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Fiscal and Monetary Policy: Debates

Fiscal and Monetary Policy: Debates. Chapter 18. 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?. Debate 1 Continued. Which one is more effective?

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Fiscal and Monetary Policy: Debates

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  1. Fiscal and Monetary Policy: Debates Chapter 18

  2. 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?

  3. Debate 1Continued • Which one is more effective? • Fiscal policy and monetary policy have different transmission mechanisms • Δ T or ΔG  Δ AE  Δ real GDP (but in sequence, counteracting effects on real GDP through money demand and interest rate) • Δ M Δ interest rate  Δ I  Δ real GDP • Which one is more effective depends on sensitivity of money demand and investment demand.

  4. 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.

  5. 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.

  6. 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..

  7. 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.

  8. 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)

  9. 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.

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