems most likely to
disenfranchise the outsiders and raise efficiency wages in order to reduce
shirking (Shapiro and Stiglitz, 1984). In the shirking model the equilibrium
level of involuntary unemployment will be increased if the amount of unemployment
benefit is raised. Layard et al. (1991) also favour reform of the
unemployment compensation system (see Atkinson and Micklewright, 1991,
for a survey of the literature).
Some new Keynesians (particularly the European branch) favour some
form of incomes policy to modify the adverse impact of an uncoordinated
wage bargaining system; for example, Layard et al. (1991) argue that ‘if
unemployment is above the long-run NAIRU and there is hysteresis, a temporary
incomes policy is an excellent way of helping unemployment return to
the NAIRU more quickly’ (see also Galbraith, 1997). However, such policies
remain extremely contentious and most new Keynesians (for example,
Mankiw) do not feel that incomes policies have a useful role to play.
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