https://cpes.org.uk/om/files/original/ba4b24ffef2667b4ec7850b636709905.pdf c47f58a00abb49567da9b4083d5da8b4 Dublin Core The Dublin Core metadata element set is common to all Omeka records, including items, files, and collections. For more information see, http://dublincore.org/documents/dces/. Title A name given to the resource Economic Policy Review Volume 3 Text A resource consisting primarily of words for reading. Examples include books, letters, dissertations, poems, newspapers, articles, archives of mailing lists. Note that facsimiles or images of texts are still of the genre Text. Text Any textual data included in the document CHAPTER 4 THE ROLE OF MONETARY POLICY IN ECONOMIC MANAGEMENT by Francis Cripps and Martin Fetherston Introduction In recent years increasing importance has been attached by commentators and some academic economists to monetary influences on the economy.! Now, for the second time within a decade (the previous occasion being in 1969) monetary targets have been given an important place in national economic∑ policy, as a result of the government's commitments on the future scale of Domestic Credit Expansion (DCE) contained in its Letter of Intent to the IMF in December 1976. This chapter proposes a framework for discussion of fiscal and monetary policy which may also be used to assess the significance of monetary targets.2 We conclude that monetary policy plays a useful, if subsidiary, role in management of the economy, but that the adoption of firm commitments on the scale of DCE is in principle a mistake which could force the government to impose an unnecessary reduction in 1eal output and employment. The present fashion for monetary policy in Britain derives from the United States where monetary influences, such as the effect of interest rates on private expenditure, have been subjected to extensive empirical examination. The paucity of comparable investigations in the UK has meant that monetarist theories have been discussed here without having to confront statistical evidence. Nor have these theories been challenged directly by applied macro-economists, who used the lack of empirical evidence as an excuse for continuing to ignme the monetary system in their models. This encouraged some commentators and politicians to react to recent disappointments in economic policy by assuming that the entire conceptual basis of the models used for conventional demand management had been incorrect. The problem is highlighted in a recent work by a leading authority on monetary policy, according to whom there has grown up an unhappy dichotomy between commonly-held beliefs about the importance of monetary policy, as a demand-management instrument, and the available empirically-estimated models ot the economy. The view has been widely expressed, by ministers and politicians of both main political parties, by eminent commentators, and by many academics, that control over the monetary aggregates is a very important, perhaps the most important element of demand-management. Yet no available model of the UK economy gives any clear indication of what effect on the level of aggregate demand a change in the rate of growth of one of the monetary series, say M I, might be expected to have and the forecasting models actuall) used, e.g. by the National Insti- 'See, for example, the range of evadence presented by e~ono mists to the Expenditure Committee, in their report, The Fmancing of Public Expenditure, HC 69-11, December 1_975. 2ln formulating this framework we have been mftuenced by a wide range of literature, as well as by discussions_with colieagues and by experimental analyses of UK annual senes coven!"g the period 1958-76. The presentation here is an outlme only; at contains neither the statistical evidence nor the cross-references to other work which we would hope to provide in a full treatment of the subject. 48 tute, imply that the effect would be negligible. How do you select an 'optimal' monetary policy under such conditions ?3 The 'issues can only be resolved in the context of a rigorous framework of analysis, i.e. a model of the financial sector of the economy (banks, the stock market, the foreign exchange market) which gives an account of how policy instruments, such as openmarket operations and restrictions on the banks, influence that sector and how developments in that sector interact with the behaviour of the rest of the economy. This chapter proposes such a framework or analysis in a form which can be precisely related to CEPG's model of fiscal policy. It sets out the main ways in which monetary policy can in principle affect both the monetary sector and the rest of the economy, and reaches conclusions about the extent to which monetary policy can supplement othe1 instruments for managing the economy. As a counterpart to the discussion here we have incorporated into the overall CEPG model a specific representation of the behaviour of the financial sector, set out below only in general terms. The financial system and its relationship to the rest of the economy will be described under fom main headings, corresponding to the principal policy decisions which the authorities must make. Section 2 examines the role of fiscal policy and the exchange rate in the determination of real output, the price level and the