Demand Management (Routledge Revivals)

Stagflation - Volume 2

David A Vines, J. M. Maciejowski, J. E. Meade

• Publisher: Routledge
• Year: 2013
• ISBN:
  9781136708541
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

First published in 1983, this is the second of two volumes on the causes and cure of stagflation – that combination of mass unemployment and rapid inflation that is currently afflicting the mixed economies of the industrially developed world. The authors deplore the unemployment due to the failure of governments to adopt Keynesian measures for the expansion of economic activity, but recognise that in present conditions such measures would lead to an unacceptable and explosive inflation of money wages and prices. They therefore advocate a dual strategy of financial policies for a steady expansion of total money incomes combined with individual wage rates set at levels to promote employment.

The book is of importance for all those concerned with macroeconomic theory and policy. The description of the meaning of a New Keynesian policy and of the arguments for it have been written in a way which should be intelligible to policy-makers and students, and not only to economists with technical training. Professional macroeconomists will be interested not only in these sections but also in the fully specified macroeconomic model used to analyse New Keynesian policies in economic terms and to carry out a counterfactual re-running of history. In addition, the unusually detailed exposition of the application of control techniques to a difficult multivariable control problem also makes the book of interest to control engineers who wish to acquaint themselves with recent generalisations of classical frequency response methods.

Part One

The Policy in Theory and Practice

CHAPTER I

Introduction

This work is concerned with the nature, the causes, the consequences and the cure of stagflation, that ugly state of affairs in which the economy is both stagnant with heavy unemployment of people and other resources and also simultaneously suffering from a rapid inflation of money costs, prices and incomes. Already in the introductory chapters of an earlier volume we have given an outline sketch of our analysis of the problem.*

We there suggested that a basic feature of the phenomenon is a general attempt on the part of the various agents in the economy to obtain standards of living that in combination exceed the supply of goods and services available for their consumption; that these overambitious claims take the form of increases in money incomes that outrun increases in productivity; that this necessarily leads to a rise in money costs and money prices, and so in the cost of living; that this results in further wage claims to offset the rise in the cost of living, leading to still further rises in costs, prices and the cost of living and thus to a vicious circle of explosive inflation of money costs, money prices and money incomes; that sooner or later the authorities must take steps to put a stop to this explosive inflationary process by restrictive fiscal, monetary and foreign-exchange policies designed to damp down the rising levels of total money expendi-tures; and that this reduction of demand results in decreased output and employment, which will have to be prolonged and severe if it is ultimately to break the overambitious claims that have caused the trouble.

In Volume 1 we suggested that the best way to tackle this problem was by means of what we called a New Keynesian policy. By this we meant (1) that the apparatus of demand management (that is to say, the combination of budgetary, monetary and foreign-exchange policies) should be so operated as to keep the total of money expenditures on the goods and services produced in the country on a steady growth path, expanding at the moderate rate of, say, 5 per cent per annum, and (2) that, against this background of a steady but moderate expansion in the total money demand for the products of labour, wage-fixing institutions should be so reformed as to ensure that pay in the various sectors of the economy was settled at rates that served to promote employment in each sector.

The main body of Volume 1 was devoted to a discussion of the various ways in which wage-fixing institutions might be reformed so as to meet the requirements of such a New Keynesian policy. Similarly the main body of the present Volume 2 will be addressed to the problems involved in using financial policies so as effectively to maintain the total money demand for the products of labour on a steady predetermined growth path. The questions that this demand-management problem involves were not discussed in Volume 1 but were enumerated on page 7 of that volume in the following words:

By what means should total money expenditures be controlled? By monetary policy? By fiscal policy through raising and lowering rates of tax and levels of public expenditure? By changes in the rate of foreign exchange or other measures to affect expenditure on UK exports and UK import-competing products? What should be the precise measure of total money expenditures which it was aimed to keep on a steady growth path? Should it be the Gross Domestic Product (i.e. the value of all goods and services produced for consumption, investment, government use, and exports)? Or would it be preferable to aim directly at keeping the total money demand for labour (i.e. total wage and salary earnings) on a steady growth path? Above all, in view of the dynamic interrelationships in the economy between taxes, interest rates, foreign exchange rates, prices, outputs, and employment, what are the best rules for operating the monetary, fiscal, or other controls for the purpose of keeping the chosen measure of total money expenditures on its target growth path?

