Price Stabilization Policy in a Modern Economy with Reference to the UK - Literature review Example

Price stabilization policy in a modern economy: with reference to UK 3. Literature review Currently available literature on the of price stabilization policy in a modern economy has both a theoretical approach and a broader empirical approach. Price stabilization policy refers to a government macroeconomic strategy designed and executed by the central bank to ensure stable economic growth based primarily on stable prices and lower unemployment levels. This is a contingency macroeconomic model that presupposes a smoothing out effect on erratic fluctuations in aggregate supply1.The broader policy level approach includes monitoring and adjusting cyclical growth process and interest rates so that aggregate demand can be managed to achieve broader macroeconomic policy goals. The European Central Bank’s Governing Council defines price stability in terms of a quantitative approach as " a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%"2. Successive British governments in modern times, especially since Margaret Thatcher, have been actively seeking to achieve price stabilization with renewed interest in controlling inflation in the economy. As of consequence such policy measures necessarily have an extended impact on the level of unemployment too. Target rates of inflation and benchmark interest rates are all part and parcel of the policy package. With ever increasing international trade flows of goods and services due to globalization, governments and their central banks are determined to build up and maintain a competitive edge over other exporting countries. This is not possible in the absence of price stability. Theories concerning price stabilization policy are varied and complex. Thus this paper would essentially focus on those theoretical underpinnings and literature that basically determine the causal correlations and regressions between variables that immediately impact on the macroeconomic outcomes. It has been a long held belief among economists that stable prices and moderate but steady economic growth rates are what needed for long term prosperity. Thus the following theoretical approaches are of great importance in this respect. 3.1. Theoretical approaches on price stabilization policy 3.1.A. The Quantity Theory of Money The quantity theory of money as enunciated by Irving Fisher3 has been variously interpreted by analysts to build up a theoretical approach to understanding the correlation between interest rates and inflation or price level. The following definition is often used by economists to discuss its various properties and their regressive behaviour. Where M stands for the total amount of money in circulation; VT is the money velocity of transactions; and Pi and qi are the price and the quantity of the ith transaction. This equation has been simplified by economists to suit their interpretations as follows. Thus it is an identity rather than an equation. Therefore it can be interpreted as “the amount of money multiplied by its velocity, is equal to the average price level multiplied by the number of transactions per period”4. 3.1.B. Wicksell’s Cumulative Process or the Natural Interest Rate Hypothesis Next Wicksell’s cumulative process5 based on interest rates shows how to achieve price stability and it has been favoured in general by central banks and monetary authorities as of recently because it’s practically sound as against the quantity theory of money. Its theoretical foundation depends on the principle that “the demand for financial use of money is solely determined by the difference between the money rate of interest and the natural rate of interest6. Assuming that the natural rate is greater than the money rate, i.e. r ˃ i, then the marginal rate of return on capital is greater than the cost of capital. Thus the argument is in favour of borrowing funds from banks to invest in high yielding capital. In other words investment expenditure will exceed savings in a given period of time. Should this proposition hold true, money supply would rise proportionately given the banks’ money creation efforts. 3.1.C. Buffer Stocks Theory Next price stabilization theory is connected with buffer stocks policy. Buffer stocks are maintained by authorities with a view to controlling prices7 As the following pair of diagrams illustrates the buffer stock maintenance is required when price instability occurs against the backdrop of a shift in demand. When the demand curve shifts downwards thus reducing the quantity sold to the difference between q2 and q4, the price remains at P*. Irrespective of to which side the demand curve shifts, i.e. to the right or the left, producers are more likely to get P*Q* as the buffer stock scheme comes into effect. The net outcome is determined by price stabilization along with some revenue stabilization as well. However, let’s assume that PQ* is less than P1 Q1+ P2 Q2 2 The net result will be a fall in revenue for producers. Buffer stocks can be more accurately explained with reference to supply shifts rather than demand shifts. Both consumers and Figure 3.1.C.a producers respond to price changes in a less predictable pattern of behaviour. Yet different elasticities can be determined through an examination of percentage changes in quantities demanded and supplied. Thus the theoretical postulates on price stabilization policy concerns different elasticities of supply and much less different elasticities of demand. For instance the price elasticity of demand or supply for a product is shown by the change in the percentage of the quantity demanded or supplied respectively. Assuming a greater percentage change in the quantity in response to a lower percentage change