10 Top Topics in Macroeconomics Allan Hodge and Jill Whittock

Anforme Limited

Contents Topic 1 The Bank of England and monetary policy 1997-2007: Have ten years of independence been a success? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Topic 2 How healthy is the state of the UK’s public finances? . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Topic 3 Labour market trends in the UK and the EU – what lessons for policy-makers? . . . . . . . . .

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Topic 4 The changing pattern of UK trade – a post-industrial success story or a growing problem? . .

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Topic 5 Understanding deficits and surpluses – global imbalances in the world economy . . . . . . .

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Topic 6 The price of oil: a major constraint to the global economy? . . . . . . . . . . . . . . . . . . . . . . . .

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Topic 7 Does globalisation level the playing field? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Topic 8 To what extent has the eurozone been a success? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Topic 9 Will the UK remain one of the world’s top locations for Foreign Direct Investment by multinationals? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Topic 10 Competitiveness and productivity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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10 Top Topics in Macroeconomics

Allan Hodge and Jill Whittock Both authors teach at Cheltenham Ladies’ College where Allan is Head of the Economics department

Published by Anforme Ltd., Stocksfield Hall, Stocksfield, Northumberland NE43 7TN. Tel: 01661 844000 Fax: 01661 844111 e-mail: [email protected] www.anforme.co.uk ISBN 978-1-905504-13-8 March 2007

TO P I C 1

The Bank of England and monetary policy 1997-2007: Have ten years of independence been a success? Both monetary policy itself, and the Bank of England’s role in implementing it in Britain, have undergone significant change since the early 1990s. Monetary policy in its broader sense involves attempts to influence, or control, both the price of money and its supply, and in the UK up until 1997 both of these methods had been used, with more or less success, at different times. 1997 proved a turning point in monetary policy, because it came to be focused on one tool only, the domestic price of money, or the rate of interest. In addition the Bank of England was, for the first time, given ‘operational independence’ to use monetary policy to achieve an inflation target set by the government. The external price of money, the exchange rate, had been targeted, without success, between 1990 and 1992, and in earlier decades the Bank of England had tried directly or indirectly, to control money supply growth and its counterpart, credit creation (bank lending).

How has monetary policy evolved in the UK since 1990? Since 1990 the emphasis has been to use monetary policy primarily to affect the rate of inflation, although in different ways. In October 1990 the UK joined the Exchange Rate Mechanism (ERM) of fixed western European currencies (the forerunner of what was later to become the Euro) at a rate widely regarded as overvalued at £1 = Deutsche Mark 2.95. An overvalued rate is one which is above its ‘true’ market equilibrium. The purpose of joining a fixed exchange rate system, and at a rate higher than might be considered realistic, given conditions in the foreign exchange market and the state of the UK economy, was to introduce an element of ‘discipline’ into British policy-making in order to reduce its high inflation rate. The reasoning was that, in the absence of a fixed exchange rate, and given Britain’s marked lack of international competitiveness, the pound sterling would continue to decline against the Deutsche Mark and other strong currencies. The temptation for government, which still controlled monetary policy through the Bank of England at this time, would be to allow this to happen rather than to take the harder decisions that would be needed to bring inflation down, such as raising interest rates. In other words, to let a falling exchange rate ‘take the strain’ and restore some degree of competitiveness internationally (a falling rate reduces export prices in a foreign currency), rather than taking difficult and unpopular measures to achieve the same objective. The Italian government used this ‘easy option’ depreciation technique over many years before joining the Euro. But since it now no longer has its ‘own’ currency that it can allow to depreciate, it is locked into its low productivity and lack of competitiveness. It is hardly a surprise therefore to hear calls by some in Italy for it to leave the Euro. With a fixed exchange rate in 1990, the British government would have no choice but to defend it if it began to weaken. A falling exchange rate is itself inflationary. The defence would initially involve intervention in the foreign exchange market by the Bank of England (using foreign currency reserves to buy sterling and push its price up), and then, if necessary, raising interest rates. In principle, higher interest rates make holding sterling deposits more attractive, so foreign currency holders sell their own currency to buy pounds, again strengthening the exchange rate. The higher the fixed exchange rate (the parity), the greater the interest rate ‘discipline’ required to maintain the rate, and the greater the downward pressure on inflation,

