This book is about the pillars of economic policy that you read about in an introductory macroeconomics textbook: monetary and fiscal policy. However, if you studied economics before the financial crisis. then the policy regimes described in the textbook may bear only a passing resemblance to the post-crash conduct of policy. A companion volume discusses the pillars of economic policy that have come to the attention of macroeconomists since the crash—but which up to that point were alien concepts to most—which can be broadly thought of as policies designed to restore or safeguard financial stability. In practice, even the post-crash treatment of these respective pillars of macroeconomic policy may only scratch the surface of what has been done.

Once upon a time the conduct of monetary policy was presented in terms of the central bank setting the quantity of money. Over time, this discussion was re-framed in terms of the central bank setting the price of money, although the precise details of how this was done might have been glossed over. The possibility that central banks might take official interest rates into negative territory, print money and purchase assets on an industrial scale or even contemplate helicopter drops of money would not have featured. Fiscal policy would likely have played a more minor role in that pre-crisis conversation about macroeconomic policy, with little more than a terse reference to taxes and non-descript ‘government spending’ influencing aggregate demand. That was not necessarily an oversight: arguably, discussion of fiscal policy belongs as much to the microeconomic realm as to the macroeconomic. However, with the coming of the crash, there was a renewed interest in using fiscal levers to achieve traditional macroeconomic goals (demand management).

The purpose of this book is to bridge the gap between the rudimentary coverage of conventional macroeconomic policy in that textbook or the baseline level of knowledge that many people who work in financial markets and beyond have acquired and the key debates in the policy world.

The section on monetary policy has two key objectives: to introduce the unconventional measures that central banks have deployed during the crisis and to explain the key issues in the policy debate that guided the use of these tools during this period. The names of those unconventional measures will already be familiar to most readers of this book: Quantitative Easing (QE), Negative Interest Rates and Forward Guidance. Likewise, the debates over the Productivity Puzzle, the Secular Stagnation and Good, Bad and Ugly Deflations may not be entirely new to those who regularly read the financial press. The purpose of this book is to place these tools and themes within a common framework, to shed some light on the conduct of policy during this period and to arrive at a more informed assessment of the future direction of monetary policy.

The second chapter deals with the conventional tool of monetary policy: interest rates. We begin by introducing the particular interest rate that central banks set, the mechanics of how policy is implemented and the monetary transmission mechanism which describes how the level of that interest rate impacts behaviour in the wider economy, enabling central banks to achieve their price stability goals. We then describe the asymmetric constraint on the conduct of monetary policy, ‘the lower bound’, which is the reason why we have seen so much innovation in the central bank’s toolkit since the crash. We review the initial dash towards that lower bound that took place in the opening act of the crisis and the reasons why different central banks stopped in different places, and then document the more recent decision to take official interest rates into negative territory. Finally, we evaluate the costs and benefits of negative interest rates as a tool and the case for resolving this problem of the lower bound once and for all.

The third chapter focuses on the key innovation in the toolbox since the crash: QE. We begin by outlining the reason why several central banks launched large-scale asset purchase programmes in the immediate aftermath of the crash before documenting the what, when, why and how of the Bank of England’s (BoE) QE programme. Different central banks have purchased different assets in different ways for different reasons since the crash, so we place QE in its proper context by presenting a taxonomy of central banks’ purchase programmes, identifying differences in size, scope and duration of those programmes according to the ultimate objective. We then address the fundamental concern of many commentators and discuss the theory and evidence on the transmission mechanism of QE. We then turn to the thorny issue of the distributional consequences of QE—the claim that it disproportionately benefits the wealthy—and end with a review of a controversial alternative to QE that has been proposed by a number of commentators: helicopter drops.

The fourth and fifth chapters focus on two key puzzles in the policy debate during the post-crash period: the surprising initial resilience of inflation and the puzzling weakness of productivity. It is impossible to understand the conduct of policy during this period without a proper understanding of these related issues.

Economic history and common sense suggested that the advanced economies were likely to slide into deflation in the depression that followed a systemic financial crisis, but this time it was different. This puzzle was particularly marked in the UK, where inflation was too high for much of the post-crisis period. Central bankers take it for granted that there is a reasonably stable relationship between the cyclical state of the economy and the extent of inflationary pressure, so the absence of deflation despite the collapse in demand prompted a bout of introspection about the state of the economy, the nature of this relationship between inflation and the state of the local economy and the influence of global demand conditions. In the fourth chapter, we review the various explanations for the puzzle and discuss possible consequences for the conduct of policy.

