Fiscal and Monetary Policy Debates

2. 18 Fiscal and Monetary Policy Debates CHAPTER

3. 1 2 3 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.

4. 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

5. 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.

6. 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.

7. 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.

8. 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.

9. 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.

10. 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.

11. 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.

12. 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.

13. 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

14. 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.

15. 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.

16. 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.

17. 18.1 FISCAL VERSUS MONETARY POLICY • Reality • Neither extreme occurs in real economies.

18. 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.

19. 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 government’s budget that does not create conflict is its automatic stabilizer effect.

20. 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.

21. 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.

22. 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.

23. 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.

24. 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.

25. 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.

26. 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.

27. 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.

28. 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 • We’ll study an economy that starts out at full employment and has no inflation.

29. 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 107—the economy goes into recession.

30. 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 we’ll study here is one in which the quantity of money remains constant.

31. 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.

32. 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.

33. 18.2 RULES VERSUS DISCRETION As aggregate demand fluctuates around AD0. Figure 18.3(b) illustrates a Keynesian activist policy. A feedback-rule policy tries to restores full employment as quickly as possible by keeping aggregate demand at AD0.

34. 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.

35. 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.

36. 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.

37. 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.

38. 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 today’s economy might be inappropriate for the state of the economy at that uncertain future date when the policy’s effects are felt.

39. 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 Fed’s 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.

40. 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.

41. 18.2 RULES VERSUS DISCRETION • Stabilizing Aggregate Supply Shocks • To see the effects of supply shocks and the policy to stabilize them, we’ll again start out at full employment with no inflation.

42. 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 113—the economy goes into recession.

43. 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.

44. 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.

45. 18.2 RULES VERSUS DISCRETION A feedback-rule policy tries to restores full employment as quickly as possible, moving the economy from B to C. A decrease in aggregate supply brings recession as the economy moves from A to B.

46. 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

47. 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.

48. 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.

49. 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.

50. 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.