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

Outline

• Quantity theory of money• Monetarism• Fiscal policy revisited• Debate over fiscal and monetary policy

Velocity & Quantity Theory Of Money

• Velocity– Speed at which money circulates

– Number of times per year an “average dollar” is spent on goods & services

– Velocity = Nominal GDP / Money StockVelocity = Nominal GDP / Money Stock

3

GDP Nominal Velocity supply Money

M

GDP NominalVelocity

M

YP

Velocity & Quantity Theory Of Money

• Equation of Exchange

4

YPVM

Velocity & Quantity Theory Of Money

• Quantity theory of money– Equation of exchange

– Economic model

– Changes in velocity – minor• Velocity - constant

– Nominal GDP• Proportional to money stock

5

YPVM %%%%

Velocity of circulation for M1 and M2, 1929–2007

Figure 1

6

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

7

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 Fed should take into account the change of v when conducts monetary change of v when conducts monetary policypolicy

Velocity & Quantity Theory Of Money

• Monetarism – Start with equation of exchange

• Equation of exchange – growth rate form

• Given ∆V, ∆M directlydirectly affects change in nominal GDP ∆(PY)

• Keynesian approach: monetary policy indirectlyindirectly affect I through interest rate

9

YPVM %%%%

Monetarism

• In short-run, V and Y are constant

• Inflation is always a monetary phenomenonInflation is always a monetary phenomenon

PM %%

Money supply and Inflation

Discussion

• Why the growth rate of M2 is always Why the growth rate of M2 is always higher than that of inflation? higher than that of inflation? (Monetarism predicts that they should (Monetarism predicts that they should be same)be same)

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

13

Fiscal Policy, Interest Rates, & Velocity

• Rise in G– Pushes interest rates higher

• Deters some investment spending (“crowding-crowding-outout” effect)

• Increase in C + I + G + (X - IM) - smaller

• Oversimplified formula 1/(1-MPC)– Overstates multiplier

1.Ignores variable importsvariable imports

2.Ignores price-level changesprice-level changes

3.Ignores income taxincome tax

4.Ignores rising interest ratesrising interest rates 14

Fiscal Policy, Interest Rates, & Velocity

• Reduce budget deficit– Contractionary fiscal policies

• Lower spending or higher taxes

– Reduce real interest rates

– Spur investment spending

15

Debate: Fiscal or Monetary Policy?• Which one is more powerfulmore powerful?

– Keynesian: fiscal policy– Monetarist: monetary policy

• Which one works fasterfaster?

– 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

Debate: the Fed - Control M or r?

• Keynesian: Fed should use OMO to control rr

• Monetarist: control MM since it is the major driving force behind inflation

17

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

The Federal Reserve’s policy dilemma

Figure 2

19

0

Money Supply (in billions of dollars)

840830

Inte

rest

Rat

es

10%9

8765

4321

S

M D0

M0

D1

M1

A

W

850

ZE

For given Fed policy

Money demand shifts out

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↑ 20

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 21

The behavior of interest rates, 1979–1985

Figure 3

22

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

23

Alternative views of the aggregate supply curve

Figure 4

24

Real GDP

Pric

e le

vel

S

S

(a)

Real GDP

Pric

e le

vel

S

S

(b)

Steep aggregate

supply curve

Flat aggregate

supply curve

Stabilization policy with a flat aggregate supply curve

Figure 5

25

Pric

e Le

vel

0

Real GDP

6,4006,000

S

S

D0

D0

100

E101

D1

D1

A

(a) Expansionary policy

Pric

e Le

vel

0

Real GDP

5,600 6,000

S

S

D0

D0

100

E

99

D2

D2

B

(b) Contractionary policy

Rise in

output

Rise in priceFall in price

Fall in

output

Debate: Shape of Aggregate Supply Curve

• Aggregate supply curve – steep– Small increase in output

– Great inflation

– Expansionary fiscal or monetary policy• Great inflation• Little change in GDP

– Contractionary policy – effective• Decrease price level

26

Stabilization policy, a steep aggregate supply curve

Figure 6

27

Pric

e Le

vel

0

Real GDP

6,1006,000

S

S D0

D0

100

E110

D1

D1

A

(a) Expansionary policy

Pric

e Le

vel

0

Real GDP

5,900 6,000

S

S D0

D0

100

E

90

D2

D2

B

(b) Contractionary policy

Rise in

output

Rise in price

Fall in price

Fall in output

Debate: Shape of Aggregate Supply Curve

• Steepness of aggregate supply schedule– Depends on time period

• Very short run – flatflat 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

28

Debate: Shape of Aggregate S Curve

• Long run – steepsteep 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

Debate: Shape of Aggregate Supply Curve

• Any change in AD will have most of its effect on outputoutput in the short run but on pricesprices in the long run

Debate: Should Government Intervene?

• Some economists (most liberal) advocate active stabilization policy– Policy has to be discretionarydiscretionary

– G↑ or T↓ or lower r when recessionary gap, “lean against the windlean against the wind”

– Reverse when inflationary gap

31

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 rulesfixed rules

Discussion

• Rule vs. Discretionary, which one do Rule vs. Discretionary, which one do you prefer?you prefer?

A typical business cycle

Figure 7

34

Time

Act

ual a

nd P

oten

tial G

DP

Potential GDP

Actual GDP

CB

D

E

A

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 election35

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 crediblecredible.

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