1. 30 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 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

2. ●Velocity and the Quantity Theory of Money ●Fiscal Policy, Interest Rates, and Velocity ●Debate: Should We Rely on Fiscal or Monetary Policy? ●Debate: Should the Fed Control the Money Supply or Interest Rates? ●Velocity and the Quantity Theory of Money ●Fiscal Policy, Interest Rates, and Velocity ●Debate: Should We Rely on Fiscal or Monetary Policy? ●Debate: Should the Fed Control the Money Supply or Interest Rates? Contents Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.

3. ●Debate: The Shape of the Aggregate Supply Curve ●Debate: Should the Government Intervene? ●Dimensions of the Rules-Versus-Discretion Debate ●Debate: The Shape of the Aggregate Supply Curve ●Debate: Should the Government Intervene? ●Dimensions of the Rules-Versus-Discretion Debate Contents Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.

4. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●Velocity = number of times per year that an “average dollar” is spent on goods and services ♦V = Nominal GDP  Money stock ♦Equation of exchange: M  V = P  Y ●Velocity = number of times per year that an “average dollar” is spent on goods and services ♦V = Nominal GDP  Money stock ♦Equation of exchange: M  V = P  Y Velocity and the Quantity Theory of Money

5. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Velocity and the Quantity Theory of Money ●The equation of exchange is simply an accounting identity. ●If V were constant, the equation would become a strict quantity theory of money. ♦  M   GDP ♦Implies that Fed can control nominal GDP ●The equation of exchange is simply an accounting identity. ●If V were constant, the equation would become a strict quantity theory of money. ♦  M   GDP ♦Implies that Fed can control nominal GDP

6. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Velocity and the Quantity Theory of Money ●In the United States, however, velocity is not constant.

7. FIGURE 30-1 Velocity of Circulation, 1929-2001 Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. V 2 0.5 1.0 1.5 2.5 2.0 3.0 Year (b) Velocity 20011990198019701960195019401930 0.0 V 1 8.5 7.5 8.0 Year (a) Velocity 20011990198019701960195019401930 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0 6.5 7.0

8. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●The Determinants of Velocity ♦Frequency of cash infusions ♦Efficiency of the payments system ♦Interest rates ♦Rate of inflation ●The Determinants of Velocity ♦Frequency of cash infusions ♦Efficiency of the payments system ♦Interest rates ♦Rate of inflation Velocity and the Quantity Theory of Money

9. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Velocity and the Quantity Theory of Money ●The Determinants of Velocity ♦Since these factors change over time, velocity also changes. ♦Only by studying the determinants of V can we hope to predict the growth rate of nominal GDP from knowledge of the growth rate of M. ●The Determinants of Velocity ♦Since these factors change over time, velocity also changes. ♦Only by studying the determinants of V can we hope to predict the growth rate of nominal GDP from knowledge of the growth rate of M.

10. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Velocity and the Quantity Theory of Money ●Monetarism: The Quantity Theory Modernized ♦Monetarism = method of studying AD by focusing on M and V, rather than on C, I, G and (X - IM) as the Keynesians do ●Monetarism: The Quantity Theory Modernized ♦Monetarism = method of studying AD by focusing on M and V, rather than on C, I, G and (X - IM) as the Keynesians do

11. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Velocity and the Quantity Theory of Money ●Monetarism: The Quantity Theory Modernized ♦When V is fairly constant, economists tend toward monetarism. ♦When V is erratic (as in recent years in the United States), most economists abandon it. ●Monetarism: The Quantity Theory Modernized ♦When V is fairly constant, economists tend toward monetarism. ♦When V is erratic (as in recent years in the United States), most economists abandon it.

12. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●There is little real difference between monetarist and Keynesian analysis. ●Fiscal policy can be analyzed through the monetarist framework, just as well as through the Keynesian, because of its effect on V. ●There is little real difference between monetarist and Keynesian analysis. ●Fiscal policy can be analyzed through the monetarist framework, just as well as through the Keynesian, because of its effect on V. Fiscal Policy, Interest Rates, and Velocity

13. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●  G  ♦  money demand ♦  interest rates ♦  V ♦  nominal GDP (equation of exchange) ●  G  ♦  money demand ♦  interest rates ♦  V ♦  nominal GDP (equation of exchange) Fiscal Policy, Interest Rates, and Velocity

14. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●But some of the impact is “crowded out.” ♦  interest rates   investment ♦ So  GDP < amount the oversimplified multiplier would predict ●But some of the impact is “crowded out.” ♦  interest rates   investment ♦ So  GDP < amount the oversimplified multiplier would predict Fiscal Policy, Interest Rates, and Velocity

15. FIGURE 30-2 The Federal Reserve’s Policy Dilemma Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. 10% Money demand shifts out 1 2 3 0 850830840 D 0 M 0 4 9 For given Fed policy 8 7 6 5 D 1 M 1 Interest Rate Money in Billions of Dollars M S W A Z E

16. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Fiscal Policy, Interest Rates, and Velocity ●Application: The Multiplier Formula Revisited ♦The oversimplified multiplier ignores: ■Variable imports ■Price-level changes ■Income tax ■The  interest rates that accompany any  autonomous spending (and vice versa) ♦All these factors   size of multiplier. ●Application: The Multiplier Formula Revisited ♦The oversimplified multiplier ignores: ■Variable imports ■Price-level changes ■Income tax ■The  interest rates that accompany any  autonomous spending (and vice versa) ♦All these factors   size of multiplier.

17. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Fiscal Policy, Interest Rates and Velocity ●Application: Deficit Reduction and Investment ♦Contractionary fiscal policies (  T and/or  G)   budget deficit ♦  deficit  ■  real interest rates ■  investment spending ●Application: Deficit Reduction and Investment ♦Contractionary fiscal policies (  T and/or  G)   budget deficit ♦  deficit  ■  real interest rates ■  investment spending

18. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Debate: Should We Rely on Fiscal or Monetary Policy? ●Fiscal policy affects the economy more quickly. ●Monetary policy can be implemented more quickly. ●Fiscal policy affects the economy more quickly. ●Monetary policy can be implemented more quickly.

19. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●Given the partisanship in Congress (where fiscal policy is decided) and the commitment in the 1990s to reduce the federal deficit, monetary policy currently appears to be the only game in town. Debate: Should We Rely on Fiscal or Monetary Policy?

20. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Debate: Should Fed Control Money Supply or Interest? ●When the demand for money is shifting, the Fed cannot control both the money supply and interest rates.

21. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●Recent history shows the harmful effects of focusing on one goal to the exclusion of the other. ●In the 1990s, the demand for money has been erratic, so the Fed has been eclectic. ●Recent history shows the harmful effects of focusing on one goal to the exclusion of the other. ●In the 1990s, the demand for money has been erratic, so the Fed has been eclectic. Debate: Should Fed Control Money Supply or Interest?

22. FIGURE 30-3 The Behavior of Interest Rates, 1979-1985 Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. Bank prime rate Year 3-month Treasury bills Percent 1985198419831982198119801979 0 21 20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5

23. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●Flat AS curve  expansionary policy ♦  unemployment ●Steep AS curve  restrictive policy ♦  inflation ●Flat AS curve  expansionary policy ♦  unemployment ●Steep AS curve  restrictive policy ♦  inflation Debate: The Shape of the Aggregate Supply Curve

24. FIGURE 30-4 Alternative Views of the Aggregate Supply Curve Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. Price Level (b) Real GDP Steep aggregate supply curve Price Level (a) Real GDP Flat aggregate supply curve S S S S

25. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●The AS curve is fairly flat in the short run and fairly steep in the long run. ●Effects of  AD ♦On output in the short run ♦On prices in the long run ●The AS curve is fairly flat in the short run and fairly steep in the long run. ●Effects of  AD ♦On output in the short run ♦On prices in the long run Debate: The Shape of the Aggregate Supply Curve

26. FIGURE 30-5 Stabilization Policy with a Flat AS Curve Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. (b) Contractionary Policy 5,6006,000 Fall in price Fall in output Real GDP D 0 D 0 S S (a) Expansionary Policy 6,0006,400 Price Level 99 100 101 Price Level 99 100 101 Rise in price Rise in output Real GDP D 0 D 0 S S E D 2 D 2 D 1 D 1 A E B

27. FIGURE 30-6 Stabilization Policy with a Steep AS Curve Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. D 1 D 1 90 Fall in output Rise in output (b) Contractionary Policy 5,9006,000 Price Level 100 110 Fall in price Real GDP D 0 D 0 (a) Expansionary Policy 6,0006,100 Price Level 90 100 110 Rise in price Real GDP D 0 D 0 S S S S A E E D 2 D 2 B

28. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●The debate is partly political. ●It also depends on strictly economic questions: ♦How long are the lags? ♦How effective are the automatic stabilizers? ●The debate is partly political. ●It also depends on strictly economic questions: ♦How long are the lags? ♦How effective are the automatic stabilizers? Debate: Should the Government Intervene?

29. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Debate: Should the Government Intervene? ●Lags and the Rules-versus-Discretion Debate ♦Long lags  attempts at stabilizing the economy can actually destabilize it ■How fast the economy’s self-correcting mechanism works ■How long the lags in stabilization policy are ■How accurate economic forecasts are ●Lags and the Rules-versus-Discretion Debate ♦Long lags  attempts at stabilizing the economy can actually destabilize it ■How fast the economy’s self-correcting mechanism works ■How long the lags in stabilization policy are ■How accurate economic forecasts are

30. FIGURE 30-7 A Typical Business Cycle Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. Potential GDP Actual GDP Actual and Potential GDP A B C D E Time

31. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Debate: Should the Government Intervene? ●Dimensions of the Rules-versus-Discretion Debate ♦Speed of the economy’s self-correcting mechanism ♦Length of lags in stabilization policy ♦Accuracy of economic forecasts ♦Size of government ♦Uncertainties caused by government policy ♦Political business cycle ●Dimensions of the Rules-versus-Discretion Debate ♦Speed of the economy’s self-correcting mechanism ♦Length of lags in stabilization policy ♦Accuracy of economic forecasts ♦Size of government ♦Uncertainties caused by government policy ♦Political business cycle

32. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●The case for active discretionary policy is strong when the economy has a serious deficiency or excess of aggregate demand. ●However, advocates of fixed rules are right that it is unwise to try to iron out every little wiggle in the growth path of GDP. ●The case for active discretionary policy is strong when the economy has a serious deficiency or excess of aggregate demand. ●However, advocates of fixed rules are right that it is unwise to try to iron out every little wiggle in the growth path of GDP. Dimensions of the Rules- Versus-Discretion Debate

33. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Dimensions of the Rules- Versus-Discretion Debate ●No end is in sight for the rule-versus- discretion debate. ♦Differences in political and philosophical beliefs ♦Differences in economic analysis ●No end is in sight for the rule-versus- discretion debate. ♦Differences in political and philosophical beliefs ♦Differences in economic analysis