Monetary Policy — 1: The Use of Policy Instruments in an Uncertain World

Summary

In a world of certainty, the authorities know the exact effect of varying their control instruments (e.g., through monetary or fiscal policy actions) upon the various objectives of policy, such as full employment, stable prices, etc. Difficulties will be encountered, however, whenever there are more objectives than instruments. In such cases, not all objectives can be fully met and the most that can be done is to achieve the best possible compromise (or trade-off) between the various objectives. An alternative and apparently more attractive approach is to search for further (independent) instruments. But it is a common experience to find that the employment of another instrument can reveal a threat to some further objective. If demand management seems incapable of maintaining both a reasonable level of employment and price stability, the introduction of a prices and incomes policy to help in containing inflation may thus endanger, inter alia, the allocative function of the price mechanism.

The most common conflict is between jam today and jam tomorrow. Policy decisions taken with the intention of affecting the economy now are likely, in many cases, to influence outcomes in future periods because of the dynamic properties of the system. In the short run with given expectations, there can be scope for expanding the level of employment without a large acceleration of inflation. But the acceleration of inflation, small though it may be initially, then gets built into the system, thereby worsening future policy options. Similarly, Mundell’s proposals’ for achieving short-term balance, both internally and externally, under a fixed exchange rate, can in some cases lead to a longer-run worsening state of affairs. Since the objectives of our society outnumber the instruments for their achievement, the most that policy can strive to attain even in a world of certainty is a fair compromise.

In Section 2, uncertainty is introduced, but only in a limited form. The authorities are assumed still to know the exact structure of the system but not to be able to foresee the stochastic shocks that may perturb it. Despite the unreality of the assumption of perfect knowledge of the structure, much of the economic forecasting and policy choices that derive from these forecasts proceed as if the deterministic models used were an accurate representation of the underlying system. The main subject of this section is how to cope with the random shocks that cannot be foreseen, even assuming the structural form of the deterministic model to be correct. Put simply, the answer is to identify where the main source of disturbance is likely to occur and to arrange a policy response, in the intervals between periodic reviews of the economy, which will provide an automatic stabilisation against shocks from this source. In the IS/LM context, if the main source of disturbance comes from shocks in the goods market (to the IS schedule), then the authorities should maintain a stable rate of monetary growth; if the shocks predominantly come in the money market (to the LM schedule), then it would be better to stabilise interest rates. Although theoretical explorations of optimal stabilisation policies along such lines have been much in vogue, their practical significance has probably been overstated. Given the assumption of a structurally correct model, the analysis has relevance only over those periods during which the source and forms of shocks to the economy cannot be identified (and thus exactly offset) while reliable data on both the monetary aggregates and interest rates can be obtained. In fact, in the United Kingdom and in many other countries where monetary data are obtained only once a month, information about the development of the economy as a whole (e.g., industrial production, trade figures, etc.) is available just about as soon and with the same (lack of) reliability as the monetary data. The concept of steering the ship by observing monetary signals while waiting for the fog to clear from the economic landscape is, perhaps, peculiar to the North American scene. In other countries, the monetary signals are also fogged out.

In any case, the real problem for policy, raised in Section 3, is that the forecasting models used are, to be sure, not accurate representations of the underlying world. Many economists ignore this problem because each believes that his own preferred model is correct; the policy-maker faced with a plethora of models and advice cannot, however, make such an assumption. This difficulty is most acute when there is a widespread belief that existing models do not capture some important aspects of reality. This was the situation in the United Kingdom, for example in the early 1970s; policy-makers and commentators generally were persuaded, largely on the basis of reports and work emanating from the United States, that monetary factors had a significant impact on the domestic economy but all the existing (extended Keynesian) forecasting models showed this impact to be negligible. So there was a sharp dichotomy in the United Kingdom between expressions of beliefs about the working of the economy and the estimated structure of the forecasting models. In these circumstances, it was difficult to choose an ‘optimal’ monetary policy and the tendency, when faced with a policy instrument which is believed to be powerful but whose effects may not have been clearly measured, is to play for safety. This final section ends by reviewing exactly what playing for safety may entail in an inflationary world.