current balance of payments, taking account of the ways in which these targets may be influenced by monetary factors. Section 3 considers the role of intervention in the foreign exchange market, and in particular the effect of monetary factors on the behaviour of short-term capital flows. Section 4 discusses the decision on sales of government securities which influences the liquidity of the banking system and the price or yield of government securities in the stock market. Section 5 analyses the question of regulation of the banking system itself, and its effects interest on rates and the availability of credit. The chapter concludes with an appraisal of the significance of targets for growth ot the money supply and DCE. I. Objectives, instruments and financial identities The role of monetary policy will be considered in the broader context of the objectives of the government in overall economic management and the various instruments conventionally employed for this purpose. The following main objectives will be considered: (I) The level of activity and hence of unemployment (2) The price level (3) The balance of payments C:∑3 A. E. Goodhart, Money, Information and Uncertainty, Mac- millan, 1975, p. 243. (4) The liquidity of the banking system (5) The level of interest rates The instruments are classified :.:s: (A) Fiscal policy (B) Official intervention in the foreign exchange market (C) Sales of public sector debt outside the banking system (D) Regulation of the banking system. Whilst the first two objectives may be regarded as ultimate objectives of economic policy, the balance of payments is more properly a constraint and bank liquidity and interest rates are intermediate objectives, not ends in themselves. Targets and instruments may be further classified by assigning to each target a 'primary' instrument, which will be the instrument to which that target is relatively most sensitive. In general, of course, each instrument will affect every target and the natut e of these interactions may impose constraints on the use of instruments or give rise to conflicts of objectives. Fiscal policy (A) is conventionally assigned to the level of activity due to the ditect impact of public spending and :taxes on aggregate demand. Likewise the obvious primary assignment for exchange-rate policy (B) is to the balance of payments, on account of the impact of exchange-rate changes on trade flows and capital movements. CEPG have argued that there are strong interactions both between fiscal policy and the current balance of payments and between the exchange rate and the rate of inflation. But the issues ot conventional economic management will be set out het e only in general terms. Nor will 1eference be made to the case for using restriction of imports or incomes policy as a means of resolving the problems to which these interactions give rise. Given fiscal and exchange-rate policy, the task of open-market operations (C) and direct regulation of the banks (0) is to control the liquidity of the banking system and the level of interest tates. We shall conclude (very conventionally) that monetary conditions- interest rates and credit availabilityhave little significance for real output, the price level and the current balance of payments but may have an important effect on short-term external capital flows. The relation of targets to instruments is fo. mally exp1essed in a set of identities and behavioural rela- tionships. The framework of identities is as follows: Flow of funds: PSFD+B==NAFA (1.1) Foreign exchange market : B+ K F + M F c.= BO F (1.2) Public sector borrowing requirement: PSBR ~- PSFD+KG (1.3a) Finance of the PSBR: PSBR==: .6BR-+-GS-BOF (1.3b) Money supply: M ~ BR .-;... BA (1.4) Domestic credit expansion: DCEc∑ f'iBA+MF +-PSBR-GS (1.5) Definitions B Current balance of payments BA Bank advances to the pt ivate, sector (net of the banks' non-deposit liabilities) and overseas (net of non-residents' deposits), plus bank lending to the public ~ector in foreign currencies. The Role of Monetary Policy in Economic Management BOF Balance for official financing BR Bank lending in sterling to the public sectm, plus notes and coin in circulation DCE Domestic credit expansion GS Sales of public sector debt to the non-bank private sector and overseas KF Structural capital flows (private direct investment and official long-term capital) KG Net capital transactions of the public sector with private and overseas sectors M Money stock (M3) MF Net shmt-term balance-of-payments capital inflows NAFA Private sector net acquisition of financial assets (before allowing for capital taxes) PSBR Public sector borrowing requirement PSFD Public secto1 financial deficit (before allow- ing for capital taxes). All these concepts can be measured, reasonably precisely and realistically, by official statistical series. The following additional concepts, some of them less pt ecise, enter into behavioural relationships: y GOP at constant prices p Genet al price level e Sterling exchange rate relative to other major currencies q Availability of credit r General level of interest rates rl Yield on government securities rs Short-term interest rate SJ, s2 Speculative sentiment in markets for for- eign exchange and government securities, re~pectively G Public expenditure Tax