C H A P T E R C H E C K L I S T

2. 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.

3. 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. • Step 3A change in the interest rate influences short-term international capital flows and thus the exchange rate of the dollar, and therefore exports and imports.

4. 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. • Step 3 Whether a given decrease in the interest rate reduces the exchange rate by a lot or a little depends on the sensitivity of the exchange rate to the interest rate; and whether this increases net exports by a little or a lot depends on the sensitivity of exports and imports to changes in the exchange rate. • These ‘sensitivities’ are empirical questions that are hotly disputed.

5. 18.1 FISCAL VERSUS MONETARY POLICY In this figure, 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 investment increases from $2 trillion to $4 trillion.

6. 18.1 FISCAL VERSUS MONETARY POLICY Here, the same change in the money supply lowers the interest rate from 6 percent to 5 percent a year and increases investment from $2 trillion to $2.25 trillion. Monetary policy is less powerful here than in the previous case.

7. 18.1 FISCAL VERSUS MONETARY POLICY • The Predictability of Monetary Policy • The 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. • At step 3, for a given change in the interest rate to have a predictable effect on aggregate expenditure through net exports, the exchange rate change and import and export demand must be predictable.

8. 18.1 FISCAL VERSUS MONETARY POLICY • So the more predictable the demand for money, investment demand, and the foreign sector, the more predictable is the effect of monetary policy. • Unfortunately, none of these is as predictable as we might like in quantitative terms – i.e. we know neither how large nor how quick the responses will be.

9. 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 purchases 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, and the exchange rate, also partially offsetting the initial aggregate demand change via changes in net exports.

10. 18.1 FISCAL VERSUS MONETARY POLICY • If a given change in the demand for money has a large effect on the interest rate and if a given change in the interest rate has a large effect on aggregate expenditure, then 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 small effect on the interest rate and if a given change in the interest rate has a small effect on aggregate expenditure, then the crowding-out effect is small and fiscal policy has a powerful effect on aggregate demand.

11. 18.1 FISCAL VERSUS MONETARY POLICY • Extreme Conditions • At one extreme, monetary policy is very powerful and fiscal policy is close to completely ineffective. • This extreme occurs if the quantity of money demanded is close to independent of the interest rate, i.e. the demand for money curve is almost vertical, so that small changes in the supply of money induce large changes in interest rates. This implies large crowding out and net export effects from fiscal policy because of the large interest rate changes it induces.

12. 18.1 FISCAL VERSUS MONETARY POLICY • At the other extreme, monetary policy is completely ineffective and fiscal policy is very powerful. • This extreme occurs if the quantity of money demanded is infinitely sensitive to the interest rate, i.e. the demand for money curve is essentially a horizontal straight line. This is known as a Liquidity trap • 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 purchases leaves the interest rate unchanged, so there is no crowding out or net export effects and fiscal policy has a large multiplier effect on aggregate expenditure.

13. 18.1 FISCAL VERSUS MONETARY POLICY • Reality • Neither extreme is likely to occur in real economies.

14. 18.1 FISCAL VERSUS MONETARY POLICY • Goal Conflicts • Societies and governments have many economic policy goals, not just stabilization. For example, rapid economic growth, equality of opportunity, external balance, alleviation of poverty, consumption protection for the old, disabled, and children, and the maintenance of particular kinds of activity [agriculture, cultural activities] may all be goals that matter. • Stabilization policy actions have side effects – impacts on other goals as well as the stabilization goal. • Goal conflict is probably more serious for fiscal policy than for monetary policy.

15. 18.1 FISCAL VERSUS MONETARY POLICY • Fiscal Policy Goal Conflicts • Fiscal policy has at least three goals: • To provide public goods and services • To redistribute income • To stabilize aggregate demand • These goals can come into conflict.

16. 18.1 FISCAL VERSUS MONETARY POLICY • Monetary Policy Goal Conflicts • Monetary policy has three main goals: price level stability, real GDP stability, and stability of the financial system, including the exchange rate system. • There is less conflict among these goals than among those of fiscal policy. • First, stability of the financial system and aggregate demand stability tend to go together. Each contributes to the other. So there is little conflict here.

17. 18.1 FISCAL VERSUS MONETARY POLICY • Second, stability of real GDP and stability of the price level or the inflation rate may both be served by stabilizing aggregate demand. • There is a conflict about how much weight to place on price level stability or inflation stability versus real GDP stability. Monetary policy also has definite redistributional effects – interest rate changes, and inflation rate changes, affect different groups differently [e.g. creditors and debtors]. • But these conflicts are also present for fiscal policy. • So fiscal policy does not outperform monetary policy in this area.

