Abstract
This Selected Issues paper analyzes the impact of globalization on United Kingdom’s inflation and relative prices over the last decade. The IMF’s Global Economy Model (GEM) is used to estimate the relative importance of the various factors argued to have influenced the evolution of inflation and relative prices over this period. The key result is the significantly different impact of the shock on relative prices in the United Kingdom compared with the United States and the Euro area.
IV. The Golden Rule and the Economic Cycle1
A. Introduction
1. Since its introduction in 1998, the golden rule has played a key role underpinning the U.K. fiscal framework. The golden rule stipulates that over the economic cycle, the government should borrow only to invest and not to fund current spending. More specifically, it requires the current budget to be in balance or surplus on average over the economic cycle. The rationale for focusing on the current budget is to protect investment spending, which is particularly important in the United Kingdom given significant infrastructure needs. The rationale for the “over the cycle” formulation is to allow automatic stabilizers to work without jeopardizing long-term fiscal sustainability. This formulation of the rule provides an ex-post test of whether the golden rule has been met. By identifying economic cycles and in turn the cyclical effects on public finances, it also aims to assess the underlying structural fiscal position.
2. While the golden rule is widely seen as having constrained discretion, the “over the cycle” formulation of the rule gives rise to two drawbacks. First, automatic stabilizers may not be allowed to operate fully, because procyclical fiscal tightening may be required toward the end of a cycle to ensure that the golden rule is met. Second, the ex-post test of fiscal performance requires precise dating of the economic cycle, which leads to controversy since alternative methodologies can yield significantly different interpretations of the cycle.
3. Against this background, the objective of this paper is to investigate an alternative modus operandi for the golden rule that would address both of these drawbacks. Specifically, the paper examines the merits of making the fiscal rule exclusively forward-looking and independent of the dating of the cycle by aiming for current balance or better over a rolling time horizon. An estimated simple open economy model of the U.K. economy is used to compare fiscal performance under different ways of implementing the golden rule. The paper focuses on the following three issues: How does the uncertainty associated with precise dating of the cycles affect the implementation of fiscal policy? How big is the risk of procyclicality in fiscal policy implementation? Are there other implications of having a forward-looking formulation?
B. Methodology
4. The paper estimates an open-economy “New Keynesian” model with rational expectations. Parameters in the model are estimated using the Bayesian technique for a sample period of 1992Q4-2006Q4. 2 The model is simulated under various stochastic shocks that fit the historical U.K. data. To evaluate performance of alternative specifications of the fiscal rule, simulations are conducted over 1000 draws that last for 100 quarters.
5. A similar approach to that used by the Treasury is adopted to define a cycle in terms of the crossing points between trend and actual output. To select only those “decisive” crossing points and exclude temporary movements around a zero output gap, four consecutive quarters of either a positive or negative output gap following a change in its sign are required in order to define crossing points. Applying this definition to the staff’s estimates of the U.K. output gap, three cycles can be identified during the period since the late 1970s. The chart below suggests that cycles have become shorter and their amplitude shallower over time. In the simulations conducted, the average cycle length is 27 quarters.
U.K. Past Cycles
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A004
U.K. Past Cycles
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A004
U.K. Past Cycles
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A004
Model-Generated Cycle Length
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A004
Model-Generated Cycle Length
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A004
Model-Generated Cycle Length
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A004
6. In the model, fiscal balances are determined by two components: automatic stabilizers and discretionary policy. Automatic stabilizers are computed using the same elasticities with respect to contemporaneous and lagged output gaps estimated by the Treasury in 2003.3 The discretionary component aims at achieving the fiscal rule, given the effects of automatic stabilizers.4 Fiscal policy decisions are made every four quarters and reflect updated macroeconomic forecasts.
7. Under the current formulation of the golden rule, discretionary policy is determined by the remaining length of the cycle, the cumulative balance since the beginning of the cycle, and the expected change in the cumulative balance till the end of the cycle. It is assumed that any adjustment required to achieve current balance or surplus over the economic cycle is introduced smoothly and gradually over the remainder of the cycle. To match the non-negativity constraint on the cumulative balance as required by the golden rule, the fiscal authorities are assumed to take the measures necessary to achieve cumulative balance over the cycle if they face a projected cumulative deficit. However, if the authorities face a projected cumulative surplus, then they are assumed not to “overspend” to offset the projected surplus.
