Wednesday, February 16, 2011

Chancellor and Governor

Later in term we will spend some time thinking about monetary and fiscal policy; these are the two ways in which governments attempt to influence economic activity, wisely or otherwise.  Both are currently in the news regularly; fiscal policy because the Coalition is running a very tight fiscal policy in order to bring down the government deficit, and monetary policy because interest rates remain essentially at zero yet inflation is high.

The current monetary policy arrangements have the Bank of England commissioned by the government to set interest rates to achieve an inflation target of 1-3%.  However, for 20 of the last 30 months, that target range has been missed by the Bank.  Every time the target is missed, the Governor of the Bank of England, Mervyn King, must write a letter to the Chancellor explaining why the Bank has failed in its duty.  The Chancellor usually responds, and these letters, in the interests of openness, are published on the internet.  Here is George Osborne's recent response to King.

The interesting aspect of this letter is that Osborne suggests that by staying the course of the government's very tight fiscal policy, this will help monetary policy to be more effectively conducted because without it, inflation would surely happen.  Of course, there are plenty of counter arguments to this assertion, not least that given inflation is generally imported inflation currently (cost push), then it will not necessarily fall due to domestic actions by governments (unless they can increase the exchange rate).  Furthermore, such a contractionary fiscal policy could yet see the UK returning to a recession (we saw negative growth in the last quarter), in which case again if inflation is imported, there seems little reason why this would make the Bank's job any easier: Inflation will still be high, and the economy in a recession.

Furthermore, whatever the government does with fiscal policy, the Bank can always counteract with monetary policy: Assuming their efficacy, if fiscal policy was loose, then tight monetary policy would suffice to keep economic activity reasonably constant, and equivalently a tight fiscal policy could be counter-balanced with a loose monetary policy (so QE2 and more).

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