INFLATION—II Fiscal Policy And Monetary Policy

Press, Volume CIX, Issue 32302, 21 May 1970, Page 15

INFLATION—II Fiscal Policy And Monetary Policy

t>R MURIEL F. LLOYD PRICHAftt), associate-professor of economic history, Auckland UnwersityJ

The continuance of inflation and the inability on the part of the Government to halt it is tpday leading many people to question the accepted orthodox methods of combating it.

Formerly, following Keynes, fiscal policy was considered of paramount importance. The view was that prosperity could be promoted by increasing government expenditure and reducing taxes so that,purchasing power could be Increased and, conversely, an overheated economy could be satisfactorily dealt with by raising taxes and cutting government expenditure. In the former case, the supply of money would increase and the price of it or the interest rate would fall and in the latter case the supply of money would fall and interest rates would rise. Such, however, has not been the experience of the post-1945 world and indeed, according to some, it was never the case that fiscal policy by itself worked miracles. However, to take recent experience in the United Kingdom, there, as the “Economist” noted in its review of the current debate over money supply, tax Instruments have been used with little or no effect The members of the monetarist school in Chicago, led by Milton Friedman, say that polices of tax increases should never have been expected to work, certainly not on their own. They find little correlation between movements in tax policy and movements in a country’s money gross national product (money GNP equals rate of inflation plus rate of real growth).

>,rency in circulation with the ( Public and £12,929 million of bank deposits. This total was £986 million or 6* per cent greater than the total for 1967, in spite of the fact that in March 1968, the Chancellor of the Exchequer introduced a stringent domestic economic policy of increased taxes and restrictions on credit, including bank credit and hirepurchasing. People had money to spend. Consumer spending rose out of all proportion to productivity and the result was, as we have indicated, that money depreciated in value between 1967 and 1968 by 4.5 per cent. Now, why was money supply allowed to rise? The answer lies in the particular situation of the Bank of England vis-a’-vis the United Kingdom economy. The Bank of England could have prevented the rise in the money supply- if it had chosen to do so but what it chose to do instead was to supply whatever amount of money was necessary to stabilise the price of the public debt at the interest rates it considered necessary. It happened this way. With respect to currency notes in circulation, the Bank of England supplied notes in response to public demand. But the Bank is also responsible for the amount of commercial bank deposits. When the Bank of England buys a Government security in the market, it pays for this by writing out a cheque upon itself. By these means it influences the level of money supply because this cheque paid over to a commercial bank increases the deposit which the bank holds with the Bank of England. The commercial banks try to hold not less than 8 per cent of their assets in reserve as cash or balance with the Bank of England but if the Bank of England increases its purchases of government securities, the Bank increases total commercial bank deposits and increases thereby the commercial banks’ ability to lend and to a considerable degree.

“Led To Disaster”

The Bank of England making open-market purchases of securities was in fact observing two rules. According to

the Bank’s Quarterly Bulletin, the Bank authorities declared themselves “always prepared to deal in response to market offers at prices judged by them (1) to conform with the underlying trend of interest rates and (2) to be consistent with the underlying long-term objective of preserving market conditions favourable to maximum official sales of government debt. But according to tbe Friedman school, observance of these rules led to disaster. First, the Bank expressed itself as willing to buy or sell government securities at prices that conform to the underlying trend of interest rates. But interest rates will rise because of inflation as people try to protect themselves against the eroded value of money. Those who hold government securities become anxious to sell. The Bank of England steps in promptly to steady the market but by buying government securities it adds to the money supply, promotes inflation and interest rates rise again. The Bank then repeats the performance and the same sequence is repeated. Second, the Bank of England, by supporting government security prices at levels consistent with the underlying long-term objective of preserving market conditions favourable to maximum official sales of government debt prevents itself from restricting tbe money supply The Bank always tries to maintain the prices of government securities by buying whenever they show signs of falling in price. But by supporting prices with purchases financed by expanding the money supply, what actually happens is that the Bank adds to inflation which causes interest rates to rise, making people turn from government securities to other investments which appear more profitable. Thus, the ludicrous situatain developed in which the Bank of England expanded the commercial banks' credit base and then the Government tried to restrict consumption by tax increases and a cut-down of hire-purchase credit and bank credit The Chicago school view as expressed by Friedman was that the Government shut the stable door long after the horse had bolted.