Tag: Rules versus Discretion

Should the object of monetary policy be simply one of keeping inflation within a target range? In a speech given on 9 October, the Governor of the Bank of England, Sir Mervyn King, questioned whether the interest-rate setting policy of the Monetary Policy Committee (MPC) has been too narrow.

He considered whether interest rates should have been higher before the financial crisis and crash of 2007–9. This could have helped to reduce the asset price bubble and discouraged people from taking out excessive loans.

But then there is the question of the exchange rate. Would higher interest rates have pushed the exchange rate even higher, with damaging effects on exports? Today the trade weighted exchange rate is some 20% lower than before the crash. The government hopes that this will encourage a growth in exports and help to fuel recovery in demand. But as Dr King said, “The strategy of reducing domestic spending and relying more on external demand is facing a real problem because not everyone can do it at the same time.”

Then there is the question of economic growth. Should a target rate of growth be part of the MPC’s target? Should the MPC adopt a form of Taylor rule which targets a weighted average of the inflation rate and the rate of economic growth?

Certainly monetary policy today in the UK and many other countries is very different from five years ago. With interest rates being close to zero, there is little scope for further reductions; after all, nominal rates cannot fall below zero, otherwise people would be paid for borrowing money! So the focus has shifted to the supply of money. Several attempts have been made to control the money supply through programmes of quantitative easing. Indeed many economists expect further rounds of quantitative easing in the coming months unless there is a substantial pick up in aggregate demand.

So what should be the targets of monetary policy? The following articles look at Dr King’s speech and at various alternatives to a simple inflation target.

Mervyn King says must face up to monetary policy’s limits’ Reuters, David Milliken and Sven Egenter (9/10/12)
Bank of England’s Mervyn King defends low interest rates pre-crisis The Telegraph, Emma Rowley (9/10/12)
Banks should have had a leverage cap before crash, says Mervyn King The Guardian, Heather Stewart and Phillip Inman (9/10/12)
King Says BOE Must Keep Targeting Inflation as Tool Revamp Looms Bloomberg, Scott Hamilton and Svenja O’Donnell (9/10/12)
After 20 years, time to change Merv’s medicine? Channel 4 News blogs, Faisal Silam (9/10/12)
King signals inflation not primary focus Financial Times, Norma Cohen and Sarah O’Connor (9/10/12)
Should Bank start the helicopter? BBC News, Stephanie Flanders (12/10/12)

Twenty years of inflation targeting Bank of England speeches, Mervyn King (9/10/12)


  1. What are the arguments for using monetary policy to target a particular rate of inflation?
  2. Would it ever be a good idea to adjust the targeted rate of inflation up or down and if so when and why?
  3. Explain how a Taylor rule would work and in what ways it is superior or inferior to pursuing a simple inflation target.
  4. Are attempts to control the money supply through quantitative easing (or tightening) consistent or inconsistent with pursuing an inflation target? Explain.
  5. What are the arguments for and against abandoning targeting in monetary policy and replacing it with discretionary policy that takes a number of different macroeconomic indicators into account?

The history of macroeconomic thought has been one of lively debate between different schools.

First there is debate between those who favour active government intervention (Keynesians) to manage aggregate demand and those who favour a rules-based approach of targeting some variable, such as the money supply (as advocated by monetarists) or the rate of inflation (as pursued by many central banks), or a hybrid rule, such as a Taylor rule that takes into account a weighted target of inflation and real output growth.

Second there is debate about the relative effectiveness of monetary and fiscal policy. Monetarists argue that monetary policy is relatively effective in determining aggregate demand, which in turn affects output in the short run but only prices in the long run. Keynesians argue that monetary policy can be weak in the short run if the economy is in recession. Quantitative easing may simply be accompanied by a decline in the velocity of circulation. It’s not enough to make more money available and keep interest rates close to zero; people must have the confidence to borrow and spend. Keynesians argue that in these circumstances fiscal policy is more effective.

Third there is the debate about the size of the state and the extent of government borrowing. Libertarians, following the views of economists such as Hayek, argue that reducing the size of the state and reducing government borrowing will create a more dynamic economy, where the private sector will expand to take up the slack created by a reduction in the size of the public sector. Their approach to policy involves a mixture of cutting deficits and market-orientated supply-side policy. Economists on the left, by contrast, argue that economic growth is best stimulated in the short term by increases in government spending and that supply-side policy needs to be interventionist, with the government investing in infrastructure, research and development, education and health. Such growth policies, they argue can be targeted on the poor and help to arrest the growing inequality in society.

These debates have been given added impetus by the global financial crisis in 2008 and the subsequent recession, slow recovery and possibility of a slide back into recession. The initial response of governments and central banks was to stimulate aggregate demand. Through combinations of expansionary fiscal policy, interest rates cut to virtually zero and programmes of quantitative easing, the world seemed set on a course for recovery. But one result of the policies was a massive expansion in government deficits and debt. This led to increasing criticisms from the right, and a move away from expansionary to austerity fiscal policies in order to contain debts that were increasingly being seen as unsustainable. And all the while the debates have raged.

The following podcast and articles look at the debates and how they have evolved. The picture painted is a more subtle and nuanced one than a stark ‘Keynes versus Hayek’, or ‘Keynesians versus monetarists’.

