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Adoption of nominal income targets is unlikely to
benefit the UK economy, argued George Alogoskoufis at a lunchtime
meeting on 19 October. Even though they may be better than monetary
targets in dealing with shocks to the velocity of money, they do nothing
to counteract the macroeconomic effects of supply-side disturbances such
as oil price shocks. Nominal income targets faced other problems as
well, Alogoskoufis noted. Under a fixed exchange rate regime, monetary
policy would be used to defend the exchange rate leaving fiscal policy
the task of achieving the nominal income target, but the lags in fiscal
policy made it unlikely that it could be used successfully to control
nominal income. James Meade, in his 1977 Nobel lecture, suggested that targets for the rate of growth of nominal GDP would be preferable to monetary targets as an intermediate target in controlling growth and inflation. Meade argued that because the velocity of money is subject to unpredictable swings, the relationship between money supply targets and the final policy objectives of output and inflation would be equally unpredictable. A number of economists and influential commentators have subsequently endorsed Meade's proposal, sometimes in conjunction with schemes for the reform of the international monetary system, such as John Williamson's proposals for exchange rate 'target zones'. But nominal income targets do nothing to tackle disturbances which arise on the supply side of the economy, according to Alogoskoufis. Suppose, for example, the economy experiences an oil price shock. As a result of the unforeseen oil price increase, inflation turns out higher than expected and, if the monetary authorities stick to the nominal income target, the rate of growth of GDP must fall. Thus the supply shock has created a recession, which nominal income targets like monetary targets fail to counteract. This inability of nominal income targets to cope with supply shocks was a major drawback, Alogoskoufis argued. His recent research (Discussion Paper No. 184) suggests that supply shocks have been among the most important determinants of aggregate fluctuations in the United Kingdom (see table). Before 1974, the main contributors to aggregate fluctuations were competitiveness and government expenditure. After 1974, in a much more unstable period, their contribution has been dwarfed by that of oil price shocks. This evidence indicated the importance of supply shocks, which a monetary policy geared to nominal income targets would fail to counteract. If monetary policy were to be aimed at nominal income targets, then either fiscal policy or an incomes policy should be used to counteract supply shocks, Alogoskoufis suggested. Failing that, nominal income targets should be flexible rather than rigid, and should be revised to accommodate fiscal policy changes and other external or domestic supply shocks. Such flexible policies could still be simple and easily understood: the target could be conditional on the deviation of the growth rate of wage settlements from the growth rate of the underlying central target. Excessive wage settlements indicate a supply shock that has manifested itself in higher price inflation and autonomous wage push, other structural changes in the labour market or an increase in labour productivity. A rigid nominal income target would prove ineffective against this sort of shock. But such flexible targets have disadvantages. Monetary accommodation of supply shocks would undermine the credibility of the authorities and hence their ability to influence the inflationary expectations of wage-setters. Serious academic research on this problem has started only recently, so the trade- offs between the benefits of flexibility and the loss of credibility are not well understood. If, however, the government's credibility is determined not by the nominal income outcome but by inflation performance, and since supply shocks affect actual inflation, the choice is whether to pay the additional cost in terms of unemployment and output loss in order to obtain relatively small gains in credibility. In any case, one should bear in mind the additional problems with nominal income targets, Alogoskoufis added. One is the recognition lag. Any intermediate target must be observed quickly and accurately, so that deviations are recognized and corrective action taken. Although there is some research suggesting that data on nominal GDP can be produced on a more timely basis, this may prove costly. The experience of 'flash' GDP estimates in the US suggests that more timely indicators may be unreliable and may have undesirable repercussions in financial markets. This should caution us against excessive reliance on nominal GDP targets. Alogoskoufis also drew attention to his other recent research ( Discussion Paper No. 183 ) which suggested that, when the authorities have imperfect information, nominal income targets are not even a close approximation to the second-best policy. Alogoskoufis ended by discussing the relation of nominal income targets to the exchange rate regime. In principle, under fixed exchange rates the authorities could maintain the exchange rate by means of monetary policy and aim at nominal income targets through fiscal policy. But since fiscal policy has far longer decision and implementation lags than monetary policy and more widespread allocative and distributional implications, it is unlikely that it could or would be used actively with a nominal income target in mind. This point might become significant if the United Kingdom ever joins the EMS, Alogoskoufis noted. Independent Contributions to Fluctuations of the UK Output/Capital Ratio ---- 1950-73 1974-85 Competitiveness 36% 14% Government Expenditure 37% 13% Relative Price of Oil 0.4% 24% ---- Source: CEPR Discussion Paper No. 184 . Some participants criticized Alogosfoukis's proposal that imported shocks should be accommodated, i.e. that output should be raised to increase the real wage to a level consistent with the new natural rate of unemployment. Had this not been tried and found wanting in the UK in the mid-1970s? Alogoskoufis maintained that such a policy would work when trade union cooperation could be obtained. Another member of the audience argued that attempts to focus exclusively on a single policy target, be it nominal income or money supply growth, were doomed to failure; the economy could only be effectively managed if efforts were made to take account of all significant macroeconomic variables. |