Fiscal and Monetary Policy Debates

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18
Fiscal and Monetary Policy Debates
CHAPTER
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C H A P T E R C H E C K L I S T

• When you have completed your study of this
  chapter, you will be able to

Discuss whether fiscal policy or monetary policy
is the better stabilization tool.
Explain the rules-versus-discretion debate and
compare Keynesian and monetarist policy rules.
Assess whether policy should target the price
level rather than real GDP.
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18.1 FISCAL VERSUS MONETARY POLICY

• Which tool does the better job of stabilizing
  short-run economic fluctuations fiscal policy or
  monetary policy?
• We look at three aspects of the fiscal policy
  versus monetary policy debate
• Policy effects
• Goal conflicts
• Timing and flexibility

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18.1 FISCAL VERSUS MONETARY POLICY

• Policy Effects
• The Effects of Monetary Policy
• The two steps in the transmission of monetary
  policy are
• Step 1 A change in the money supply influences
  the interest rate.
• Step 2 A change in the interest rate influences
  investment and other interest-sensitive
  components of aggregate expenditure.

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18.1 FISCAL VERSUS MONETARY POLICY

• Step 1 Whether a given increase in the money
  supply decreases the interest rate by a lot or a
  little depends on the sensitivity of the demand
  for money to the interest rate.
• Step 2 Whether a given decrease in the interest
  rate increases aggregate expenditure by a lot or
  a little depends on the sensitivity of investment
  and other components of aggregate expenditure to
  the interest rate.
• Figure 18.1 on the next slides illustrate these
  propositions.

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18.1 FISCAL VERSUS MONETARY POLICY
1. When the money supply increases from 1
trillion to 1.2 trillion, the interest rate
falls from 6 percent to 4 percent a year and
2. Investment increases from 2 trillion to 4
trillion.
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18.1 FISCAL VERSUS MONETARY POLICY

• 3. The same change in the money supply lowers the
  interest rate from 6 percent to 5 percent a year
  and

4. Investment from 2 trillion to 2.25 trillion.
Monetary policy is less powerful here than in the
previous case.
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18.1 FISCAL VERSUS MONETARY POLICY

• The Predictability of Monetary Policy
• The two steps in the transmission of monetary
  policy determine the predictability of monetary
  policy.
• At step 1, for a given change in the money supply
  to have a predictable effect on the interest
  rate, the demand for money must be predictable.
• At step 2, for a given change in the interest
  rate to have a predictable effect on investment
  and aggregate expenditure, the investment demand
  must be predictable.

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18.1 FISCAL VERSUS MONETARY POLICY

• So the more predictable the demand for money and
  investment demand, the more predictable is the
  effect of monetary policy.

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18.1 FISCAL VERSUS MONETARY POLICY

• The Effects of Fiscal Policy
• The three steps in the transmission of fiscal
  policy are
• Step 1 An increase in government expenditure or a
  tax cut increases aggregate expenditure and
  increases aggregate demand with a multiplier.
• Step 2 A change in real GDP changes the demand
  for money, which changes the interest rate.
• Step 3 A change in the interest rate changes
  investment and other components of aggregate
  expenditure in a crowding- out effect.

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18.1 FISCAL VERSUS MONETARY POLICY

• The crowding-out effect is large and fiscal
  policy has a weak effect on aggregate demand if
• A given change in the demand for money has a
  large effect on the interest rate and
• A given change in the interest rate has a large
  effect on aggregate expenditure.

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18.1 FISCAL VERSUS MONETARY POLICY

• The crowding-out effect is small and fiscal
  policy has a powerful effect on aggregate demand
  if
• A given change in the demand for money has a
  small effect on the interest rate and
• A given change in the interest rate has a small
  effect on aggregate expenditure, then

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18.1 FISCAL VERSUS MONETARY POLICY

• Extreme Conditions
• At one extreme, monetary policy is all-powerful
  and fiscal policy is completely ineffective.
• This extreme occurs if the quantity of money
  demanded is independent of the interest rate.