Keynes v Hayek: The debate continues BBC Today Programme, Nicholas Wapshott and Paul Ormerod (23/12/11)

Von Hayek Revisited – Warts and All CounterPunch, David Warsh (26/12/11)
Fed up with Bernanke Reuters, Nicholas Wapshott (20/12/11)
Paul Krugman Versus Milton Friedman Seeking Alpha, ‘Shareholders Unite’ (6/12/11)
Keynes Was Right New York Times, Paul Krugman (29/12/11)
Keynes, Krugman, and Austerity National Review Online, William Voegeli (3/1/12)
The Madness of Lord Keynes The American Spectator, Samuel Gregg (19/12/11)
Central Bankers vs. Natural Stock Market Cycles in 2012 The Market Oracle, David Knox Barker (28/12/11)
Now is the time to eat, drink and be merry Financial Times, Samuel Brittan (29/12/11)


  1. To what extent is quantitative easing consistent with (a) Keynesian and (b) monetarist approaches to macroeconomic policy?
  2. What is meant by the ‘liquidity trap’ and what are its implications for monetary policy? Have we witnessed a liquidity trap since the beginning of 2009?
  3. What are the arguments for and against an independent central bank?
  4. Explain Milton Friedman’s assertion ‘that it was the Fed’s failure in 1930 to pursue “open market operations” on the scale needed that deepened the slump’.
  5. What are the implications of growing government deficits and debt for policies to avoid a slide back into recession?

The latest inflation release from the Office for National Statistics shows the annual rate of CPI inflation for April at 3.7%, up from 3.4% in March. In other words, the average price of a basket of consumer goods – the Consumer Price Index – was 3.7% higher in April than in the same month last year. In three of the last four months, the rate of inflation has been in letter-writing territory, i.e. more than 1 percentage point away from the government’s central inflation rate target of 2%. Of course, this time it was George Osborne, the new Chancellor of the Exchequer, who was the recipient of the obligatory explanatory letter from Mervyn King, the Governor of the Bank of England.

Over the past six months the average annual rate of rate of consumer price inflation in the UK has been 3.1%. It is, therefore, no surprise that there is considerable debate amongst commentators about the need for the Bank to raise interest rates. Part of the debate concerns the extent to which the Bank is right to argue that the current inflationary pressures are essentially short term and, according to May’s letter from the Governor to the Chancellor ‘are masking the downward pressure on inflation from the substantial margin of spare capacity in the economy’.

The Bank points to the impact on the inflation figures of what we might term ‘one-off effects’. These include, for instance, the restoration in January of the standard rate of VAT to 17½% and the raising in the Budget in March of certain excise duties (commodity taxes), such as those on alcoholic beverages and on petrol. The Bank also points to the effects from the weakening of Sterling, specifically on the prices of imports, and from the increase over the past year in the price of oil because of higher demand on the back of the global economic recovery. Again, the Bank continues to argue that these pressures should weaken over the next 12 months.

As you might expect of the economics profession, there are others who argue that the Bank is being somewhat complacent over the prospects for inflation. Of course, these are incredibly uncertain times. In effect, the Bank is having to assess, on the one hand, the significance of cost pressures, such as those emanating from oil and other commodity prices, and, on the other hand, the future strength of aggregate demand, particularly in response to the likely fiscal tightening, not only in the UK, but in many other parts of the world too.

While economists will always hold divergent views on the prospects for inflation and, more generally, the economy, we may see another debate reignited in the months ahead: the debate over the extent to which the government’s powers over both fiscal and monetary policy are constrained.

Since 1997, the Bank of England has had a clear mandate to target the rate of inflation. But, to what extent might this mandate cause tensions between fiscal and monetary policy in the months ahead given the government’s plans for fiscal consolidation? In particular, with a tightening of fiscal policy, so as to reduce the size of the government’s budget deficit, will the Bank of England be able to maintain low interest rates and thereby help to sustain aggregate demand? This will, of course, depend on the path of inflation and, importantly, the sources of inflation. Nonetheless, it will be interesting to see whether the clear, if limited, remit of the Bank of England places pressure on the UK’s macroeconomic policy framework in these difficult economic times.


UK inflation hits 17 month-high BBC News (18/5/10)
A tale of two zones BBC News blogs: Stephanomics, Stephanie Flanders (18/5/10)
Shock rise in inflation risks higher rates and unemployment Independent, Sean O’Grady (19/5/10)
Q&A: Unpleasant surprise for Threadneedle St Financial Times, Chris Giles (18/5/10)
Inflation rise see King rebuked Financial Times, Chris Giles (19/5/10)
UK inflation fears Financial Times (18/5/10)
Inflation: mercury rising Guardian (19/5/10)
The elephant in the room just got bigger Times Online, David Wighton (19/5/10)
Weak pound and tax rises lift inflation to a 17-month high (including video) Times Online, Grainne Gilmore (19/5/10)


Latest on inflation Office for National Statistics (18/5/10)
Consumer Price Indices, Statistical Bulletin, April 2010 Office for National Statistics (18/5/10)
Consumer Price Indices, Time Series Data Office for National Statistics
For CPI (Harmonised Index of Consumer Prices) data for EU countries, see:
HICP European Central Bank


  1. What do you understand by cost-push and demand-pull inflation? To what extent are each of these significant in explaining the current rise in the rate of inflation?
  2. Outline the potential advantages and disadvantages of granting the Bank of England independence to set interest rates in meeting an inflation rate target.
  3. If the Bank of England’s remit were relaxed, say to include targeting output growth too, how might this affect its response to rising cost-push inflation? What about rising demand-pull inflation?
  4. Distinguish between a rise in the level of consumer prices and a rise in the rate of consumer price inflation.
  5. Describe the likely impact of an increase in the standard rate of VAT on the average consumer price level and on the annual rate of consumer price inflation both in the short term and in the longer term.