in price of the product, it’s said that elasticity is greater than one. Thus the geometric indication is that the particular range of the curve shows the degree of price elasticity relevant to that price change. Next there is price and income stabilization policy in which incomes are sought to be stabilized just with a view to controlling prices. The national minimum wage policy is part and parcel of this strategy of the central bank. The ECB also tentatively supports such attempts by central banks of member countries though such national efforts have been rendered less relevant and impacting in the wake of EU monetary union. However, Britain is not yet a member country of the monetary union. Finally there is the futures market price stabilization policy which assumes very little significance in the current context of analysis. Therefore these last two theories are beyond the remit of this paper and hence would not be referred to hereinafter. 3.2. Analysis The quantity theory of money has received marginal adoption by the British monetary authorities, i.e. the Bank of England, as of recently in their efforts to stabilize prices. Though the British monetary authorities partially depend on the ECB’s price stability approach, its current emphasis is rather on the Wicksell’s cumulative process. The target rate of inflation adopted by the Bank of England is 2.5% which seems to be a fair enough target within the achievable range. The quantity theory of money was presumably given a place of importance under the Thatcher’s Government. But nevertheless by now its relative significance has waned though a thorough analysis of it here is essential for a comparative understanding of the other theories. According to Fisher V and T are relatively constant and thus any change in the other two variables, M and P, would be directly proportionate to the first two. Fisher placed too much of emphasis on P (Price level) rather than M (Money supply). As a result the quantity theory of money fails to take into account the changes in the business cycle8. The principal defects in this theoretical approach to price stabilization are based on its hypotheses. In the first place money supply (M) is assumed to be an exogenous factor. Thus, secondly the money supply growth decides the source of inflation. Next demand for money is a volatility-free function of nominal income, rates of interest and so on. It’s the productivity and price of capital among other things that determine real interest rates. During the 1980’s and 1990’s governments and monetary authorities began to realize the real significance of financial intermediation instead of money supply. As a result there was an ever increasing doubt about the efficacy of controlling money supply in order to achieve price stability. Since the theory assumes that an expansion in money supply would cause nothing but price inflation, it is open to doubt if it’s the reality. Here Say’s Law is used by economists to argue that aggregate supply matters much more than price inflation in the economy. If real output does not increase to offset that money inflation the economy moves into imbalance, thus causing price instability. As to the question how an equilibrium occurs with MV = PT, Fisher gives a very simplistic answer. According to him if T/V remain constant against a rise in M, then M/P ˃ T/V. In other words money supply exceeds the demand for money. What follows is a still more simplistic explanation. People with excess money in their hands would now demand seek to replace it with goods, thus causing a further rise in P. This will cause a fall in the real value of money supply to match the real money demand, i.e. T/V. There is equilibrium. The following regression analysis is based on a data set obtained from the Indian economy. The focus here is on narrow money supply and broad money supply has been avoided because its impact is much less obvious. Table 1: Price changes estimated with reference to income and money in the Indian economy from 1960 to 1999     Y(R) M1 P. Index INT Series 1 Mean -0.73 0.84       Max -0.30 1. 00       Min -1.10 0.65       SD 0.27 0.12     Series 2 Mean -0.81 0.88   0. 00   Max -0.39 1.04   0. 00   Min -1.18 0.69   -0.01   SD 0.26 0.12   0. 00 Series 3 Mean -0.69 0.83 0.01     Max -0.10 1. 00 0.12     Min -1.10 0.57 0. 00     SD 0.32 0.14 0.04   Series 4 Mean -0.76 0.85 0. 00 0. 00   Max -0.14 1.03 0.01 0. 00   Min -1.18 0.59 0. 00 -0.01   SD -0.33 0.14 0.01 0. 00 Roll-over regressions in this sample begin with the period 1966-67 to 1998-99. Thus the second regression is from 1967-68 to 1998-99; the third is from 1968-69 to 1998-99; and the fourth is from 1969-70 to 1998-99. The four variables used are real income, narrow money, price index and interest rate. There are 20 regressions altogether in this example. In the first series income and narrow money are used as independent variables. Thus we have the following results for the first series. The mean of the income coefficient is -0.73, standard deviation is 0.27 and the range from min. -1.10 to max. 0.30. The mean of the money co-efficient is 0.84. (See Appendix 1 for data). The results clearly demonstrate the current belief that narrow money, as against broad money has a greater impact on the price level and therefore price stabilization policies of monetary authorities are influenced by it. The recent focus of attention on price level targeting instead of investment targeting by the Bank of England’s Monetary Policy Committee (MPC) in order to stabilize prices and control inflation has led to a reevaluation of the hitherto adopted monetary policy practices. In this latest effort the MPC has invariably adopted a policy of cutting the interest rate to achieve price stability goals with a much greater