Course Code: 12102 Handout #14/01
Alternative Approaches To “Fine-Tuning”
A. Short-term and long-term relationships
Many of the relationships we assume in the AS/AD model or predict from it are much less obvious in short-run data than they are in long-run data. The most likely reason for this is that the underlying relationships that we are considering are in the short run overwhelmed by dynamics and/or the “noise” created by influences that we have ignored on the grounds that they are unsystemmatic or transitory.
As an illustration of this point consider the two graphs below. They both depict the relationship between the percentage rate of growth of the US quantity of money and the rate of growth of US prices. And they use the same monthly data. But the first plots the month to month rates of growth of the two variables expressed at an annual rate whilst the second plots the 5-year moving average rates of growth also expressed as an annual average. Our model predicts a clear positive relationship between the two series. The longer-run data supports that prediction but the relationship is much harder to detect from the short run data: in the short run the “true” relationship is heavily obscured by “noise”. (In both graphs the dotted line is the rate of monetary growth.)
Source: Federal Reserve Board. Money is M2; Prices are consumer prices.
This noisiness in short-run relationships makes them, in the view of many economists, unsuitable for use by governments for the purposes of “fine-tuning” the economy. In January and February 1983, for example, the month-to-month rate of change of the US money supply was very high (33% and 22% respectively) but there was no corresponding obvious rise in inflation either in those months or any other subsequent month. The month-to-month relationship is just not close enough for the government to fine-tune the monthly inflation rate by appropriate variation in the monthly monetary growth rate.. But the longer-term data does nevertheless support the proposition that over a longer period monetary growth and inflation are fairly closely linked .
B. Impose Formal/Informal Limits on Government Policy
It may be possible to enforce desired policies through the imposition of formal or informal limits on government behaviour.
Example #1.Proposed amendment to the US constitution suggested by M&R Friedman in Free to Choose (Secker & Warburg, 1980)
"Congress shall have the power to authorize non-interest bearing obligations of the government in the form of currency or book entries, provided that the total dollar amount outstanding increases by no more than 5 per cent per year and no less than 3 per cent.."
Example #2.Gramm-Rudman-Hollings bill or Balanced Budget and Emergency Deficit Control Act, 1985.
In 1985 the US Congress adopted the above Act which required a steadily decreasing deficit from $172 in fiscal year 1986 to a budget balance in 1991. If the budget proposed by Congress was above a ceiling, spending on all programs was cut by the same percentage to meet the target.
Example #3.The Medium-Term Financial Strategy of the Thatcher Government.
In its first full budget in 1980 the government announced its Medium Term Financial Strategy - which involved a commitment to reduced monetary growth and to a reduction in the public sector borrowing requirement as a proportion of national income.
Growth in £M3 (%)PSBR as % of GDP
Planned ActualPlannedActual
1980/817-11 15.43.85.25
1981/826-10 11.13.03.25
1982/835-9 11.22.33.25
1983/844-8 7.2 .53.25
C. Fixing Exchange Rates/ Currency Boards
Governments can restrict themselves by committing themselves to exchanging units of their currency for another country's at some fixed rate. The approach places strong limits on the country's ability to operate an independent monetary policy.
Some countries take this further and operate currency boards. This is an arrangement whereby the country commits itself to converting domestic currency into a specified foreign currency on demand at a fixed rate, and where, to make this commitment credible, the currency board holds reserves of foreign currency equal at the fixed exchange rate to at least 100% of the domestic currency issued.
The best known currency board is that of Hong Kong where, since 1983, the Hong Kong dollar has been officially fixed at HK$7.80 per US$. Its foreign exchange reserves cover its domestic M1 money supply four times over so it is particularly soundly based; and this probably is the main reason its currency has been able to withstand recent attack.
Other countries operating currency boards are Argentina (where the Argentine peso has been convertible into one US$ since the currency board was introduced in 1991.), Bulgaria, Estonia and Lithuania. As this list suggests, currency boards are a useful device through which countries who have not established anti-inflation credibility might be able to do so.
D. Independent Central Bank.
In a growing number of countries the Central Bank is formally independent of the government. The UK government announced on May 6th 1997 a move towards greater independence for the Bank of England. The main argument for an independent central bank is that it is likely to control inflation more successfully because it is free from the political influences which tempt governments to inflate.
Ho_14.doc