What policy options are open to countries seeking to contain inflation while maintaining acceptable levels of output growth and employment? Is it possible for such policies to be internationally compatible in an international environment of increasing economic integration, or must they rely on one country exporting its economic ills abroad? Does the achievement of compatible policies require international policy coordination or reform of the world exchange rate system? These issues were addressed at a conference on 'Exchange Rate Regimes, Money GDP Targets and Macroeconomic Policy', held at Clare College, Cambridge on 6/8 July. The conference formed part of the 'Open Economy Management' project directed by James Meade (University of Cambridge) and David Vines (University of Glasgow and CEPR). The conference was organized by Martin Weale (University of Cambridge) in conjunction with CEPR; financial support for the project has been provided by the Economic and Social Research Council, British Telecom plc, Guiness Peat Group plc, Standard Chartered plc, Lloyds Bank plc, Barclays Bank plc, National Westminster Bank plc, Midland Bank plc, S G Warburg & Co Ltd, British Gas plc, Booker plc and, through the award of its Fellowship to Martin Weale, the Houblon-Norman Fund at the Bank of England.
The major conference themes were introduced in the first two papers, which summarized recent work on the open economy management project. James Meade presented the first paper, 'Monetary Policy and Fiscal Policy: The Assignment of Weapons to Targets', which dealt with Tinbergen's classic question: the principles governing the assignment of macroeconomic policy instruments to policy objectives. Meade assumed that the objectives of macroeconomic policy were the rate of price inflation and the proportion of national income devoted to investment, although employment was also important. In practice, these objectives might be achieved by maintaining target paths for national income and for an appropriate measure of wealth. The fiscal policy instrument was taken to be the rate of an appropriate indirect tax (such as VAT), and the monetary policy instrument to be the rate of interest.
Meade considered first a conventional short-term structural model of a closed economy. Only the wage equation was unusual: it contained explicit 'cost-push' and 'demand-pull' elements of wage inflation. Cost-push was an important influence when the rate of wage increase was less than an 'aspiration' level and demand-pull when the economy approached full employment.
The assignment problem can be resolved by considering the strength of the effects of the fiscal and monetary instruments on policy objectives. The direction of these effects was clear in Meade's model, with the exception of the impact of changes in tax rates on inflation. Here cost-push and demand-pull generated opposite effects: if the former dominated, then an increase in taxation actually increased inflation. The likely signs and relative magnitudes of these effects led Meade to conclude that both full employment and acceptably low inflation were likely to be attainable only at the expense of investment and a running down of the capital stock. To avoid this might require reforms which enhance the demand-pull and diminish the cost-push elements in wage behaviour. Without such reforms, it may be impossible to assign fiscal policy to the control of nominal GDP; instead, monetary policy may have to be assigned to the control of nominal GDP and fiscal policy to the investment objective.
Andrew Blake (University of Cambridge) and Martin Weale, in 'Exchange Rate Targets and Wage Formation', analysed the exchange rate as an intermediate target and underscored the dramatic difference between economies where cost-push as opposed to demand-pull elements dominate wage behaviour. Blake and Weale reported simulation results from a modified version of the NIESR model. In one simulation, the estimated wage equation contained strong cost-push elements, while in the other the wage equation was modified to represent reforms designed to enhance demand-pull effects in the labour market.
The objectives of policy in these simulations were again nominal GDP, the ratio of investment to national income and the level of foreign exchange reserves. Intervention in the foreign exchange markets was available as a policy instrument, as well as the fiscal and monetary policy instruments studied by Meade. Policy involved both short-term (daily) and longer-term (quarterly) policy rules: the short-term rules operated almost instantaneously, whereas lags in the availability of data meant that the longer-term rules could only react with a lag of at least one period. The long-term rules were designed to achieve national income and wealth targets using fiscal policy and the target exchange rate. The short-term rules involved use of the interest rate and foreign exchange market intervention to steer the exchange rate towards its target level and to achieve the desired level of foreign exchange reserves.
