Transcript Principle of Macroeconomics - Gene Chang, University of Toledo

Debate over
Monetary Policy and Fiscal Policy
Gene H Chang
University of Toledo
Econ 1150
Differences between Fiscal and
Monetary Policies
 Effects
on different economic
variables
 Different impacts on the interest rate
 Time lags are different
Differences
 Direct
effects on different economic
variables
 Look at AE = C + I + G + NX
• Fiscal policy: on C, G
• Monetary policy: on I
Differences
 Different
impacts on the interest rate
• An expansionary fiscal policy causes the
interest rate to go up
• An expansionary monetary policy
causes the interest rate to go down
 The
different direction in interest rate
will affect:
• Investment
• Exchange rate and net exports
Time lags
Proposing policy
Policy lag
Policy approved and
implemented
Action lag
Impact on the
economy
Differences
 Time
lags
• Fiscal policy: long "policy lag" but "short
action lag"
• Monetary policy: short "policy lag" but
long "action lag"
Keynesian views
 Fiscal
policy is more powerful: direct
and more predictable
 Monetary policy is weak, especially in
recession:
• Liquidity trap
• Investment is insensitive to interest rate
• Effect of the monetary policy is indirect
and less predictable
Monetary School and Monetarism
 Challenge
to the Keynesian view in
1960s and 1970s
 Monetary School and Monetarism
 Milton Friedman
• July 31, 1912 – Nov. 16, 2006
• considered to have been one of the two
most influential economists of the 20th
century
• Nobel Prize in Economics, 1976
Monetary School and Monetarism
 Equation
of exchange
M × V = P × Y
• M = money stock or money supply
• V = velocity
• P = price
• Y = real GDP
• PxY = nominal GDP
Monetary School and Monetarism
 Velocity
• The speed at which money circulates in
a year
 What
affects V?
• Interest rate
• Payment frequency
Monetary School and Monetarism
 Monetarists
use the equation of
exchange to explain the economy
• The impact of an increase in M
 More
direct impact
• The impact of an increase in G
 Less
direct impact
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
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
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

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?
Monetary School and Monetarism
 Monetarism
considers the fiscal
policy is less powerful
• Indirect impact
• AS may be vertical
• Crowding-out effect
 An
increase in government spending crowds
out the private investment.
Monetary School and Monetarism
 Crowding-out
effect
• An increase in government spending
crowds out the private investment.
• G increases => AE goes up
• Interest up
• Private investment goes down => AE
goes down
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
Milton Friedman
 Strongly
advocating a free market
economy, and a minimal role of
government
• “Free to choose” a best seller of nonfiction book
 Against
government intervention and
discretionary economic policies,
• consider they will destabilize the
economy
 Argued
for a policy rule
Policy rule
Friedman argued for some policy
rules:
 Constant money growth rate
 Says it will be automatic stabilizer
Automatic Stabilizer
 Constant
money growth rate
• If the economy is overheating
• So long as the money growth is
constant
• Interest rate will up
• Then investment will down
• Cool down the economy
Automatic Stabilizer
 Stable
income tax scheme
• If the economy is overheating
• Tax goes up
• Consumption down
• Cool down the economy
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
Fed funds rate (interest rate)
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