1. Debate over Monetary Policy and Fiscal Policy Gene H Chang University of Toledo Econ 1150

2. Differences between Fiscal and Monetary Policies  Effects on different economic variables  Different impacts on the interest rate  Time lags are different

3. Differences  Direct effects on different economic variables  Look at AE = C + I + G + NX Fiscal policy: on C, GFiscal policy: on C, G Monetary policy: on IMonetary policy: on I

4. Differences  Different impacts on the interest rate An expansionary fiscal policy causes the interest rate to go upAn expansionary fiscal policy causes the interest rate to go up An expansionary monetary policy causes the interest rate to go downAn expansionary monetary policy causes the interest rate to go down  The different direction in interest rate will affect: InvestmentInvestment Exchange rate and net exportsExchange rate and net exports

5. Time lags Proposing policy Policy approved and implemented Impact on the economy Policy lag Action lag

6. Differences  Time lags Fiscal policy: long "policy lag" but "short action lag"Fiscal policy: long "policy lag" but "short action lag" Monetary policy: short "policy lag" but long "action lag"Monetary policy: short "policy lag" but long "action lag"

7. Keynesian views  Fiscal policy is more powerful: direct and more predictable  Monetary policy is weak, especially in recession: Liquidity trapLiquidity trap Investment is insensitive to interest rateInvestment is insensitive to interest rate Effect of the monetary policy is indirect and less predictableEffect of the monetary policy is indirect and less predictable

8. Monetary School and Monetarism  Challenge to the Keynesian view in 1960s and 1970s  Monetary School and Monetarism  Milton Friedman July 31, 1912 – Nov. 16, 2006July 31, 1912 – Nov. 16, 2006 considered to have been one of the two most influential economists of the 20th centuryconsidered to have been one of the two most influential economists of the 20th century Nobel Prize in Economics, 1976Nobel Prize in Economics, 1976

9. Monetary School and Monetarism  Equation of exchange  M × V = P × Y M = money stock or money supplyM = money stock or money supply V = velocityV = velocity P = priceP = price Y = real GDPY = real GDP PxY = nominal GDPPxY = nominal GDP

10. Monetary School and Monetarism  Velocity The speed at which money circulates in a yearThe speed at which money circulates in a year  What affects V? Interest rateInterest rate Payment frequencyPayment frequency

11. Monetary School and Monetarism  Monetarists use the equation of exchange to explain the economy The impact of an increase in MThe impact of an increase in M  More direct impact The impact of an increase in GThe impact of an increase in G  Less direct impact

12. Monetary School and Monetarism The impact of an increase in M  MV = PY  Ms increases  M X V up  P X Y up = nominal GDP go up  P rises and/or Y rises

13. Monetary School and Monetarism  The impact of an increase in G  MV = PY  G increases  Interest rate up  V rises  PxY goes up  Prices up and/or Y up

14. Monetary School and Monetarism  Will price increase more or output increase more from an expansionary policy?  depending on the shape of the aggregate supply (AS) curve  From Equation of exchange M×V=P×Y  %M + %V = %P + %Y  Growth rate of money + growth rate of velocity = inflation rate + GDP growth rate

15. Monetary School and Monetarism  Growth rate of money + growth rate of velocity = inflation rate + GDP growth rate  Exercise: what will be the inflation rate from a 10 percent growth in money supply?

16. Monetary School and Monetarism  Monetarism considers the fiscal policy is less powerful Indirect impactIndirect impact AS may be verticalAS may be vertical Crowding-out effectCrowding-out effect  An increase in government spending crowds out the private investment.

17. Monetary School and Monetarism  Crowding-out effect An increase in government spending crowds out the private investment.An increase in government spending crowds out the private investment. G increases => AE goes upG increases => AE goes up Interest upInterest up Private investment goes down => AE goes downPrivate investment goes down => AE goes down

18. Comments on Monetarism  Keynesians would argue that monetarists may go too far  What about crowd-in effect as the government spending takes the leading role  Liquidity and interest rate trap  AS may be horizontal in recession

19. Milton Friedman  Strongly advocating a free market economy, and a minimal role of government “ Free to choose” a best seller of non- fiction book“ Free to choose” a best seller of non- fiction book  Against government intervention and discretionary economic policies, consider they will destabilize the economyconsider they will destabilize the economy  Argued for a policy rule

20. Policy rule Friedman argued for some policy rules:  Constant money growth rate  Says it will be automatic stabilizer

21. Automatic Stabilizer  Constant money growth rate If the economy is overheatingIf the economy is overheating So long as the money growth is constantSo long as the money growth is constant Interest rate will upInterest rate will up Then investment will downThen investment will down Cool down the economyCool down the economy

22. Automatic Stabilizer  Stable income tax scheme If the economy is overheatingIf the economy is overheating Tax goes upTax goes up Consumption downConsumption down Cool down the economyCool down the economy

23. Remarks on automatic stabilizer  Does it work?  In 1970s and early 1980s the Fed follows the constant money growth rule then the interest rate fluctuated greatly  Caused a lot of pains to the economy  So Fed returns to the previous practice to focus more on the interest rate stability

24. Fed funds rate (interest rate)

25. Remarks on monetarism  Although not a main-stream, monetary school has made a great impact on economics thinking.  Most economists are very much influenced by the monetarism  We now also consider the importance of money