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The Debate over Monetary and Fiscal Policy
Chapter 14 The Debate over Monetary and Fiscal Policy The love of money is the root of all evil. THE NEW TESTAMENT Lack of money is the root of all evil. GEORGE BERNARD SHAW
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Outline Quantity theory of money Monetarism Fiscal policy revisited
Debate over fiscal and monetary policy
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Velocity & Quantity Theory Of Money
Speed at which money circulates Number of times per year an “average dollar” is spent on goods & services Velocity = Nominal GDP / Money Stock
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Velocity & Quantity Theory Of Money
Equation of Exchange
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Velocity & Quantity Theory Of Money
Equation of exchange Economic model Changes in velocity – minor Velocity - constant Nominal GDP Proportional to money stock
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Figure 1 Velocity of circulation for M1 and M2, 1929–2007
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Velocity & Quantity Theory Of Money
Determinants of velocity Efficiency of payments system decreases M, and hence increases v Financial innovation: credit card, … Computerization: online banking, … Interest rates (opportunity cost of holding cash) Higher r → lower M, higher velocity
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Caveat for Fed Monetary Policy
Fed – increase money supply (M↑) Interest rates – decrease Velocity – decrease M ˣ V increase < increase in M Fed should take into account the change of v when conducts monetary policy
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Velocity & Quantity Theory Of Money
Monetarism Start with equation of exchange Equation of exchange – growth rate form Given ∆V, ∆M directly affects change in nominal GDP ∆(PY) Keynesian approach: monetary policy indirectly affect I through interest rate
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Monetarism In short-run, V and Y are constant
Inflation is always a monetary phenomenon
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Money supply and Inflation
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Discussion Why the growth rate of M2 is always higher than that of inflation? (Monetarism predicts that they should be same)
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Fiscal Policy, Interest Rates, & Velocity
Monetary policy Increase bank reserves & money supply Reduce interest rates Stimulates demand for investment Fiscal policy Increases in G or tax cuts Raise Y and P through multiplier effect PY↑ increases money demand Pushes up interest rates
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Fiscal Policy, Interest Rates, & Velocity
Rise in G Pushes interest rates higher Deters some investment spending (“crowding-out” effect) Increase in C + I + G + (X - IM) - smaller Oversimplified formula 1/(1-MPC) Overstates multiplier Ignores variable imports Ignores price-level changes Ignores income tax Ignores rising interest rates
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Fiscal Policy, Interest Rates, & Velocity
Reduce budget deficit Contractionary fiscal policies Lower spending or higher taxes Reduce real interest rates Spur investment spending
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Debate: Fiscal or Monetary Policy?
Which one is more powerful? Keynesian: fiscal policy Monetarist: monetary policy Which one works faster? Expenditure lag: fiscal policy is faster G or T affects AD more promptly Policy lag: monetary policy is shorter Made frequently (FOMC) Executed immediately (OMO) Fiscal policy has to go through annual budget cycle
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Debate: the Fed - Control M or r?
Keynesian: Fed should use OMO to control r Monetarist: control M since it is the major driving force behind inflation
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Debate: the Fed - Control M or r?
Fed cannot control both r and M simultaneously Demand curve for money - shifts outward (by expansionary fiscal policy) Rise in interest rates ( r) Rise in money stock (M) The Fed Keep M steady (use OMO sale) r - rises even more Keep r steady (use OMO purchase) M – rises even more
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Money Supply (in billions of dollars)
Figure 2 The Federal Reserve’s policy dilemma S M D0 M0 D1 M1 Interest Rates 10% 9 8 7 6 5 4 3 2 1 For given Fed policy W A 840 Z E 830 850 Money demand shifts out Money Supply (in billions of dollars)
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Debate: the Fed - Control M or r?
Dilemma of monetary policy target Target money supply (M) Demand for money – variable Difficult Wide fluctuations in interest rates Target interest rates (r) Change money supply to stabilize r Destabilize economy (M↑ in boom, M↓ in recession) AD↑ → Y and P↑ → Md↑ → r↑ → Fed has to lower down r by using OMO purchase → M↑ → AD↑
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Debate: the Fed - Control M or r?