The simulations confirmed theoretical analysis: fiscal policy was assigned primarily to the wealth objective in economies where cost-push pressures were dominant and to national income where demand-pull pressures prevailed. Blake and Weale 're-ran history' over the period 1975-84. In simulations of the 'cost- push economy' there was more exchange rate appreciation than had been observed historically because a more stringent disinflationary policy was followed; the effects on unemployment in the simulations, however, were similar to those which actually occurred. But the target and actual exchange rate were very volatile, and the authorities actively intervened in the exchange markets. By contrast, the 'demand-pull economy' required little exchange rate appreciation, since inflation was controlled by changes in tax rates. Employment rose slightly as a result of export-led growth in output, and the nominal GDP target was tracked quite closely. There was a sharp fall in the share of national income accounted for by employment income over the period, reflecting the success of the wage reforms in breaking the wage-price spiral.
Discussing the two papers, John Odling-Smee (HM Treasury) accepted the rationale for income and wealth targets but suggested that using the tax rate to fine-tune fiscal policy might give rise to undesirable uncertainty. More attention should be given to government expenditure, Odling-Smee argued: although changing the level of government expenditure involved greater administrative lags their impact would be felt more quickly, so the total lag may be no longer than for tax rate changes. Also the direction and magnitude of the effects of changes in government expenditure were clearer. Some participants argued that, as inflation was the ultimate concern, the authorities should be judged on their performance in controlling the price level rather than nominal income; others preferred targeting aggregates which could be straightforwardly controlled. Furthermore, adopting GDP at current factor cost as an 'intermediate' target had the advantage that a national norm for income would be more likely to assist in the control of wage demands.
The two papers that followed analysed further the merits of using nominal income measures as intermediate targets. In his paper, 'Wage Push, Supply Shocks and Nominal Income Targets in an Open Economy', George Alogoskoufis (Birkbeck College, London, and CEPR) used a simple analytic macroeconomic model with sluggish wage adjustment to compare the performance of monetary and nominal GDP targets with that of 'fully optimal' stabilization policy. Alogoskoufis found that if policy-makers had full information concerning the shocks affecting the economy, monetary targeting could eliminate the welfare loss arising from the shocks. By contrast, pursuing an unconditional nominal income target was sub-optimal, since it failed to counteract autonomous wage-push or aggregate supply shocks and gave rise to unemployment. Nevertheless, nominal income targeting could perform as well as the fully optimal policy if it were supplemented by an additional policy instrument, such as a wage policy, or if it fully accommodated imported inflation and partially accommodated real wage shocks.
A similar static model with stochastic shocks was used by David Vines in his paper, 'Money GDP Targets and Fiscal Policy in an Open Economy'. Vines analysed the response of various intermediate targets to shocks in different exchange rate regimes. In a floating exchange rate regime in which fiscal policy was inoperative, nominal GDP targets were better able to offset shocks than were monetary targets; the latter partially accommodated shocks via an 'idle balances' effect. Both policies were, however, likely to give rise to exchange rate volatility. If exchange rate targets were adopted in order to reduce this volatility, the government's ability to control inflation resulting from supply shocks was considerably weaker. Vines also considered a third regime, in which monetary policy was used to achieve a target exchange rate and fiscal policy to control nominal GDP. This seemed to achieve the best of both regimes: effective responses to supply and demand shocks as well as exchange rate stability.
In the discussion, however, it was argued that the exchange rate regime seemed to play a more important role in these results than did the adoption of a nominal GDP target. The models used by Alogoskoufis and Vines were criticized in so far as they lacked dynamics and were completely reliant on macroeconomic policy rather than microeconomic policy as a cure for unemployment.
Successful implementation of the policies discussed at the conference might require important departures from past practices in the labour market. In 'The Function and Form of Internationally Competitive Wage Strategies', Arthur Brown (University of Leeds) and William Brown (University of Cambridge) discussed the institutional arrangements which could give rise to internationally competitive wage-setting behaviour. Bruno and Sachs have argued that countries with competitive wage strategies tend to be characterized by labour market 'corporatism' and by nominal wages lagging behind prices in inflationary circumstances, but this analysis provides little guidance for policy. Brown and Brown maintained that it is essential to analyse wage-fixing as a political process: some of Meade's earlier proposals of 'not quite compulsory arbitration' failed to recognize this. As an institutional remedy, they suggested that the wage bargaining process should become more centralized, with greater coordination among management and a national agreement between management and unions; uncoordinated decentralized wage bargaining may exacerbate inflation. A centralized system would, however, need to permit some local wage drift to meet local needs.
