Fiscal vs' Monetary

1
Fiscal vs. Monetary

• The real world

2
Conventional Wisdom about Monetary and Fiscal
Policy

• Monetary and fiscal policy are not tools to
  fine-tune the economy, but they can be useful in
  guiding it toward the macroeconomic goals.
• Monetary policy is more important in the
  short-run because it is more flexible and less
  influenced by politics.
• Long-run consequences of expansionary policy
  include
• Inflation (monetary policy)
• Higher interest rates and crowding out (fiscal
  policy)

3
Conventional Wisdom about Monetary and Fiscal
Policy

• Monetary and fiscal policy are useful to achieve
  high growth, low inflation, and low unemployment.

4
Conventional Wisdom about Monetary and Fiscal
Policy

• Of the two, monetary policy is the more important
  policy for short-run stabilization.

• It is more flexible and less influenced by
  politics than fiscal policy.

5
Conventional Wisdom about Monetary and Fiscal
Policy
6
Conventional Wisdom about Monetary and Fiscal
Policy
Disadvantages
Advantages
Option
1. May increase output growth in the short
run. 2. May help solve short-run political
problems. 3. Decreases unemployment. 1. May
help fight inflation. 2. May allow a better
monetary/fiscal mix. 3. Trade deficit may
decrease. 4. Interest rates may fall,
stimulating investment and growth in the
long run.
Expansionary Contractionary
Fiscal policy
1. Budget deficit worsens. 2. Hurts countrys
ability to borrow in the future. 3. Trade
deficit may increase. 4. Upward pressure on
interest rate, discouraging growth. 1.
Risks recession. 2. Increases unemployment. 3.
Slows output growth in the short run. 4.
May help cause short-run political problems.
7
Alternatives and Supplements to Monetary and
Fiscal Policy

• Monetary and fiscal policy arent the only
  policies that affect aggregate demand.
• Any policy that affects autonomous spending
  without having offsetting effects on other
  expenditures can achieve the same results.

8
Directed Investment Policies Policy Affecting
Expectations

• Poor investor expectations can become
  self-fulfilling.
• If they expect a recession, they might not
  invest, driving the economy into a Depression.

9
Rosy Scenario Talking the Economy into Fiscal
Health

• Gloomy government pronouncements may affect
  expectations and decrease investment and
  consumption spending.
• Rosy scenario government policy of making
  optimistic predictions and never making gloomy
  predictions.

10
Financial Guarantees

• Government guarantees or promises of guarantees
  can bolster business confidence.

11
Autonomous Consumption Policy

• Making credit more available to consumers can
  expand aggregate demand.
• Economists watch indexes of consumer credit and
  consumer confidence to gauge the direction of the
  economy.

12
Trade Policy and Export-Led Growth

• Export-led growth policies policies designed to
  stimulate U.S. exports and increase aggregate
  expenditures on U.S. goods.
• Any policy that restricts imports will have the
  same effect on the economy.

13
Interdependencies in the Global Economy

• Any time a nation attempts to restrict imports,
  it is equivalent to getting another country to
  follow an import-led decline of its economy.

14
Interdependencies in the Global Economy

• There is a risk of retaliation whenever a nation
  applies trade restrictions against another nation.

15
Exchange Rate Policies

• Exchange rate policy a policy of deliberately
  affecting a countrys exchange rate in order to
  affect its trade balance.
• A low value of a countrys currency relative to
  other currencies encourages exports and
  discourages imports, and vice versa.

16
Credibility in Aggregate Demand Policy

• Effective policy must be credible policy.

17
Rational Expectations

• People generally act rationally in the sense that
  they are forward looking.
• Rational expectations forward-looking
  expectations that use available information.

18
Rational Expectations

• For example, if the public is convinced that the
  Fed is deadly serious about its goal of cooling
  down the economy, the policy will work.

19
Uncertainty About the Effects of Policy

• The central role of expectations means that there
  is a great deal of uncertainty in the economy.
• There are a multiplicity of expectational
  strategies which can shift rapidly.

20
Uncertainty About the Effects of Policy

• This undermines the ability to develop
  deterministic models of the economy which gives
  the economy an unpredictability that precludes
  fine tuning.

21
Uncertainty About the Effects of Policy

• Depending on the beliefs that individuals have,
  monetary and fiscal policy will work in different
  ways.

22
Policy Regimes and Expectations

• A policy regime is a rule.
• It is a predetermined statement of the policy
  that will be followed in various circumstances.

23
Policy Regimes and Expectations

• A policy is a one-time reaction to a problem.

• It is chosen without a predetermined framework.

24
Policy Regimes and Expectations

• Policy regimes can help generate the expectations
  that make the governments tools work.

25
Rules versus Discretion and Credibility

• The focus on credibility has led to a call for
  rules to guide policy rather than giving
  policymakers wide policy discretion.

26
Summary

• Fiscal policy is affected by the following
  problems
• Interest rate crowding out.
• The government may not know what the situation
  is.
• The government may not know the economys
  potential income.
• Government can not respond quickly.
• The size of the government debt does matter.
• Economic goals may conflict.
• Activist policy is now built into U.S.
  institutions through automatic stabilizers.
• Economists challenge is to find the appropriate
  mix of policy to balance the trade-off between
  low unemployment, high growth, and low inflation.

27
Summary

• Three alternatives to monetary and fiscal policy
  are
• Directed investment policies
• Autonomous consumption policy
• Trade policy
• Policy is a process, not a one-time event, and
  policy regimes are often more important than any
  particular policy.
• Credibility can be built by establishing policy
  rules, but the trade-off is that policymakers
  will be unable to respond to an unforeseen event.

28
Review Question 14-1 Identify three automatic
stabilizers and explain how they would lessen the
severity of a recession.
Welfare payments, unemployment insurance, and
income tax are automatic stabilizers. In the
case of a recession, unemployment increases, so
welfare payments and unemployment insurance
increase, offsetting some of the decrease in
income. With lower incomes, people pay less tax.
An increase in government spending and a
decrease in taxes is an expansionary policy that
will increase AD.
Review Question 14-2 What are the six
assumptions of the AS/AD model that lead to
problems with fiscal policy?
1. Financing the deficit has no effect. (It can
cause crowding out). 2. The government knows
what the situation is. (The government uses
estimates of the mpe and other exogenous
variables. 3. The government knows potential
income. (There is a wide range of estimates). 4.
The government has flexibility in changing
spending and taxes. 5. Size of the debt doesnt
matter. 6. Fiscal policy doesnt affect other
economic goals.