Money consists of two main elements.

Photo by thejonoakley on Flickr

The first is cash (notes and coins). The total amount of cash in the UK is just over £50bn, with about £43bn circulating outside the banks and £7bn in banks’ safes, tills and cash machines.

But cash is a relatively small proportion of the total amount of money. So what is the rest?

Read More: Where has all the money gone? John Sloman

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Increased public spending on incapacity benefits, health and pensions can all help the economy recover in a slowdown or recession. That is one of the findings of new research by Professors Julia Darby and Jacques Melitz presented at the Royal Economic Society’s 2008 annual conference.

In a slowdown some policies help the economy recover automatically. A recession increases the total amount spent on unemployment benefit (as more people are claiming it) and reduces the total tax take (as people’s tax bills drop). This helps to stimulate the economy without any active government intervention.

The report finds that these automatic stabilisers play an even greater role smoothing the business cycle than previously thought. This is because programmes such as incapacity benefit, pensions and health spending all act as such stabilisers as well.

In fact, active government intervention may even destabilise the economy if it doesn’t properly take account of these automatic effects.

These benefits are likely to help prevent recession as spending on each of them grows as a slowdown starts:

• Pensions: workers tend to retire at an earlier age in recessions and at a later age in booms. So pension payments are higher in recessions and lower in expansions. This is partly because employers encourage older workers to retire in recessions, as they are relatively more expensive to employ.
• Health spending: older workers are also likely to be those with bigger health problems. Those who retire earlier in recessions may have especially severe health problems. In addition, retired people have more time to devote to health care. So health spending may increase in a recession.
• Incapacity benefits: in the UK (among other countries), workers who are laid off in a recession and who qualify for incapacity benefit may turn to it instead of unemployment benefit. These have increased substantially over the last 25 years: total spending on such benefits is about 30% more than that on unemployment benefit across all developed countries.

These automatic stabilisers play an important role in stabilising economies in the OECD. For every pound reduction in output in a recession, it is generally thought that close to 50p flows right back to the private economy automatically through a fall in tax revenues and a rise in government spending.

This report shows that the contribution of government taxes and spending to automatic stabilisation is even higher than is generally thought. Significant contributions are also made through cyclical movements in retirement benefits, public health spending and invalidity benefits.

The contributions from these other sources of social spending are more than twice as high as those coming from unemployment compensation alone. As a result, following a fall of one pound in output, private income only goes down by 40p at most rather than by 50p on average.

This means that we tend to exaggerate the role of active fiscal policy in stabilising developed economies. The government gets too much credit for the automatic forces at work.

Moreover, we know from past studies that fiscal policy can sometimes destabilise the economy. During booms, this policy can occasionally overheat the economy by generating deficits. Based on their results, the researchers argue that such destabilising behaviour is actually even greater than previously thought since the behaviour was strong enough to overcome forces that now seem more powerful.

The study also has implications for the European Union’s Stability and Growth Pact. If automatic stabilisation is greater than generally believed, then staying within the 3% deficit limit is more difficult than previously thought during recessions. This may explain some of the difficulties that countries like France, Germany, Italy and Portugal have encountered in their efforts to meet the deficit ceilings in the last eight or nine years.

Notes for editors: Labour Market Adjustment, Social Spending and the Automatic Stabilisers in the OECD by Julia Darby and Jacques Melitz was presented at the Royal Economic Societyâ’s annual conference at the University of Warwick, 17-19 March 2008.

Julia Darby is at the University of Strathclyde. Jacques Melitz is at Heriot-Watt University.

For further information: contact Julia Darby on 07971 681210 (email: julia.darby@strath.ac.uk); Jacques Melitz on 0131 451 3626 or by email (J.Melitz@hw.ac.uk); or Romesh Vaitilingam on 07768 661095 (email: romesh@compuserve.com)

Read more research papers by Jacques Melitz at EconPapers. Intute: Social Sciences features more Internet resources on the topic of economics.

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Monetary policy-makers do not make minor adjustments to interest rates when inflation is close to the inflation target  but they do respond vigorously when inflation begins to move further from the target. That is the central argument of new research by Professors Christopher Martin and Costas Milas, presented to the Royal Economic Society’s 2007 annual conference at the University of Warwick.

UK interest rates were increased in January 2007 in response to an unexpectedly high jump in inflation, to 3%. The immediate danger of higher interest rates may have passed as inflation fell below 3% in February. But the Monetary Policy Committee is known to be concerned that oil and gas prices will lead to increased wage demands; and the Governor of the Bank of England has signalled willingness to act to avoid this.

This has led many commentators to expect higher interest rates this spring. The analysis of Martin and Milas suggests that this response could be stronger than many think: further, even small, rises in inflation are likely to trigger higher interest rates.

Interest rates are often constant for long periods of time. The Bank of England base rate did not change in 2002 or between the summer of 2004 and autumn 2005. This is puzzling. The Monetary Policy Committee of the Bank of England adjusts interest rates in order to keep inflation close to the target. In these periods, inflation changed, so why where interest rates kept constant?

The argument of this research builds on the opportunistic approach to monetary policy, an analysis of the behaviour of the Federal Reserve by the Fed’s own economists. The opportunistic approach suggests that interest rates remain constant so long as inflation remains within a zone of discretion around the inflation target but are adjusted when inflation moves outside the zone (the United States does not have an official inflation target, but most observers feel the Fed aims at an inflation rate of around 2%).

