CHALLENGES TO KEYNESIAN ECONOMICS Module 35

Problems of Fiscal Policy Problems of timing recognition lag administrative lag operational lag

Political problems Political business cycles - fiscal policy may be corrupted for political purposes and may cause economic fluctuations Complications Crowding Out – expansionary fiscal policy (deficit spending) will increase the interest rate and reduce consumer and business spending, thereby weakening or canceling the stimulus of expansionary policy.

Fiscal Policy and Crowding Out

EFFECTIVENESS OF MONETARY POLICY Strengths The Federal Open Market Committee can act swiftly. Isolation from political pressure No Crowding Out

Monetary Policy and Crowding Out

Problem of Monetary Policy Monetary Neutrality In the long-run an increase in the money supply raises price level, but does not affect output or employment

Monetarism Monetarist advocate increases in the money supply should match increases in GDP If GDP is increasing by 3 % the money supply should increase by only 3% This is reasonable given the equation of exchange and a constant money velocity.

Monetary Equation of Exchange (MV=PQ) Monetarists adhere to this equation: money times velocity = price times quantity. (M) Money is the stock of money, M1; currency in circulation, traveler’s checks, and checkable deposits. (V) Velocity means the income (GDP) velocity of circulation; the average number of times a dollar is spent on final goods and services per time period (usually one year). V = GDP/M = PQ/M (P) Price is the average price level of the final goods and services in GDP. (Q) Quantity is the real output; the quantity of goods and services in GDP.

Problems with Monetarism Although the velocity of money had been fairly constant, starting in the 1980s it became very erratic. This led the Federal Reserve to drop monetarism as a means of controlling the money supply and to adopt targeting the Federal Funds rate.

Shortcomings, problems & issues Substantial operational lag. Monetary transmission process is lengthy. A change in Fed policy leads to a change in money supply, leads to a change in interest rates, leads to a change in Investment, leads to a change in AD, leads to a change in output, employment, price level

Cyclical asymmetry – if the economy is poor consumers and businesses are not likely to act in a positive fashion and vice versa (you can lead a horse to water but you can’t make it drink). Less control - near monies (M2 savings), global & underground holdings (2/3 of the money supply), e-cash Interest is income to savers, so high interest rates will increase their income thus partially offsetting a contractionary monetary policy.