Macroeconomists spend remarkably little time thinking about the supply side of the economy given its central importance to our collective standard of living. Indeed, in the pre-crisis period, it was often implicitly assumed that productivity growth was exogenously given and constant. The financial crisis shook the profession out of that complacent attitude: the absence of deflation in the face of a collapse in demand implied that the supply side had been damaged by the crisis and the anaemic state of productivity during the recovery in the years that followed revealed that this scar to supply was proving painfully persistent. The level of activity is currently far below an extrapolation of its pre-crisis trend and shows little indication of returning to it in the near future. In the fifth chapter, we introduce a range of plausible explanations for this persistent hit to productivity and offer some thoughts on their relative role in accounting for the puzzle.

The sixth chapter focuses on the increasing importance that central banks attached to communication about the conduct of monetary policy during this period—or what is known as ‘forward guidance’. We begin with a review of the tradition of central banks’ communication and provide a useful framework for thinking about the nature of the information that central banks release. Next, we outline an influential academic proposal for a particular variant of forward guidance that in theory could be used to ease monetary conditions at the lower bound (i.e., as a substitute for asset purchases). We then review the BoE’s iterations of forward guidance before outlining an alternative, more comprehensive, approach to communication and then ending with a discussion of the role of communication in a crisis.

The seventh chapter introduces the conjunctural development that dominated the policy debate from late 2013 onwards. Having spent most of the post-crisis period defying economic gravity and the Bank’s 2 % target, UK inflation fell to earth and eventually into negative territory in early 2015. Two factors played a key role in driving the UK economy into deflation during this period: an appreciation in the value of the pound and a collapse in the price of oil. We review the transmission of these two shocks into consumer prices before turning to discuss the real issue that was raised by this brief run of near-zero and sub-zero inflation prints—the possibility that inflation expectations might be dislodged, leading to a more sustained period of low or no inflation.

In the eighth and final chapter of the section on monetary policy, we discuss the exit strategy from the lower bound. At the time of writing, Bank Rate was still at 0.5 %, more than seven years after the Monetary Policy Committee (MPC) had stopped cutting rates and despite a sustained recovery in output and employment, and seemingly at odds with the output of simple monetary policy rules. We discuss the tactical reasons why central bankers might choose to keep interest rates low for longer at (or near) the lower bound: from a traditional risk management approach; to a deliberate attempt to over-heat the economy in an attempt to heal the supply-side scars caused by the crisis; to concerns about the reputational damage in the event that the central bank has to reverse course and return to the lower bound. We then turn to more structural reasons for very low level of interest rates—often referred to as the Secular Stagnation. We distinguish between the various concepts of equilibrium interest rates, both nominal and real and short and long term, and introduce a number of explanations for the low level of rates. We conclude by noting how the Federal Reserve (Fed) and the BoE parted company at the end of 2015, with the Fed lifting off and the Old Lady hunkering down as the referendum on the UK’s continued membership of the European Union loomed into view.

The objective of the section on fiscal policy is to provide a framework for thinking about the central macroeconomic issue of the day: austerity. The financial crisis dealt a savage blow to the health of the public finances across many of the advanced economies. Deficits ballooned out and the debt stock was placed on a worrying trajectory even in countries where the burden of debt was still relatively low. But with the economy still in fragile shape, finance ministers faced a dilemma over the appropriate pace of deficit reduction: move too early and they might prolong the depression in activity; move too late and the stock of debt would grow ever larger and they may even struggle to continue funding that debt. A great deal has been said by macroeconomists on this question since the crash. This book does not attempt to resolve this issue decisively but it does try to systematically review the key issues in this debate.

The ninth chapter begins with the basics of fiscal arithmetic. We start with the facts of the deterioration in the public finances as the wheels fell off the Great Stability. We then turn to discuss cyclical influences on the health of the public finances, differentiating between the well-known impact of the business cycle on tax receipts and government spending and the less well-understood relationship between the financial cycle and the public finances. Next, we introduce the basic relationship which economists use to think about the dynamics of debt and the factors which dictate the primary surplus that finance ministers need to run if they wish to stabilise the burden of debt. Then, we step back to take a more comprehensive perspective on the state of the public finances before turning to discuss the pros and cons of the conventional approach to calibrating the pace of fiscal consolidation, so-called structural balance targeting. Finally, we end with a discussion of the stance of fiscal policy from a macroeconomic perspective and the inevitable interdependence with monetary policy.

