2. When you have completed your study of this chapter, you will be able to C H A P T E R C H E C K L I S T Discuss whether fiscal policy or monetary policy is the better stabilization tool. 1 Explain the rules-versus-discretion debate and compare Keynesian and monetarist policy rules. 2 Assess whether policy should target the price level rather than real GDP. 3

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.

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. Figure 18.1 on the next slides illustrate these propositions.

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.

7. 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.

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 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.

12. 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.

13. 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.

14. 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.

15. 18.1 FISCAL VERSUS MONETARY POLICY 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 and fiscal policy has a large multiplier effect on aggregate expenditure.

16. 18.1 FISCAL VERSUS MONETARY POLICY Reality Neither extreme occurs in real economies.

17. 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.

18. 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.

19. 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. 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.

20. 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.

21. 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.

22. 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.

23. 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.

24. 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.

25. 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.

26. 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.

27. 18.2 RULES VERSUS DISCRETION Figure 18.2 shows a decrease in aggregate demand brings recession. Aggregate demand decreases from AD 0 to AD 1. Real GDP decreases to $9.8 trillion, and the GDP deflator falls to 107—the economy goes into recession.

29. 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 study here is one in which the money supply remains constant.

30. 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 A feedback-rule policy tries to restores full employment as quickly as possible by keeping aggregate demand at AD 0. Figure 18.3(b) illustrates a Keynesian activist policy.

35. 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.

36. 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.

37. 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.

38. 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.

39. 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.

40. 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.

41. 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.

42. 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.

43. 18.2 RULES VERSUS DISCRETION Figure 18.4 shows how a decrease in aggregate supply brings recession. Aggregate supply decreases from AS 0 to AS 1. Real GDP decreases to $9.9 trillion, and the GDP deflator rises to 113—the economy goes into recession.

45. 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. Figure 18.5 on the next slides show the effects of these policy actions.

46. 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. A decrease in aggregate supply brings recession as the economy moves from A to B.

48. 18.2 RULES VERSUS DISCRETION A feedback-rule policy tries to restores full employment as quickly as possible, moving from B to C. A decrease in aggregate supply brings recession as the economy moves from A to B.

50. 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

51. 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

52. 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 AS 1 and AS 2, monetary policy aims to change aggregate demand to keep real GDP on target at $10 trillion.

54. 18.3 TARGETING INFLATION 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

55. 18.3 TARGETING INFLATION The blue band is the price level target. Figure 18.6(b) shows a monetary policy that targets the price level. As aggregate supply fluctuates between AS 1 and AS 2, monetary policy aims to change aggregate demand to keep the price level on target at 110.

57. 18.3 TARGETING INFLATION More General Targets Monetary policy might target something less extreme than either real GDP or the price level. It might place some weight on fluctuations in both real GDP and the price level. You can think of the macroeconomic stabilization target as the target in a shooting contest. Figure 18.7 on the next slide shows three possible shapes for the target.

58. 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.

60. 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 more stable real GDP.

61. 18.3 TARGETING INFLATION  Zero Versus Positive Inflation The 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.

62. 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 does not stand up to a close look.

63. 18.3 TARGETING INFLATION Labor Market Lubricant A view is based on the belief that the natural rate hypothesis is incorrect and that a long-run tradeoff between inflation and unemployment exists—the long- run Phillips curve is not vertical. While there is plenty of evidence that money wage rates are sticky, there is no evidence that they are stickier downward than upward.

64. 18.3 TARGETING INFLATION So while there is plenty of evidence that a short-run tradeoff exists, there is no evidence that a long-run tradeoff exists. The natural rate hypothesis appears to be correct, so this argument for positive inflation is incorrect.

65. 18.3 TARGETING INFLATION The Zero Lower Bound Lawrence Summers, former U.S. Treasury Secretary, suggested that there is a long-run tradeoff between inflation and unemployment that arises from the fact that the nominal interest rate cannot fall below zero. This argument is an old one.

66. 18.3 TARGETING INFLATION It was a subject of much debate before and during the Great Depression and has, for many years, been known to be incorrect. The Fed can always inject more money into the economy. And even if the nominal interest rate does not fall, more money brings more spending by way of an exchange rate effect and a buying power of money effect.