The study of these questions that follows consists of three main strands:

(1) In the investigation of demand-management policies one must consider the relations between monetary policies, budgetary policies and foreign-exchange-rate policies and their effects on the balance of payments and capital investment as well as on the total level of money expenditures. These relationships and their implications for control policies are discussed in Chapters I–VI in general terms.

(2) The choice of precise rules for setting tax rates, interest rates and foreign-exchange rates in order to control the performance of a dynamic economy requires the techniques of control engineering. The relevant techniques, and the way we have used them to devise policy rules, are described in Chapters XII–XIV.

(3) A description of how the UK economy might have fared had such policy rules been applied to it is given in Chapters VII and VIII. Such an exercise in rerunning history of course requires a dynamic economic model and the one that we have used is described in Appendix A.

In addition to these three main strands, Chapters IX–XI describe the practical difficulties that would be involved in making frequent and prompt changes in rates of tax of the kind that our control rules might require.

The present volume must be regarded as an interim report on a subject on which much further work needs to be done. We are conscious of the following six major limitations of the present analysis, which raises problems on which we are continuing to work.

(1) The model of the United Kingdom economy used in this volume could itself be developed to serve our purposes more completely. In particular, it needs to be expanded to cover the movement of capital funds in the balance of payments (and thus to integrate the effects of interest changes fully into the system on the lines discussed in Chapter V). In addition, the production function needs to be modified to consider the effects of interest-rate changes upon investment, along the lines discussed in Chapter V.

(2) In the present volume we consider as the basic demand-management target the maintenance on a steady growth path of the Money GDP (i.e. of the total of domestically produced money incomes). This target is much more ambitious than attempting to keep not the level, but the rate of growth of the Money GDP at a predetermined figure. Moreover, for a New Keynesian economic strategy it might be better to take as target not the total Money GDP but only the earnings component of the Money GDP (see Section 2 of Chapter III).

(3) In the present work we have designed rules for tax rates that depend solely on what is happening to the Money GDP and rules for the foreign-exchange rate that depend solely on what is happening to the current account of the balance of payments. But in reality there are three ‘weapons’ of financial policy (typified by the rates of tax, of interest and of foreign exchange) and three ‘targets’ for financial policy (typified by the level of money incomes, the overall balance of payments and the proportion of the community's resources devoted to capital accumulation at home or abroad). A revision of the rules that took into account the effect of each of the ‘financial weapons’ on each of the ‘financial targets’ might appreciably increase the effectiveness of the policy (see Section 5 of Chapter V).

(4) A major question is whether the particular control rules derived from the particular model examined in this volume are robust enough to be reasonably effective, indeed not to do more harm than good when applied to another model – or, above all, if applied to the actual United Kingdom economy. We have not yet undertaken any systematic enquiry into the robustness of our rules to meet deviations from the assumed underlying relationships.

(5) In our work we have not allowed for the fact that the adoption of a publicised New Keynesian policy may cause people to react to various developments in ways that differ from their previous reactions in the absence of those declared policies. For example, we have assumed that consumers would react in their purchases to a rise in VAT in the same way as before, even though it were now announced that a rise in VAT was to be operative only so long as it was necessary to damp down an undesired inflation of total money incomes. If the consequential rise in the price of goods is expected on these grounds to be only temporary, there would be an added reason to postpone purchases; and to the extent that our model did not take such reactions into account the proposed rules for changing rates of VAT would be misjudged. It is uncertain how far such influences are at work and difficult to know how to measure their effect. But they may be very important.

(6) The model of the UK economy on which we have based our work is essentially one in which output and employment depend upon Keynesian effective demand. It makes simple assumptions about the production function: (a) total output is assumed to respond to changes in demand so long as there is unemployed labour; (b) incentives to invest in new capital equipment are modelled so as to ensure that there is always a margin of unused capacity; and (c) output per head is assumed to grow exogenously at a given rate. Such simple assumptions are reasonably adequate for our present purpose, which is to examine whether finely tuned controls of total demand can prevent substantial short-run fluctuations of output and employment; but a more sophisticated production function would be needed if the purpose of our analysis were extended to take into account the longer-run effects on output and employment of the important technological revolutions (in micro-electronics, robotics, information techniques, etc.) through which we are now passing.

