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Lecture 16: Policy I – Controlling Business Cycles with Monetary and Fiscal Policy
How do you deal with problems of inflation, unemployment, and tax and
spending policies?
The Hypothetical Lake Pleasant Meetings
Once a year, the famous Lake Pleasant Resort is host to economists from all
over the world. Representatives from a variety of countries discuss their particular
economic problems and get advice from eminent economists from around the world.
This year, representatives from Upper, Middle, and Lower Bedrock are making the
presentations. At one time, the three countries were actually one, but split. Because of their common history, the countries are quite similar and indeed similar to
the United States.
Our Basic Model – Slightly Restated
This figure summarizes a slightly different way of stating the
basic model. The difference here is that the requirement that
the supply and demand for loans be in balance is replaced with
the requirement that aggregate supply and aggregate demand
be in balance. There is both a short run aggregate supply
curve and a long run aggregate supply curve. They intersect
at the expected price level.
Upper Bedrock
Upper Bedrock's real Gross Domestic Product (GDP) has been growing at
about 3 percent a year for some time. Unemployment equals the natural rate.
Alas, the money supply has been growing at 15% a year. As the quantity theory
predicts, the inflation rate is:
%Growth in Prices 
%Growth in the Money Supply - %Growth in Real GDP =
15% - 3% = 12%
The government wants to bring the inflation rate down, essentially to zero,
but it wants to keep the unemployment rate at the natural rate. Economists from
the Central Bank and the Ministry of Finance have assembled to discuss their options.
American economists recognize the Central Bank of Upper Bedrock as
roughly corresponding to the United States Federal Reserve System. The United
States splits the responsibilities of the Finance Ministry among the United States
Department of the Treasury, the Office of Management and Budget and the Council of Economic Advisors.
Why Worry
At this point, someone in the audience wondered why Upper Bedrock should
worry about inflation. He recalled Fisher's Law, which states that
rN  reR + e
When inflation was unexpected, a gainer matched each loser. Given that,
why go to the trouble of eliminating inflation, particularly when the data from other countries indicated that stopping inflation could be a painful task?
Recall the basic equation:
%Growth in Prices  %Growth in the Money Supply - %Growth in Real GDP
As we know the more imperfect is information, the harder it is to make correct decisions. Thus the greater the rate of inflation, the greater is the uncertainty in the
economy. By eliminating inflation, we must eliminate a source of uncertainty.
The Dilemma
The mechanics of ending inflation is not such a big deal. Every beginning
economics student knows the basic equation for inflation:
%Growth in Prices  %Growth in the Money Supply - %Growth in Real GDP
and that Upper Bedrock had gotten in this predicament by allowing the money
supply to grow at 15% per year. To get an inflation rate of zero, all the Central
Bank of Upper Bedrock need do is to cut the rate of growth of the money supply
from 15 percent a year to three percent a year.
The inflation rate has been 12 percent a year for so long that people are
clearly expecting a 12 percent inflation rate next year. The aggregate demand
curve and the short run aggregate supply curve will intersect the long run aggregate supply curve where the price level is 112 (or 112 percent of this year's price
level.). If the Central Bank only allows the money supply to grow by three percent,
the aggregate demand curve will shift down by 12%.
The concern is how people will react to the cut in the money supply growth
rate. There are two possibilities.

If people believe the government is serious about cutting the rate of
growth of the money supply the short run aggregate supply curve will
also shift down by 12%. The aggregate demand curve and the short
run aggregate supply curve will intersect along the long aggregate
supply curve, but with a price level of 100, the same as last years.

