1. PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University 1 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 –Number of times per year that an “average dollar” is spent on goods and services –The ratio of nominal gross domestic product (GDP) to the number of dollars in the money stock 2 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3. Velocity Nominal GDP –Nominal gross domestic product –Measure of money value of transactions =Real GDP (Y) price level (P) 3 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4. Velocity Equation of exchange –States that the money value of GDP transactions –Must be equal to the product of the average stock of money times velocity 4 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5. Quantity Theory Of Money Quantity theory of money –Assumes that velocity is (approximately) constant Nominal GDP is proportional to the money stock –Transforms the equation of exchange From an arithmetic identity into an economic model 5 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

6. Velocity In real world –Velocity is not a fixed number V1 –Velocity of M1 money supply –Moves more erratically V2 –Velocity of M2 money supply –Much more stable 6 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

7. Figure 1 Velocity of Circulation, 1929–2010 7 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

8. Velocity Some determinants of velocity –Efficiency of payments system Funds move quickly in and out of M1 and M2 –Interest rates Opportunity cost of holding money Increase, velocity rises The Fed raises the money supply (M) –M ˣ V increase by a smaller percentage than M 8 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

9. Velocity Monetarism –Uses the equation of exchange –To organize and analyze macroeconomic data Monetarists –Velocity changes are fairly predictable –Equation of exchange in growth-rate form 9 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

10. Debate: The Fed – Unconventional Debate: should the Fed use unconventional monetary policies? Conventional monetary policy –Change the federal funds rate Down – boost the economy Up - to restrain the economy –Open market operations –Buy T-bills – to create bank reserves –Sell T-bills – to destroy reserves –Lends money to banks 10 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

11. Debate: The Fed – Unconventional Unconventional monetary policy –Create bank reserves – buy Treasury bonds Private-sector assets, mortgage-backed securities –Lending massive amounts to banks And even to some nonbanks –Emergency “rescue” operations for troubled financial institutions 11 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

12. Debate: The Fed – Unconventional Why the extraordinary policies? –Federal funds rate reached zero –Two options Do nothing Try unconventional and unprecedented policies 12 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13. Debate: The Fed – Unconventional 2009, FOMC – purchase over $1 trillion of mortgage-backed securities (MBS) –Buyer of last resort [of MBS] Sky high interest rates on MBS –Interest rate spreads on MBS over Treasuries had soared to extraordinary levels –Intent: to raise MBS prices and lower their yields Shrinking the risk spreads over Treasuries –The Fed – turned a profit 13 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

14. Debate: The Fed – Unconventional Why did the Fed take the risk of purchasing MBS? –Time was of the essence during the acute stages of the crisis –Only the central bank can serve as lender of last resort –The huge federal budget deficit Increasingly serious constraint on fiscal policy 14 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

15. Debate: The Fed – Unconventional Critics of Fed’s unconventional policies –Assuming authority that belongs to the Congress and inserting itself into politics Decide which financial institutions would survive and which would fail –Tacitly appropriating taxpayer money Power reserved to Congress By putting its own money at risk –Opening the door to future inflation By printing so much money 15 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

16. Debate: Fight Asset Price Bubbles? Debate: should policy makers fight asset price bubbles? The Fed’s traditional answer: NO –Identifying asset price bubbles before they burst is a tricky business –The Fed may not have any policy instruments that it can aim directly at an asset price bubble 16 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

17. Debate: Fight Asset Price Bubbles? Rethinking the issue –History: most harmful bubbles are those that are financed by heavy borrowing and extensive use of leverage –Mitigate the consequences of bubbles Keep a watchful eye on bank lending practices The Dodd-Frank Act of 2010 –Impossible to prevent bubbles 17 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

18. Debate: Fiscal or Monetary Policy? Debate: should we rely on fiscal or monetary policy? Lags in stabilization policy refer –Delays between the time when the need for stabilization policy arises –And the time when the policy has its actual effects on the economy 18 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

19. Debate: Fiscal or Monetary Policy? Fiscal policy decisions –Affects aggregate demand faster than monetary policies –Policy lags Study the economy Decide steps Then implement the decisions 19 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

20. Debate: Fiscal or Monetary Policy? Monetary policy decisions –Made frequently by FOMC –Executed immediately –Policy lags – shorter Old conventional wisdom –Policy lags are normally much shorter for monetary policy than for fiscal policy 20 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

