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Transcript
Debate over Monetary Policy and Fiscal Policy Gene H Chang University of Toledo Econ 1150 Differences between Fiscal and Monetary Policies Effects on different economic variables Different impacts on the interest rate Time lags are different Differences Direct effects on different economic variables Look at AE = C + I + G + NX • Fiscal policy: on C, G • Monetary policy: on I Differences Different impacts on the interest rate • An expansionary fiscal policy causes the interest rate to go up • An expansionary monetary policy causes the interest rate to go down The different direction in interest rate will affect: • Investment • Exchange rate and net exports Time lags Proposing policy Policy lag Policy approved and implemented Action lag Impact on the economy Differences Time lags • Fiscal policy: long "policy lag" but "short action lag" • Monetary policy: short "policy lag" but long "action lag" Keynesian views Fiscal policy is more powerful: direct and more predictable Monetary policy is weak, especially in recession: • Liquidity trap • Investment is insensitive to interest rate • Effect of the monetary policy is indirect and less predictable Monetary School and Monetarism Challenge to the Keynesian view in 1960s and 1970s Monetary School and Monetarism Milton Friedman • July 31, 1912 – Nov. 16, 2006 • considered to have been one of the two most influential economists of the 20th century • Nobel Prize in Economics, 1976 Monetary School and Monetarism Equation of exchange M × V = P × Y • M = money stock or money supply • V = velocity • P = price • Y = real GDP • PxY = nominal GDP Monetary School and Monetarism Velocity • The speed at which money circulates in a year What affects V? • Interest rate • Payment frequency Monetary School and Monetarism Monetarists use the equation of exchange to explain the economy • The impact of an increase in M More direct impact • The impact of an increase in G Less direct impact Monetary School and Monetarism The impact of an increase in M MV = PY Ms increases M X V up P X Y up = nominal GDP go up P rises and/or Y rises Monetary School and Monetarism The impact of an increase in G MV = PY G increases Interest rate up V rises PxY goes up Prices up and/or Y up Monetary School and Monetarism Will price increase more or output increase more from an expansionary policy? depending on the shape of the aggregate supply (AS) curve From Equation of exchange M×V=P×Y %M + %V = %P + %Y Growth rate of money + growth rate of velocity = inflation rate + GDP growth rate Monetary School and Monetarism Growth rate of money + growth rate of velocity = inflation rate + GDP growth rate Exercise: what will be the inflation rate from a 10 percent growth in money supply? Monetary School and Monetarism Monetarism considers the fiscal policy is less powerful • Indirect impact • AS may be vertical • Crowding-out effect An increase in government spending crowds out the private investment. Monetary School and Monetarism Crowding-out effect • An increase in government spending crowds out the private investment. • G increases => AE goes up • Interest up • Private investment goes down => AE goes down Comments on Monetarism Keynesians would argue that monetarists may go too far What about crowd-in effect as the government spending takes the leading role Liquidity and interest rate trap AS may be horizontal in recession Milton Friedman Strongly advocating a free market economy, and a minimal role of government • “Free to choose” a best seller of nonfiction book Against government intervention and discretionary economic policies, • consider they will destabilize the economy Argued for a policy rule Policy rule Friedman argued for some policy rules: Constant money growth rate Says it will be automatic stabilizer Automatic Stabilizer Constant money growth rate • If the economy is overheating • So long as the money growth is constant • Interest rate will up • Then investment will down • Cool down the economy Automatic Stabilizer Stable income tax scheme • If the economy is overheating • Tax goes up • Consumption down • Cool down the economy Remarks on automatic stabilizer Does it work? In 1970s and early 1980s the Fed follows the constant money growth rule then the interest rate fluctuated greatly Caused a lot of pains to the economy So Fed returns to the previous practice to focus more on the interest rate stability Fed funds rate (interest rate) Remarks on monetarism Although not a main-stream, monetary school has made a great impact on economics thinking. Most economists are very much influenced by the monetarism We now also consider the importance of money