Download The Debate over Monetary and Fiscal Policy

Chapter 14
The Debate over Monetary
and Fiscal Policy
The love of money is the root of all evil.
THE NEW TESTAMENT
Lack of money is the root of all evil.
GEORGE BERNARD SHAW
Outline
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Quantity theory of money
Monetarism
Fiscal policy revisited
Debate over fiscal and monetary policy
Velocity & Quantity Theory Of Money
• Velocity
– Speed at which money circulates
– Number of times per year an “average
dollar” is spent on goods & services
– Velocity = Nominal GDP / Money Stock
Nominal GDP
P Y
Velocity 

M
M
Money supply  Velocity  Nominal GDP
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Velocity & Quantity Theory Of Money
• Equation of Exchange
M V  P  Y
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Velocity & Quantity Theory Of Money
• Quantity theory of money
– Equation of exchange
– Economic model
– Changes in velocity – minor
• Velocity - constant
– Nominal GDP
• Proportional to money stock
%M  %V  %P  %Y
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Figure 1
Velocity of circulation for M1 and M2, 1929–2007
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Velocity & Quantity Theory Of Money
• Determinants of velocity
– Efficiency of payments system decreases
M, and hence increases v
• Financial innovation: credit card, …
• Computerization: online banking, …
– Interest rates (opportunity cost of holding
cash)
• Higher r → lower M, higher velocity
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Caveat for Fed Monetary Policy
• Fed – increase money supply (M↑)
– Interest rates – decrease
– Velocity – decrease
– M ˣ V increase < increase in M
– Fed should take into account the
change of v when conducts monetary
policy
Velocity & Quantity Theory Of Money
• Monetarism
– Start with equation of exchange
• Equation of exchange – growth rate form
%M  %V  %P  %Y
• Given ∆V, ∆M directly affects change in
nominal GDP ∆(PY)
• Keynesian approach: monetary policy
indirectly affect I through interest rate
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Monetarism
• In short-run, V and Y are constant
%M  %P
• Inflation is always a monetary phenomenon
Money supply and Inflation
Discussion
• Why the growth rate of M2 is always
higher than that of inflation?
(Monetarism predicts that they should
be same)
Fiscal Policy, Interest Rates, & Velocity
• Monetary policy
– Increase bank reserves & money supply
• Reduce interest rates
• Stimulates demand for investment
• Fiscal policy
– Increases in G or tax cuts
• Raise Y and P through multiplier effect
• PY↑ increases money demand
• Pushes up interest rates
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Fiscal Policy, Interest Rates, & Velocity
• Rise in G
– Pushes interest rates higher
• Deters some investment spending (“crowding-
out” effect)
• Increase in C + I + G + (X - IM) - smaller
• Oversimplified formula 1/(1-MPC)
– Overstates multiplier
1.Ignores variable imports
2.Ignores price-level changes
3.Ignores income tax
4.Ignores rising interest rates
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Fiscal Policy, Interest Rates, & Velocity
• Reduce budget deficit
– Contractionary fiscal policies
• Lower spending or higher taxes
– Reduce real interest rates
– Spur investment spending
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Debate: Fiscal or Monetary Policy?
• Which one is more powerful?
– Keynesian: fiscal policy
– Monetarist: monetary policy
• Which one works faster?
– Expenditure lag: fiscal policy is faster
• G or T affects AD more promptly
– Policy lag: monetary policy is shorter
• Made frequently (FOMC)
• Executed immediately (OMO)
• Fiscal policy has to go through annual
budget cycle
Debate: the Fed - Control M or r?
• Keynesian: Fed should use OMO to
control r
• Monetarist: control M since it is the major
driving force behind inflation
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Debate: the Fed - Control M or r?
• Fed cannot control both r and M
simultaneously
• Demand curve for money - shifts outward (by
expansionary fiscal policy)
– Rise in interest rates ( r)
– Rise in money stock (M)
– The Fed
• Keep M steady (use OMO sale)
– r - rises even more
• Keep r steady (use OMO purchase)
– M – rises even more
Figure 2
The Federal Reserve’s policy dilemma
M0
10%
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8
7
6
5
4
3
2
1
S
M1
For given Fed policy
Interest Rates
W
A
Z
E
M
0
Money demand shifts out
D0
D1
830 840 850
Money Supply (in billions of dollars)
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Debate: the Fed - Control M or r?
• Dilemma of monetary policy target
• Target money supply (M)
– Demand for money – variable
• Difficult
• Wide fluctuations in interest rates
• Target interest rates (r)
– Change money supply to stabilize r
• Destabilize economy (M↑ in boom, M↓ in
recession)
– AD↑ → Y and P↑ → Md↑ → r↑ → Fed has to
lower down r by using OMO purchase → M↑ →
AD↑
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Debate: the Fed - Control M or r?