There was disagreement among participants over the ability of governments to change wage-fixing institutions. There were political difficulties in obtaining the solidarity among employers necessary for centralized bargaining; and John Flemming (Bank of England) expressed concern over the potential inflationary consequences of the wage drift envisaged in the analysis.
Can reliable estimates of quarterly nominal GDP be made quickly enough for use in targeting GDP? Andrew McKay (Clare College, Cambridge) presented 'Preliminary Estimates of Money GDP', in which he reported the results of an attempt to produce a 'preliminary' estimate (two weeks after the quarter concerned) of the various measures of current and constant price GDP. The estimates were based on predictions of the major components of GDP using whatever information from the current quarter was available, together with projections based on time-series analysis for unavailable data. A balancing technique was used to reconcile the separate GDP estimates, thereby increasing the accuracy of the overall estimate. The information on which the estimates were based was inevitably incomplete and subject to revision; but McKay argued that it might nevertheless be practicable to implement a nominal GDP target using these estimates, even though their inaccuracy limits the the extent to which fine-tuning should be used in pursuing the targets.
McKay used 'measurement' relationships, such as those between quarterly consumers' expenditure and monthly retail sales data. Discussing the paper, Frederick van der Ploeg (LSE and CEPR) suggested that the incorporation of behavioural relations might improve the accuracy of the estimates. Forecasts of GDP from a recognized large-scale econometric model could also be incorporated into the preliminary estimates. There are difficulties with this, of course: behavioural relations could only be employed if they were based on data available at the time the preliminary forecast was made. In addition, private sector responses to shifts in policy may affect behavioural more than measurement relations and make them less useful for forecasting. Other participants suggested that the accuracy of McKay's preliminary GDP estimates should be compared with that of forecasts made by a more straightforward method such as a vector autoregression.
The remaining papers concerned appropriate international arrangements for policy, and in particular the merits of policy coordination. David Currie (Queen Mary College, London, and CEPR) and Paul Levine (London Business School and CEPR) presented their paper, 'Reputation and International Coordination: An Analytical Treatment'. They argued that in considering cooperation, it was important to distinguish between reputational policies, in which government policy is credible to the private sector (in the sense that it is not expected to renege on its announced policies), and non-reputational policies conducted by a government without such credibility. Currie and Levine used a simple two-country model with which it was assumed that money is neutral and that there is a natural rate of unemployment. When fiscal policy is fixed and only monetary policy is varied, then if governments have reputation, the equilibrium is one of zero inflation, with or without cooperation. Whether cooperation is desirable in the absence of reputation depends on whether a price shock in one country has a beneficial or detrimental effect on the output of the other. When fiscal policy is allowed to vary, cooperation is desirable because it leads to lower government spending and (within the context of the model) to higher equilibrium income. In the non-reputational case, inflation depends positively on the difference between target and equilibrium income; in the absence of cooperation, countries have lower equilibrium incomes and hence higher inflation rates. This analysis provides a reason for wishing to cooperate in the setting of fiscal policy, even in the absence of reputation. The gains from fiscal cooperation may well outweigh the more familiar reasons for not cooperating over monetary policy in the absence of reputation. Fiscal policy was found to be important in assessing the gains from policy coordination in the model, even though monetary policy is more often the focus of attention.
Marcus Miller (University of Warwick and CEPR) was concerned that the model lacked dynamics. He also thought it should incorporate a stochastic element, since the government's incentive to renege on commitments may arise because of shocks as well as a straightforward lack of time consistency.
James Boughton (IMF) discussed 'The Indicator Approach to Policy Coordination'. Exchange rate agreements such as target zones are only likely to be successful if countries are able to carry out the appropriate domestic policies. A better approach to taking account of interdependencies might be to consider a broader range of objectives in policy coordination: indicators of macroeconomic performance, of policy stance and of the processes linking policy to performance. The number of indicators should be comprehensive enough to reflect countries' policy objectives but small enough to permit focusing on the main issues.
