Old and New Keynesianism agree on the important causal relations in the economy; the difference between them lies in the design of instruments of control. Orthodox Keynesianism suggests that the level of real output and employment should determine monetary and fiscal policy while `incomes policy' should be used to control inflation. The New Keynesianism suggests that control of total monetary expenditures (and so of inflation) should be the responsibility of monetary and fiscal policies and that wage- and price-setting institutions should ensure that money wages and prices are held at levels which translate these money expenditures into high levels of employment rather than higher inflation.


In Discussion Paper No. 246, James Meade and Research Fellow David Vines consider the design of `Keynesian' monetary and fiscal policy for both open and closed economies, within the framework of a static, short-run macroeconomic model. They assume that monetary policy is concerned with setting a short-term rate of interest and fiscal policy with setting a rate of income tax. The price of domestic output in this model is set by a mark-up on costs, so that control of price inflation is linked to that of wage inflation. The authorities have no direct control over wage determination, and so must design fiscal and monetary policies given existing wage-setting institutions.
Meade and Vines argue that Keynesian policy design, both Old and New, should take account of a third policy objective in addition to those of full employment and the control of inflation: control over the growth of national wealth. Otherwise, Meade and Vines argue, even the most inflationary wage-setting institutions will permit full employment with stable prices, through lax fiscal policy. Excessive government borrowing can be used to finance subsidies which restrain costs and prices. The excessive consumption due to the subsidization of expendable incomes can therefore be offset by a tight monetary policy, which reduces expenditures on real capital resources. Full employment combined with low inflation can thus be achieved by living off the capital stock, with disastrous longer-term results.
The authors examine ways in which inflation could be controlled without such an undesirable outcome. Their analysis highlights the importance for policy design of the relative strengths of demand-pull and cost-push factors in wage determination. A shift in the strength of these factors can cause fundamental changes in the rules governing policy instruments and may affect whether fiscal or monetary policy should be `assigned' to the control of inflation. It may even determine whether the tax rate should be raised or lowered in order to reduce inflation.
The shift from a closed to a small open economy also has significant consequences for the `assignment' of policy instruments. Opening a small economy to international influences increases the sensitivity of capital movements to interest rate changes. This sensitivity makes monetary policy a much more potent policy instrument of control. Capital movements now affect the exchange rate and so the real terms of trade. This in turn affects the balance of trade so that monetary policy now influences aggregate demand through its effect on net exports as well as through domestic investment. Changes in the terms of trade affect the price of imports and thus the cost of living in an open economy, so that monetary policy now exercises an important influence over the cost-push factor in wage determination. These new channels of influence suggest, according to Meade and Vines, that monetary policy should be more closely `assigned' to the control of inflation in a small open economy.
In Discussion Paper No. 247, Andrew Blake, Martin Weale and Research Fellow David Vines explore further the implications of wealth targets. They examine how fiscal and monetary policy rules can be designed that not only steer nominal GDP to a target value but also keep national wealth close its target. The authors note that if real wages are sticky because wages are closely indexed to prices, the authorities may be tempted to buy off current inflation at the expense of future wealth. If real wages are sticky, a real exchange rate appreciation will be attractive as a means of reducing inflationary pressures, despite the reduction in both domestic and foreign investment which it causes. Blake, Vines and Weale propose policy rules which will avoid this difficulty. Their theoretical analysis demonstrates the impact that wage indexation has on policy options: if the economy has strong cost-push elements in wage determination then it is likely that reliance will have to be placed on monetary policy as a means of fighting inflation, while if cost-push is weak, fiscal policy may be more appropriate.
The authors also calculate fully specified empirical rules designed to control nominal GDP, national wealth and the exchange rate, based on using a modified version of the National Institute model of the UK economy. The empirical rules calculated by the authors confirm their theoretical results on the importance of the structure of the labour market for policy design. The simulations suggest that with high degrees of wage indexation and using taxes as the fiscal instrument, the comparative advantage in fighting inflation lies with monetary policy. Only if government consumption can be deployed as the fiscal instrument does fiscal control of inflation become feasible. This suggests, according to the authors, that even a moderate degree of wage indexation would make it impossible to operate Williamson's system of exchange rate target zones.
The modifications to the National Institute model allow it to be solved under the assumptions of regressive or of rational expectations formation. The authors find that policy rules can be designed which perform satisfactorily, independently of whether expectations are model-consistent or regressive. The nature of expectations is not nearly as important as that of wage determination in influencing the design of appropriate policy rules, they conclude.

Monetary Policy and Fiscal Policy: Impact Effects with a New Keynesian `Assignment' of Weapons to Targets James Meade and David Vines
Wealth Targets, Exchange Rate Targets and Macroeconomic Policy Andrew Blake, David Vines and Martin Weale

Discussion Paper Nos. 246 and 247, June 1988 (IM)