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18.1 FISCAL VERSUS MONETARY POLICY

• At the other extreme, monetary policy is
  completely ineffective and fiscal policy is
  all-powerful.
• This extreme occurs if the quantity of money
  demanded is infinitely sensitive to the interest
  rate.
• Liquidity trap
• An interest rate at which people are willing to
  hold any quantity of money.

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18.1 FISCAL VERSUS MONETARY POLICY

• In a liquidity trap, a change in the money supply
  changes the quantity of money held but has no
  effect on the interest rate and so it has no
  effect on aggregate expenditure.
• But a change in government expenditure leaves the
  interest rate unchanged, so there is no crowding
  out and fiscal policy has a large multiplier
  effect on aggregate expenditure.

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18.1 FISCAL VERSUS MONETARY POLICY

• Reality
• Neither extreme occurs in real economies.

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18.1 FISCAL VERSUS MONETARY POLICY

• Goal Conflicts
• Stabilization policy actions have side effects.
• Goal conflict is more serious for fiscal policy
  than for monetary policy.

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18.1 FISCAL VERSUS MONETARY POLICY

• Fiscal Policy Goal Conflicts
• Fiscal policy has three goals
• To provide public goods and services
• To redistribute income
• To stabilize aggregate demand
• These goals can come into conflict.
• One aspect of the governments budget that does
  not create conflict is its automatic stabilizer
  effect.

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18.1 FISCAL VERSUS MONETARY POLICY

• In contrast, discretionary fiscal policy actions
  create goal conflicts.
• The main source of conflict is the very large
  number of spending programs and tax arrangements
  in place and the difficulty of changing them to
  balance the costs and benefits of one against the
  costs and benefits of others.

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18.1 FISCAL VERSUS MONETARY POLICY

• Monetary Policy Goal Conflicts
• Monetary policy has three main goals
• Price level stability
• Real GDP stability
• Stability of the financial system.
• There is less conflict among these goals than
  among those of fiscal policy.
• First, stability of the financial system and
  aggregate demand stability go together. Each
  contributes to the other. So there is no conflict
  here.

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18.1 FISCAL VERSUS MONETARY POLICY

• Second, stability of real GDP and stability of
  the price level are both served by stabilizing
  aggregate demand.
• There is a conflict about how much weight to
  place on price level stability versus real GDP
  stability.
• But this conflict is also present for fiscal
  policy.
• So fiscal policy does not outperform monetary
  policy in this area.

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18.1 FISCAL VERSUS MONETARY POLICY

• Timing and Flexibility
• The ability to forecast the near future state of
  the economy and act at the appropriate time to
  counteract any unwanted recession or inflation is
  a crucial part of a successful stabilization
  policy.

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18.1 FISCAL VERSUS MONETARY POLICY

• Inflexible Fiscal Policy
• Fiscal policy is political.
• The election cycle dominates fiscal policy
  making.
• Fiscal policy is inflexible and incapable of the
  rapid-fire response.
• Flexible Monetary Policy
• Stabilization is the purpose of monetary policy.
• Monetary policy effects are long and drawn out,
  but actions can be taken quickly.

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18.1 FISCAL VERSUS MONETARY POLICY

• And the Winner Is?
• There is no clear winner.
• Automatic fiscal stabilizers do an important part
  of the job of maintaining macroeconomic
  stability.
• Discretionary fiscal policy is sometimes a vital
  part of the policy mix, especially if the economy
  is in a deep recession or in a seriously
  overheated condition.
• But for dealing with normal fluctuations,
  monetary policy is the preferred stabilization
  tool because it is more flexible in its timing.

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18.2 RULES VERSUS DISCRETION

• Discretionary Policy
• Discretionary monetary policy is monetary policy
  that is based on the judgments of the policy
  makers about the current needs of the economy.
• Discretionary monetary policy is setting the
  discount rate and determining open market
  operations on the basis of the expert opinions of
  the members of the FOMC and their advisors.

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18.2 RULES VERSUS DISCRETION

• Fixed-Rule Policies
• A fixed-rule policy specifies an action to be
  pursued independently of the state of the
  economy.
• Milton Friedman keep the quantity of money
  growing at a constant rate year in and year out,
  regardless of the state of the economy, to make
  the average inflation rate zero.
• Fixed rules are rarely followed in practice.