It may well be asked whether the publication of their results by three miserable sinners who have left undone so many things that they ought to have done serves any useful purpose. We make bold to justify our publisher's action. To remove the deficiencies enumerated above will require prolonged work. Meanwhile there are in the real world a number of urgent decisions to be taken about policies for demand management, a state of affairs that justifies the publication of an interim report if that report has any serious contribution to make to the current discussion. We feel that, even in its present form, it has contributions to make under each of the following nine headings:

(1) In the first place, the theory of policy that we set forth in Chapters I–VI provides a systematic exposition: of the relationships between monetary policies, budgetary policies and foreign-exchange-rate policies; of their effects on the total level of money expenditures, on the balance of payments and on capital investment; and of the implications for demand management. For reasons explained in Chapter II, this particular package of policies seems to us more desirable than either Orthodox Keynesianism or monetarism.

(2) A central issue is whether fine-tuning through frequent and prompt feedback variations of financial instruments (rates of tax, interest and foreign exchange) has any real contribution to make to a successful management of demand. Our study suggests that it can be helpful; we have in fact found control rules that, given the dynamic properties of our model, do in fact keep Money GDP very closely on its predetermined growth path in spite of the exceptional turmoils of the period studied, which include a fourfold rise of oil prices, the development of North Sea oil and the impact of the great world recession on the United Kingdom economy.

(3) Our study of these matters provides an instructive exercise in the development of control-theory techniques for their application to dynamic economic systems, a matter that consciously or unconsciously is in fact at the heart of all demand-management policies, no matter what theory of policy is adhered to. Indeed, we would recommend Chapters XII–XIV as providing a basic text for any economist who for the purpose of considering macro-economic policies wishes to familiarise himself with the relevant elements of control theory.

(4) As stated above, we have not yet systematically investigated the robustness of our fiscal rules; but our study makes it clear that if fiscal fine-tuning is to be tried it is most important in the interests of robustness as well as of direct effectiveness that adjustments of tax rates should be made with the minimum of delay in response to deviations of the Money GDP from its target growth path (see Section 1 of Chapter VIII). For this purpose some changes in the administrative arrangements for income tax and/or for national insurance contributions would be most desirable. A change from the present cumulative to a non-cumulative system for PAYE would be of outstanding assistance (see Chapters IX–XI).

(5) Our study also suggests that while fiscal feedback fine-tuning can play an important part, this does not preclude simultaneous attempts to control the situation by the forward planning of tax structures or of various governmental expenditures. Indeed, an appropriate arrangement might well consist of two elements: (a) an annual review at the time of the budget at which the whole structure of taxes and of further expenditures was planned ahead with the object among other things of keeping the Money GDP on its planned path, combined with (b) the use of fine-tuning adjustments of certain taxes in the period between one annual review and the next to help to correct unforeseen deviations that occurred during that period (see Section 3 of Chapter VI).

(6) Successful stabilisation of the Money GDP through finely tuned fiscal measures will necessarily depend, as our study confirms, on a willingness to face, and ability to finance, large fluctuations in the balance of overseas payments. We can hope to make prompt adjustments to total money expenditures, which will lead to prompt fluctuations in the demand for foreign goods and services; but the readjustments then needed to the balance of payments by changes in the exchange rate will work only slowly because of the slow response of the channels of international trade to changes in relative prices (see Section 1 of Chapter VIII).

(7) Another cost of successful stabilisation of the Money GDP through finely tuned fiscal measures is the need to face frequent temporary variations in the real value of take-home pay. The more closely one aims at keeping the Money GDP on its target growth path, the more marked and frequent must be the upward and downward adjustments of the tax rates used for this purpose and so of the post-tax real value of any given money wage (see Section 1 of Chapter VIII).

Nor is this simply a matter of short-run fluctuations; we have to face an even more important problem of longer-run variations in real living standards, owing to the fact that the balance of international trade adjusts only slowly to the foreign-exchange measures taken to control it. During a period of balance-of-trade deficit, our policy implies that tax rates should be low in order to stimulate domestic consumption demands and thus offset the low demand for UK products in export and import competing markets; with the subsequent restoration of the balance of trade, taxes must be raised in order to restrain consumers' demands to offset the restoration of net foreign demand. As a result, under our policies during ...

Table of contents

• Cover
• Half Title
• Full Title
• Copyright
• Contents
• Preface
• PART ONE THE POLICY IN THEORY AND PRACTICE
• PART TWO RERUNNING HISTORY
• PART THREE SOME ADMINISTRATIVE PROBLEMS OF FISCAL CONTROL
• PART FOUR THE DERIVATION OF CONTROL RULES FOR ECONOMIC POLICY
• Appendix A The Economic Model
• Appendix B The Policy Rules Discussed in Chapter XIV
• References
• Index