rates Exogenous factors such as the conditions of world trade, 'world' interest rates and internal structural trends will not be represented explicitly. Behavioural relationships written symbolically in the following sections are intended only as a shorthand notation for the interdependence of targets, instruments and monetary variables .without indicating the specific form or dynamics of their interaction. The identities set ~ut above and the behavioural assumptions set out iq the following sections together define how the economy reacts to policy instruments. The flow-of-funds identity is logically equivalent to the income-expenditure identity; on our assumptions it constrains the joint effect of policy instruments on real GOP, the price level and the balance of payments on current account (discussed in section 2 below). The second identity shows how the balance of payments is financed; it provides the basis for an explicit discussion in section 3 of intervention in the foreign exchange market and its effect on the exchange rate. Identities 1.3a and 1.3b show how public sector transactions are financed, providing a link between fiscal policy, intervention in the foreign exchange market, sales of government securities and public sector borrowing from the banking system; the trade-off between the two latter sources of finance is examined in section 4. The money supply identity represents the balance sheet of the banking system in a form which permits discussion of the effects of public sector borrowing on interest rates and the availability of credit (section 5). Finally, the definition Qf DCE 49 Economic Policy Review (identity 1.5) forms the basis of an analysis in section 6 of the constraint on choice of policies which is implied by a commitment to ensure that DCE attains pre-determined target values. 2. Fiscal policy Consider the flow-of-funds identity PSFD+B'- NAFA (1.1) Tax rates and public expenditure authorisations are fixed by the government, but the ex post public sector financial deficit is also influenced by the actual level of prices and output. Thus we may write PSFD=f(r, G, y, p) (2.1) Given the volume of world trade and prices in world markets, the balance of payments on current account depends on GOP, the domestic price level and the exchange rate: B=f(e,y,p) (2.2) The private sector financial surplus, NAFA, is princi- pally influenced by movements in private disposable income, itself determined by tax rates, GOP and the price level. Monetary conditions- in particular interest 1ates, security prices and the availability of credit - may also affect the level of private expenditure rela- tive to income, thus entering into the determination of NAFA: NAFA,=f(t, r, q, y, p) (2.3) Equations 1.1 and 2.1 to 2.3 constitute a set of four equations to determine four variables - PSFD, B, NAFA, andy- for given values oft, e, G, r, q and p. Discussions of economic management in the UK during the 1960s concentrated on the policy choices implicit in this system, often taking the price level as an exogenous factor dete1 mined more-or-less independ- ently by money wage settlements. Public expenditure, interest rates and credit restrictions as well as the struct- ure of taxation would be decided mainly with regard to income distribution and the desired allocation of resources between different types of expenditure. The general level of taxation," t, was the principal instrument for determining real output, y, and hence the level of unemployment. Either incomes policy (designed to influence p) or the exchange rate, e, or both were the instruments for controlling the balance of payments on current account and it was assumed that a roughly zero balance on the current account would normally permit the government to keep con- trol over the exchange rate while maintaining an adequate level of exchange reserves. More recently attention has been paid to the inter- dependence of the price level, the exchange rate and the level of taxation, which may be written symbolic- ally as p =f(t, e) (2.4) The existence of a feedback of this kind implies that, unless incomes policy can inteivene effectively and permanently, there may be a conflict of objectives. For the five equations 1.1 and 2.1 to 2.4 now serve to dete1 mine three targets, y, p and B as a function of only two instruments, t and e (always assuming that G, r and q are decided in relation to other objectives). The inherent conflict between objectives for output, the balance of payments and inflation has been one with which recent analyses have been much concerned. CEPG's present econometric model is designed to elucidate this conflict by giving a specific and detailed 50 representation ot the economic structure underlying equations 2.1 to 2.5. The fact that monetary instruments, r and q, enter into the determination of NAFA implies that they can be used for demand management purposes. But this does not mean that they could contribute significantly to resolution ot the conflict of objectives mentioned above. For, by comparison with taxation, their effects on private expenditure are weak and uncertain; and there are strong objections to the use of very htgh interest rates or tight credit restrictions as a major alternative to taxation - not least that they would discourage investment and