Chapter 14 - The Debate over Monetary and Fiscal Policy

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Chapter 14 - The Debate over Monetary and Fiscal Policy Powered By Docstoc
					    Chapter 14
The Debate over Monetary
    and Fiscal Policy
Velocity & Quantity Theory Of Money
 • Velocity
    – Speed – at which money circulates
    – Number of times per year
    – An “average dollar”
    – Is spent - goods & services
    – Ratio of
      • Nominal gross domestic product (GDP)
      • To number of dollars in money stock


                                               2
Velocity & Quantity Theory Of Money

             Value of transactions Nominal GDP P  Y
  Velocity                                  
                 Money stock           M        M

 Money supply  Velocity  Nominal GDP

 • Equation of exchange
    – Money value of GDP transactions =
    = Average stock of money ˣ velocity
      M V  P  Y

                                                  3
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

     %M  %V  %P  %Y

                                      4
Figure 1
Velocity of circulation, 1929–2007




                                     5
Velocity & Quantity Theory Of Money
 • Determinants of velocity
    – Efficiency of payments system – ease and
      speed with which it is possible to exchange
      money for other assets
    – Interest rates – higher, greater the opportunity
      cost of holding money - higher velocity
 • Fed – increase money supply (M)
    – Interest rates – decrease
    – Velocity – decrease
    – M ˣ V increase < increase in M
    – Thus, on increase in money supply, M*V
      increases by a smaller percentage than does M      6
      itself.
Fiscal Policy, Interest Rates, & Velocity
  • Monetary policy
    – Increase bank reserves & money supply
       • Reduce interest rates
       • Stimulates demand for investment
  • Fiscal policy
    – Increases in government spending
       • Or tax cuts
       • Increase real GDP (Y) and price level , rising
        prices and rising output pushes the demand
        curve for bank reserves outward. Thus if
        there is no change in supply of reserves,
                                                          7
        interest rates rise
Fiscal Policy, Interest Rates, & Velocity

  • Rise in G
    – Pushes interest rates higher
       • Deters some investment spending
       • Increase in C + I + G + (X - IM) - smaller
  • Oversimplified formula 1/(1-MPC)
    – Overstates multiplier
       1.Ignores variable imports
       2.Ignores price-level changes
       3.Ignores income tax
       4.Ignores rising interest rates
                                                      8
Fiscal Policy, Interest Rates, & Velocity

  • Lower government budget deficit
    – Higher levels of private investment
  • Reduce budget deficit
    – Contractionary fiscal policies
       • Lower spending or higher taxes
    – Reduce real interest rates
    – Spur investment spending



                                            9
Debate: Fiscal or Monetary Policy?
• Stabilization policy - Lags
  – Fiscal policy
     • Affects aggregate demand faster
     • Policy lags
        – Study the economy, data collection is time
          consuming
        – Decide steps
        – Implement decisions
  – Monetary policy decisions
     • Made frequently
     • Executed immediately
     • Policy lags - shorter                           10
Debate: the Fed - Control M or r?

• Demand curve for money - shifts outward
  – Rise in interest rates ( r)
  – Rise in money stock (M)
  – The Fed
     • Keep M steady
        – r - rises even more
     • Keep r steady
        – M – rises even more




                                            11
Figure 2
The Federal Reserve’s policy dilemma

                                                      S
                         M0
                                 M1

               10%                     W                  For given Fed policy
                 9
                 8
   Interest Rates




                 7                           A
                 6
                 5                               Z
                                  E                            Money demand shifts out
                 4
                 3
                 2
                 1        M                      D0       D1

                     0              830 840 850
                              Money Supply (in billions of dollars)
                                                                                         12
Debate: the Fed - Control M or r?

• Target money supply
  – Demand for money – variable
     • Difficult
     • Wide fluctuations in interest rates – unsettling
      atmosphere for business decisions.
• Target interest rates
  – Change money supply
     • Destabilize economy



                                                      13
Debate: Shape of Aggregate Supply Curve
 • Aggregate supply curve – flat
   – Large increase in output can be achieved
     with little inflation
   – Expansionary policy - successful
   – Restrictive stabilization policy – not
     effective enough to bring inflation down.
     Instead, it serves mainly to reduce output.



                                               14
Figure 4
Alternative views of the aggregate supply curve
                                                               S



                  Flat aggregate
                                                                   Steep aggregate




                                       Price level
Price level




                  supply curve     S
                                                                   supply curve
              S




                                                     S

                   Real GDP                          Real GDP

                     (a)                                 (b)
                                                                                     15
Figure 5
Stabilization policy with a flat aggregate supply curve




                                                           Price Level
 Price Level



                   D0        D1                                                     D0



                                                      S                        D2
                                             A                                                                       S
                                    E                                                                      E
101
    Rise in price                                                                            B
100                                                        100               Fall in price
                                                            99
                   S                                                              S
                                                      D1
                                     Rise in     D0                                              Fall in            D0
                                     output                                                                    D2
                                                                                                 output
               0                  6,000   6,400                          0               5,600 6,000
                                  Real GDP                                                   Real GDP

                       (a) Expansionary policy                                 (b) Contractionary policy
                                                                                                                    16
Debate: Shape of Aggregate Supply Curve
 • Aggregate supply curve – steep
   – Small increase in output leads to high
     inflation
   – Expansionary fiscal or monetary policy
     • High inflation
     • Little change in GDP
   – Contractionary policy – effective
     • Decrease price level



                                              17
Figure 6
Stabilization policy, a steep aggregate supply curve




                                                           Price Level
 Price Level



                   D0        D1                  S                                  D0

                                          A                                                              S
110                                                                            D2
                   Rise in price      E                                                              E
100                                                        100
                                                                             Fall in price     B
                                                           90
                                                      D1
                            S        Rise in     D0                                      S               D2   D0
                                     output                                                  Fall in output
               0                   6,000 6,100                           0                   5,900 6,000
                                   Real GDP                                                  Real GDP

                     (a) Expansionary policy                                   (b) Contractionary policy
                                                                                                              18
Debate: Shape of Aggregate Supply Curve

  • Thus, in case of a flat supply curve, stabilization
    policy is much more effective at combating
    recession than inflation

  • In case of a steep supply curve, stabilization policy
    is more effective at combating inflation than
    recession




                                                          19
Debate: Shape of Aggregate Supply Curve
 • Steepness of aggregate supply schedule
   – Depends on time period
 • 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

                                            20
Debate: Should Government Intervene?
 • Stabilization policy
   – Long lags
   – May destabilize the economy
 • Some economists argue
   – Natural self-correcting forces
   – Automatic stabilizers




                                       21
Figure 7
A typical business cycle

                                                      Potential GDP
    Actual and Potential GDP




                                                             E
                                            D


                               A                Actual GDP


                                        C
                                   B



                                       Time


                                                                      22
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 –
  frequent changes in tax laws, government
  spending etc make it difficult for consumers
  to carry out rational plans
                                               23
• Political business cycle
Fiscal Lag

• Inside Lag
  – Recognition lag: Time that it takes policy
    makers to realize that a disturbance has
    occurred and a policy response is
    needed.

  – Decision lag: Time that it takes to decide
    on the most desirable policy response
Fiscal Lag

  – Legislative lag: Lag in the legislative
    process to give a go ahead to the
    proposed fiscal policy measures
  – Action lag: time it takes to implement the
    policy measure in terms of obtaining
    approval from ministries etc.
  Outside lag: Time that it takes for the policy
    measure once implemented to have an
    effect on the economy

				
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