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18.2 RULES VERSUS DISCRETION

• Feedback-Rule Policies
• A feedback-rule policy specifies how policy
  actions respond to changes in the state of the
  economy.
• A feedback-rule for monetary policy is one that
  changes the quantity of money or the interest
  rate in response to the state of the economy.
• Stabilizing Aggregate Demand Shocks
• Well study an economy that starts out at full
  employment and has no inflation.

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18.2 RULES VERSUS DISCRETION

• Figure 18.2 shows a decrease in aggregate demand
  brings recession.

Aggregate demand decreases from AD0 to AD1.
Real GDP decreases to 9.8 trillion, and the GDP
deflator falls to 107the economy goes into
recession.
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18.2 RULES VERSUS DISCRETION

• Fixed Rule Monetarism
• A monetarist is an economist who believes that
  fluctuations in the quantity of money are the
  main source of economic fluctuations and who
  advocates that the quantity of money grow at a
  constant rate.
• The fixed rule that well study here is one in
  which the quantity of money remains constant.

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18.2 RULES VERSUS DISCRETION

• Figure 18.3(a) shows a monetarist stabilization
  policy in the face of an aggregate demand shock.

A fixed-rule policy leaves real GDP and the price
level to fluctuate from A to B, to C, to D and
back to A.
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18.2 RULES VERSUS DISCRETION

• Feedback Rule Keynesian Activism
• A Keynesian activist is an economist who believes
  that fluctuations in investment are the main
  source of economic fluctuations.
• And who advocates interest rate cuts when real
  GDP falls below potential GDP and interest rate
  hikes when real GDP exceeds potential GDP.

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18.2 RULES VERSUS DISCRETION
Figure 18.3(b) illustrates a Keynesian activist
policy.

• As aggregate demand fluctuates around AD0.

A feedback-rule policy tries to restores full
employment as quickly as possible by keeping
aggregate demand at AD0.
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18.2 RULES VERSUS DISCRETION

• The Two Rules Compared
• Under a fixed-rule policy, a decrease in
  aggregate demand puts real GDP below potential
  GDP, where it remains until either a fall in the
  money wage rate or a subsequent increase in
  aggregate demand restores full employment.
• Under a feedback-rule policy, a policy action
  pulls the economy out of a recessionary gap or an
  inflationary gap.
• There is no need to wait for an adjustment in the
  money wage rate for full employment to be
  restored.

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18.2 RULES VERSUS DISCRETION

• Real GDP decreases and increases by the same
  amounts under the two policies, but real GDP
  stays below potential GDP and above potential GDP
  for longer with a fixed rule than it does with
  the feedback rule.

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18.2 RULES VERSUS DISCRETION

• Are Feedback Rules Better?
• Despite the apparent superiority of a feedback
  rule, many economists remain convinced that a
  fixed rule stabilizes aggregate demand more
  effectively than does a feedback rule.
• These economists assert that fixed rules are
  better than feed-back rules because
• Potential GDP is not known.
• Policy lags are longer than the forecast horizon.
• Feedback-rule policies are less predictable than
  fixed-rule policies.

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18.2 RULES VERSUS DISCRETION

• Knowledge of Potential GDP
• It is necessary to determine whether real GDP is
  currently above or below potential GDP.
• But potential GDP is not known with certainty.
• As a result, there is often uncertainty about the
  direction in which a feedback policy should be
  pushing the level of aggregate demand.

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18.2 RULES VERSUS DISCRETION

• Policy Lags and the Forecast Horizon
• The effects of policy actions taken today are
  spread out over the following two years or even
  more.
• But no one is able to forecast accurately that
  far ahead.
• So feedback-rule policies that react to todays
  economy might be inappropriate for the state of
  the economy at that uncertain future date when
  the policys effects are felt.

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18.2 RULES VERSUS DISCRETION

• Predictability of Policies
• To forecast the inflation rate, it is necessary
  to forecast aggregate demand.
• And to forecast aggregate demand, it is necessary
  to forecast the Feds policy actions.
• If the Fed sticks to a rock-steady, fixed rule
  for money growth rate, then policy is predictable
  and it does not contribute to unexpected
  fluctuations in aggregate demand.