might provoke business bankruptcies. It is worth emphasising at this point that empirical tests of the effect of monetary conditions on NAFA must allow for the well attested influence of changes in income, and that monetary factors should be represented in such tests in an explicit form which could plausibly be perceived, and reacted to, by households and firms. An example of failure to observe either of these methodological principles was provided in the Economic Outlook recently issued by the London Business School, I which presented an empirical relationship for changes in real domestic expenditure as a function only of changes in the aggregate real money supply. Apart from its implausibility as a behavioural hypothesis, this involves the LBS in inconsistency with the assumptions of their own forecasting model, in which expenditures are determined as functions of income- an inconsistency which is not only confusing, but is something which formal models are intended to prevent. In theory it is possible that real domestic expenditure depends only on the real money supply, even if consumption expenditure is a function of disposable income and thus incorporates a direct fiscal policy effect. For example, if income tax were reduced whilst the real money supply was held constant by selling gilts, it might conceit∑ah/y happen that consumption would rise, but investment would fall by the same amount, the rise in interest rates required to sell the extra gilts serving to discourage just the necessary amount of private investment. (lsuch a mechanism is assumed ''to be in operation, then it should be made explicit, especially in order to show under what conditions the rise in consumption would be exactly offset by a fall in investment. There is another reason for making the interest effect explicit. If a tax cut were to be offset in such a manner, the government and the public would certainly want to know by how much interest rates would have to 1ise. 3. The foreign exchange market A second way in which monetary instruments may play a part in economic management is through their effect on the capital account of the balance of pay- ments. Explicit attention to the foreign exchange market has in any case become necessary, because capital flows have in recent years become so large and volatile. The supply and demand for sterling in txchange for foreign currency may be written B+KF+MF BOF (1.2) where capital movements are divided into 'structural' 'A. Budd and T. Burns, Economic Outlook, 1977-80, London Business School Centre for Economic Forecasting, January 1977 flows, KF, whicll will here be treated as exogenous, and net short-term flows, MF. BOF is the balance for official financing which, if in surplus, permits repayment of external debt and accumulation of exchange reserves or, if in deficit, is met by drawings on reserves and by official foreign currency borrowing. Short-term flows in relation to income depend on speculative judgments which range from the highly political to such measurable factor~ as interest rates, the current account surplus or deficit and the over- valuation of sterling relative to other currencies in terms ot costs of production. MF=f(r,e,p,B,s 1) (3.1) There is a continuum of possible approaches to management of the foreign exchange market. At one extreme is a policy of fixing the exchange rate at some level e* so that, given all the other factors which influ- ence current and capital flows, BOF becomes a residual inflow ( +) or outflow (-) which the. authorities guarantee to absorb through their exchange reserves or foreign borrowing. At the other extreme is the so-called 'free float', where the authorities determine their accumulation of reserves and debt repayment entirely a priori at some level BOF*, leaving the exchange rate to rise or fall in the market to a point at which short-term inflows or outflows balance all other transactions; e is then formally determined as the solution to: B(e)+ KF + M F(e) = BOF* There is thus in principle a trade-off between the exchange rate and official financing which is influenced (a)∑ by the current balance and structural capital flows, (b) by interest tates, (c) by other factors affecting speculative confi- dence. Given r, y, p and s, it may happen that whatever strategy for intervention is chosen, this trade-off is an unsatisfactory one, in the sense that the authorities cannot achieve any acceptable combination of e and BOF. In contemporary circumstances short-term flows are so large and volatile as to make currency 'crises' a frequent and troublesome occurrence. When speculation is adverse the authorities face an alarming choice between massive support, which can quickly exhaust reserves and borrowing facilities, or allowing the exchange rate to fall at the risk of a sharp impetus to cost inflation. If speculation favours sterling they may equally face a difficult choice between accumulat- ing large increases in reserves or allowing the exchange rate to rise at the risk of squeezing industrial profits and investment. These problems at the same time reflect and inten- sify the fundamental conflict of objec~ives in manage- ment of the economy identified in the previous section. For when equations I.2 and 3.1 are combined with equations I.I and 2. I to 2.4, we derive a