8. Alternatively, the operational target of the golden rule could be changed from current balance or better “over the cycle” to aiming for current balance or better “at a 3-year ahead rolling horizon”. In this case, the discretionary component of fiscal policy is aimed at achieving current balance (or better) in 3 years. As in the “over the cycle” formulation, fiscal adjustments are introduced gradually. For example, if a fiscal deficit of 1 percent of GDP is projected in three years with no policy change, 1/3 of the needed fiscal adjustment is introduced in the first year. To allow for the non-negativity constraint, if the expected 3-year ahead fiscal balance is in surplus, fiscal policy is assumed to let the automatic stabilizers operate for one year until the fiscal projections are revised in light of new developments.
C. Simulation Results
9. The simulation results suggest a high degree of ex-ante uncertainty about the economic cycle, even though cycles are perfectly observable ex-post. For example, a cycle that is initially forecast to begin with a strong period of upswing can change its course to a downturn following adverse shocks to the economy. Also, during a cycle, as different shocks hit the economy, the projected end of the cycle may shift unexpectedly and continuously. In addition, depending on the relative size and the composition of the shocks, downswings and upswings can differ in terms of their intensity or duration.
10. The uncertainty about the end of the cycle has implications for achieving cumulative balance in the current formulation of the golden rule. Simulations suggestthat, under the “over the cycle” implementation of the golden rule, the 95 percent confidence interval for the cumulative balance at the end of the cycle is in the range of ±1 percent of GDP. This implies that the golden rule would be breached nearly half of the time. This is because sometimes cycles end unexpectedly before the required adjustment can occur. However the likelihood of missing by a large margin—defined as more than ½ percentage point of GDP—is only about 15 percent.
Cumulative Balance at the End of the Cycle
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A004
Cumulative Balance at the End of the Cycle
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A004
Cumulative Balance at the End of the Cycle
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A004
11. Thus, in the over-the-cycle formulation, there is an important risk that fiscal policy becomes procyclical toward the end of the cycle. In general, surpluses need to be accumulated during good times so as to compensate for deficits during bad times. However, if the projected end of the cycle is suddenly nearer, or if the downswings are longer or more intense than expected, achieving current balance or better over the cycle may require fiscal adjustment over a short period toward the end of the cycle. Simulation results suggest that, in trying to achieve current balance or better over the cycle, the risk of such procyclicality increases progressively as the cycle approaches the end. In particular, in about 12 percent of the simulated cycles, fiscal policy was procyclical during the entire last quarter of each cycle. In contrast, under the forward-looking 3-year rule, such risk is virtually zero. This is because early overperformance cannot be used to offset later underperformance.
The Risk of Procyclical Fiscal Policy 1/
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A004
1/ Procyclical by more than ½ percentage points of GDP for entire quartile.The Risk of Procyclical Fiscal Policy 1/
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A004
1/ Procyclical by more than ½ percentage points of GDP for entire quartile.The Risk of Procyclical Fiscal Policy 1/
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A004
1/ Procyclical by more than ½ percentage points of GDP for entire quartile.12. By reducing the risk of procyclical fiscal policy, the volatility of output and prices can be reduced. In general, automatic stabilizers play an important role in lowering macroeconomic volatility. Both the “over the cycle” and the forward-looking formulation add stability to economic activity. However, because fiscal policy under the “over the cycle” formulation could be sometimes procyclical toward the end of the cycle, the forward-looking formulation reduces the volatility of output and prices by about 5 to 7 percent.
Volatility (Standard Deviation)
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A004
Volatility (Standard Deviation)
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A004
Volatility (Standard Deviation)
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A004
13. Implementing the golden rule at a rolling horizon gets rid of procyclicality, but imposes a somewhat looser constraint on debt over any given cycle. With the “over the cycle” formulation, the 95 percent confidence interval for the cumulative balance (equivalent in the model to the debt-to-GDP ratio) over economic cycles is ±5 percentage points of GDP. In contrast, under the forward-looking formulation, the 95 percent confidence interval is slightly larger at ±7 percentage points of GDP.
