Transcript The Policy Debate: Keynesians versus Monetarists

The Policy Debate:
Keynesians versus Monetarists
Should the Government Intervene?
Monetary or Fiscal Policy?

Given that there is instability in aggregate
demand,
(i) Should the government intervene?
(ii) When and how should monetary and/or
fiscal policy be used?
7: A Typical Business Cycle
Potential GDP
E
Potential GDP
Actual and
FIGURE
D
Actual GDP
A
B
C
Time
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Should the Government Intervene?



Should policymakers follow “rules” or
“discretion?”
How long is the short run? Slope of AS curve
and effect on Y and P.
If AS curve is steep, then
(i) Business cycles are less severe.
(ii) Policies have smaller effects on economy.
There is less need for government intervention.

If AS curve is flatter, then
(i) Business cycles are more severe.
(ii) Policies will have greater effect on economy.
Government policies can and should be used to
stabilize economy
 Time lags involved with policies:

(i) Recognition
(ii) Appropriate policy?
(iii) Implementation
(iv) Response
Policy lags imply monetary and fiscal policies
can actually destabilize economy.
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Keynesian View:
(1) AS curve is very flat in SR  severe
recessions and depressions.
(2) Self-correcting forces are inadequate.
(3) Rules are too rigid to be useful
 Monetarist (Classical) View:
(1) AS curve is steep, even in short-run 
recessions will not be severe.
(2) Self-correcting forces are sufficient to
stabilize the economy.
(3) Policy makers should follow “rules.”
Discretionary policies do more harm than
good.
Monetary or Fiscal Policy?
MONETARY POLICY
 The case for monetary policy:
(1) Easy implementation
(2) Interest rates respond very quickly to MS
(3) Lower interest rates are an effective way
to stimulate private spending and demand.

The case against monetary policy:
(1) MS also depends on other factors (banking
system) which can be unpredictable.
(2) Lower interest rates may be less effective
if business or consumer confidence is low.
(3) Increasing MS will ultimately lead to
higher inflation.
(4) Federal reserve officials are not accountable
to public.
FISCAL POLICY
 The case for fiscal policy:
(1) Gov purchases has direct effect on
aggregate demand. Worked for recovery
from Great Depression!
(2) Lower taxes increases disposable incomes
and stimulates consumption.
(3) Congress and President are responsible to
the public.

The case against fiscal policy:
(1) Time lags from political process too long.
(2) Big government leads to wasteful spending.
(3) Tax cuts may be ineffective if
business/consumer confidence is low.
(4) Expansionary fiscal policy leads to large
budget deficits.
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If government policies are necessary, which
(monetary or fiscal) is better?
Answer depends on the cause of recession:
- If AD is low because consumers/businesses
cannot find adequate low cost financing,
monetary policy maybe better.
- If AD is low because of low consumer/business
confidence, then increasing G may be more
effective.

Monetary-Fiscal Mix:
(i) 1979-80 Recession.
(ii) 1992-96 Budget Deficits.