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The Policy Debate: Keynesians versus Monetarists Should the Government Intervene? Monetary or Fiscal Policy? Given that there is instability in aggregate demand, (i) Should the government intervene? (ii) When and how should monetary and/or fiscal policy be used? 7: A Typical Business Cycle Potential GDP E Potential GDP Actual and FIGURE D Actual GDP A B C Time Copyright © 2006 South-Western/Thomson Publishing. All rights reserved. Should the Government Intervene? Should policymakers follow “rules” or “discretion?” How long is the short run? Slope of AS curve and effect on Y and P. If AS curve is steep, then (i) Business cycles are less severe. (ii) Policies have smaller effects on economy. There is less need for government intervention. If AS curve is flatter, then (i) Business cycles are more severe. (ii) Policies will have greater effect on economy. Government policies can and should be used to stabilize economy Time lags involved with policies: (i) Recognition (ii) Appropriate policy? (iii) Implementation (iv) Response Policy lags imply monetary and fiscal policies can actually destabilize economy. Keynesian View: (1) AS curve is very flat in SR severe recessions and depressions. (2) Self-correcting forces are inadequate. (3) Rules are too rigid to be useful Monetarist (Classical) View: (1) AS curve is steep, even in short-run recessions will not be severe. (2) Self-correcting forces are sufficient to stabilize the economy. (3) Policy makers should follow “rules.” Discretionary policies do more harm than good. Monetary or Fiscal Policy? MONETARY POLICY The case for monetary policy: (1) Easy implementation (2) Interest rates respond very quickly to MS (3) Lower interest rates are an effective way to stimulate private spending and demand. The case against monetary policy: (1) MS also depends on other factors (banking system) which can be unpredictable. (2) Lower interest rates may be less effective if business or consumer confidence is low. (3) Increasing MS will ultimately lead to higher inflation. (4) Federal reserve officials are not accountable to public. FISCAL POLICY The case for fiscal policy: (1) Gov purchases has direct effect on aggregate demand. Worked for recovery from Great Depression! (2) Lower taxes increases disposable incomes and stimulates consumption. (3) Congress and President are responsible to the public. The case against fiscal policy: (1) Time lags from political process too long. (2) Big government leads to wasteful spending. (3) Tax cuts may be ineffective if business/consumer confidence is low. (4) Expansionary fiscal policy leads to large budget deficits. If government policies are necessary, which (monetary or fiscal) is better? Answer depends on the cause of recession: - If AD is low because consumers/businesses cannot find adequate low cost financing, monetary policy maybe better. - If AD is low because of low consumer/business confidence, then increasing G may be more effective. Monetary-Fiscal Mix: (i) 1979-80 Recession. (ii) 1992-96 Budget Deficits.