Macro Policy
Bondism?

The question of whether and how monetary and fiscal policy should be coordinated is a crucial one for policy design. The UK Medium Term Financial Strategy (MTFS) envisages the setting of targets for financial aggregates, together with targets for the Public Sector Borrowing Requirement (PSBR). As a consequence automatic fiscal stabilizers are switched off, so that in periods when aggregate demand and government revenues fall, tax rates must be increased or expenditure cut to achieve the PSBR target, thereby augmenting the fall in demand.

An alternative policy would combine adherence to monetary targets with the operation of automatic fiscal stabilizers, so that the short-term stabilizing influence of fiscal policy can be obtained with monetary targeting. There is a large body of economic analysis which suggests, however, that this policy combination is unstable, at least for a closed economy. The difficulty occurs in periods of low aggregate demand when the budget deficit is high. A budget deficit financed by bond sales to the private sector will tend to increase the financial wealth of the private sector. This may drive up the demand for money, through wealth and portfolio effects. With a given supply of money, interest rates would rise, further depressing aggregate demand, while the increased burden of servicing government debt increases the budget deficit. In a wide range of models, the result is overall instability.

This issue has been thoroughly examined in the context of a closed economy, but the analysis for an open economy has received less attention, as have questions of expectations formation. In Discussion Paper No. 78, Rod Whittaker, Simon Wren-Lewis, Keith Blackburn and David Currie, Co-Director of CEPR's International Macroeconomics programme, re-examine the design of monetary and fiscal policy in the context of a detailed model of a small open economy. The stability properties of the model are studied using both analytical techniques and simulation procedures. For the latter, parameters are chosen to be consistent with empirical evidence, as embodied in the properties of the UK Treasury model. The authors also conduct extensive sensitivity analysis to ensure that results are robust, i.e. they are not sensitive to the particular parameter values chosen. Expectations in the labour and foreign-exchange markets are assumed to be formed either 'adaptively' or 'rationally', so as to test whether one or the other method affects the stability of the model.

Two alternative policy regimes are considered: a 'monetarist' policy, which sets the growth of the nominal money supply; and a 'bondist' policy, which sets the growth of nominal government debt. Automatic fiscal stabilizers are assumed to be in operation under both policies. The analytical results show that for any given set of assumptions concerning the economy's structure, these two policy rules cannot simultaneously be stable.
The monetarist policy rule is generally unstable, Currie and his co-authors argue. Only if post-tax real interest rates are negative is there any possibility of stability, and even then it requires that capital be highly mobile internationally and that expectations be formed rationally in the foreign-exchange market. By contrast, the bondist policy rule is stable over a wide range of parameter values, including the case of positive post-tax real interest rates. The simulation results therefore broadly confirm in a detailed model the results obtained from simple analytical models of a closed economy. They suggest that the combination of monetary targeting and automatic fiscal stabilizers is not a viable policy option. Fiscal stabilizers can however be combined with a bondist policy rule of targeting government debt, and other nominal targeting regimes may also be feasible. Whether these alternative bondist policies are superior to a policy which combines PSBR and monetary targeting is still an open question, the authors conclude.


Alternative Financial Policy Rules in an Open Economy Under Rational and Adaptive Expectations
Rod Whittaker, Simon Wren-Lewis, Keith Blackburn and David Currie

Discussion Paper No. 78, October 1985 (IM)