The tenth chapter steps back and evaluates the objectives of fiscal policy. We begin with the stylised case for inaction on the part of government before turning to identify the traditional sources of market failure to build the case for government intervention. Although this book is about macroeconomics, we then take a brief detour into microeconomics to discuss the scale and source of the inequality problem and the literature on the trade-off between the pursuit of equity and efficiency. Next, we discuss what economics has to say about the objectives of the fiscal authority, distinguishing between the social planner seeking to maximise welfare and a politician seeking re-election. We then introduce the other key dimension of fiscal policy: the stability agenda, offering a broader perspective than just leaning against the business cycle. Finally, we pivot towards a key theme of the post-crash policy debate: structural policies.

The eleventh chapter reviews the traditional literature on the subject on which so much ink has been spilled: the fiscal multiplier. We start with the simple arguments that economists deploy to explain the efficacy of a fiscal stimulus and the concepts of crowding out that others use to query its macroeconomic impact. We then turn to discuss the more sophisticated literature on crowding out that introduces forward-looking households and endogenous private sector saving that can potentially neuter the impact of fiscal stimulus. We highlight the reasons why the extreme result in this literature—Ricardian Equivalence—does not hold in practice before introducing the possibility that fiscal policy can influence the supply side too. Finally, we review how the impact of fiscal stimulus might vary according to how it is implemented—that it makes a difference whether you increase spending on public sector pay, transfer payments or procurement of private sector output—before discussing the macro- and micro-econometric evidence on the impact of fiscal policy.

The twelfth chapter turns to the issue at the heart of the debate over the conduct of macro-policy since the crash: whether fiscal policy has any role to play in stabilising demand in the presence of an independent central bank using monetary levers to pursue its price stability mandate. We discuss the mechanics of monetary dominance, wherein central banks systematically neutralise the macroeconomic impact of fiscal stimulus, and then highlight the three situations in which this result will not hold: when there is a geographical mismatch between the focus of fiscal and monetary policy, when the central bank bows to political pressure and when monetary policy becomes ineffective. We then discuss whether the final scenario applied when interest rates hit the lower bound when central banks still had access to unconventional levers. Finally, we focus on a particular moment in early 2011 when some commentators were advocating a looser fiscal stance and argue that, based on the tone of the internal policy debate at the BoE, it seems likely that monetary dominance would have applied.

The thirteenth chapter turns to another key issue: the risk that over-indebted governments can face a crisis in financial markets. Potential creditors in financial markets will start to demand a higher return for lending money to weak governments and, at some point, the public finances become so frail that a government may face difficulties rolling over its debts. We begin with a review of what constitutes debt sustainability. We then develop a framework for thinking about how the interest rate that governments are obliged to pay to raise funds can vary according to the state of the public finances and financial markets. We introduce positive feedback mechanisms through which the initial impact of bad news on market conditions and the cost of debt are amplified, potentially to the point where funding markets effectively close. In particular, we highlight a critical source of amplification—the interplay between the health of the public finances and the banking sector—and the role it played in driving the sovereign crisis that unfolded in the Eurozone in the years that followed the financial crash.

The fourteenth chapter focuses on unconventional solutions to a debt problem. We begin with a claim that attracted a lot of attention as the era of austerity began: the idea that fiscal consolidation could paradoxically boost activity when the public finances are in a fragile state. We then turn to discuss the options that have been pursued in the past—inflating away debt, financial repression and restructuring debt—and highlight how none of these options are painless, in that someone ultimately pays the price of reducing the debt burden. Finally, given events on the Continent and the resolution of the Eurozone sovereign debt crisis, we review whether and how domestic and international institutions can rescue a sovereign engulfed in a fiscal crisis.

The fifteenth and final chapter focuses on the institutions of fiscal policy and the role they can play in preventing and resolving crises. We begin with the theory of political business cycles and the tendency of politicians to run deficits. We then turn to discuss the pre-crisis solution to this problem: fiscal rules. We review the literature on writing fiscal rules and evaluate how these rules have performed in practice. Then, we turn to the recent innovation in this area—the creation of fiscal councils—and end with an evaluation of the UK’s fiscal council: the Office for Budget Responsibility.