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through the effects of the higher interest rate on spending (the ‘transmission mechanism’ – see below), and through the direct effect on import prices, which are lower the higher the exchange rate is. In fact, Britain’s time of ERM membership was one of great difficulty. To maintain the sterling parity interest rates had to be kept high when the economy was entering an unprecedented period of technical recession (negative economic growth) and rising unemployment. In addition, the pain was made worse when the German central bank raised interest rates, and Britain was obliged to follow. The time lag between interest rate changes and inflation changes is quite long – 18 to 24 months – but growth and unemployment respond quicker, so the negative effects of the high interest rates were obvious before the positive ones. In fact, in the face of an overwhelming speculative assault in the foreign exchange markets against the pound (massive selling), Britain suspended its membership of the ERM on ‘Black Wednesday’, September 16th 1992. In effect it left the fixed exchange rate system, never (yet) to return. On that day, before the suspension, the Bank of England was instructed to raise interest rates by 2% initially, and then a further 3%, to encourage foreign purchase of sterling. It was seen as a panic measure, and it failed to halt sterling’s slump. An exchange rate target needs an interest rate tool to maintain it – in other words, interest rates have to be changed to maintain the parity chosen. In the period of unprecedented difficulties in the early 1990s, this did not prove possible, but in less volatile times this relationship holds. However, if there is an exchange rate target to be maintained with the use (after foreign exchange market intervention) of changes in interest rates, then the rate of interest cannot at the same time be used to achieve an independent inflation target. In 1990, the hope was that success with the exchange rate target would also reduce inflation, because of the implied high level of interest rates needed; the overall plan did not work, but it is true nevertheless that the government could not, at the same time, declare a target for both the exchange rate and inflation while using only one tool to achieve them, the interest rate. • Why interest rate policy cannot be used to achieve independent exchange rate and inflation targets If the exchange rate is fixed as a target, as in 1990-2, the rate of interest has to be varied if the market exchange rate deviates unacceptably from its parity. If it weakens, the rate of interest has to be raised, if it strengthens, it has to be lowered. The monetary authorities have to accept whatever impact the interest rate change might have on the inflation rate. In 1990-2, they hoped that the exchange rate target chosen would lead to an interest rate policy that would also act to reduce inflation. Hence a target for one would be accompanied by a desirable movement in the other – nevertheless, they could not set a target for inflation, because the rate of interest was being used as a tool to achieve a precise target of a different sort. In other words, focusing on the exchange rate meant that they would have to accept whatever inflation rate resulted from their choice of interest rate (although they hoped it would be lower). After exchange rate targeting was dropped in 1992, and formal inflation targeting adopted after 1997, the opposite happened. Since 1997, the interest rate has been set to achieve a precise inflation target (with some variation allowed around it, just as had been the case with the exchange rate target before), and so the monetary authorities have to accept whatever exchange rate results from their policies, even if this is unpalatable to others in the economy. For example, British exporters have complained over several years that sterling is too high and damaging their export competitiveness, but their complaints have fallen on deaf ears at the Bank of England, because to vary interest rates to try to influence the exchange rate would be to turn their backs on the inflation target; they cannot target both at the same time (and certainly would not want to weaken sterling in 2007, because that would be inflationary through higher import prices).

