Economic Models - Convex Optimization

70 Andrew Hughes Hallet
have, therefore, been left to act passively through the automatic stabilizers,
which are part of any fiscal system, while the discretionary part (the bulk of
the policy measures) is set to achieve these long-term objectives. Monetary
policy, meanwhile, is left to take care of any short-run stabilization around
the cycle; that is, beyond what, predictably, would be done by the automatic
stabilizers. 1
To draw a sharp distinction between actively managed long-run policies,
and non-discretionary short-run stabilization efforts restricted to the
automatic stabilizers, is of course the strategic policy prescription of Taylor
(2000). Marrying this with an activist, monetary policy directed at cyclical
stabilization, but based on an independent Bank of England and a monetary
policy committee with the instrument (but not target) independence,
appears to have been the innovation in the UK policies. It implies a leadership
role for the fiscal policy, which allows both fiscal and monetary
policies to be better co-ordinated — but without either losing their ability
to act independently. 2
Thus, Britain appears to have adopted a Stackelberg solution, which lies
somewhere between the discretionary (but Pareto superior) co-operative
solution, and the inferior but independent (non-co-operative) solution, as
shown in Fig. 1. 3 Nonetheless, by forcing the focus onto long-run objectives,
to the exclusion of the short term, this set-up has imposed a degree of
pre-commitment (and potential for electoral punishment) on fiscal policy
because governments naturally wish to lead. But, the regime remains nonco-operative
so that there is no incentive to renege on earlier plans in the
1 The Treasury estimates that the automatic stabilizers will, in normal circumstances, stabilize
some 30% of the cycle; the remaining 70% being left to monetary policy (HM Treasury,
2003). The option to undertake discretionary stabilizing interventions is retained “for
exceptional circumstances” however. Nevertheless, the need for any such additional interventions
is unlikely: first, because of the effectiveness of the forward looking, symmetric
and an activist inflation targeting mechanism adopted by the Bank of England; and, second,
because the long-term expenditure (and tax) plans are deliberately constructed in nominal
terms so that they add to the stabilizing power of the automatic stabilizers in more serious
booms or slumps.
2 For details on how this leadership vs. stabilization assignment is intended to work, see HM
Treasury (2003) and Section 3 below. Australia and Sweden operate rather similar regimes.
3 Figure 1 is the standard representation of the outcomes of the different game theory equilibria
when the reaction functions form an acute angle. The latter is assured for our context
when both sets of policy makers have some interest in inflation control and output stabilization,
and the policy multipliers have the conventional signs (Hughes Hallett and Viegi,
2002). Stackelberg solutions, therefore, imply a degree of co-ordination in the outcomes,
relative to the non-co-operative (unco-ordinated) Nash solution.