Macro Policy Strategies
Expectations and robustness

There has been much recent discussion of macroeconomic policies which involve control of nominal Gross Domestic Product, or money GDP. In earlier work Jan Maciejowski, James Meade and David Vines have explored fiscal policies designed to control money GDP. If money GDP rises above its target, for example, taxes may be increased. These tax increases may, however, influence money GDP in a perverse direction. If wages are indexed to the price level, then raising indirect taxes may set off a spiral of wage and price increases which may push money GDP even further from its target.

In Discussion Paper No. 122, Nicos Christodoulakis, Research Fellow David Vines and Martin Weale explore approaches to nominal GDP control that do not involve manipulation of fiscal policies. Their work is part of a much larger research project on the management of open economies being pursued with James Meade. For example, if money GDP rises above target, monetary policy can be tightened. Present macroeconomic policy in the United Kingdom appears to operate like this, the authors argue: interest rates are raised if money GDP appears to be too high. This policy does not, however, influence money GDP through its effects on domestic demand, but rather through the downward pressure of exchange rate appreciation on domestic costs and prices.

Christodoulakis, Vines and Weale consider a variant of this policy, which does not rely on any unanticipated appreciation of the exchange rate when money GDP appears to be rising too rapidly. Instead the government would set interest rates so as to engineer a 'crawling appreciation' of the exchange rate, with the details of this policy fully known to the private sector. If the private sector finds the government's exchange rate rule to be credible - the case considered in the paper - then the interest rate would need to be lowered during such a crawl.

The authors also discuss the methodology of policy comparisons, and in particular the treatment of expectations. Any investigation of the problems of policy formation, they argue, has to take account of the way in which expectations may be formed. The assumption of rationality is often made because there are no grounds to assume any other, particular bias about views of the future. Some authors take this further, and argue that it is unwise to adopt policies which would only work if they were misunderstood by the public. It is equally important, however, that policies should not rely on rationality to be successful, the authors argue; any policy package should be tested for robustness under a variety of expectational regimes.

The authors conduct policy simulations using a version of the National Institute (NIESR) model of the UK economy. Modifications to the model allow the identification of expectational effects in financial markets, and enable the authors to analyse financial policy more thoroughly than was possible in earlier work. They consider the effectiveness of a policy that is designed assuming that expectations are formed rationally, but applied to an economy in which financial markets form their expectations adaptively.

It is important to explore alternative policy strategies in an open economy, the authors argue. Some of these policies require tax rate adjustments, while others involve large movements in exchange rates. Recent moves towards international coordination of exchange rates, however, would restrict the freedom of national governments to manipulate exchange rates as part of their national macroeconomic management. Such restrictions would oblige governments to consider some of the other types of policies that Christodoulakis, Vines and Weale investigate.


Policy Design and Operation in a Macroeconomic Model with a Managed Exchange Rate under Different Expectational Regimes
Nicos Christodoulakis, David Vines and Martin Weale

Discussion Paper No. 122, August 1986 (IM)