system in which (given G, rand q) three main targets, y, p and B, still depend on only two instruments, t and BOF, with added hazards of volatile speculation, s~o and a feed- back from p to e implicit in equation 3. I, which rein- forces the effect of the feedback from e to p (equa- tion 2.4). It is sometimes argued that the balance of payments can be left to look after itself on the basis that the cut rent account, B. need not be a target and that The Role ofMonetary Policy in Economic Management official intervention, BOF, can be determined a priori, leaving the exchange rate to float freely. It may be true that in a very long-term sense it is BOF, rather than B, which matters. But this is no comfort in the short or medium term, when the prosperity of domestic industty depends on maintaining stable trade and when capital flows may be very different from what can be expected in the long term. And even if it were true that B could be ignored, the fundamental conflict of objectives would still remain because, it a target fer BOF ts adhered to, the two other main targets, y and p, come to depend on a single main instrument, t. Monetary policy has an important and distinctive influence on the f01 eign exchange mat ket because it bears particularly on short-term capital flows, M F, which are not directly affected by fiscal policy; these flows are essentially 'monetary' in character since they represent additions to or subtractions from bank deposits and holdings of government securities. The potential role for monetary policy in this context is twofold: firstly, there is the direct effect on short-term flows which may be brought about by raising or lowering domestic interest tates relative to foreign interest rates; secondly, there is the more psychological effect on speculative confidence of shifts in the direction of monetary policy. The first gives rise to a conflict of objectives, since attempts to hold interest rates down for domestic reasons, e.g. to encourage investment, may exacerbate short-term outflows on the f01eign exchange market. Conversely, the taising ot interest rates to encourage a capital inflow Jesuits in some discouragement of domestic investment due to the high cost of borrowing. The effects of monetary policy on speculative confidence are more difficult to assess: success in speculation lies not so much in strictly rational assessment of alternatives, but rather in anticipation of ∑what the market will do next, which requires knowledge of the (not necessarily rational) psychology of the market. Thus to take only one example, if the market believes in, or is believed to believe in, the importance of monetary aggregates such as DCE or money supply, failure of the authorities to achieve a monetary tatget will advetsely affect speculative confidence, irrespective of whether that monetary target has in itself good or bad real effects on the UK economy. The psychological effect of monetary expttnsion will usually compound the direct effect of lower interest rates. In such circumstances a sudden tightening of monetary policy can be of great assistance in stabilising the exchange rate. 4. Sales of public sector debt Up to this point interest rates have been treated as if they were directly controlled by the government. To examine the management of interest rates and ctedit, it is necessary to consider open-market operations (sales of government debt) and the functioning of the banking system. This section deals with the former. The money supply, short-term interest rates and the availability of bank advances will be discussed in sec- tion 5 below. ∑ The finance of the public sector borrowing require- ment may be represented by the identity PSBR=-t,BR+GS-BOF (1.3) where PSBR =PSFD+KG Thus the borrowing requirement may be financed in 51 Economic Policy Review three ways: borrowing from the banking system, L,BRI, borrowing through sales of public sector debt to the non-bank private sector and overseas, GS, and borrowing from abroad through reduction in the stock of foreign exchange reserves or drawings on foreign currency loans, - BOF. The public sector deficit, PSFD, will have been determined in relation to targets for GDP and the current balance of payments (section 2 above), with some limited scope for use of monetary policy as an alternative through the latter's impact on private ex- penditure. KG consists of items such as official loans and acquisition of assets from the private sector less receipts from capital taxes, here regarded as an exogen- ous requirement. External financing (BOF) is deter- mined with regard to stabilisation of the foreign exchange market (section 3 above). Although monet- ary policy may also assist exchange-rate policy, it will normally be needed to reinforce, rather than displace, direct intervention. Given the PSBR and external financing (BOF), the authorities must decide how to divide residual financ- ing of the public sector as between sales of securities (GS) and recourse to the banks (L:,BR). Since bank lending to the public sector, BR, constitutes in essence the reserves of the banking system, the normal objec- tive would be to inject a certain increase ( L:,BR) to provide the banking system with sufficient, but not excessive, reserves and then to fund the remainder of the PSBR by sales