Chapter 14

1. 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 • Velocity • 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 • 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. Figure 2 The Federal Reserve’s policy dilemma S M1 M0 Money demand shifts out For given Fed policy 10% W 9 Z A E 8 7 Interest Rates 6 5 4 3 2 D1 D0 1 M 830 850 840 0 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 Flat aggregate supply curve Steep aggregate supply curve S Price level Price level S S Real GDP Real GDP (b) (a)

25. Figure 5 Stabilization policy with a flat aggregate supply curve S S D0 D0 D2 D1 E E B A Price Level Price Level Rise in price Fall in price 100 100 101 99 Rise in output Fall in output S S D0 D0 D2 D1 0 0 6,000 6,000 (b) Contractionary policy (a) Expansionary policy 6,400 5,600 Real GDP Real GDP

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

27. S Figure 6 Stabilization policy, a steep aggregate supply curve D0 D0 D2 S D1 E E B A Price Level Price Level Rise in price Fall in price 100 100 110 90 Rise in output S D2 Fall in output D0 D0 D1 0 0 S 6,100 6,000 6,000 (b) Contractionary policy (a) Expansionary policy 5,900 Real GDP Real GDP

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 D A E C B Actual and Potential GDP Actual GDP 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