Ec 111 week 3b(1)


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Ec 111 week 3b(1)

  1. 1. EC-111 British EconomyRecent UKMacroeconomic TrendsDr Catherine RobinsonF35, Richard Price BuildingOffice Hours: Mondays 10:30-11:30 and Thursdays 9.30-10.30Appointments: 3:21
  2. 2. Recapitulating yesterday... Thatcher came in… Adopted Medium Term Financial Strategies Followed a monetarist policy for the first of these The cost was unemployment and particularly hard hit wasthe manufacturing sector Reverted to a fixed exchange rate system withinEurope ERM Pegged to the DeutschmarkWeek 3:22
  3. 3. The exchange rate became thetarget Monetarism had pretty much failed Fiscal policy was seen as a short run instrument to balancethe budget No long term function of Keynesian times But what happened in the ERM? It was the ONLY external policy target and the interest rate was the only instrument Sterling was pegged too high By late 1992, sterling had been forced out of the ERM Sterling fell by 14% against the DM and 20% against the $ This all led to fear of inflation driven by higher import prices The resurgence of fiscal policy!Week 3:23
  4. 4. Pro-ERM case If UK inflation increased within a fixedexchange rate system, UK goods wouldbecome uncompetitive leading to a currentaccount deficit, which would tend to lead to anoverall balance of payments deficit. Then, either central bank intervention to buy £’s or rise in interest rates (to attract mobile capital)automatic tightening of monetary policy, andreduction of inflationary pressure.Week 3:24
  5. 5. Anti-ERM case If UK inflation increased within a fixedexchange rate system, investors wouldanticipate a rise in UK interest rates, andmove mobile capital into sterling, leading tocapital account surplus and thus either central bank intervention to sell £’s or cut in interest rates (to deter mobile capital) In both cases leading to a loosening ofmonetary policy, and acceleration of inflationarypressure.Week 3:25
  6. 6. MAIN SHORT RUN ECONOMICISSUE Would ERM membership be helpful or harmful inthe fight against inflation?Week 3:26
  7. 7.  The debate was really about whether the currentaccount or capital account (especially short run capitalmovements) adjustment tended to dominate. Current account dominance → ERM membershipwould be stabilizing. Capital account dominance → ERM membershipwould be destabilizing.Week 3:27
  8. 8.  In 1985, the anti-ERM faction (led by PM Thatcher)won the debate about membership, and the UKstayed out. But the pro-ERM faction (led by ChancellorLawson and Foreign Secretary Howe) continued toargue the case. By 1987, Lawson was running an unofficialstrategy of ‘shadowing the DM’ (intervening on thecurrency markets to keep the exchange rate withinthe range £1=DM2.80 to £1=DM3.00).Week 3:28
  9. 9. The evolution of Policy Meanwhile the economy was boomingunsustainably due to: Substantial income tax cuts (basic rate was cut from30% to 25% 1986-8), More financial deregulation, A housing market boom which increased consumerspending. Against this inflationarybackground, ‘shadowing the DM’ provided atest case for pro and anti-ERM arguments.Week 3:29
  10. 10. WHAT HAPPENED? Speculative pressure in favour of sterling (1987-8) Relaxation of monetary policy (cut interest rates) toprevent £ exceeding its upper limit leading to Sharply increased inflation.Week 3:210
  11. 11. WHAT HAPPENED?In Spring 1988: interest rates were increased sharply, ‘shadowing the DM’ was abandoned and £ rosesharply.Week 3:211
  12. 12. VALIDATION OF THE ANTI-ERMCASE? Perhaps, but pro-ERM faction argued shadowing failedbecause it had been attempted without convergencebetween UK and European economies.Week 3:212
  13. 13. The aftermath The collapse of the experiment in shadowing the DMdid not bring the boom conditions to an end at once. But the continued monetary squeeze eventually led toa fall in household spending. In 1990 the economy fell into another deeprecession, one led, most unusually, by a fall inconsumption.Week 3:213
  14. 14. The aftermath So independent discretionary monetary policy did notseem to be particularly happy either. Thoughts turned once again to attempts to choose anoutside anchor for UK monetary policy.Week 3:214