This approach implies that more traditional models of monetary policy, which assume that interest rates respond proportionately to all movements in the inflation rate are wrong; they over-predict interest rate changes when inflation is close to the target and under-estimate changes when inflation is further away.

Martin and Milas estimate various statistical models of interest rates and conclude that policy-makers in the United States do indeed follow the opportunistic approach and that the traditional model is wrong. They argue that the width of the zone of discretion is 2%, so inflation is allowed to fluctuate within 1% either side of the inflation target without triggering an interest rate response. Once the zone is breached, however, the response of interest rates is stronger than previously thought.

What are the implications for the UK? The UK economy is similar to that of the United States and the UK has a similar policy-making structure. Therefore the opportunistic approach is likely to be equally applicable to the UK (other statistical analysis by Martin and Milas confirms this).

This is the likely explanation of the long periods of static interest rates in recent years. This can also explain the large rapid changes in interest rate that have occurred in recent years, for example the fall of nearly 2.5 percentage points in 9 months in the late 1990s and the fall of 2 percentage points in 2001.

But there is one important difference between the UK and the United States, which is that UK policy-makers must write an open letter of explanation if inflation deviates from the target by more than 1%. The desire to avoid this suggests that the zone of discretion in the UK is narrower, less than the 2% zone estimated for the United States.

Notes for editors: Testing the Opportunistic Approach to Monetary Policy by Christopher Martin and Costas Milas was presented at the Royal Economic Society’s 2007 annual conference at the University of Warwick, 11-13 April.

Christopher Martin is at Brunel University. Costas Milas is at Keele University.

For further information: contact Romesh Vaitilingam on 07768-661095 (email: romesh@compuserve.com).

Find more papers by Christopher Martin and Costas Milas at EconPapers and search for more Internet resources on the topic of interest rates at Intute: Economics.

Much attention has been given in the press as to whether new MPC appointments are doves or hawks. But past work by Charles Bean now the Bank’s chief economist but then an LSE professor implied that, providing the Bank remains properly independent, we should not really worry. Both hawks and doves will normally make roughly the same decision and both are likely to serve society well.

The new study by Professor Vines and colleagues shows that this conclusion is only valid if policy-makers take a long-term view of the economy. Policy-makers who take a short-term view are much more likely to disagree and may not serve society well.

We know that the MPC cares about keeping inflation stable, but how much should it also care about stabilising unemployment? The Bank’s remit does not pin this down with any precision nor is it clear how it could. So how much the MPC cares about unemployment must depend largely on the preferences of its individual members. These preferences in large part determine the differences between doves and hawks.

The issue is this. When inflation rises above target, there is a real trade-off between the objectives of controlling inflation and controlling unemployment. How much unemployment is needed to get inflation down again? How can we know how the MPC will respond in such a situation given that we do not know how much it cares about unemployment? And will it respond in a way that is in the best interests of society?

Bean’s work suggests that our lack of knowledge is not a problem. This is because policy-makers with quite different ideas on the trade-off will actually choose fairly similar policies. The reason is that to get inflation down means restraining demand, with the regrettable consequence of unemployment.

If policy-makers whether hawks or doves take a long-term view then, Bean shows, they will agree among themselves as to how this trade-off should be managed. So long as their preferences fall into a broad range that can be described as reasonable, the outcomes of policy are not likely to be much altered as policy-makers come and go. And these outcomes are likely to be similar to the policy of an ideal policy-maker, one who cares about inflation-unemployment trade-off in exactly the right way.

The new study shows that this happy conclusion will not hold if policy-makers focus on the short-term outcomes of policy, rather than taking a long-term view. The reasons are subtle. Doves who take a short-term view will be likely to want less unemployment after an inflation shock, and to prefer a policy that would take longer to get inflation down. They would like to put off the necessary unemployment until the future, when as viewed from the present it will seem less costly. They want to have a good time now rather than high unemployment now, which would deliver low inflation in the future.

But paradoxically, hawks with short-term view are likely to want to do exactly the opposite. It may be possible to get inflation down very fast by having high unemployment now. This will be especially true if tight monetary policy now can cause exchange rate appreciation and enable lower inflation to be imported through cheaper import prices. Impatient hawks might be prepared to do this now, and then to deal with any problems caused by unwinding the currency appreciation in the future, when  as viewed from the present these problems will seem less costly. They too will want to have a good time now and that means getting inflation down now, without worrying about the future consequences.

We can thus see that there will be a problem if MPC members take a short-term view: the views of hawks and doves may come to differ significantly from each other, and from the ideal policy. In becoming more short-termist, the hawks and the doves will come to disagree much more strongly among themselves, and their desired policies may differ very significantly from ideal policy.

Professor David Vines comments:

It is important to stress that there is nothing in our work to suggest that members of the MPC have in fact taken a short-term view. Indeed, the widely perceived success of the MPC process would actually suggest otherwise.

But we believe that institutional arrangements that deter short-termism from arising in the future could be very worthwhile. For example, the term of service for a member of the MPC is currently only three years. This term is unlikely to safeguard against short-termism: it implies that the average MPC member has a remaining term of only 18 months. Our suggestion is that the terms of appointment to the MPC should be lengthened.

Notes for editors: The Effect of Discounting on Policy Choices in Inflation Targeting Regimes by Brian Henry, Mathan Satchi and David Vines is published in the January 2006 issue of the Economic Journal. The authors are at the University of Oxford.

For further information: contact RES Media Consultant Romesh Vaitilingam on 07768-661095 (email: romesh@compuserve.com)

Search Intute: Social Sciences for more web resources on the issues of inflation and monetary policy