of securities (GS). The considerations which might guide the authori- ties in choosing a target for L:,BR will be discussed below (section 5). Here we must consider the problems of achieving a suitable sale of securities. The stock demand for public sector debt may be expected to be influenced by the level ofGDP, the price level and the gap between yields on securities and short-term money rates. It will al ;;o be affected by speculative anticipa- tion of future interest rate changes and by short-term capital flows on the balance of payments. If the dyna- mics are left implicit, the flow demand can be repre- sented as GS=f(rl-rs,y,p, MF,s2) (4.1) As with the foreign exchange market, there are two extreme alternative techniques fot intervention in the market for government securities. Given rs, y, s2, etc., the authorities can either determine their requirements for sales of debt and allow prices of s,ecurities, and hence rl, to adjust to the level desired by the market, or determine some desired level of long-term interest rates and accept whatever level of purchases of securi- ties results. The effect of the latter strategy would be to leave borrowing from the banking system as the residual source of finance. But note that in the first ca~e the authorities can (within reason) sell as much or as little as they want, provided they are willing to accept whatever price the market offers. Difficulties arise only if speculation in this market or in the foreign exchange market causes potential purchasers to seek yields which are out of line with what the authorities regard as reasonable, particularly in the case where the 'This item, which includes the increase in currency in circula- tion, broadly corresponds to changes in the stock of highpowered money (apart from changes in the banking sector's holdings of public sector liabilities which do not count as eligible reserve assets, e.g. longer-dated government stocks). 52 yields sought are so high as to impose heavy debt service charges on the government. Such a situation can occur for either of two main reasons: (a) a net outflow of funds abroad (b) a disinclination to hold government securities as against money. The first case, although it may upset planned sales of gilts, will not have much effect on the main objec- tive of financing- namely government borrowing from the banks. For if the market for government securities weakens under the impetus of an outflow from sterl- ing, the reduction in sales of securities (GS) will be offset by an increase m external financing (- BOF). leaving L:,BR unchanged. The problem will be one of foreign exchange management, not of domestic mone- tary policy, although it may lead the authorities to seek higher interest rates to discourage the outflow from sterling, at the cost of higher yields on govern- ment securities and some discouragement of private spending. ∑ The second case; where the market for government securities is deserted in favour of cash, is more likely to force the government into increased borrowing from the banks. Speculative stocks of money will inflate bank deposits and bank reserves; the ratio of bank reserves to advances will rise, increasing the liquidity of the banking system. In these circumstances the authorities have three alternatives: (a) to allow such an increa~e in the liquidity of the banking system, in the hope that a fall in short- tel m interest rates will soon revive speculative demand for government secUI ities, (b) to force sales of government securities onto the market, driving down their price to the point at which speculators feel that yields have reached a peak and therefore buy back into the market, or ~c) to intervene directly in the banking system to prevent easy credit and low interest rates while excess reserves remain with the banks. Alternative (c) is further discussed in section 5 below. It should be noted that a large PSBR is not in itself necessarily more difficult to finance than a small one, precisely because it may be the counterpart of a high level of private sector demand for financial asset~ in- stead of expenditure on goods and services. In this instance the large PSBR could be financed by an appropriate mix of sales of government securities and borrowing from the banking system, provided yields on government stocks are high enough relative to short-term rates, and provided also that the private sector's demand for financial assets is not allowed to extend to foreign currency. The cost, at most, would be a widening of the yield differential between govern- ment securities and short-term deposits. 