If people do not believe the government is serious about cutting the
rate of growth of the money supply the short run aggregate supply
curve will not shift down, and the intersection will occur below long
run aggregate supply. In short, there will be a recession.
Equilibrium in Upper Bedrock
with lower growth in the money supply if
the government is credible
ASLR
P
ASSR
112
ASSR
AD
100
AD'
Y
If the government cuts the rate of growth of the money supply
from 15 percent a year to 3 percent a year, the aggregate demand curve will shift down by 12% to AD'. If people believe
the government is serious about cutting the inflation rate, the
short run aggregate supply curve will also drop by 12%. The
new intersection will be at a price level of 100, but still at long
run aggregate supply. In short, prices will be stable and there
will be full employment.
Equilibrium in Upper Bedrock
with lower growth in the money supply if
the government is not credible
ASLR
P
ASSR
112
AD
100
AD'
Y
If the government cuts the rate of growth of the money supply
but has no credibility with the public, the short run aggregate
supply curve will not shift. The initial effect will be an intersection of aggregate supply and aggregate demand below long
run aggregate supply. Thus, there will be a recession. Of
course, with time, Lincoln's Law works and the economy will
move back to full employment. However, the recession can be
brutal.
Expectations in Upper Bedrock
There were several unsuccessful attempts to control inflation in the past.
As each of these programs began, the head of the Central Bank went on all the TV
talk shows and promised faithfully that he was serious about stopping inflation.
However, every time he announced a program to control inflation there were great
fears of a recession, and he ultimately backed away from the policy. By the end of
their terms, cartoonists were comparing the head of the Central Bank to Lucy, with
her annual ritual of faithfully promising Charlie Brown each fall that this time she
would positively hold the football. The public in Upper Bedrock was not so stupid
and had lost confidence.
In short, the new head of the central bank had a problem: credibility. No
one believes he is serious about reducing inflation. The public’s expectation of inflation will not change merely because he says that inflation will come down. The
short-run aggregate supply curve will stay put, and there will be a reduction in the
level of output.
In plain English, a cut in the inflation rate from 12 percent to zero percent a
year meant a recession.
Summary
What then should Upper Bedrock do?
Upper Bedrock could continue to accept the high inflation rate
It could accept the recession as the price of bringing price stability.
It could figure out some magical way of restoring their credibility.
Middle Bedrock
Middle Bedrock is in a recession, with the aggregate demand function intersecting the short run aggregate supply curve below long run aggregate supply.
Historically this has been due to monetary mismanagement, fiscal mismanagement, or the end of a war causing a significant reduction in military spending.
Four suggestions:

Increase the Money Supply

Increase Government Spending

Cut Taxes

Do nothing
Middle Bedrock's Dilemma
Middle Bedrock finds itself in a recession. The question of the
moment is how it should get out of this dilemma.
Increasing the Money Supply
If the aggregate demand curve is at AD, the economy can be brought back to
full employment by a judiciously increasing the money supply until the aggregate
demand curve shifts to the left to AD'.
Using Monetary Policy to Bring Middle Bedrock out
of its recession
Suppose the short run and long run aggregate supply curves
are ASSR and ASLR respectively, and that the aggregate demand curve is AD. In theory, Middle Bedrock can be brought
back to full employment by increasing the money supply
enough to shift the aggregate demand curve to AD'.
Impact on Interest Rates
From the Fisher's Law,
rN  reR + e
Changing the growth rate of the money supply could change expected inflation.
The public could view the increase in the money supply as inflationary and hence
change inflationary expectations.
Could the Central Bank change the real component?
Increase Government Spending or Cut Taxes
If the Government increases its spending, the G component of aggregate
demand, Y = C + I + G + (X-M) increases and the aggregate demand curve shifts to
the right. If spending is increased enough aggregate demand will shift to AD'.
The government can cut taxes. If it does so, people will have more income
and thus will increase consumption demand. The effect will be to increase the C
component of aggregate demand Y = C + I + G + (X-M). If taxes are decreased
enough aggregate demand will shift to AD'.
The Case for Activist Fiscal Policy
This graph shows the case for cutting taxes or increasing
spending to fight a recession. Suppose the long run and short
run aggregate supply curves and the aggregate demand curve
is as depicted. Then output will be less than long run aggregate supply. Economists favoring these policies argue that, by
use of tax cuts and spending increases, you can increase aggregate demand and thus push the economy back to full employment.
Other Options for the Government
 Middle Bedrock's problems could also be addressed by government
measures to stimulate investment demand.

