Download Chapter 32 THE DEBATE OVER MONETARY POLICY

30
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
Contents
● Velocity and the Quantity Theory of Money
● Fiscal Policy, Interest Rates, and Velocity
● Debate: Should We Rely on Fiscal or
Monetary Policy?
● Debate: Should the Fed Control the Money
Supply or Interest Rates?
Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.
Contents
● Debate: The Shape of the Aggregate
Supply Curve
● Debate: Should the Government Intervene?
● Dimensions of the Rules-Versus-Discretion
Debate
Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.
Velocity and the Quantity
Theory of Money
● Velocity = number of times per year that
an “average dollar” is spent on goods and
services
♦ V = Nominal GDP  Money stock
♦ Equation of exchange: M V = P Y
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Velocity and the Quantity
Theory of Money
● The equation of exchange is simply an
accounting identity.
● If V were constant, the equation would
become a strict quantity theory of money.
♦  M   GDP
♦ Implies that Fed can control nominal GDP
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Velocity and the Quantity
Theory of Money
● In the United States, however, velocity is
not constant.
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30-1 Velocity of
Circulation, 1929-2001
3.0
V1
8.5
8.0
7.5
7.0
6.5
6.0
5.5
5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
2.5
V2
2.0
Velocity
Velocity
FIGURE
1.5
1.0
0.5
1930
1940
1950
1960 1970
Year
(a)
1980
1990
2001
0.0
1930
1940
1950
1960 1970
Year
(b)
1980
1990
2001
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Velocity and the Quantity
Theory of Money
● The Determinants of Velocity
♦ Frequency of cash infusions
♦ Efficiency of the payments system
♦ Interest rates
♦ Rate of inflation
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Velocity and the Quantity
Theory of Money
● The Determinants of Velocity
♦ Since these factors change over time, velocity
also changes.
♦ Only by studying the determinants of V can we
hope to predict the growth rate of nominal
GDP from knowledge of the growth rate of M.
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Velocity and the Quantity
Theory of Money
● Monetarism: The Quantity Theory
Modernized
♦ Monetarism = method of studying AD by
focusing on M and V, rather than on C, I, G and
(X - IM) as the Keynesians do
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Velocity and the Quantity
Theory of Money
● Monetarism: The Quantity Theory
Modernized
♦ When V is fairly constant, economists tend
toward monetarism.
♦ When V is erratic (as in recent years in the
United States), most economists abandon it.
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Fiscal Policy, Interest Rates,
and Velocity
● There is little real difference between
monetarist and Keynesian analysis.
● Fiscal policy can be analyzed through the
monetarist framework, just as well as
through the Keynesian, because of its effect
on V.
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Fiscal Policy, Interest Rates,
and Velocity
● G 
♦  money demand
♦  interest rates
♦V
♦  nominal GDP (equation of exchange)
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Fiscal Policy, Interest Rates,
and Velocity
● But some of the impact is “crowded out.”
♦  interest rates   investment
♦ So  GDP < amount the oversimplified
multiplier would predict
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30-2 The Federal
Reserve’s Policy Dilemma
FIGURE
10%
M0
M1
S
W
9
8
A
7
Interest Rate
For given
Fed policy
6
5
E
Z
4
Money
demand
shifts out
3
2
1
M
D0
D1
0
830 840 850
Money in Billions of Dollars
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Fiscal Policy, Interest Rates,
and Velocity
● Application: The Multiplier Formula
Revisited
♦ The oversimplified multiplier ignores:
■Variable imports
■Price-level changes
■Income tax
■The  interest rates that accompany any 
autonomous spending (and vice versa)
♦ All these factors   size of multiplier.
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Fiscal Policy, Interest Rates
and Velocity
● Application: Deficit Reduction and
Investment
♦ Contractionary fiscal policies ( T and/or  G)
  budget deficit
♦  deficit 
■ real interest rates
■ investment spending
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Debate: Should We Rely on
Fiscal or Monetary Policy?