5. The banking system The balance sheet of the banking system may be represented by the identity 2 . M BR+BA (1.4) Thi~ section considers the factors which might guide the authorities in choosing a target for the change in "Official foreign currency borrowing via the banking system is included in BA, not in BR, as indicated in section 4. bank liquidity ( L,BR) and the effects on the rest of the economy. A change in banks' reserve assets above or below the level necessary to support the existing level of deposits provides potential for bank expansion or contraction. An approach commonly used in abstract models and in informal discussions of monetary policy is to suppose that the eventual change in money supply which will be associated with a given change in reserve assets is determined by a 'credit multiplier', which is itself a function of two supposedly stable ratios - the ratio of private sector holdings of currency to their bank deposits and the ratio of bank reserves to bank depo- sits. But, as Goodhart points out,I 'this approach ... abstracts from all the main operational problems facing the authorities. It reveals nothing about the difficulties possibly confronting the authorities in achieving any desired level for the monetary base. It suggests by itself nothing of the implications for interest rates, markets and financial institutions of the authorities' choice of targets and market pro- cedures.' A proper analysis of the effects of changes in bank liquidity requires a clear account of the way in which banks respond to changes in their liquidity by adjust- ment of the terms they offer for deposits and advances. First note that, given all other financial flows, in par- ticular the change in bank liquidity, one further rela- tionship determining either the change in the money stock or the change in bank advances must, in the light of 1.4, determine the other as a residua1.2 Here we specify a conventional demand-for-money rela- tionship: M=f(rs,rl,q,y,p,s2) (5.1) and then treat BA as a residual. If the non-bank pri- vate sector is in equilibrium, in that it has adjusted its bank deposits and its borrowing from the banks to levels appropriate to income, interest rates and specu- lative anticipations, the banks may find themselves out of equilibrium. For consider first the effects of an in- crease in bank liquidity arising out of an increase in deposits not matched by advances. As indicated in the previous section, this may occur when an increase in the public sector borrowing requirement is not financed by higher sales of government secUI ities, or as the result of a short-term inflow to UK banks from abroad, or through a shift in market preferences for bank deposits away from other domestic assets, such as gilts.3 Whatever the cause, the banks will find themselves in disequilibrium with unprofitable excess reserves. Their response can involve both lowering of interest rates to encourage loans and discourage deposits and direct attempts to expand advances to the private sector by relaxation of normal lending criteria, etc. This is the real meaning of 'excess growth of money 1op. cit., p. 153. "No behavioural inconsistency or disequilibrium is implied on this account. !:, BA, together with all other non-bank financial transactions, must satisfy the budget constraint LBA = 6M +GS- NAFA -KF -KG- ME Once equilibrium values of all the variables on the RHS have been specified, behaviour with resrect to L:iBA is left implicit. Note that BA includes net lending by banks overseas a~ well as loans to the UK private sector, so that this is not merely a matter of the latter's portfolio. 3This may itself be influenced by the authorities' open-market operations in existing government debt. The Role ofMonetary Policy in Economic Management supply'. The possible adverse consequences include 'unsound' loans, lending for 'speculative' purposes, and an outflow of hot money across the exchanges set off by lower interest rates. An exaggerated movement of bank liquidity in the opposite direction could also have damaging effects. The banks must react to shortage of reserves by raising interest rates and/or rationing credit to borrowers. In a very tight situation they might even be forced to call in loans to the extent of creating widespread financial collapse. The level of bank liquidity cannot therefore be a matter of indifference for the authorities. In general they would hope to provide that degree of liquidity which is appropriate to the private sector's demand for money at whatever interest rates the government judges desirable. This objective will normally be achieved through appropriate levels of gilt sales (section 4), but the authorities must have some means of coping with disruptive effects of speculation which may temporarily increase or reduce bank deposits, and hence bank liquidity. The instruments used for this purpose are intended to offset the effects of shortrun changes in bank liquidity by restricting the banks' normal lending and deposit-taking activities. Such instruments include special deposits, quantitative restrictions on lending, and restrictions on the growth of interest-bearing deposits (the 'corset'); they have the effect either of artificially modifying the size of the banks' reserve asset base (as in the case of special deposits) or of influencing the extent to which the banks can expand their assets and liabilities from a given liquidity base. Equipped with these instruments as well as openmarket operations, the authorities should be able to control interest rates and maintain orderly bank lending. This does not mean that they can nullify speculation in the market for government securities and maintain any desired flow of sales at an entirely steady rate. But it should mean that they can prevent a temporary disturbance to the market for government securities from influencing the general level of interest rates and bank lending. Unfortunately the instrument in use - the 'corset' - does not achieve these objectives effectively because, being a penalty on excess growth of deposits, it has the effect that unless the banks collectively decide to restrict their advances to a sufficient extent (given the level ot' bank reserves as determined by GS, BOF and the PSBR) they will individually tend to find their deposits exceed the limits allowed and may seek to drive away short-term money, forcing interest rates down in a rather unstable manner. 