The previous chapter considered issues relating to the optimal time path of government debt. In this chapter, we consider the wider policy implications of the fact that the economy may be subject to large negative demand shocks, which may be so severe that even if the central bank reduces its policy rate by as much as is feasible, this is insufficient to restore a satisfactory level of output and employment.

The first set of policies considered below are policies that make the economy less likely to suffer such a demand shock; the second set of policies are policies to be pursued in “normal” times, which make it easier for the authorities to combat such a crisis, should it occur; and the third set of policies are those that might be pursued in the aftermath of a severe demand shock.

Policies to reduce the probability of a severe negative demand shock

Regulatory policies

It is undoubtedly the case that the main way in which a large negative demand shock may occur is through the financial system. The result of a financial crisis may be a severe contraction of lending by financial intermediaries, such as in the GFC of 2007–08. So better regulatory policies, which reduce the likelihood of a financial crisis, should reduce the chances of such a large negative shock to demand. It is scarcely a controversial statement to say that better regulation is needed – the crucial question is how this is to be achieved.

There have been major changes in the way regulation of the financial sector is carried out in most major economies. In the UK, the Financial Services Act of 2012 abolished the Financial Services Authority and established the Financial Policy Committee, the Prudential Regulatory Authority (both part of the Bank of England) and the Financial Conduct Authority (not part of the Bank of England). The Financial Services (Banking Reform) Act of 2013 implemented the recommendations of the Independent Commission on Banking, the main recommendation of which was that banks should “ring-fence” their retail banking divisions from their investment banking arms. The Bank of England is hence much more heavily involved in regulation and in particular there is much more of a focus on macro-prudential risks, which is what the Financial Policy Committee is charged with monitoring, than before the crisis.