● Fiscal policy affects the economy more
quickly.
● Monetary policy can be implemented more
quickly.
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Debate: Should We Rely on
Fiscal or Monetary Policy?
● Given the partisanship in Congress (where
fiscal policy is decided) and the
commitment in the 1990s to reduce the
federal deficit, monetary policy currently
appears to be the only game in town.
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Debate: Should Fed Control
Money Supply or Interest?
● When the demand for money is shifting, the
Fed cannot control both the money supply
and interest rates.
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Debate: Should Fed Control
Money Supply or Interest?
● Recent history shows the harmful effects of
focusing on one goal to the exclusion of the
other.
● In the 1990s, the demand for money has
been erratic, so the Fed has been eclectic.
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30-3 The Behavior of
Interest Rates, 1979-1985
Percent
FIGURE
21
20
19
18
17
16
15
14
13
12
11
10
9
8
7
6
5
0
Bank prime rate
3-month Treasury bills
1979
1980
1981
1982
1983
1984
1985
Year
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Debate: The Shape of the
Aggregate Supply Curve
● Flat AS curve  expansionary policy
♦  unemployment
● Steep AS curve  restrictive policy
♦  inflation
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30-4 Alternative Views of
the Aggregate Supply Curve
FIGURE
Flat aggregate
supply curve
S
Price Level
Price Level
S
Steep aggregate
supply curve
S
S
Real GDP
(a)
Real GDP
(b)
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Debate: The Shape of the
Aggregate Supply Curve
● The AS curve is fairly flat in the short run
and fairly steep in the long run.
● Effects of  AD
♦ On output in the short run
♦ On prices in the long run
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30-5 Stabilization Policy
with a Flat AS Curve
FIGURE
D1
D0
D2
A
101
Rise in price
100
99
Price Level
Price Level
D0
S
E
101
E
100
Fall in price
99
S
S
B
S
D0
Rise in output
6,000
6,400
D1
D2
D0
Fall in output
5,600
6,000
Real GDP
Real GDP
(a) Expansionary Policy
(b) Contractionary Policy
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30-6 Stabilization Policy
with a Steep AS Curve
FIGURE
D1
S
S
D0
D0
A
110
Rise in
price
E
D1
100
90
D0
S
Rise in
output
6,000 6,100
Real GDP
(a) Expansionary Policy
Price Level
Price Level
110
D2
E
100
Fall in
price
B
90
D0
S
Fall in
output
D2
5,900 6,000
Real GDP
(b) Contractionary Policy
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Debate: Should the
Government Intervene?
● The debate is partly political.
● It also depends on strictly economic
questions:
♦ How long are the lags?
♦ How effective are the automatic stabilizers?
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Debate: Should the
Government Intervene?
● Lags and the Rules-versus-Discretion
Debate
♦ Long lags  attempts at stabilizing the
economy can actually destabilize it
■How fast the economy’s self-correcting mechanism
works
■How long the lags in stabilization policy are
■How accurate economic forecasts are
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FIGURE
30-7 A Typical Business
Cycle
Potential GDP
Potential GDP
Actual and
E
D
Actual GDP
A
B
C
Time
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Debate: Should the
Government Intervene?
● Dimensions of the Rules-versus-Discretion
Debate
♦ Speed of the economy’s self-correcting
mechanism
♦ Length of lags in stabilization policy
♦ Accuracy of economic forecasts
♦ Size of government
♦ Uncertainties caused by government policy
♦ Political business cycle
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Dimensions of the RulesVersus-Discretion Debate
● The case for active discretionary policy is
strong when the economy has a serious
deficiency or excess of aggregate demand.
● However, advocates of fixed rules are right
that it is unwise to try to iron out every little
wiggle in the growth path of GDP.
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Dimensions of the RulesVersus-Discretion Debate
● No end is in sight for the rule-versusdiscretion debate.
♦ Differences in political and philosophical
beliefs
♦ Differences in economic analysis
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