What has Fed really done? Post WWII – target interest rates 1960s – monetarism Interest rate pegging actually destabilize the economy Should stabilize money supply growth rate 1979 – Volcker shifted the Fed target to money stock growth 1982 – back to target interest rates 1993 – Greenspan confirmed that Fed was no longer using M to guide policy
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Figure 3 The behavior of interest rates, 1979–1985
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Debate: Shape of Aggregate Supply Curve
Aggregate supply curve – flat Large increase in output Little inflation Anti-recession policy - successful Restrictive stabilization policy - fighting inflation by contracting AD – not effective
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Figure 4 Alternative views of the aggregate supply curve S Price level
Flat aggregate supply curve S Steep aggregate supply curve Real GDP Real GDP (a) (b)
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(a) Expansionary policy (b) Contractionary policy
Figure 5 Stabilization policy with a flat aggregate supply curve Price Level Price Level D0 D1 D0 S D2 A S E E 101 Rise in price 6,400 B 100 100 Fall in price 6,000 6,000 99 5,600 Rise in output Fall in output Real GDP Real GDP (a) Expansionary policy (b) Contractionary policy
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Debate: Shape of Aggregate Supply Curve
Aggregate supply curve – steep Small increase in output Great inflation Expansionary fiscal or monetary policy Little change in GDP Contractionary policy – effective Decrease price level
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(a) Expansionary policy (b) Contractionary policy
Figure 6 Stabilization policy, a steep aggregate supply curve Price Level Price Level D0 D1 S D0 A S D2 110 Rise in price 6,100 E E 100 100 6,000 Fall in price 6,000 B 90 5,900 Rise in output Fall in output Real GDP Real GDP (a) Expansionary policy (b) Contractionary policy
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Debate: Shape of Aggregate Supply Curve
Steepness of aggregate supply schedule Depends on time period Very short run – flat aggregate supply Workers cannot predict the inflation accurately, real wage ↓, firms thus like to expand the capacity Fluctuations in aggregate demand Large effects on output Minor effects on prices
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Debate: Shape of Aggregate S Curve
Long run – steep aggregate supply Workers get enough information and experience to predict the inflation, real wage not eroded by P↑, firms thus reluctant to increase production Changes in demand Affect prices, not output
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Debate: Shape of Aggregate Supply Curve
Any change in AD will have most of its effect on output in the short run but on prices in the long run
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Debate: Should Government Intervene?
Some economists (most liberal) advocate active stabilization policy Policy has to be discretionary G↑ or T↓ or lower r when recessionary gap, “lean against the wind” Reverse when inflationary gap
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Debate: Should Government Intervene?
Stabilization policy Difficulties in forecasting demand Long lags May destabilize the economy Some economists (most conservative) argue Natural self-correcting forces Automatic stabilizers Passive policy, adhere to fixed rules
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Discussion Rule vs. Discretionary, which one do you prefer?
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Figure 7 A typical business cycle Potential GDP E
Actual and Potential GDP Potential GDP Actual GDP E D A C B Time
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Rules-vs.-Discretion Debate
Economy’s self-correcting mechanism If fast & efficient - No intervention If slow - Discretionary policy Lags in stabilization policy Accuracy of economic forecasts Size of government – bogus argument Uncertainties - by government policy Political business cycle Expansionary policy near election
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Rules-vs.-Discretion Debate
Kydland & Prescott: “Time Inconsistency Problem” Public observes policy-makers and forms expectations of their likely actions. Policy-makers with discretion can renege on today’s pronouncements tomorrow; so, the public may come to discount such pronouncements as cheap talk Rules produce time-consistent outcomes because they make policy-makers’ pronouncements credible.
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Summary Quantity Theory of Money: MV=PY
Monetarism: inflation is always a monetary phenomenon Debate over monetary and fiscal policy Should we reply on Mon or Fis policy? Should Fed control M or r? AS curve is flat or steep? Government intervention: rule vs. discretion
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