The Debate Over Monetary and Fiscal Policy

15

Debates over Monetary and Fiscal Policy

• Stabilization policy• During the 2008-09 financial crisis the Obama

administration and the FED took dramatic steps to offset the recession.• Fiscal policy was classic text-book response. • Monetary policy started off “conventional” and then

went “unconventional”(see previous chapter)

• Some prominent economists feel attempts to stabilize the economy don’t work – best to either stay out or follow a fixed rule.

• Up to this point we have studied Keynesian type theories. Now we talk about Monetarism and compare

• Debates over the appropriate design of policy

From Chapter 11 - Some Harsh Realities

• Complications• Expectations, technology, events abroad, and

other factors constantly shift expenditure functions

• Multipliers not precisely known• Full-employment GDP difficult to measure• Fiscal policies act with time lags• Politicians are in charge

3

Chapter 11:Problems and Complication With Fiscal Policy

4

0

Real GDP

Rea

l Exp

endi

ture 45°

C+I+G0+(X-IM)

7,000

PotentialGDP

(a)

Recessionary gap is a guess

Expectations, technology, events abroad, and other factors constantly shift expenditure functions – AE is not stable or predictable

Full-employment GDP difficult to measure

6,000

Monetarism, Velocity and the Quantity Theory of Money

• The Quantity Theory of Money• Velocity

• Number of times per year that an “average dollar” is spent on goods and services

• Calculated as the ratio of nominal gross domestic product (GDP) to the number of dollars in the money stock• V = Nominal GDP / Money Stock

5

Velocity

• Nominal GDP• Measure of money value of transactions• Real GDP (Y) x Price level (P)

6

Velocity (V )=Value of Transactions

Money Stock¿

Nominal GDPM ¿

P xYM

Velocity

• M x V = P x Y: 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

• Note this an arithmetic link (i.e., true by definition), not economic

7

Quantity Theory Of Money

• Quantity theory of money• Assumes that velocity is (approximately)

constant so nominal GDP is proportional to the money stock

• Rewrite equation of exchange in growth rates

• If velocity is constant then %ΔV = 0

• If true, monetary policy is simple - rate of growth in the money supply determines nominal GDP.

8

% Δ M x % Δ V=% Δ P x % ΔY

M xV =P xY

Figure 1 Velocity of Circulation, 1929–2013

9

In real world, velocity not constant

Velocity• Strict quantity theory not an adequate

model of AD because V is not constant• Determinants of velocity

• Changes in/and efficiency of payments system• Funds move quickly in and out of M1 and M2

• Interest rates• Interest rate is the opportunity cost of holding money.• As interest rates increase, people hold smaller cash

balances which means the stock of money circulates faster

• velocity increases when interest rates rise.

10

Velocity

• If velocity is NOT constant (or predictable) the impact of monetary policy is not predictable.

• As the Fed increases the money supply (M)

• Interest rates fall so velocity falls as well• Part of the impact of the increase in M is offset fall a

decrease in V• M x V increase by a smaller percentage than M

11

M xV =P xY

Velocity

• Monetarism • Uses the equation of exchange to organize and analyze

macroeconomic data • Assumes velocity (V) change is fairly predictable,

especially in long run

• versus Keynesians:C + I + G + NX = Y

12

% Δ M x % Δ V=% Δ P x % ΔY

• Two competing theories of AD.• In Keynesian theory: M => r => I = Y• In Monetarism: M => P x Y , role of money not

limited to working through the interest rate.

Should the Fed Use Unconventional Policy?

• Conventional monetary policy is hard enough!• Adjust the federal funds rate using open market operations

• Expansionary policy• Purchase T-Bills to increase bank reserves and

reduce the federal funds rate• Contractionary policy

• Sell T-Bills to decrease bank reserves and increase the federal funds rate

• Lend reserves to banks

13

Monetary Policy Chain of Causation

Expansionary Policy

(1) Injection of reserves into the banking system pushes down interest rates

Need to know how sensitive interest rates are to change in reserves

Monetary Policy Chain of Causation

Expansionary Policy

(1) Injection of bank reserves pushes down interest rates

Need to know how sensitive C and I are to changes in interest ratesNeed to know size of multiplier.

