NS3040 Fall Term 2014 Keynesian/Monetarist Debates

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 2

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. 3

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 4

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

Keynes-Monetarist V 6

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 7

Keynes-Monetarist VII 8

Keynes-Monetarist VIII 9

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 10

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. 11

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 12

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

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. 14