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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
PowerPoint Slides prepared by:
Andreea CHIRITESCU
Eastern Illinois University
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1
Velocity
• Velocity
– Number of times per year that an
“average dollar” is spent on goods and
services
– The ratio of nominal gross domestic
product (GDP) to the number of dollars in
the money stock
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
2
Velocity
• Nominal GDP
– Nominal gross domestic product
– Measure of money value of transactions
=Real GDP (Y) ᵡ price level (P)
Value of transactions
Velocity 

Money stock
Nominal GDP P  Y


M
M
Money supply  Velocity  Nominal GDP
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
3
Velocity
• Equation of exchange
– States that the money value of GDP
transactions
– Must be equal to the product of the
average stock of money times velocity
Money supply  Velocity = Nominal GDP
M V  P  Y
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
4
Quantity Theory Of Money
• Quantity theory of money
– Assumes that velocity is (approximately)
constant
• Nominal GDP is proportional to the money
stock
– Transforms the equation of exchange
• From an arithmetic identity into an economic
model
%M  %V  %P  %Y
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5
Velocity
• In real world
– Velocity is not a fixed number
• V1
– Velocity of M1 money supply
– Moves more erratically
• V2
– Velocity of M2 money supply
– Much more stable
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Figure 1
Velocity of Circulation, 1929–2010
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Velocity
• Some determinants of velocity
– Efficiency of payments system
• Funds move quickly in and out of M1 and M2
– Interest rates
• Opportunity cost of holding money
• Increase, velocity rises
• The Fed raises the money supply (M)
– M ˣ V increase by a smaller percentage
than M
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Velocity
• Monetarism
– Uses the equation of exchange
– To organize and analyze macroeconomic
data
• Monetarists
– Velocity changes are fairly predictable
– Equation of exchange in growth-rate form
%M  %V  %P  %Y
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Debate: The Fed – Unconventional
• Debate: should the Fed use
unconventional monetary policies?
• Conventional monetary policy
– Change the federal funds rate
• Down – boost the economy
• Up - to restrain the economy
– Open market operations
– Buy T-bills – to create bank reserves
– Sell T-bills – to destroy reserves
– Lends money to banks
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
10
Debate: The Fed – Unconventional
• Unconventional monetary policy
– Create bank reserves – buy
• Treasury bonds
• Private-sector assets, mortgage-backed
securities
– Lending massive amounts to banks
• And even to some nonbanks
– Emergency “rescue” operations for
troubled financial institutions
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
11
Debate: The Fed – Unconventional
• Why the extraordinary policies?
– Federal funds rate reached zero
– Two options
• Do nothing
• Try unconventional and unprecedented
policies
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Debate: The Fed – Unconventional
• 2009, FOMC – purchase over $1 trillion of
mortgage-backed securities (MBS)
– Buyer of last resort [of MBS]
• Sky high interest rates on MBS
– Interest rate spreads on MBS over Treasuries had
soared to extraordinary levels
– Intent: to raise MBS prices and lower their
yields
• Shrinking the risk spreads over Treasuries
– The Fed – turned a profit
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Debate: The Fed – Unconventional
• Why did the Fed take the risk of
purchasing MBS?
– Time was of the essence during the acute
stages of the crisis
– Only the central bank can serve as lender
of last resort
– The huge federal budget deficit
• Increasingly serious constraint on fiscal policy
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14
Debate: The Fed – Unconventional
• Critics of Fed’s unconventional policies
– Assuming authority that belongs to the
Congress and inserting itself into politics
• Decide which financial institutions would
survive and which would fail
– Tacitly appropriating taxpayer money
• Power reserved to Congress
• By putting its own money at risk
– Opening the door to future inflation
• By printing so much money
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
15
Debate: Fight Asset Price Bubbles?
• Debate: should policy makers fight
asset price bubbles?
• The Fed’s traditional answer: NO
– Identifying asset price bubbles before they
burst is a tricky business
– The Fed may not have any policy
instruments that it can aim directly at an
asset price bubble
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Debate: Fight Asset Price Bubbles?
• Rethinking the issue
– History: most harmful bubbles are those
that are financed by heavy borrowing and
extensive use of leverage
– Mitigate the consequences of bubbles
• Keep a watchful eye on bank lending
practices
• The Dodd-Frank Act of 2010
– Impossible to prevent bubbles
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Debate: Fiscal or Monetary Policy?