The United States had also used a series of wage and price controls
to try to push down the short run aggregate demand curve.

Other nations had followed a policy of manipulating their international exchange rates as a means of encouraging exports and discouraging exports.
Do Nothing


Given time, the short run aggregate supply curve would rotate back
to the long run aggregate supply curve. As it does, the problem
would correct itself.
If the recession is due to inept government policies. The options of
increasing the money supply, cutting taxes or raising spending might
also prove to be inept.
Dissenting Views
Some may feel that the analysis and prescriptions do not apply to some recent experience. In the 1990's, Europe experienced a period of low growth. Pacific
Rim countries have undergone a significant recession in the 1990's. Russian GDP
declined sharply in the 1990’s. However, these recessions were quite different in
character.
The Soviet Union
Many economists had expected that the end of the Communist System
would bring a period of economic growth to Russia. In fact, the reverse happened.
By a number of measures, Russian GDP had fallen dramatically. At the same
time, Russia had suffered from a major inflationary period. In the 1980's, the Ruble was "officially" at par with the US dollar, but by 2000, had fallen to about
20,000 Rubles to the dollar.1 A lot of money was printed and it had not made the
situation better.
What was going on?
If the new Russian State had made a rapid move to adopt the basics of economic freedom – free markets, the rule of law and the like – the effect would have
During this period, the Russians had introduced a new ruble at the rate of one new ruble
for 1000 old rubles. Thus, the published exchange rates suggested only 20 rubles to the dollar.
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been to shift the aggregate supply curve to the right. Perhaps inflation was inevitable, but the standard of living would have improved. Certainly, the transition
would have been difficult and not as smooth as this simple graph suggests, but life
would have gotten better.
Alas, that is not what happened in Russia. Instead, the Yeltsin era brought
a complete collapse in basic institutions inside Russia. Corruption became endemic, as criminal syndicates known as the "Russian Mafia" arose. Tax policy became
quixotic, with the passage of new bizarre taxes collected on a haphazard basis.
Moreover, any passing thought of using Russian courts or administrative processes
to protect property rights was only that – just a passing thought.
At the same time, Russian Authorities speeded up the rate of growth of the
money supply. The effect is higher prices and lower output.
The Pacific Rim
During the 1980's and the early 1990's, a number of Asian countries (Thailand, South Korea, Taiwan, and Malaysia) had experienced rapid economic growth.
These countries were the "Poster Children" for the possibilities for nations adopting
pro-growth policies. The economies were essentially "open" economies, doing significant trading with the United States. They had pegged their currencies to the
American dollar.
In 1996, problems arose in Thailand. Its financial institutions had not kept
pace with its rapid economic development. Banks did not follow prudent business
practices; many corporations still borrowing money were essentially bankrupt. In
1996, both Thais and foreign investors lost confidence in the Thai economy in general and in the domestic Thai currency, the Baht.
An Increase in the Demand for Money
Lower Prices
Higher Prices
If money demand increases, the equilibrium price moves to a
higher level, 1/P1 instead of 1/Po, meaning a lower price level.
The Collapse of the Thai Economy
ASLR
ASSR
AD
AD'
Because so much of their trade and commerce was with the
United States, the real money in Thailand was the dollar, not
the Baht. The monetary panic caused an increased demand
for dollars, which caused the aggregate demand curve to shift
to the left. The effect was to reduce "the price level" and output fell as the economy moved along the short run aggregate
supply curve.
When the demand for the dollar rose in Thailand, Velocity fell. It took more dollars
to support the Thai economy. The consequence is that the aggregate demand curve
fell, or moved to the left.
The upshot was that Thailand went through a classic recession caused by a
movement along the short run aggregate supply curve, when we measure prices in
dollars. The price of goods in Thailand, measured in Dollars, fell.
At the same time, because people were trying to get out of Baht, the Bahtdollar exchange rate was changing dramatically.
What was Thailand to do?
The Thai government could do two things. First, it could turn to the International Monetary Fund for a loan of Dollars to increase the domestic supply of dollars and thus help shift the aggregate demand curve back to the right. Second, it
could begin fixing Thai monetary institutions to restore confidence in the Baht.
Summing Up
What should Middle Bedrock Do?
The right mix of Monetary and Fiscal policies is needed to combat their recession or simply wait it out.
The Recessions of the 1990's
These were surely "real business cycles ", caused my mismanagement of aggregate supply.
The Russians made fundamental mistakes with their economy. Once the
Communist system of central planning disappeared, they failed to implement a
market economy along with all of the legal protections a market economy required.
Thus, they had gotten the worst of all possible worlds: no central planning and no
incentives for individual entrepreneurship. It was high time for the Russians to get
their act together and begin market reforms.
Even more than in Thailand, Russians had lost confidence in the domestic
currency. In fact, the Russians also borrowed from the International Monetary
Fund to increase their supply of dollars. Much to the chagrin of the IMF, Russians
stole the $15 billion they borrowed. They had also defaulted on their international
debts, completely wrecking any credibility they had in international financial markets.
As to the Pacific Rim, the financial institutions failed. They needed to be
repaired. The Asian economies were coming out of their recessions. However, the
steam seems to have run out of their efforts to fix their financial institutions. The
consequences might be a recurrence of the problem at some time in the future.
Lower Bedrock – Domestic and International Policy Rules
Their inflation rate is quite low, and their unemployment rate is relatively
close to the natural rate. Thus, they had no short turn economic problems. However, the difference between Lower Bedrock and their neighbors was luck. They
want to focus on what kind of policy rules they should adopt to reduce the likelihood of having similar problems in the future.
Lower Bedrock had just selected a new head of its Central Bank, who faced
a number of problems:

Some of his advisors were arguing for a discretionary monetary policy, to keep aggregate demand and long run aggregate supply in Balance. Others were arguing against a discretionary monetary policy,
and instead for a non-intervention policy.

Questions had been raised about the actual status of the Central
Bank. Some were proposing that it be abolished or substantially restructured.

The Central Bank also had responsibility for international monetary
policy, and the head wanted to look at some options.
Domestic Monetary Policy
Thanks to new technology, capital accumulation and population growth, aggregate supply continues to grow each year in Lower Bedrock. In some years, aggregate demand would be less than aggregate supply; in yet other years aggregate
demand would be more than aggregate supply.
In the first case, the Central Bank can increase the money supply and move
the aggregate demand curve to the left. In the second case, it can decrease the
money supply and move the aggregate demand curve to the right.
Aggregate Supply and Demand out of Balance
P
ASLR
ASLR
ASSR
ASSR
AD
AD
Y
Y
Aggregate demand is less than aggregate supply. The unemployment
rate will be higher than the natural
rate
Aggregate demand is greater than
aggregate supply. The unemployment rate will be lower than the natural rate
This is essentially the policy followed in the United States by the Federal
Reserve System.

The Federal Reserve System is following a loose monetary policy if it increases the growth rate of the monetary base or some broader measure
such as M1 or M2. (Sometimes people talk about a loose monetary policy
as one that decreases the federal funds rate.)