• What has Fed really done?
– Post WWII – target interest rates
– 1960s – monetarism
• Interest rate pegging actually destabilize the
economy
• Should stabilize money supply growth rate
– 1979 – Volcker shifted the Fed target to
money stock growth
– 1982 – back to target interest rates
– 1993 – Greenspan confirmed that Fed
was no longer using M to guide policy
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Figure 3
The behavior of interest rates, 1979–1985
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Debate: Shape of Aggregate Supply Curve
• Aggregate supply curve – flat
– Large increase in output
– Little inflation
– Anti-recession policy - successful
– Restrictive stabilization policy - fighting
inflation by contracting AD – not effective
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Figure 4
Alternative views of the aggregate supply curve
Flat aggregate
supply curve
S
S
Steep aggregate
supply curve
Price level
Price level
S
S
Real GDP
(a)
Real GDP
(b)
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Figure 5
D0
D1
S
A
101
Rise in price
100
D0
D2
S
E
E
100
99
S
Rise in
output
0
Price Level
Price Level
Stabilization policy with a flat aggregate supply curve
6,000
D0
6,400
Real GDP
(a) Expansionary policy
Fall in price
B
S
D1
Fall in
output
0
D0
D2
5,600 6,000
Real GDP
(b) Contractionary policy
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Debate: Shape of Aggregate Supply Curve
• Aggregate supply curve – steep
– Small increase in output
– Great inflation
– Expansionary fiscal or monetary policy
• Great inflation
• Little change in GDP
– Contractionary policy – effective
• Decrease price level
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Figure 6
D0
D1
Price Level
Price Level
Stabilization policy, a steep aggregate supply curve
S
A
D0
S
D2
110
Rise in price
E
E
100
100
Fall in price
S
0
Rise in
output
D0
6,000 6,100
Real GDP
(a) Expansionary policy
D1
B
90
D2
S
D0
Fall in output
0
5,900 6,000
Real GDP
(b) Contractionary policy
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Debate: Shape of Aggregate Supply Curve
• Steepness of aggregate supply schedule
– Depends on time period
• Very short run – flat aggregate supply
– Workers cannot predict the inflation
accurately, real wage ↓, firms thus like to
expand the capacity
– Fluctuations in aggregate demand
• Large effects on output
• Minor effects on prices
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Debate: Shape of Aggregate S Curve
• Long run – steep aggregate supply
– Workers get enough information and
experience to predict the inflation, real
wage not eroded by P↑, firms thus
reluctant to increase production
– Changes in demand
• Affect prices, not output
Debate: Shape of Aggregate Supply Curve
• Any change in AD will have most of its
effect on output in the short run but on
prices in the long run
Debate: Should Government Intervene?
• Some economists (most liberal) advocate
active stabilization policy
– Policy has to be discretionary
– G↑ or T↓ or lower r when recessionary
gap, “lean against the wind”
– Reverse when inflationary gap
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Debate: Should Government Intervene?
• Stabilization policy
– Difficulties in forecasting demand
– Long lags
– May destabilize the economy
• Some economists (most conservative)
argue
– Natural self-correcting forces
– Automatic stabilizers
– Passive policy, adhere to fixed rules
Discussion
• Rule vs. Discretionary, which one do
you prefer?
Figure 7
A typical business cycle
Actual and Potential GDP
Potential GDP
E
D
Actual GDP
A
B
C
Time
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Rules-vs.-Discretion Debate
• Economy’s self-correcting mechanism
– If fast & efficient - No intervention
– If slow - Discretionary policy
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Lags in stabilization policy
Accuracy of economic forecasts
Size of government – bogus argument
Uncertainties - by government policy
Political business cycle
– Expansionary policy near election
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Rules-vs.-Discretion Debate
• Kydland & Prescott: “Time Inconsistency
Problem”
• Public observes policy-makers and forms
expectations of their likely actions.
• Policy-makers with discretion can renege
on today’s pronouncements tomorrow;
so, the public may come to discount such
pronouncements as cheap talk
• Rules produce time-consistent outcomes
because they make policy-makers’
pronouncements credible.
Summary
• Quantity Theory of Money: MV=PY
• Monetarism: inflation is always a
monetary phenomenon
• Debate over monetary and fiscal policy
– Should we reply on Mon or Fis policy?
– Should Fed control M or r?
– AS curve is flat or steep?
– Government intervention: rule vs.
discretion