6. The role of monetary targets Monetary aggregates were first introduced into official policy in .1969 (the year of a previous lMF visit). The two main aggregates are the money supply and domes- tic credit expansion, the purpose of the latter definition being essentially to adjust changes in the money supply for balance-of-payments surpluses or deficits. The definition given above, DCE= 6BA+MF +PSBR-GS (1.5) is equivalent to DCE= 6M-(B+KF) (6.1) i.e. domestic credit expansion is equal to the c,,hange in 53 Economic Policy Review the money supply less the surplus on the 'basic' balance of payments.! The term (PSBR-GS) in 1.5 can be regarded as the 'high-powered' element of DCE: that ~art of the PSBR which is not funded by sales of public sector debt must be reflected either in bank lending to the public sector ( ,6BR) or in a deficit on the balance for official fin<J,ncing ( _:_ BOF). The role of these monetary aggregates as described in a Treasury article when they were first introduced in 19692 was modest enough: 'These monetary indicators are intended to complement, not replace, other economic indicators. The fact that more use is being made of monetary indicators does not affect the choice of instruments of economic management in a particular situation ... Monetary instruments will continue as in the past to take their place with other instruments of economic management.' But in the Letter of Intent to the IMF in December 1976 figures for DCE were accepted as firm targets, not just indicators, and were a principal feature of the government's commitment. The DCE and growth of money supply are susceptible to erratic short-term movements, but may nevertheless be of value to the authorities in decisions on the use of short-term monetary instruments and the finance of the PSBR. If however they are used as firm targets rather than indicators, they implicitly constrain fiscal policy and may frustrate real policy objectives. For example, if the government decides on a large fiscal deficit, money income will rise rapidly and other things being equal the basic balance of payments will be in smaller surplus. The demand for money will rise with income; DCE will respond even more strongly because it reflects both the combined growth of money supply and the basic balance-of-payments deficit. Under such circumstances it would be extremely difficult to reduce the demand for money by monetary instruments in order to confine DCE to within any restrictive target level. 3 Thus if the DCE target were to be achieved fiscal policy would have to be tightened up, and DCE would be reduced by means of deflation of money income and an improvement in the current account balance or payments. The only way to judge whether it is desirable to operate fiscal policy acc01ding to a DCE rule is to examine the consequences for output, employment, the balance of payments and inflation using a conventional fiscal model. But such an approach makes the DCE target itself redundant. In our view there is no justification at all for incorporating a DCE target in official economic policy. It will either prove ineffective because the increase in demand for money and the balance of payments deficit fall within the limits set for the DCE; or, it it is effective, it will constrain fiscal policy in an obscurantist manner, rega.dless of the consequences for growth of income and employment. Fiscal policy, together with use of the exchange rate or other trade policy measures, should continue to be used to manage domestic income and the current balance; the role ot monetary policy should be to ma.ntain an orderly financial system, supporting domestic objectives of fiscal policy or helping to counter speculation in the foreign exchange market. Targets for the DCE have no legitimate place in either. ∑ 'The definition of DCE in this exposition differs slightly from the official one. 2Money supply and domestic credit, Economic Trends, May 1969, p. xxiv. 54 "A credit squeeze and rise in interest rates increases the demand for money relative to income. Application of the 'corset' can be effective in reducing demand for mone) for reasons given in section 5 above; but it will do so by reducing interest rates, risking outflows of 'hot money'. [ Economic Poicy Review ] [ Page 55 ]  Dublin Core The Dublin Core metadata element set is common to all Omeka records, including items, files, and collections. For more information see, http://dublincore.org/documents/dces/. Title A name given to the resource Chapter 4 The Role of Monetary Policy in Economic Management Creator An entity primarily responsible for making the resource Francis Cripps Martin Fetherston Source A related resource from which the described resource is derived Economic Policy Review volume 3, pages 48 - 55 Date A point or period of time associated with an event in the lifecycle of the resource March 1977