21. Debate: Fiscal or Monetary Policy? Questioning the conventional wisdom –Speedy fiscal responses Congress can act quickly when it must –Massive recessionary gap Developed starting in 2008 We needed both fiscal and monetary policy –Once the federal funds rate reaches zero Monetary policy faces special problems Can use some help from fiscal policy 21 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

22. Debate: Shape of the AS Curve Debate: the shape of the aggregate supply curve Aggregate supply curve – quite flat –Large increase in output can be achieved with little inflation –Antirecession policy - successful –Restrictive stabilization policy – not effective Small decrease in inflation with large decrease in real GDP 22 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

23. Figure 2 Alternative Views of the Aggregate Supply Curve 23 Real GDP Price level S S (a) Real GDP Price level S S (b) Steep aggregate supply curve Flat aggregate supply curve © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

24. Figure 3 Stabilization Policy with a Flat Aggregate Supply Curve 24 Price Level 0 Real GDP 6,400 6,000 S S D0D0 D0D0 100 E 101 D1D1 D1D1 A (a) Expansionary policy Price Level 0 Real GDP 5,600 6,000 S S D0D0 D0D0 100 E 99 D2D2 D2D2 B (b) Contractionary policy Rise in output Rise in price Fall in price Fall in output © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

25. Debate: Shape of AS Curve Aggregate supply curve – quite steep –Prices respond strongly to changes in output –Expansionary fiscal or monetary policy Great inflation Little change in GDP –Contractionary policy – effective Decrease price level 25 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

26. Figure 4 Stabilization Policy with a Steep Aggregate Supply Curve 26 Price Level 0 Real GDP 6,100 6,000 S S D0D0 D0D0 100 E 110 D1D1 D1D1 A (a) Expansionary policy Price Level 0 Real GDP 5,900 6,000 S S D0D0 D0D0 100 E 90 D2D2 D2D2 B (b) Contractionary policy Rise in output Rise in price Fall in price Fall in output © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

27. Debate: Shape of AS Curve Steepness of aggregate supply schedule –Depends on the time frame Very short run – flat aggregate supply –Fluctuations in aggregate demand Large effects on output Minor effects on prices Long run – steep aggregate supply –Changes in demand Affect prices, not output 27 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

28. Debate: Government Intervention? Debate: should the government intervene at all? Most fundamental and controversial debate of all –Is it likely that government policy can stabilize the economy successfully? –Or are even well-intentioned efforts likely to do more harm than good? 28 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

29. Debate: Government Intervention? Liberals –More intervention-minded –More favorably disposed toward an activist stabilization policy Conservatives –More inclined to keep the government’s hands off the economy –Favor adhering to fixed rules 29 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

30. Debate: Government Intervention? Critics of stabilization policy –Lags and uncertainties - fiscal and monetary policies –Skepticism - ability to forecast the future –Worry that stabilization policy may fail –Advise: passive policies 30 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

31. Debate: Government Intervention? Advocates of active stabilization policies –Perfection is unattainable –More optimistic about the prospects for success –Much less optimistic about how smoothly the economy would grow –Advocate active policies 31 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

32. Debate: Government Intervention? Lags and the Rules-versus-Discretion Debate Lags –Lead to a fundamental difficulty for stabilization policy –Attempts at stabilizing the economy may actually succeed in destabilizing it 32 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

33. Figure 5 A Typical Business Cycle 33 Time Actual and Potential GDP Potential GDP Actual GDP C B D E A © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

34. Rules-vs.-Discretion Debate Dimensions of the rules-versus-discretion debate Economy’s self-correcting mechanism –If fast and efficient - No intervention –If slow - Discretionary policy Lags in stabilization policy –Long and unpredictable lags –Short and reliable lags 34 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

35. Rules-vs.-Discretion Debate Accuracy of economic forecasts –Not terribly accurate –Good enough for policy makers Discretionary stabilization policy to close persistent and sizable gaps between actual and potential GDP Size of government – bogus argument –Active fiscal policy must inevitably lead to a growing public sector 35 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

36. Rules-vs.-Discretion Debate Uncertainties caused by government policy –Frequent changes – more difficult for businesses –Better for the economy Political business cycle –Fiscal policy – by elected politicians Subject to “political manipulations” –Monetary policy – by the Fed - apolitical 36 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.