  15. 15. Trying Again John Major (new Chancellor) announced entry in Oct1990, still before convergence had been achieved. PM Thatcher was replaced by Major in Nov 1990. Entry at a central parity of £1=DM2.95 (with a 6%margin on either side permitted).Week 3:215
  16. 16. BACKGROUND TO ERMMEMBERSHIP By 1990, economy was in deep recession, due topolicy responses to the ‘Lawson Boom’. Underlying theme of the 2-year period of membership –conflict between: Need to cut interest rates (to combat recession), Need to maintain interest rates to prevent £ from falling.Week 3:216
  17. 17. THE EXPERIENCE OF ERM £ was below its ERM central parity (1991).Then a brief improvement, due to: Maastricht Treaty (Dec 1991) which gave atimetable for European Monetary Union (UK &Denmark could opt out), 4th Conservative election victory (April 1992). Then, a ‘No’ vote in Danish Maastrichtreferendum (June 1992) unsettled the currencymarkets.Week 3:217
  18. 18. THE EXPERIENCE OF ERM Speculation against £ (& the lire) increased(summer 1992). UK raised interest rates from 10% to 12%, then15%. But £ still fell below its lower ERM bound on‘Black Wednesday’ (Sept 16 1992). £3bn of foreign currency reserves were lost in theattempt to stay in the ERM. Summer 1993: further currency market turbulenceforced a widening of all ERM bands to 15% (muchlooser arrangement). So European monetary union was put on hold.Week 3:218
  19. 19. WHAT WENT WRONG? Weakness of the German economy in the early1990s, following monetary unification of West/EastGermany (July 1990). Guaranteed parity between DM and Ostmarks(public subsidy from west to east) meant that highinterest rates were required to curb inflationarypressure. High German interest rates attracted mobile capitalinto DM, away from currencies such as £. Downward pressure on £ implied that the UK hadto keep interest rates high, despite recession.Week 3:219
  20. 20. WHAT WENT WRONG? In effect this is a textbook’ argument against fixedexchange rates: a ‘shock’ affecting one country strains the entiresystem, forcing exchange rates apart. ERM crisis brought out a contradiction between theBundesbank’s duty to keep German inflation low, andits responsibility for stability of ERM.Week 3:220
  21. 21. WHAT WENT WRONG?Other factors included: The UKs parity was too high. At the time, £1=DM2.95 did not reflect true purchasing parities. Difficulties in establishing the credibility ofcommitment to ERM, due to the UK’s poor trackrecord, & anti-European rhetoric. No realignments within the ERM had taken placesince 1987, so pressures were building up anyway.Week 3:221
  22. 22. Effective Exchange RateSterling effective exchange rate 1975-2005, monthly average020406080100120140160Jan-75Jan-77Jan-79Jan-81Jan-83Jan-85Jan-87Jan-89Jan-91Jan-93Jan-95Jan-97Jan-99Jan-01Jan-03Jan-05monthexchangerateindexWeek 3:222
  23. 23. Base Ratesbase rates 1975-200502468101214161802/01/197502/01/197702/01/197902/01/198102/01/198302/01/198502/01/198702/01/198902/01/199102/01/199302/01/199502/01/199702/01/199902/01/200102/01/200302/01/2005dateratepercentWeek 3:223
  24. 24. DM/£ exchange RateDM/£ exchange rate 1975-20010123456Mar-75Mar-77Mar-79Mar-81Mar-83Mar-85Mar-87Mar-89Mar-91Mar-93Mar-95Mar-97Mar-99Mar-01datePriceof£inDMsWeek 3:224
  25. 25. MTFS 5: 1993-1996 POST ERM Shift in focus – to the domestic side of things Policy of debt sustainability Focus on the ratio of debt to GDP Should not be allowed to accelerate rapidly Loose fiscal policy This led to a need for tight monetary policy Long term aim of fiscal balance by 2000 Inflation targeting, but broad limits (1-4%) The ERM experience led the chancellor to focus on a widerrange of intermediate objectives and instruments A shift to more of a Theil-type approach to target setting Macroeconomic modelling became important againWeek 3:225
  26. 26. So now you know... A bit more about the Thatcher years and macropolicies.... The rise and fall of monetarism The role of exchange rates in controlling inflation The fundamental problems with exchange rate systemsWeek 3:226
  27. 27. Next Week.... The Blair years... Bank of England independence The emergence of ‘spin’ But what changed in terms of macro policy?Week 3:227
  28. 28. References Griffiths and Wall 9th edition, chapter 24 Managing theeconomy Also chapter on European Union and exchange ratesand trade performance(chapter 27 in 12th edition)Week 3:228