The Federal Reserve System is following a tight monetary policy if it decreases the growth rate of the monetary base or some broader measure
such as M1 or M2. (Sometimes people talk about a tight monetary policy
as one that increases the federal funds rate.)
Policy Rules
The central bank has three choices



A Simple Policy Rule
A Discretionary Policy Rule
A Contingent Policy Rule
Simple Policy Rules
A simple rule, is something like:
Conduct open market operations so that M1 grows by five percent per year.
Another way of stating this rule is:
Adopt a long-term policy for the money supply. If it turns out that
aggregate demand and aggregate supply are not in balance,
wait for the normal adjustment policies to take effect.
Discretionary Monetary Policy Rules
In the United States, as in most major countries, its central bank, the Federal Reserve System, follows a very simple discretionary policy rule:
We will do what we think best. We will set monetary policy according
to "economic conditions"
The FOMC announces its decisions as they make them and gives an indication of the direction in which it is leaning. Thus it might say something like "we are
adopting a tight monetary policy, but we see no reason why it might become tighter
in the future" or perhaps "we are adopting a tight monetary policy and it is likely
that it will become tighter in the future".
Contingent Policy Rules
Under a contingent policy rule, the money supply varies depending on unemployment, inflation, or other economic variables. A very simple one would be
If the unemployment rate is between four and six percent, let the money supply grow at
3% per year. If the unemployment rate is above six percent, let the money supply grow
at 5% per year. If the unemployment rate is below four percent, let the money supply
grow at 1% per year.
This is not a good policy rule – in fact, it is a bad one – but it is a good illustration of a contingent policy rule.
Debates about monetary policy take up two issues:

Should the Central Bank do something or should it do nothing?

If the Central Bank is going to do something, should it follow a
discretionary policy or an automatic rule?
The case for doing nothing
Those advocating a non-intervention policy make several points points.
Lincoln's Law Works
The recession came about because of imperfect information. It is not that
people are stupid, but merely that people are fallible. Lincoln's Law tells us that
people do wise up.
Lags in discretionary policies
It takes time for discretionary policies to come into effect. There are two
kinds of lags in the effects of policies.

Lags in implementing policies because of lags in getting information
about the economy.

Lags in effects of discretionary policies.
Lack of Information
People do not always respond the same way to a change in economic conditions, and are conditioned on what they expect the government to do.
The case for a Policy Rule
The question is whether the economy is best served by discretionary intervention or by a contingent policy rule. Discretionary policy states that policy decisions should be made on all the information and any simple rule will fail to take
into account all information.
Policy Rules have their own benefits
A credible rule for actions can lead to better results than even the best actions chosen on a case-by-case (discretionary) basis. Rules that are announced in
advance and that are credible, that people believe the government will follow, can
produce better results than policies not based on rules, because credible rules
change peoples’ incentives, and decreases uncertainty about the economy. This allows people to make better decisions because they know what to expect.
Fiscal Policy
Two kinds of lags complicate fiscal policies – lags in implementing policies
and lags in the effects of fiscal policies.
Credible rules for fiscal policy can improve economic performance by changing people's incentives. The best tax and spending policies involve a good deal of
constancy.
Ricardian Equivalence
There is a controversy about whether tax cuts are of any value in fighting a
recession. Ricardian Equivalence states that the increase in the supply of loans
equals the increase in the demand for loans. If so, interest rates remain constant
and aggregate demand does not increase.
Impact on Aggregate Demand
The the view that there is no shift in aggregate demand, formally known as
Ricardian Equivalence, is highly controversial. Most economists do not believe in
Ricardian Equivalence. Partial Ricardian Equivalence, the view that the shift in
the supply of loans will offset the bulk of the increase in the demand for loans is
not controversial.
Summing Up
Discretionary fiscal policy is so cumbersome that any management of business cycles is best left to the Central Bank.
Restructuring the Central Bank
The Central Bank needs to be relatively independent of the government.
The data indicate that countries with independent monetary authorities have lower
inflation rates than countries without independent monetary authorities. Why?
When the elected government directly controls the monetary authority, the temptation to print money is hard to resist. Independent monetary authorities have more
credibility than political monetary authorities.
No Central Bank
In some sense, this idea has already come about. Major banks issue shortterm certificates of deposit that many corporations and money market funds hold
like money.
The drawback to this idea is that it might be very inefficient. If Americans
constantly had to compare how much a Key Bank dollar was worth in terms of
Bank One dollars, financial transactions would be quite complicated.
Relations to International Currencies
Lower Bedrock has a floating exchange rate, where the value of its currency,
the Pebble, fluctuates relative to the American dollar ($), the European Euro (€)
and the Japanese Yen (¥). The value of the Pebble is set each day by the laws of
supply and demand.
Many economists suggest that Lower Bedrock reconsider its monetary system. Some of the proposals on the table were

