Fiscal and Monetary Policy: Debates

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Fiscal and Monetary Policy Debates

• Chapter 18

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Debate 1

• Which policy to use? Fiscal or monetary?
• Which one is more effective?
• Which one has less goal conflicts?
• Which one is more flexible?

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Debate 1Continued

• Which one is more effective?
• Fiscal policy and monetary policy have different
  transmission mechanisms
• ? T or ?G ? ? AE ? ? real GDP (but in sequence,
  counteracting effects on real GDP through money
  demand and interest rate)
• ? M? ? interest rate ? ? I ? ? real GDP
• Which one is more effective depends on
  sensitivity of money demand and investment demand.

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Debate 1Continued

• Which one had less goals conflict?
• More goals conflict with fiscal policy than with
  monetary policy because fiscal policy tends to
  target a specific group while the effect of
  monetary policy is neutral.
• Which one is more flexible
• Monetary policy because of less bureaucratic red
  tapes.

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Debate 2

• Rule vs. discretion in monetary policy
• Three options
• Discretionary monetary policy
• Carrying out monetary policy on the basis of the
  judgment of policy makers
• Rule-based (or fixed rule) policy monetarism
• Policy pursued according to a certain rule,
  independently of the state of economy
• Feedback-rule policy Keynesian activism (e.g.
  Taylor rule)
• Carrying out monetary policy by predetermined
  feedback rules according to changes in the state
  of economy.

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Debate 2Continued

• When there is a AD shock,
• Monetarism
• Allow real GDP and the price level to fluctuate
  and come back to the full employment equilibrium
  through the natural course.
• Keynesian activism
• Restore the full-employment equilibrium as
  quickly as possible.
• Despite the apparent superiority of the feedback
  rule policy, rule-based policy is better because
  of uncertainty about the target and lags and
  unpredictability of policies..

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Debate 2Continued

• When there is a supply shock,
• Monetarism
• Allow real GDP and the price level to fluctuate
  and come back to the full employment equilibrium
  through the natural course.
• Keynesian activism
• Restore the full-employment equilibrium as
  quickly as possible.
• The feedback rule policy restores full employment
  faster, but with higher price level.

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Debate 3

• Should policy target real GDP, the price level or
  both?
• Targeting only one would be extreme.
• Stabilizing real GDP only means destabilizing the
  price level in the face of shocks to AS.
• Stabilizing the price level only means
  destabilizing the real GDP in the face of shocks
  to AS.
• More general targeting would be placing some
  weight on fluctuations in both real GDP and the
  price level (probably with more weight on the
  price level)

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Debate 3Continued

• If we concentrate on the price level, should the
  target inflation rate be zero or positive?
• Arguments for positive inflation
• Because of built-in overstated measurement bias
• As product and labor market lubricant
• Mild inflation make profit increase and cost
  reduction, so more labor employment
• Some economists do not buy this idea.