vigour than in the past9 This approach is in conformity with Wicksell’s natural interest rate hypothesis. Therefore what’s important to notice here is the fact that Wicksell’s theory is more suitable for price stabilization efforts of a variety of governments across the globe despite its initial shortcomings. According to Wicksell there is a tendency for the average price level in the economy to rise when the market rate of interest is below its natural rate and the opposite happens when the market rate rises above it. Fisher also acknowledged that Wicksell’s theoretical foundations on bank discount rates and prices were true. In the first instance prices, according to Wicksell, move in the direction of interest rates. Wickell held the view that classical quantity theory of money had some shortcomings in its explanation of changes in the general price level. He placed emphasis on interest rates instead of value, thus ignoring classical approach. However, Wicksell’s cumulative process was basically taken from the classical monetary analysis though the latter was not open-ended in its applications. As already illustrated above, Wicksell does not agree that investment expenditure is limited by savings. In fact he ignored the identity between I and S in the classical theory. But nevertheless it’s imperative that equilibrium in financial markets have to come through this equality. The goods market must eventually clear. That’s why Keynes had his multiplier10 which would clear the markets at both ends, i.e. demand and supply. Wicksell did not offer such a solution in his cumulative process of accounting for inflation though. However he referred to the banks’ reserve constraint as a self regulating mechanism11 Thus when the natural rate is greater than the money rate (r ˃ i), investment must be greater than savings (I ˃ S). This additional degree of investment demand in the economy would have its impact on the capital market. Let’s assume a level of full employment here. Naturally the additional demand for capital coming from investors cannot be met by the market. The additional demand pressure would force suppliers of capital to raise prices. This in turn sets off a spiral effect on the rest of the economy. Prices would rise indefinitely because investors are able to borrow from the banking system continuously. This will not be a difficult task as long as the natural rate of interest,(i.e. marginal product of capital) remains higher than the money rate of interest (i.e. the rate at which banks lend loans). This cumulative process will continue because demand for loans continues with banks creating money at a faster rate than savings are able to match. Thus this process will include markets for goods as well leading finally to a situation where a persistent rise in money supply would lead to a rise in the general price level in the economy. Next buffer stocks theory can be extended to include some theoretical arguments as follows. As the above diagrams show in the absence of a proper price stabilization policy, average revenues of producers would be given by the following equation. P2 Q2+P3 Q3 2 If the government were to introduce a stabilization policy the average revenues of producers would be given by, P* (Q1+Q4) 2 Price stabilization policy has effectively raised the revenues of producers but nevertheless when the supply curve alone happens to shift leaving the market demand curve intact, what would be the outcome? Naturally price stability in the market would increase the revenue fluctuations for producers as both the demand curve and the supply curve shift either way12 However, the final outcome depends on the relative shifts and the sizes of price elasticity of both. The British government has not been able to make use of a constant buffer stock policy due to two reasons. In the first place the operation of the EU’s Common Agricultural Policy (CAP) has not enabled the adoption of an independent buffer stock policy for the member governments. Despite this drawback still producers’ revenues in EU in general and Britain in particular had risen during the past two decades while the prices paid by consumers had risen substantially. EU subsidies under CAP basically ensure better prices for producers while for consumers they remain substantially higher. Secondly a buffer stock policy is perceived to be against the rules and regulations of the World Trade Organization (WTO). However still Britain has made use of market-based mechanisms to stabilize prices and successfully adopted farm income support schemes under CAP to achieve some stable prices in the economy thus effectively controlling its annual inflation rate around the target rate of 2.5%. 3.3. Critical analysis Price stabilization policy has been sometimes taken to mean undesirable government efforts that go against free market economic principles. This is because of the fact that any price stability attempt by the government finally leads to both a redistribution of income and a deliberate attempt to keep prices lower in the domestic markets so that exports would rise. While price stabilization is a macroeconomic concept there are some microeconomic supply-side elements as well. The quantity theory of money is a classical economic concept which has been used by neo-classical theorists to support monetarist approach to controlling inflation13 As already pointed out above Fisher’s equation is basically faulted by modern economists who believe that the equation is rather regressive in nature because it does not support a theoretically sound analysis on the basis of price level but places much emphasis on the money supply14 It also ignores the extraordinary role played by banks in creating money to increase business volumes. While money supply increases