The Importance of Macroeconomic Frameworks for

Economic Stability

Dave Ramsden11 January 2006

2

Why does stability matter?

Higher living standards Higher economic growth via

Better resource allocation Decisions taken for the long-term Clearer relative price signals

3

UK has moved from one of the least stable to the most stable economy in the G7 and OECD

G7 OECD G7 OECD G7 OECD G7 OECDStability of real GDP growth

4 9 5 17 5 17 1 2

Stability of the output gap

4 10 7 23 5 10 1 1

Stability of inflation

6 18 5 17 7 20 1 1

1970s 1980s 1990-1997 1998-2004

4

GDP and inflation volatility in the G7 – 1997-2005

Germany

France

Japan

CanadaUSA

Italy

UK

0.5

1.0

1.5

2.0

0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

Inflation Volatility

GD

P G

row

th V

ola

tility

Low

er

GD

P g

row

th v

ola

tilit

y

Lower inflation volatility

Standard deviation

5

GDP growth has risen as GDP growth volatility has fallen

1960s

1997Q3-2005Q3

1980s

1970s1950s

1990-1997Q2

0.5

1.0

1.5

2.0

2.5

3.0

1.5 2.0 2.5 3.0 3.5

Average GDP growth

GD

P g

row

th v

ola

tilit

y

Low

er G

DP

gro

wth

vola

tility

Higher GDP growth

6

Both inflation and inflation volatility have fallen

1970s

1980s

1950s

1990-1997Q2

1960s1997Q3-2005Q3

0

1

2

3

4

5

6

7

0 2 4 6 8 10 12 14

Average Inflation

Inflatio

n v

ola

tilit

y

Low

er in

flatio

n v

ola

tility

Lower inflation

7

Why has UK stability improved?

• Key lesson from pre-1997 is the importance of having credible macroeconomic frameworks.

• Before 1997, macroeconomic policy was characterised by:

inappropriate objectives; poorly specified objectives; a failure to look forward; unclear and inconsistent roles and

responsibilities; and Politicisation of monetary policy decisions.

8

Principles of UK fiscal framework

Transparency in the setting of fiscal policy objectives

Stability in the fiscal policy process and in the way fiscal policy impacts on the economy;

 Responsibility in the management of the public finances;

Efficiency in the design and implementation of fiscal policy and in managing both sides of the public sector balance sheet; and

  Fairness, including between generations.

9

Fiscal rules

Golden rule: over the economic cycle, the Government

will borrow only to invest and not to fund current spending

Sustainable investment rule: public sector net debt as a % of GDP will

be held over the economic cycle at a stable and prudent level (40%)

10

Performance of fiscal framework - meeting the golden rule

-7

-6

-5

-4

-3

-2

-1

0

1

2

3

Average over 1986-87 to 1997-98 cycle Average over 1997-98 to 2008-09 cycle Current budget surplus

Per cent of GDP

Introduction of new fiscal framework Projections

11

Performance of fiscal framework – net debt

26

28

30

32

34

36

38

40

42

44

Public sector net debt

Per cent of GDP

Introduction of new fiscal framework Projections

12

Principles of UK monetary policy framework

Clear and precise objectives (a 2% annual rise in CPI inflation)

Full operational independence for the Bank of England’s Monetary Policy Committee (MPC)

Openness, transparency and accountability

Credibility and flexibility

13

Performance of monetary policy framework

0

1

2

3

4

5

6

7

8

9

10

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Per

cen

t

RPIX Inflation Expectations

RPIX Inflation

CPI Inflation

CPI Expectations

Introduction ofinflation targeting

Target range

Introduction of new framework

2.5% RPIX target

Introduction of new CPI target

2 per cent CPI target

14

Summary• Important to get the principles right in

macroeconomic policy frameworks.• Precise form of rules differs between

countries according to national circumstances

• Credibility is achieved by having rules underpinned by the right objectives and ensuring that the rules are met

• Credibility ensures that macroeconomic frameworks play a full role in contributing to stability.

15

Role of GES and HMT economists

• Macro stability also helps allocate resources within government

• GES - 900 economists working in 32 departments

• 100+ economists in HM Treasury – increasing proportion looking beyond macro policy.

Analyse evidence to inform policy Advise on choices & alternatives Make a difference on important issues

16

Role of OECD and EU

• Economies of scale• Learning from the experience of

other countries• OECD pioneers of micro peer

review• EU peer review, Lisbon Strategy