Cumulative Balance over the Cycles 1/
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A004
1/ Defined as a change during the cycles.Cumulative Balance over the Cycles 1/
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A004
1/ Defined as a change during the cycles.Cumulative Balance over the Cycles 1/
Citation: IMF Staff Country Reports 2007, 090; 10.5089/9781451978438.002.A004
1/ Defined as a change during the cycles.14. These results—that a 3-year ahead formulation of the golden rule would tend to lower output and price volatility but raise debt volatility relative to an over–the–cycle formulation—are robust to different time horizons for the forward-looking formulation of the golden rule. A comparison of fiscal performance using a 2-year ahead and 5-year ahead rolling time horizons suggests that the volatility of output and prices remain broadly unchanged from the results under the 3-year time horizon. Ex-ante, the projected fiscal balance is different, as the two-year ahead rule aims at achieving current balance or better in two years, while the five-year rule would aim for five-year ahead. However, ex-post, the realized fiscal balances are broadly similar with some small differences in the cumulative balance over the cycle. The volatility in the cumulative balance over the cycle remains large.
15. The results presented in this paper are subject to a number of caveats. The model specification is simple and abstracts from other important issues in assessing fiscal policy. For example, the model does not explicitly take into account movements in asset prices. This may be particularly important for the United Kingdom given the increasing role the financial sector plays in economic activity. Also, while the simulations use estimated parameters and shocks that fit the historical U.K. data, the true parameters may be different going forward.
D. Concluding Remarks
16. The analysis presented in this paper suggests that there are pros and cons to a forward-looking formulation of the golden rule. On one hand, a forward-looking formulation would not require precise dating of the economic cycle and would enhance macroeconomic stability by reducing the risk of procyclical fiscal policy. On the other hand, a forward-looking formulation increases debt variability. In addition, the successful implementation of a forward-looking rule continues to depend on unbiased revenue projections. Otherwise, there is a risk that fiscal slippages could accumulate, increasing the debt burden. Indeed, as the forward-looking rule does not provide an ex-post test of fiscal performance, the need for unbiased ex-ante forecasts is arguably even more important.
References
Artis, M., 2002, “Dating the Business Cycle in Britain,” CGBCR Discussion Paper Series, available at http://www.ses.man.ac.U.K./cgbcr/discussi.htm
Berg, A., P. Karam, and D. Laxton, 2006, “Practical Model-Based Monetary Policy Analysis—How-To Guide,” IMF Working Paper 06/81 (Washington, D.C.: International Monetary Fund).
Emmerson, C., C. Frayne, and S. Love, 2004, “Updating the U.K.’s Code for Fiscal Stability,” IFS Working Paper 04/29.
HM Treasury, 1997, “Fiscal Policy: Lessons from the Last Economic Cycle”, available at http://www.hm-treasury.gov.U.K./mediastore/otherfiles/lessons.pdf.
HM Treasury, 1999, “Fiscal Policy: Public Finances and the Cycle,” available at http://www.hm-treasury.gov.uk/media/415/CB/cycles.pdf.
HM Treasury, 2003a, “End of Year Fiscal Report,” available at http://www.hm-treasury.gov.uk/media/324/70/end_of_year_352.pdf.
HM Treasury, 2003b, “Evidence on the UK Economic Cycle,” available at http://www.hm-treasury.gov.uk/media/2E6/A5/economic_cycles190705.pdf.
Honjo, K., and B. Hunt, 2006, “Stabilizing Inflation in Iceland”, IMF Working Paper 06/262 (Washington, D.C.: International Monetary Fund).
Koeva, P., 2003, “The Implementation of the Golden Rule,” IMF Country Report 05/81 (Washington, D.C.: International Monetary Fund).
Van den Nord, P., 2000, “The Size and Role of Automatic Fiscal Stabilizers in the 1990s and Beyond”, OECD Working Paper 230.
Prepared by Keiko Honjo. A more detailed version of this paper is forthcoming as an IMF Working Paper.
See (Berg and Laxton, 2006) and (Honjo and Hunt, 2006) for a detailed description of the basic model used.
The estimates based on the empirical analysis suggest that a 1 percent increase (decline) in output relative to trend reduces (increases) the elasticity of the current balance with respect to output is 0.7, of which 0.5 comes from contemporaneous and 0.2 from lagged output gaps. These coefficients are obtained by regressing spending and revenue ratios to GDP on estimates of contemporaneous and lagged output gaps.
Note that a positive (negative) gap in the fiscal balance implies a surplus (deficit).
