Keynesian vs. Monetarist Debates: Policy Issues and Differences

1. NS3040 Fall Term 2019Keynesian/Monetarist Debates

2. Keynes-Monetarist I Keynesian vs. Monetarist Doctrine: Policy Issues • Many areas of disagreement between the two schools. • The chapter draws on rather extreme positions of each school to sharpen their differences. • In actuality the differences between the two schools are often not as extreme as painted here. • The main areas of disagreement: • Rules vs. Discretion – what should guide policy makers? • Monetary vs. Fiscal Policy – which is stronger in managing the economy? • Monetary aggregates vs. money market conditions as a policy guide • Fixed vs. flexible exchange rates – which are better? • Trade-off vs. no trade-off – disagreement over constraints on policymaking

3. Keynes-Monetarist II Rules vs. Discretion. • Should policy makers by confided by a set policy rule, or should they have the flexibility to respond to economic problems as they develop? • Debate centers around the timing of policy impacts. • Keynesians contend that their models are such that they can offset expected ups and downs in the economy. • Monetarists contend that the record shows discretionary policy has been destabilizing more than stabilizing. • Issue centers around a series of policy lags – the lag between the time a problem develops and the final impact of the policy action. • Keynesians contend lags are fairly predictable • Monetarist – lags are long and variable making their pattern impossible to systematically counter.

4. Keynes-Monetarist III Rules vs. discretion (contd.) • The monetarist problem is finding the best rule to follow. • Originally it was the money supply defined as M1 (currency and coin and demand deposits) – what people use to settle transactions • That rule broke down with financial deregulation and the proliferation of financial instruments • Now use the Taylor Rule – basically controlling short term interest rates to hit inflation targets. • Might work, but Federal Reserve has taken on employment as one of its targets, so can not follow rule. • Rule difficult to apply because in a crisis situation everyone expects a strong (discretionary) response. • -- can’t just say our hands are tied because we have this rule that is very technical and hard to explain to the voters. • Of course things may change so that the Taylor Rule needs to be modified – then have no rule

5. Keynes-Monetarist IV • Fiscal vs Monetary Policy – depends on shapes of LM and IS curves

6. Keynes-Monetarist V

7. Keynes-Monetarist VI • Monetary Aggregates vs. Money Market Conditions as a policy guide • What should the authorities by focused on – the money supply or interest rates? • Depends on which has more stable links to real income. • Specifically would targeting the money supply give more predictable results or would targeting interest rates? • Depends on the relative stability of the Keynesian vs Monetary multipliers

8. Keynes-Monetarist VII

9. Keynes-Monetarist VIII

10. Keynes-Monetarist IX • Fixed vs. Flexible Exchange Rates • Positions between the two schools not as sharp • In general monetarists like markets so prefer flexible exchange rates • Keynesians skeptical of market efficiency so usually opt for fixed rates. • Currently, however some countries can clearly be managed better with fixed exchange rates – fiscal policy strong, financial markets underdeveloped – China • In other cases good financial markets and dysfunctional fiscal policy – U.S. -- better to go with monetary policy and flexible exchange rates

11. Keynes-Monetarist X • Rational Expectations • Spin-off from the monetarist school • Argument centers on rational behavior and information. • Rational expectations economists feel any government policy will ultimately come at a cost • Rational people know this and will take action to avoid the cost – or at least prepare themselves for the time when it hits • Examples – monetary expansion – should lower interest rates and stimulate investment • Rational expectations suggest people anticipate the inflationary effects of money supply increases and actually raise interest rates to avoid negative rates of return. • Easy to see following the S&L crisis in the late 1970s.

12. Keynes-Monetarist XI • Ricardian (yes, same fellow) equivalence. • Government has a fiscal stimulus financed by debt to increase economic activity • Rational people know sooner or later their tax bill will go up to pay for the deficit – cut consumption so the fiscal stimulus is neutralized. • Rational expectations economists claim the government policy can’t affect the economy because rational people can’t be fooled and will protect themselves • Often produce detailed statistical studies supporting their case – especially for Ricardian equivalence which seems a little too rational • Keynesians contend there are still enough stupid people out there so monetary/fiscal policies are effective

13. Keynes-Monetarist XI • Trade-off, no trade-off

14. Keynes-Monetarist XII • Problem of short vs. long run • Monetarists assume economy is fairly competitive • Keynesians look more at market rigidities • In the short run a fiscal stimulus might reduce unemployment – if there is a wage lag behind prices • Employment could increase because the real wage is suppressed. • In the longer term however workers want a cost of living increase to compensate for the price inflation • Real wage back to starting point and so is unemployment • Trade-off is a short-run illusion • Monetarists – can not reduce unemployment at going wages unless increase productivity of workers.