under pressure of aggregate demand, aggregate supply remains constant in the short run. However this pressure as shown by Wickshell must be transferred somewhere. Theoretically the quantity theory of money does not explain this proposition except to equate MV with PT. This shortcoming where it jumps from one problem to the next without adequately explaining first is regarded as the bane of it. The quantity theory of money has another shortcoming in the eyes of modern economists. For instance as it’s applied to stabilize prices in the economy, there is very little that it can do by way of laying a theoretical foundation for analysis. For example as Salvary suggests “if as posited that changes in the general level of prices are not a function of changes in the supply of money but of changes in the composition of aggregate demand and supply, then the money supply rule for monetary policy would be ineffective at best and disruptive at worst”15. Whatever the price stabilization principles derived from this theoretical structure, therefore, should have some shortcomings cannot be denied. Thus Salvary concludes that under the relative theory of money economic agents are better informed16. Quantity theory of money has very little to offer by way of information to economic agents to make decisions. However it must be said that the quantity theory of money has enabled economic agents to quantify monetary aggregates such as banks deposits and money stocks to arrive at informed conclusions about inflationary targets. The British monetary authorities have been aware of this particular advantage associated with this theory and therefore have partially adopted it in their price stabilization efforts. Wicksell’s cumulative process of inflation control has been a very dynamic theoretical postulate used by monetary authorities throughout the world in price stabilization efforts. Ranging from the Federal Reserve of America to China, Wicksell’s natural rate hypothesis has acquired a degree of critical appraisal in the light of recent developments in the sphere of financial intermediation, a process in which banks as financial intermediaries borrow from consumers or savers and lend to businesses or investors17 This new hypothesis has made use of Wicksell’s theory to enunciate a very radical approach to financial intermediation. For instance Wicksell’s argument that there must be a natural rate of interest around which the market rate would hover and finally would come to, is taken seriously by modern economists in their analyses of price stabilization. Thus it’s the natural rate that finally determines the equilibrium level of finances in the economy. Buffer stocks too have been made use of by government authorities to stabilize prices in the economy, though such efforts are basically limited to controlling prices of commodities. This paper essentially focuses on that aspect of buffer stocks to achieve what’s known in modern economics as stable prices of critically important commodities. For instance certain commodity prices would definitely have a universal impact on the economy as and when the final outcomes of such interventionist behaviour of the government unfold. Theoretically speaking such buffer stocks schemes enable monetary authorities to stabilize prices across a range of essential commodities to achieve macroeconomic objectives, including stable incomes for producers. However, such policies are actively discouraged under new WTO rules. REFERENCES 1. Athanasioua,G., Karafyllisb, I., and Kotsios, S. 2008, Price stabilization using buffer stocks, Journal of Economic Dynamics and Control, Vol. 32, Issue 4, pp.1212-1235 2. Blaug, M. 1997, Economic Theory in Retrospect 5th Edition, Cambridge University Press, Cambridge. 3. Coleman, W.O. 2002, Wicksells Cumulative Process, International Journal of Applied Economics and Econometrics, Vol. 10, pp. 165-184. 4. Dalziel, P. 2001, Money, Credit and Price Stability (Routledge International Studies in Money and Banking), Routledge, London. 5. Friedman, M. 1959, The Demand for Money: Some Theoretical and Empirical Results, Journal of Political Economy, Vol.67,pp.327-351. 6. Han, X. V.2004, Teaching money, prices, income, and the quantity theory of money.( Economics Economic Articles) , Journal of Economics and Economic Education Research, from, www.encyclopeda.com 7. Hartwig, J. 2004, Keynes’s Multiplier in a Two-Sectoral Framework, Journal Review of Political Economy, Vol.16,Issue3, pp309-334. 8. Haubrich, J. 1989, Financial Intermediation, Delegated Monitoring and Long Term Relationship, Journal of Banking and Finance, Vol.13, pp.3-20 9. Jappelli, T., Padula, M., & Pistaferri, L. 2008. A Direct Test of The Buffer-Stock Model of Saving, Journal of the European Economic Association, Vol. 6(6), pp. 1186-1210. 10. Kara, A. and Edward, E. 2003, The Exchange Rate and Inflation in the UK, Scottish Journal of Political Economy, Vol.50, pp.582-608. 11. Massel, B.F. 1969, Price Stabilization and Welfare, The quarterly Journal of Economics, Vol.83(2), pp.284-298. 12. www.ecb.int 13. Mises, L.V. 1971, The Theory of Money and Credit, 2nd Edition, Foundation for Economic Education, New York. 14. Reserve Bank of India, 2006, Handbook of monetary statistics of India, www.rbi.org 15. Salvary,S.C.W. 2008. Informedness of Economic Agents and the Quantity Theory of Money, Icfai University Journal of Monetary Economics, Vol. 0(1), pp. 61-85. 16. Svensson, L.E.O. 1999, Price –Level Targeting Versus Inflation Targeting: A Free Lunch, Journal of Money, Credit and Banking, Vol. 31(3)pp. 277-295. APEENDIX ONE Table: Selected statistics on Indian economy for the period 1960 to 1999 and used in the regression analysis of this paper. Source: Handbook of monetary statistics of India, www.rbi.org Read More