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10 Top Topics in Macroeconomics

In summary: Exchange Rate Targeting, 1990-92, UK If interest rates are used to support a fixed exchange rate target, they cannot, at the same time, be used to achieve a fixed inflation target Target

Tool

Exchange Rate

Interest Rate

No precise target for inflation possible

Inflation Rate Targeting, 1997 onwards, UK If interest rates are used to support a fixed inflation target, they cannot, at the same time, be used to achieve a fixed exchange rate target

No precise target for exchange rate possible

Tool

Target

Interest Rate

Inflation Rate

In September 1992, the exchange rate target was abandoned, and there began an interim period which would result in the adoption of the inflation target which we still have today, monitored by a Bank of England with operational independence to achieve it with interest rate policy:

• October 1990 – September 1992: exchange rate target (ERM membership) • September 1992: exchange rate target abandoned

• October 1992: first inflation targeting, 1%-4% RPIX, with intention that it be at lower end of range within 4 years; Bank of England asked to assess inflation every 3 months in independent report, but still does not have ‘operational independence’ to conduct monetary policy • December 1992: first Monthly Monetary Report published, and February 1992: first Inflation Report published • April 1994: first record of monthly meetings between the Chancellor of the Exchequer and the Governor of the Bank of England • June 1995: first more precise inflation target published: 2.5% or less RPIX

• May 1997: Bank of England given operational independence, and the Monetary Policy Committee established to take monthly interest rate decisions • June 1997: inflation target announced: RPIX 2.5% ± 1% (a ‘symmetrical’ target treating inflation above or below target as equally bad, but allowing some flexibility) • December 2003: target changed to CPI 2.0% ± 1% (the current situation)

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What is the difference between RPIX and CPI? The starting point for this enquiry is the Retail Prices Index (RPI). It covers about 650 separate items of expenditure: about 550 are surveyed each month by ‘price collectors’, mostly through personal visits to shops, and the remainder are obtained from central sources (for example, train fares and council tax charges), or are sent directly to the ONS, for example by large supermarkets which have national pricing polices. Adjustments may be made, month by month, for quality improvements, for example in personal computers. The RPI is then calculated using weights to give more importance to some items, and less to others. The weights are derived mostly from the ONS’s Expenditure and Food Survey, where several thousand households record their spending patterns over two weeks (the top 4% of income households, and low-income pensioner households, are excluded, as they are not considered typical). RPIX, which was the first price index targeted by the Bank of England, differs from RPI by excluding mortgage interest payments from its calculation. The argument here was that they did not want an item in the target index that would automatically change with a change of interest rates by the Bank; also, perversely, if the Bank raised interest rates to reduce inflation, the inflation rate would actually rise if mortgage interest rates were included – so they were excluded and RPIX was targeted instead of RPI. The Consumer Prices Index (CPI), which was adopted in December 2003, is a further variation. It is also known as the Harmonised Index of Consumer Prices (HICP), which is used internationally (unlike the RPI) and enables price comparisons to be made more easily with other countries, especially in the EU. It also differs from RPI in the following main ways: • like RPIX, it excludes mortgage interest payments, but also other housing costs such as council tax payments and house insurance; on the other hand, it includes items for some services, such as charges for financial services • CPI covers a much broader population than RPI: all private households as well as foreign visitors and people living communally, for example in retirement homes and universities • the method of calculation is different from that of the RPI, so that the RPI always gives a higher inflation rate than the CPI for the same data

Why target inflation? High inflation has a number of costs to the economy and society: 1. High inflation distorts price signals and creates a climate of uncertainty which is extremely damaging to the business and investment climate – firms need price stability in order to plan and invest for the future; it makes firms less competitive abroad and at home, makes them fearful of deflationary government policies, and encourages high wage claims; 2. As output, growth and investment suffer, so does employment; 3. High inflation redistributes income and wealth away from lenders and those on fixed incomes, and towards borrowers and those who can get matching pay rises.

Why do we need a symmetrical target? Unlike the European Central Bank (ECB), which has an inflation target ‘close to, but below, 2%’, with no stated flexibility, the Bank of England target, while fixed at 2%, does allow a 1% margin either side. This follows from the Chancellor’s view of the target, reconfirmed in March 2006:

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10 Top Topics in Macroeconomics