One major problem such policy coordination might encounter would be the difficulty of reaching agreement on how the world economy functions and, ultimately, of agreeing on a single economic model. Nevertheless, coordination might be feasible with consensus on the general nature of such relationships, such as the sign and approximate magnitude of multipliers. Difficulties might also arise if countries were not willing to take account of the domestic objectives of other countries in setting their own policies. Boughton went on to discuss the case in which agreement could be reached only on objectives for the current account of the balance of payments. Even such a limited agreement, he argued, would significantly influence domestic policies. In particular, policy-makers would need to pay careful attention to their fiscal policies: external deficits were unlikely to improve if domestic imbalances were not corrected. Boughton echoed Currie's call for fiscal policy to play a more prominent role in discussions of policy coordination.
In the discussion of Boughton's paper, James Meade argued against the idea of current account objectives in favour of his own framework, in which countries had objectives concerning the sum of domestic investment and the current account surplus (which represents the accumulation of foreign assets). Boughton's analysis was also criticized for its failure to provide an explicit model of the relationship between fiscal and external deficits.
Finally, Marcus Miller presented a paper, written jointly with John Williamson, on 'The International Monetary System: An Analysis of Alternative Regimes'. The analysis concentrated specifically on 'symmetric' regimes (rather than ones dominated by a single country, such as the Bretton Woods system). Miller used a simple two-country stochastic model with sluggish price adjustment to compare the merits of various anti-inflationary policies in different exchange rate regimes. Ronald McKinnon has advanced a series of proposals for international monetary reform, involving a fixed exchange system in which anti-inflationary policy takes the form of a global monetary target or, more recently, an explicit price level target. Miller's analysis suggested that the latter was preferable: even at the global level the velocity of money remains unstable and hence introduces unnecessary additional 'policy noise' into the anti-inflationary policy. The model also served as a framework for considering an extreme form of Williamson's 'target zones' proposal, in which the real exchange rate was fixed. It had been argued that such a policy is liable to destabilize inflation, but Miller and Williamson showed that if deflationary pressure is exerted by assigning fiscal policy to a nominal income objective, then the consequences for price and output will be similar to those under the McKinnon proposals - with the additional benefit of real exchange rate stability. In practice, they concluded, an intermediate regime might be preferable.
Martin Weale criticized the model used by Miller and Williamson for its failure to recognize the importance of a wealth objective and to give full attention to the wage-price process. Their model ignored the effects of tax changes on inflation, which in Weale's analysis affected the appropriate assignment of monetary and fiscal policy instruments. Weale also argued that it was important to be more specific about the fiscal policy envisaged - some forms of fiscal policy (such as taxation) will affect labour market behaviour whereas others such as government spending or poll tax may not.
One point which emerged clearly in the discussion was the importance of labour market behaviour for the assignment of policy instruments and the lack of conceptual and empirical agreement over the operation of the labour market. Differences in actual or perceived labour market behaviour could lead to different assignments of policy instruments across countries; in such circumstances it may be legitimate for a country with a particularly stubborn wage-price spiral to 'export' inflation to a country more easily able to cope with it.
In the final session, David Vines summarized some of the main themes and problems raised during the conference. There seemed to be agreement among participants about the general nature of the economic model which should underlie policy analysis, though disagreements remained concerning some specific features - in particular the labour market - and the most appropriate means of simplifying models. Vines also thought there was broad agreement over the aims of the analysis: simple objectives and simple policy rules, assignment of policy instruments according to the strength of dynamic multipliers, and the need for a long-run wealth target, but without the need for tight control to achieve it. Despite this, several serious difficulties remained about the relative weights which should be placed on fiscal and monetary policy in the regulation of inflation and wealth. There are clear limits to the flexibility of fiscal policy, so that rapid and tight control of nominal income may also require the use of monetary policy. In addition, wages may be too heavily influenced by cost-push factors to allow fiscal control of money GDP. Slow adjustment of the current account to changes in exchange rates (due to 'J curve' effects) might also require that fiscal policy be used to correct wealth disturbances arising from current account imbalances.