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18.2 RULES VERSUS DISCRETION

• In contrast, if the Fed pursues a feedback rule,
  there is more scope for the policy actions to be
  unpredictable.
• With a feedback-rule policy, it is necessary to
  predict the variables to which the Fed reacts and
  the extent to which it reacts.
• Consequently, a feedback rule for monetary policy
  can create more unpredictable fluctuations in
  aggregate demand than a fixed rule can.

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18.2 RULES VERSUS DISCRETION

• Stabilizing Aggregate Supply Shocks
• To see the effects of supply shocks and the
  policy to stabilize them, well again start out
  at full employment with no inflation.

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18.2 RULES VERSUS DISCRETION

• Figure 18.4 shows how a decrease in aggregate
  supply brings recession.

Aggregate supply decreases from AS0 to AS1.
Real GDP decreases to 9.9 trillion, and the GDP
deflator rises to 113the economy goes into
recession.
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18.2 RULES VERSUS DISCRETION

• Fixed Rule
• Under a fixed-rule policy, the decrease in
  aggregate supply has no effect on aggregate
  demand.
• Feedback Rule
• Under a Keynesian activist feedback rule, when
  aggregate supply decreases, policy actions
  increase aggregate demand.
• Figure 18.5 on the next slides show the effects
  of these policy actions.

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18.2 RULES VERSUS DISCRETION
A decrease in aggregate supply brings recession
as the economy moves from A to B.
A fixed-rule policy leaves real GDP and the price
level to gradually return from B to A as the
money wage rate falls.
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18.2 RULES VERSUS DISCRETION
A decrease in aggregate supply brings recession
as the economy moves from A to B.

• A feedback-rule policy tries to restores full
  employment as quickly as possible, moving the
  economy from B to C.

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18.3 ALTERNATIVE POLICY TARGETS

• Real GDP Versus Inflation
• How should monetary policy try to influence
  aggregate demand when aggregate supply changes?
• Two possible targets for monetary policy are
• Real GDP
• The price level

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18.3 ALTERNATIVE POLICY TARGETS

• Real GDP Target
• If monetary policy targets real GDP, it seeks to
  neutralize the effects of aggregate supply shocks
  on real GDP.
• That is,
• An increase in aggregate supply is met by
  decrease in aggregate demand.
• And a decrease in aggregate supply is countered
  by an increase in aggregate demand.

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18.3 ALTERNATIVE POLICY TARGETS

• Figure 18.6(a) shows a monetary policy that
  targets real GDP.

The blue band is the real GDP target.
As aggregate supply fluctuates between AS1 and
AS2, monetary policy aims to change aggregate
demand to keep real GDP on target at 10 trillion.
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18.3 ALTERNATIVE POLICY TARGETS

• Price Level Target
• If monetary policy targets the price level, it
  seeks to neutralize the effects of aggregate
  supply shocks on the price level.
• That is,
• An increase in aggregate supply is met by an
  increase in aggregate demand.
• And a decrease in aggregate supply that is
  countered by a decrease in aggregate demand.

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18.3 ALTERNATIVE POLICY TARGETS
Figure 18.6(b) shows a monetary policy that
targets the price level.

• The blue band is the price level target.

As aggregate supply fluctuates between AS1 and
AS2, monetary policy aims to change aggregate
demand to keep the price level on target at 110.
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18.3 ALTERNATIVE POLICY TARGETS

• Inflation Targeting
• Inflation targeting
• A monetary policy framework that combines an
  announced target range for the inflation rate
  with the publication of the central banks
  economic forecasts and analysis.
• Despite its name, inflation targeting is an
  attempt to stabilize output and employment while
  maintaining an unwavering commitment to keeping
  inflation firmly inside an announced target range.

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Policy Debates in YOUR Life

• Recently Ben Bernanke succeeded Alan Greenspan as
  Fed chairman.

Chairman Greenspan was credited with keeping
inflation in check and avoiding serious
recession. Will Chairman Bernanke be as
successful? Before his appointment, Ben Bernanke
said he wanted the United States to set an
inflation target. What do you think is best for
the United States? Should the Fed announce an
inflation target? Do you think that Chairman
Bernanke will push for an inflation target for
the Fed?