CROWDING OUT AND DIFFERENT SOURCES OF MONETARY EXPANSION IN THE U.K.*
| Author | ANDREW A. STEVENSON,TERRY MOODY |
| DOI | http://doi.org/10.1111/j.1468-0084.1980.mp42004004.x |
| Published date | 01 November 1980 |
| Date | 01 November 1980 |
CROWDING OUT AND DIFFERENT
SOURCES OF MONETARY EXPANSION
IN THE U.K.*
By ANDREW A. STEVENSON and TERRY MOODY
INTRODUCTION
In recent years the controversy between Monetarists and Keynesians has
centred on the issue of 'crowding out', i.e. the question of whether bond-financed
increases in government expenditure have a significant impact on real incme
and/or inflation, and, if so, for how long such effects persist. The Keynesian
position is that such expenditure has sufficient impact to make it important for
short-term stabilization policy, whereas Monetarists believe that any impact is
'certain to be temporary and likely to be minor'. {Friedman (1 972)}. The issue
has been debated both at a theoretical level {see, for example, Blinder and Solow
(1973), and Stein (ed.) (1976) } and by reference to empirical studies {see, for
example, Anderson and Jordan (1968), Andersen and Canson (1970), Artis and
Nobay (1971), Ando (1974), Modigliani and Ando (1976), and Stein (1976)} and has
come to be regarded as a cornerstone of the Monetarist controversy.
The tendency to focus on the crowding out issue is associated with recognition
in recent years of the importance of the government budget identity in relation to
monetary and fiscal policies {see, for example, Ott and Ott (1965), Christ (1968),
Silber (1970), Currie (1977) and Artis (1979) }. Once it is explicitly recognized that
a budget deficit (surplus) must necessarily be associated with an increase (decrease)
in the stock of high-powered money and/or of government bonds, then the clear-cut
dichotomy between fiscal policy and monetary policy becomes difficult to
maintain. Instead, it becomes clear that, for a Monetarist, so-called fiscal policy is
subsumed under monetary policy, being significant only to the extent that its
financing involves changes in the high-powered money stock, whereas a Keynesian
would judge the effects of monetary changes in terms of whether they are associated
with changes in the budget deficit and hence with fiscal policy.
Both would agree that a money-financed increase in the government deficit
unambiguously expands nominal incomeMonetarists because it expands the
money supply, Keynesians because of the monetary expansion plus the increase in
the deficit. Also, it is not denied by most Keynesians that monetary expansion
without an increased deficit may be expansionary to some extent. But Monetarists
would deny that an increased deficit without increased high-powered money could
expand income significantly. Hence it is this last case upon which it is convenient
to focus. The fact that in any given year government expenditure is not totally
financed by selling bonds does not render the crowding out issue irrelevant.
Although in what follows we shall concentrate initially on totally bond-financed
* We are indebted to our colleagues Gus O'Donnell and Mark Partridge for their very helpful
comments on earlier drafts of this paper. 345
346 BULLETIN
expenditure, the debate clearly has real world implications for the relative impacts
of different policy mixes.
The paper is in three sections. In section 1 we review the Keynesian position
on the crowding out debate; section 2 presents a simple model based on the IS-LM
framework incorporating a budget identity, whose reduced form suggests a possible
empirical test; and section 3 discusses further the problems of such empirical work
and presents some tentative results for the U.K.
SEcTIoN 1
In this section, we offer an interpretation of the Keynesian view on crowding
out. The conventional Keynesian model concentrates on the short run which may,
as we shall see, partly account for the neglect of the phenomenon of crowding out
in the less recent Keynesian literature. The Keynesian approach also assumes a
clear distinction between fiscal and monetary measures. However, once the
government budget identity is explicitly recognized, monetary and fiscal policies
can no longer be regarded as entirely independent, since fiscal deficits have to be
financed and hence they affect portfolios of money and financial assets, while
changes in high-powered money will, according to Keynesians, have different
consequences depending on whether they are associated with changes in the stock
of bonds outstanding (open-market operations) or with fiscal changes.
Bearing this in mind, the Keynesian position can be expressed briefly, in IS-LM
terms, as follows. If additional high-powered money is generated by, let us say, an
increase in government expenditure, the immediate impact on equilibrium income
can be illustrated by a rightward shift in both the IS and the LM curves. If, on the
other hand, the additional high-powered money is generated by government open-
market purchases of bonds, then the LM curve will shift to the right with no
corresponding shift in IS.
Thus, one can view the outcome of a bond-financed increase in government
expenditure as a combination of the expansionary effect of an increase in high-
powered money financing increased government spending, and the simultaneous
contractionary effect of an equal reduction in high-powered money through open-
market sales. The net outcome is that, due to the increased government spending,
the IS curve shifts to the right, but, because this is financed by selling bonds, the
money stock remains constant and there is no shift in LM. The only mechanisms
for crowding out here is that of so-called 'Hicksian' crowding out {see Modigliani
and Ando (1976, p. 24) } whereby the interest cost of mobilizing the idle balances
which are required to meet the increased demand for transactions balances chokes
off some private expenditure.
However, an important criticism of the account so far relates to its neglect of
wealth effects. If the addition of government bonds to private sector portfolios has
significant wealth effects on the demand for money, for example, then it is difficult
to deny the possibility, at least, of complete crowding out occurring in the long run.
The question of whether wealth effects results from bond-financed government
deficits is one of how far private sector transactors treat government bonds as net
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