18. 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. • Unfortunately, we know we cannot do this in a reliable manner. Economic forecasting is not bad and getting better, but we know that we cannot forecast turning points of the business cycle with any precision, and that is what we would need for really good stabilization policy.

19. 18.1 FISCAL VERSUS MONETARY POLICY • Inflexible Fiscal Policy • Fiscal policy is inherently political – taxes and spending are decided by the legislature. • The election cycle tends to dominate fiscal policy making. • Fiscal policy in the US is inflexible and incapable of rapid response. • Flexible Monetary Policy • Stabilization is the major purpose of monetary policy. • Monetary policy effects are long and drawn out, but actions can be taken quickly.

20. 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, even in the US, 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. • With non-USA institutions, often fiscal policy is the tool of choice for stabilizing output and employment, monetary policy for stabilizing the inflation rate.

21. 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 target Federal Funds Rate [and discount rate] and determining open market operations to achieve the target on the basis of the expert opinions of the members of the FOMC and their advisors.

22. 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 if ever followed in practice. More common are fixed goals. For example, the law in New Zealand states that the Central Bank must achieve an inflation rate between zero and 3% per annum; if it fails, the Governor can be fired!

23. 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 illustrate with an economy that starts out at full employment and has no inflation.

24. 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.

25. 18.2 RULES VERSUS DISCRETION • Fixed Rule: Monetarism • A monetarist is an economist who believes that fluctuations in the money stock 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 consider here is one in which the money supply remains constant.

26. 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.

27. 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.

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

29. 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, the economy is pulled out of a deflationary gap or an inflationary gap by a policy action. • There is no need to wait for an adjustment in the money wage rate for full employment to be restored.

30. 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. • However, this is only so for sure if the discretionary actions are always the right ones applied at the right times.

31. 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.

32. 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 can be uncertainty about the direction in which a feedback policy should be pushing the level of aggregate demand.

33. 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 future dates when the policy’s effects are still being felt.

34. 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 supply growth, then policy is predictable and it does not contribute to unexpected fluctuations in aggregate demand.

35. 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 might create more unpredictable fluctuations in aggregate demand than a fixed rule can. • However, fixed money supply growth rules are less predictable in their effects than they might seem. Because of changes in financial technology and institutions, the connections between monetary aggregates and the macro economy are themselves not wholly stable.

36. 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.

37. 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.

38. 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 the aggregate supply decreases, policy actions increase aggregate demand.

39. A decrease in aggregate supply brings recession as the economy moves from A to B. 18.2 RULES VERSUS DISCRETION A fixed-rule policy leaves real GDP and the price level to gradually return from B to A as the money wage rate falls.

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

41. 18.3 TARGETING INFLATION • Real GDP Versus the Price Level • 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

42. 18.3 TARGETING INFLATION • 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: • A decrease in aggregate demand • And a decrease in aggregate supply is countered by an increase in aggregate demand

43. 18.3 TARGETING INFLATION 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.

44. 18.3 TARGETING INFLATION • Price Level Target • If monetary policy targets the price level [in the real world, more likely target the inflation rate], 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 is countered by a decrease in aggregate demand

45. Figure 18.6(b) shows a monetary policy that targets the price level. 18.3 TARGETING INFLATION 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.

46. 18.3 TARGETING INFLATION • More General Targets • Monetary policy might target something less extreme than either real GDP or the price/inflation level. • It might place some weight on fluctuations in both real GDP and the price or inflation level. • You can think of the macroeconomic stabilization target as the target in a shooting contest. • The next slide shows three possible shapes for the target.

47. 18.3 TARGETING INFLATION In part (a), equal weight is placed on fluctuations in real GDP and the inflation rate. In part (b), an output-gap miss is penalized more heavily than an inflation miss. In part (c), an inflation miss is penalized more heavily than an output-gap miss.

48. 18.3 TARGETING INFLATION • A Tradeoff or a Free Lunch? • The connection between the monetary policy target and the stability of aggregate supply tilts the balance against directly targeting real GDP and toward targeting the price level. • But directly targeting the price level brings the “free lunch” of a more stable aggregate supply and therefore perhaps more stable real GDP.

49. 18.3 TARGETING INFLATION • Zero Versus Positive Inflation • Three reasons why a positive inflation might be preferred to zero inflation are: • The measured inflation rate overstates the true inflation rate. • Inflation lubricates the labor market. • The nominal interest rate cannot fall below zero.

50. 18.3 TARGETING INFLATION • Measurement Bias • If measurement bias were the only reason for a positive target inflation rate, the target rate for the currently measured CPI would be less than 1 percent a year. • And it would be easy to construct a value-of-money index (VMI) that equals the CPI scaled back for the best available estimate of the upward measurement bias. • So this argument for positive inflation is not wholly convincing.