• Debate: should we rely on fiscal or
monetary policy?
• Lags in stabilization policy refer
– Delays between the time when the need
for stabilization policy arises
– And the time when the policy has its
actual effects on the economy
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Debate: Fiscal or Monetary Policy?
• Fiscal policy decisions
– Affects aggregate demand faster than
monetary policies
– Policy lags
• Study the economy
• Decide steps
• Then implement the decisions
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Debate: Fiscal or Monetary Policy?
• Monetary policy decisions
– Made frequently by FOMC
– Executed immediately
– Policy lags – shorter
• Old conventional wisdom
– Policy lags are normally much shorter for
monetary policy than for fiscal policy
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Debate: Fiscal or Monetary Policy?
• Questioning the conventional wisdom
– Speedy fiscal responses
• Congress can act quickly when it must
– Massive recessionary gap
• Developed starting in 2008
• We needed both fiscal and monetary policy
– Once the federal funds rate reaches zero
• Monetary policy faces special problems
• Can use some help from fiscal policy
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
21
Debate: Shape of the AS Curve
• Debate: the shape of the aggregate
supply curve
• Aggregate supply curve – quite flat
– Large increase in output can be achieved
with little inflation
– Antirecession policy - successful
– Restrictive stabilization policy – not
effective
• Small decrease in inflation with large
decrease in real GDP
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Figure 2
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)
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Figure 3
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
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Debate: Shape of AS Curve
• Aggregate supply curve – quite steep
– Prices respond strongly to changes in
output
– Expansionary fiscal or monetary policy
• Great inflation
• Little change in GDP
– Contractionary policy – effective
• Decrease price level
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Figure 4
D0
D1
Price Level
Price Level
Stabilization Policy with 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
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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Debate: Shape of AS Curve
• Steepness of aggregate supply schedule
– Depends on the time frame
• Very short run – flat aggregate supply
– Fluctuations in aggregate demand
• Large effects on output
• Minor effects on prices
• Long run – steep aggregate supply
– Changes in demand
• Affect prices, not output
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Debate: Government Intervention?
• Debate: should the government intervene
at all?
• Most fundamental and controversial
debate of all
– Is it likely that government policy can
stabilize the economy successfully?
– Or are even well-intentioned efforts likely
to do more harm than good?
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Debate: Government Intervention?
• Liberals
– More intervention-minded
– More favorably disposed toward an
activist stabilization policy
• Conservatives
– More inclined to keep the government’s
hands off the economy
– Favor adhering to fixed rules
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
29
Debate: Government Intervention?
• Critics of stabilization policy
– Lags and uncertainties - fiscal and
monetary policies
– Skepticism - ability to forecast the future
– Worry that stabilization policy may fail
– Advise: passive policies
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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30
Debate: Government Intervention?
• Advocates of active stabilization policies
– Perfection is unattainable
– More optimistic about the prospects for
success
– Much less optimistic about how smoothly
the economy would grow
– Advocate active policies
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31
Debate: Government Intervention?
• Lags and the Rules-versus-Discretion
Debate
• Lags
– Lead to a fundamental difficulty for
stabilization policy
– Attempts at stabilizing the economy may
actually succeed in destabilizing it
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32
Figure 5
A Typical Business Cycle
Actual and Potential GDP
Potential GDP
E
D
Actual GDP
A
B
C
Time
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33
Rules-vs.-Discretion Debate
• Dimensions of the rules-versus-discretion
debate
• Economy’s self-correcting mechanism
– If fast and efficient - No intervention
– If slow - Discretionary policy
• Lags in stabilization policy
– Long and unpredictable lags
– Short and reliable lags
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34
Rules-vs.-Discretion Debate
• Accuracy of economic forecasts
– Not terribly accurate
– Good enough for policy makers
• Discretionary stabilization policy to close
persistent and sizable gaps between actual
and potential GDP
• Size of government – bogus argument
– Active fiscal policy must inevitably lead to
a growing public sector
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35
Rules-vs.-Discretion Debate
• Uncertainties caused by government
policy
– Frequent changes – more difficult for
businesses
– Better for the economy
• Political business cycle
– Fiscal policy – by elected politicians
• Subject to “political manipulations”
– Monetary policy – by the Fed - apolitical
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