1. The Debate over Monetary and Fiscal Policy
Chapter 14
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

2. Outline Quantity theory of money Monetarism Fiscal policy revisited
Debate over fiscal and monetary policy

3. Velocity & Quantity Theory Of Money
Speed at which money circulates
Number of times per year an “average dollar” is spent on goods & services
Velocity = Nominal GDP / Money Stock

4. Velocity & Quantity Theory Of Money
Equation of Exchange

5. Velocity & Quantity Theory Of Money
Equation of exchange
Economic model
Changes in velocity – minor
Velocity - constant
Nominal GDP
Proportional to money stock

6. Figure 1
Velocity of circulation for M1 and M2, 1929–2007

7. Velocity & Quantity Theory Of Money
Determinants of velocity
Efficiency of payments system decreases M, and hence increases v
Financial innovation: credit card, …
Computerization: online banking, …
Interest rates (opportunity cost of holding cash)
Higher r → lower M, higher velocity

8. Caveat for Fed Monetary Policy
Fed – increase money supply (M↑)
Interest rates – decrease
Velocity – decrease
M ˣ V increase < increase in M
Fed should take into account the change of v when conducts monetary policy

9. Velocity & Quantity Theory Of Money
Monetarism
Start with equation of exchange
Equation of exchange – growth rate form
Given ∆V, ∆M directly affects change in nominal GDP ∆(PY)
Keynesian approach: monetary policy indirectly affect I through interest rate

10. Monetarism In short-run, V and Y are constant
Inflation is always a monetary phenomenon

11. Money supply and Inflation

12. Discussion
Why the growth rate of M2 is always higher than that of inflation? (Monetarism predicts that they should be same)

13. Fiscal Policy, Interest Rates, & Velocity
Monetary policy
Increase bank reserves & money supply
Reduce interest rates
Stimulates demand for investment
Fiscal policy
Increases in G or tax cuts
Raise Y and P through multiplier effect
PY↑ increases money demand
Pushes up interest rates

14. Fiscal Policy, Interest Rates, & Velocity
Rise in G
Pushes interest rates higher
Deters some investment spending (“crowding-out” effect)
Increase in C + I + G + (X - IM) - smaller
Oversimplified formula 1/(1-MPC)
Overstates multiplier
Ignores variable imports
Ignores price-level changes
Ignores income tax
Ignores rising interest rates

15. Fiscal Policy, Interest Rates, & Velocity
Reduce budget deficit
Contractionary fiscal policies
Lower spending or higher taxes
Reduce real interest rates
Spur investment spending

16. Debate: Fiscal or Monetary Policy?
Which one is more powerful?
Keynesian: fiscal policy
Monetarist: monetary policy
Which one works faster?
Expenditure lag: fiscal policy is faster
G or T affects AD more promptly
Policy lag: monetary policy is shorter
Made frequently (FOMC)
Executed immediately (OMO)
Fiscal policy has to go through annual budget cycle

17. Debate: the Fed - Control M or r?
Keynesian: Fed should use OMO to control r
Monetarist: control M since it is the major driving force behind inflation

18. Debate: the Fed - Control M or r?
Fed cannot control both r and M simultaneously
Demand curve for money - shifts outward (by expansionary fiscal policy)
Rise in interest rates ( r)
Rise in money stock (M)
The Fed
Keep M steady (use OMO sale)
r - rises even more
Keep r steady (use OMO purchase)
M – rises even more

19. Money Supply (in billions of dollars)
Figure 2
The Federal Reserve’s policy dilemma S M D0 M0 D1 M1
Interest Rates
10% 9 8 7 6 5 4 3 2 1
For given Fed policy W A
840 Z E
830
850
Money demand shifts out
Money Supply (in billions of dollars)

20. Debate: the Fed - Control M or r?
Dilemma of monetary policy target
Target money supply (M)
Demand for money – variable
Difficult
Wide fluctuations in interest rates
Target interest rates (r)
Change money supply to stabilize r
Destabilize economy (M↑ in boom, M↓ in recession)
AD↑ → Y and P↑ → Md↑ → r↑ → Fed has to lower down r by using OMO purchase → M↑ → AD↑

