An era of Monetarist Keynesianism?

How do we describe UK economic policy-making in 2015? Are we Monetarist, Keynesian, or some hybrid? Well, just as the Phillips Curve adapted by Friedman takes a Keynesian trade-off and adapts it, so it could be argued, modern policy makers take a monetarist idea of monetary fine tuning and adapt it for demand management.

The Government uses two direct policy instruments: interest rate adjustments and quantitative easing. The aim is to influence consumer spending, which is the biggest component of aggregate demand. Interest rates are the price of money (the cost of borrowing) and quantitative easing acts directly on the supply of money. So we have demand management by monetary instruments.

Remember that at the heart of monetarism is a hypothesis about the relationship between monetary growth and prices. It can be explained by reference to the Quantity Theory of Money. Central to this theory is an identity.

MV = PQ

Described another way, the quantity of money M in circulation multiplied by the velocity of circulation of money equals nominal GDP (which as we’ve seen on page 2, can be split into a price component P and a real GDP component, Q). So what do we make of the MPC dual targets of inflation and unemployment?

Unemployment corresponds to a level of GDP (output) given some level of factor productivity. The MPC believes therefore that if unemployment falls too far too fast, it will translate into an overheated economy where inflation starts to rise. Hence the emphasis on two targets – inflation is the monetary effect of overheating, where prices rather than real output rises. Unemployment is a useful indicator because it shows us the state of one key resource, labour, which is of course crucial to production, a real indicator.

The Bank then adjusts interest rates (via the MPC) according to demand conditions – keeping interest rates low if spare capacity exists and raising them as we approach full capacity to prevent overheating. Interest rates act on both consumers and producers. Consumers find the opportunity cost of consumption rises as interest rates rise – we give up more in lost interest to buy that TV. And producers find the cost of borrowing alters the marginal efficiency of investment – put simply, a higher return is needed to make the capital spending worth it.

And because two-thirds of us own houses, the majority with mortgages, interest rate rises feed directly through to consumer spending as more and more of our income goes into mortgage repayments (assuming we have variable rate mortgages).

Where does this leave the quantity theory identity above? Well you can target the left hand side of the equation (M) or you can target nominal GDP (PQ) and at the same time, try to tune the economy so that there is rather more Q than P – roughly speaking we are looking at 3.5% for real growth and 1.0% inflation forecasts for 2015 – a favourable P/Q split for long-term economic health.