Throughout the past decade, the `Medium Term Financial Strategy' (MTFS) has been presented annually by the UK government as the framework for economic policy. Whereas the original MTFS, with its unconditional monetary targets, was seen as contrary to the prevailing economic consensus, the MTFS has subsequently evolved, so that monetary aggregates are now seen as one of a number of policy indicators. Equally, an extensive analysis of `simple rules', which may make use of such indicators, has been developed in the academic literature on policy optimization. Despite this apparent convergence, there is now surprisingly little academic discussion of the MTFS itself, and the authorities seem reluctant to discuss the MTFS in the context of the current academic debate.

In Discussion Paper No. 411, Peter Westaway and Research Fellow Simon Wren-Lewis provide a critique of recent versions of the MTFS from a policy optimization perspective, and they discuss the setting of policy instruments in order to achieve an optimal outcome of objectives subject to the perceived constraints of the economic system. They focus on three areas in which the correspondence between the MTFS and `optimal' policy becomes unclear.

First, it is unclear whether nominal GDP is intended to be an intermediate target for policy or a final objective. If money GDP targets are viewed as indicators to guide policy `in between' MTFS plans, then the target paths for M0 and money GDP can be derived from an optimal policy setting on the basis of a central forecast, and policy will simply involve applying an (unpublished) feedback rule to respond to unexpected short-term deviations from these indicator paths. Unfortunately a textual analysis of the MTFS also suggests an alternative interpretation in which money GDP is the final objective of policy.

Second, while the MTFS appears to acknowledge that policy can influence inflation through demand and output, it seems to consign the objective of increasing output and employment to microeconomic supply-side policies alone. Westaway and Wren-Lewis use the National Institute of Economic and Social Research's model of the UK economy to show that including output in the objective function affects the optimal policy setting.

Third, fiscal policy currently appears to put most of the burden of short-term macroeconomic management on to monetary policy, and specifically interest rates. Westaway and Wren-Lewis use optimal control runs on the NIESR's model to show that the macroeconomic costs of abandoning fiscal policy as an instrument are very large indeed.

These issues represent in many respects the `ground rules' of economic policy formulation, which underlie any assessment of other issues like the design of feedback rules or EMS membership. The authorities need to spell out their view of these ground rules before macroeconomists can begin to give helpful and critical advice to the government on the design of macroeconomic policies.

Is There a Case for the MTFS?
Peter Westaway and Simon Wren-Lewis

Discussion Paper No. 411, April 1990 (IM)