21. Debate: the Fed - Control M or r?
What has Fed really done?
Post WWII – target interest rates
1960s – monetarism
Interest rate pegging actually destabilize the economy
Should stabilize money supply growth rate
1979 – Volcker shifted the Fed target to money stock growth
1982 – back to target interest rates
1993 – Greenspan confirmed that Fed was no longer using M to guide policy

22. Figure 3
The behavior of interest rates, 1979–1985

23. Debate: Shape of Aggregate Supply Curve
Aggregate supply curve – flat
Large increase in output
Little inflation
Anti-recession policy - successful
Restrictive stabilization policy - fighting inflation by contracting AD – not effective

24. Figure 4 Alternative views of the aggregate supply curve S Price level
Flat aggregate
supply curve S
Steep aggregate
supply curve
Real GDP
Real GDP
(a)
(b)

25. (a) Expansionary policy (b) Contractionary policy
Figure 5
Stabilization policy with a flat aggregate supply curve
Price Level
Price Level D0 D1 D0 S D2 A S E E
101
Rise in price
6,400 B
100
100
Fall in price
6,000
6,000 99
5,600
Rise in
output
Fall in
output
Real GDP
Real GDP
(a) Expansionary policy
(b) Contractionary policy

26. Debate: Shape of Aggregate Supply Curve
Aggregate supply curve – steep
Small increase in output
Great inflation
Expansionary fiscal or monetary policy
Little change in GDP
Contractionary policy – effective
Decrease price level

27. (a) Expansionary policy (b) Contractionary policy
Figure 6
Stabilization policy, a steep aggregate supply curve
Price Level
Price Level D0 D1 S D0 A S D2
110
Rise in price
6,100 E E
100
100
6,000
Fall in price
6,000 B 90
5,900
Rise in
output
Fall in output
Real GDP
Real GDP
(a) Expansionary policy
(b) Contractionary policy

28. Debate: Shape of Aggregate Supply Curve
Steepness of aggregate supply schedule
Depends on time period
Very short run – flat aggregate supply
Workers cannot predict the inflation accurately, real wage ↓, firms thus like to expand the capacity
Fluctuations in aggregate demand
Large effects on output
Minor effects on prices

29. Debate: Shape of Aggregate S Curve
Long run – steep aggregate supply
Workers get enough information and experience to predict the inflation, real wage not eroded by P↑, firms thus reluctant to increase production
Changes in demand
Affect prices, not output

30. Debate: Shape of Aggregate Supply Curve
Any change in AD will have most of its effect on output in the short run but on prices in the long run

31. Debate: Should Government Intervene?
Some economists (most liberal) advocate active stabilization policy
Policy has to be discretionary
G↑ or T↓ or lower r when recessionary gap, “lean against the wind”
Reverse when inflationary gap

32. Debate: Should Government Intervene?
Stabilization policy
Difficulties in forecasting demand
Long lags
May destabilize the economy
Some economists (most conservative) argue
Natural self-correcting forces
Automatic stabilizers
Passive policy, adhere to fixed rules

33. Discussion
Rule vs. Discretionary, which one do you prefer?

34. Figure 7 A typical business cycle Potential GDP E
Actual and Potential GDP
Potential GDP
Actual GDP E D A C B
Time

35. Rules-vs.-Discretion Debate
Economy’s self-correcting mechanism
If fast & efficient - No intervention
If slow - Discretionary policy
Lags in stabilization policy
Accuracy of economic forecasts
Size of government – bogus argument
Uncertainties - by government policy
Political business cycle
Expansionary policy near election

36. Rules-vs.-Discretion Debate
Kydland & Prescott: “Time Inconsistency Problem”
Public observes policy-makers and forms expectations of their likely actions.
Policy-makers with discretion can renege on today’s pronouncements tomorrow; so, the public may come to discount such pronouncements as cheap talk
Rules produce time-consistent outcomes because they make policy-makers’ pronouncements credible.

37. Summary Quantity Theory of Money: MV=PY
Monetarism: inflation is always a monetary phenomenon
Debate over monetary and fiscal policy
Should we reply on Mon or Fis policy?
Should Fed control M or r?
AS curve is flat or steep?
Government intervention: rule vs. discretion