(2) Lower r, stimulates investment and possibly consumer spending

(3) An increase in I and C causes total spending to increase

(4) GDP increases: multiplier analysis

Should the Fed Use Unconventional Policy?

• Unconventional monetary policies (from chapter 14)• Created bank reserves by buying other assets

• Treasury bonds, private-sector assets, MBS• Lent massive amounts to banks and to some

nonbanks• Emergency “rescue” operations for troubled

institutions• Why the extraordinary policies?

• Federal funds rate reached zero• Fed could do nothing or try unconventional policies

16

Should the Fed Use Unconventional Policy

• 2009, FOMC – purchased over $1 trillion of MBS• Interest rate spreads on MBS over Treasuries had soared• Even with high spreads no buyers for MBS• With high spread, mortgage rates remained high• Fed intent was to to raise MBS prices and lower yields• Result: MBS yields and mortgage rates fell

17

Should the Fed Use Unconventional Policy?

• Why did the Fed take the risk of purchasing MBS?• Time was of the essence; Congress moves to slow to

address unfolding housing crisis• Only the central bank can serve as lender of last resort• Size of the federal budget deficit constrained fiscal policy

• Criticisms of Fed’s unconventional policies• Assuming authority that belongs to the Congress

• Fed was choosing which companies would fail or not• Putting tax payer money at risk• Huge injection of reserves opening the door to future

inflation

18

Should Policy Makers Fight Asset Price Bubbles?

• Defined – asset prices rise above fundamental value• Fed’s tradition answer is no. Two main reasons.

• Difficult to identifying bubbles before they burst• How do we separate fundamentals from the “bubbly”

• Fed may not have any policy instruments that it can use to target just the bubble, e.g., run away stock prices.

• Increasing interest rates might deflate bubble but also slow economy

19

Should Policy Makers Fight Asset Price Bubbles??

• Rethinking the issue – it is impossible to prevent “bubbles” but possible to limit the impact• Most harmful bubbles financed by heavy borrowing

and extensive use of leverage: housing vs. tech stock bubble

• Rather than prevent bubbles, mitigate the consequences

• Better awareness/monitoring of bank lending practices• Reduce the use of leverage• The Dodd-Frank Act of 2010

• Bubbles are inherent part of cycle of financial capitalism• Sturdier financial system can limit size and effects of bubbles

20

Should We Rely on Fiscal or Monetary Policy?

• The great recession rekindled an old debate. Should we rely on fiscal or monetary policy

• Which policy type works faster?• Lags in stabilization policy

• Delays between the time when the need for stabilization policy arises and the time when the policy has its actual effects on the economy

• The lags can be long and variable.

21

Time Lags The use of discretionary monetary and fiscal

policy is hampered by three time lags: Recognition lag—the time it takes to figure out

that fiscal policy action is needed. Policy-making lag (implementation lag)—the time

it takes Congress to pass the laws needed to change taxes or spending.

Impact lag—the time it takes from passing a tax or spending change to its effect on real GDP being felt.

Regarding Fiscal Policy -•Economists have diverging views about the size of the spending and tax multipliers because there is insufficient empirical evidence on which to pin their size with accuracy.

•This fact makes it impossible for Congress to determine the amount of stimulus needed to close a given output gap.

•Also, the actual output gap is not known and can only be estimated with error.

•So discretionary fiscal policy is risky business.

Lags also apply to Monetary Policy?

• Recognition lag is the same for fiscal and monetary policy

• Policy and Impact lags are very different

• Fiscal policy• Changes in G or T affect aggregate demand faster than

monetary policies • G has an immediate impact• But fiscal policy has long policy lags

• Monetary policy• Policy lags normally much shorter

• FOMC meets often and on short notice if necessary• Policy decisions executed immediately• But monetary policy has a long impact lag.

