1. Challenges to Keynesian Economics
Module 35

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

3. Political problems Complications
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.

4. Fiscal Policy and Crowding Out

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

6. Monetary Policy and Crowding Out

7. 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

8. 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.

9. 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.

10. 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.
Not all economists were convinced that monetarism was the way to go.
In 1968, Milton Friedman and Edmund Phelps of Columbia University, working independently, proposed the concept of the natural rate of unemployment.
In Module 34 we saw that the natural rate of unemployment is also the non-accelerating inflation rate of unemployment, or NAIRU.
Note: this could be a good opportunity to use the Phillips curve to review how higher inflation becomes embedded into expectations. In order to avoid accelerating inflation over time, the unemployment rate must be high enough so that actual inflation equals the expected inflation rate.
The important result is that if the unemployment rate is kept below the NAIRU, inflation will start to rise.
The natural rate hypothesis was validated with empirical testing and the influence of monetarism declined.