A return to the gold standard

A return to fixed exchange rates

Establish a Currency Board
Returning to the Gold Standard
The argument for the gold standard is a simple one. Under the Gold Standard, gold flows between countries would adjust the domestic price level in each
country. Deflation occurred in countries with less desirable goods by it spending its
gold to buy more desirable foreign goods, thereby decreasing the money supply.
There would be inflation in the country with the more desirable goods, since they
will be receiving gold from selling their goods to other countries and increasing the
money supply. Neither government had the power to set prices or the money supply.
As a practical matter, this gold standard is a major deterrent to inflation.
Governments abuse their control over the money supply and cause inflation. A return to the gold standard would end this problem. It would end all political control
over the money supply, and reduce the long run inflation rate.
However, while some economists argue for a return to the gold standard,
most disagree. Major discoveries of gold mean that the world gold supply increases, as does the price level. When there are no new gold discoveries, economic
growth usually means declining prices.
In sum, there is little reason to recommend a return to the Gold Standard. 2
The Case for a Fixed Exchange Rate
A fixed-rate system is much more convenient than a floating-rate system.
Because the exchange rate does not change every day, information costs are lower
and hence people can plan more easily, knowing what the exchange rate will be.
This helps to promote international trade. Under a floating exchange-rate system,
exchange rates change frequently. Speculation may cause changes in exchange
rates, and relative prices between domestic goods and imports. The resulting overvaluations or under-valuations of money cause economic inefficiencies and may affect a country’s exports, imports, real GDP and employment. In contrast, a fixed
exchange rate system can avoid these problems if countries follow appropriate
monetary and fiscal policies.
A fixed-rate system imposes discipline on governments. They cannot raise
the money supply rapidly and create high inflation, save at the risk of a major exchange rate crisis. However, a fixed exchange rate requires that nations surrender
sovereignty over their domestic monetary policy. Its Central Bank completely loses
its independence.
In many cases, it appears to be worth it. In January 1999, the European
Union began converting to a common currency, the Euro (€). Their decision to go
for common money suggests how strong are the advantages of a common currency,
or fixed exchange rate.
Currency Boards
If Lower Bedrock unilaterally simply declared that its exchange rate was set
at one Pebble to the dollar, its commitment would not have credibility. The credible way set a fixed exchange rate is to establish a currency board. Many countries
such as Argentina and Lithuania have currency boards instead of a central bank.
The main goal of a currency board is to maintain a country’s fixed exchange rate. A
foreign currency backs the domestic currency. The currency board has enough reserves that it is willing and able to exchange domestic currency for foreign currency
at the country’s fixed exchange rate. Essentially the country has abandoned an independent monetary policy and has decided to stabilize its currency relative to another. The principal reason a country adopts a currency board is to end domestic
inflation. This system is credible and foolproof. If the currency board is very public
about what it is doing, the citizens will see that there is always enough backing to
redeem all of the domestic currency.
Is a currency board a good policy? It may be credible, but it comes at a
price: You cannot have an independent monetary policy.
As an interesting historical footnote, The Wizard of Oz is really a story about US monetary
policy during the late 19th century.
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Where is this going
It seems reasonably clear where the international monetary system is going:

In the Western Hemisphere, the economies seem to be moving to a single
currency: the US dollar.

In Europe, the Euro is coming. In other European countries that are not
members of the European Monetary Union, their local currencies will
end up being pegged to the Euro.

In Asia, we need to look down the road. The Chinese economy is taking
off, and no one can see an Asian society without the Chinese currency
involved. We may see an AMU (Asian Monetary Union), involving China, Japan and Korea.