24

• Conventional wisdom• Although monetary policy takes longer to take effect, short

policy lags win out

• Questioning conventional wisdom• Congress can act quickly when it must• Massive recessionary gap suggested both necessary• Once the federal funds rate reaches zero conventional

monetary policy could use help from fiscal policy

25

Should We Rely on Fiscal or Monetary Policy?

The Shape of the AS Curve: Flat or Steep

• Another debate over stabilization policy is the shape of the aggregate supply curve.

• Think about what happens to price and GDP when there is a change in AD.

26

Alternative Views of the Aggregate Supply Curve

27

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

28

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 inoutput

Rise in priceFall in price

Fall inoutput

• Expansionary policy leads to a substantial increase in real GDP with only a small increase in inflation.

• This is desirable.• Can expand the economy with little inflation cost.

• Contractionary policy however requires a large decrease in real GDP to get a relatively small decrease in inflation.

• Not so desirable. • Fighting inflation is costly.

29

When the aggregate supply curve is flat

Stabilization Policy with a Steep Aggregate Supply Curve

30

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 inoutput

Rise in price

Fall in price

Fall in output

When the aggregate supply curve is steep

• Expansionary policy leads to a substantial increase in inflation with only a small increase in real GDP

• This is not desirable• Expansionary policy is costly in terms of inflation

• Contractionary policy leads to a large decrease in inflation with only a small decrease in real GDP

• This is desirable. The cost of bringing down inflation is relatively small.

31

The Shape of the AS Curve: Flat or Steep

• So is AS flat or steep?• Depends on the time frame• Short run – flat aggregate supply

• Fluctuations in aggregate demand have large effects on output and minor effects on prices

• Long run – steep aggregate supply • Fluctuations in aggregate demand have large effects

on prices and minor effects on output• A change in AD will have most of its affect on output in

the SR but on prices in the LR

32

Should the Government Intervene at All?

• Main issue• Can government policy successfully stabilize the

economy?• Or do well-intentioned efforts do more harm than good

• Politics and Philosophy: Conservative vs. Liberal views• Conservatives favor hands off government and favor

fixed rules• Liberals more favorably disposed toward an activist

stabilization policy

33

Should the Government Intervene at All?

• Critics of stabilization policy • Lags and uncertainties - fiscal and

monetary policies. All the stuff we have talked about.

• Skeptical about our ability to forecast the future – most forecast are wrong.

• Stabilization policy may fail• Advise: passive policies

34

Should the Government Intervene?

• Advocates of active stabilization policies• Perfection is unattainable• Economy may not self-correct quickly. • Advocate active policies: use of G, T

changes in the money supply to keep the economy close to full employment.

35

Should the Government Intervene?

• Lags and the Rules-versus-Discretion Debate

• Problem with lags• Attempts at stabilizing the economy may

actually do more harm than good by destabilizing the economy.

36

A Typical Business Cycle

37

Time

Act

ual a

nd P

oten

tial G

DP

Potential GDP

Actual GDP

CB

D

E

A

A Typical Business Cycle

38

Time

Act

ual a

nd P

oten

tial G

DP

Potential GDP

Actual GDP

CB

D

E

A

Rules vs. Discretion Debate

• What issues matter when deciding policy course?

• Speed of the economy’s self-correcting mechanism• Is the economy slow to recover, then discretionary policy

may be warranted.• If fast – stay out.

• Length of lags in stabilization policy• Mixed evidence on lag timing, so no conclusion

• Accuracy of economic forecasts• Can economists make good forecast?

39

Rules vs. Discretion Debate

• Size of government • Proper size of government issue separate from rules vs.

discretion debate• Monetary policy neither increase nor decreases size

• Uncertainties caused by government policy• Frequent changes in policy make it difficult to make

rational plans – favors rules• But economic instability also creates problems

40

Dimensions of Rules vs. Discretion Debate

• Political business cycle• Fiscal policy decisions subject to “political

manipulations”• Monetary policy made by the Fed –

apolitical• “Time Inconsistency” problem

41

Examples of Fixed Rules

• Mostly on the monetary side

• Inflation targeting, such as the Bank of England.

• On the fiscal side – automatic stabilizers