Transcript Fiscal Policy

Chapter 17
Parks Econ124
Monetarism
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Monetarism
• Monetarism is an economic school of thought
that stresses the primary importance of the
money supply in determining nominal GDP
and the price level.
• The "Founding Father" of Monetarism is
economist Milton Friedman.
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Characteristics of Monetarism
1. The theoretical foundation is the Quantity
Theory of Money.
2. The economy and financial markets are
inherently stable.
3. The Fed should be bound to fixed rules in
conducting monetary policy.
4. Fiscal Policy is often bad policy. A small
role for government is good.
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The Equation of Exchange
• The equation of exchange (a tautology) is the
building block for monetarist theory.
MxV=PxY
M = money supply
V = velocity
P = price level
Y = real GDP
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The Quantity Theory of Money: The
Short Run
• Monetarists make a seemingly innocuous
assumption that velocity is stable in the short
run, or
MxV=PxY
where V implies that velocity is fixed in the short run.
• Any change in M1 will impact P × Y (nominal
GDP). Changes in the money supply are the
dominant forces that change nominal GDP.
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The Quantity Theory of Money: The
Long Run
• Monetarists believe that the economy is always
near or quickly approaching full employment
because markets work well.
• In the long run, output will be equal to
potential output, YP.
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The Quantity Theory of Money: The
Long Run
• In the long run, the quantity theory of money
becomes:
• 'M' and 'P' are the only variables in this
equation that change in the long run.
• In the long run, changes in the money supply
only cause inflation.
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The Rules vs. Discretion Debate
• Monetarists argue that control of the money
supply (and, hence, inflation) should not be left
to the discretion of central bankers.
• They propose a money-growth rule: The Fed
should be required to target the growth rate of
money such that it equals the growth rate of
real GDP, leaving the price level unchanged.
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The Rules vs. Discretion Debate
• Keynesians advocate giving central bankers
discretion.
• They attribute little significance to the Quantity
Theory of Money because they believe that
velocity is unstable.
• Keynesians also argue that the economy is
subject to periodic instability, so it is dangerous
to take discretionary power away from the
central bank.
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Fiscal Policy
• Because Monetarists dislike big government
and tend to trust free markets, they do not like
government intervention and believe that fiscal
policy is not helpful.
• Where fiscal policy could be beneficial,
monetary policy can do the job better BUT will
probably not (Friedman).
• Automatic stabilizers are sufficient sources of
fiscal policy.
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Empirical Evidence of Monetarism
• The suppositions of monetarism depend
crucially on
– the stability of velocity
– the efficiency of markets
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Empirical Evidence of Monetarism
Velocity
9.0
1970-2005
•Recent evidence
suggests that
velocity has been
unstable and
unpredictable since
the 1980s.
8.0
7.0
6.0
5.0
4.0
3.0
1970
1975
1980
1985
1990
1995
2000
2005
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M1growth versus inflation
14
12
10
Inflation
8
6
4
2
0
-2
-4
0
2
4
6
8
10
12
14
16
M1 Growth
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M2 growth versus inflation
14
12
Inflation
10
8
6
4
2
0
0
2
4
6
8
10
12
14
M2 growth
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Money and Nominal GDP
•The lack of
correlation
between M1 and
nominal GDP
also depicts the
instability of
velocity.
Growth of M1 and Nominal GDP
(1975-2005)
GDP
(%)
M1
16.0
11.0
6.0
1.0
-4.0
1975
1980
1985
1990
1995
2000
2005
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Why did velocity become unstable?
• Most economists think the breakdown was
primarily the result of changes in banking rules
and other financial innovations.
– In the 1980s, interest-earning checking accounts
altered the demand for money and further blurred
the line between transaction and savings accounts.
– Also, money markets, mutual funds and other
financial assets became substitutes for traditional
bank deposits.
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Keynesians vs. Monetarists
• Keynesians and Monetarists fought head-tohead in the 1970s.
• Most economists conclude that Keynesians
won the war, but Monetarists won many
battles.
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Keynesians vs. Monetarists:
Key Differences
TABLE 1
Monetarists
Tie monetary policy to rules
Keynesians
Give policymakers discretion.
Fiscal policy is not useful.
Fiscal policy may be useful.
AS curve has a steep slope. Economy can be unstable.
Economy is inherently stable. AS curve can be flat.
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Taylor rule
• Stanford economist John Taylor created
Taylor’s rule as a tool to manage monetary
policy
• research has shown that Taylor’s rule provides
an accurate prediction of the proper course of
monetary policy
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_
it   t  r  a ( t   )  ay (y t  y t )
*
t
*
t
• where it is the short-term nominal interest rate, πt
is the inflation rate measured by the GDP
deflator,
• πt* is the desired rate of inflation,
• rt* is the assumed equilibrium real interest rate,
• yt is the logarithm of real GDP, and
_
• y t is the logarithm of potential output
• aπ and ay should be positive = .5
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• Taylor rules offer a simple and transparent
framework with which to organize the
discussion of systematic monetary policy. Their
adoption as a tool for policy discussions has
facilitated a welcome convergence between
monetary policy practice and monetary policy
research and proved an important advance for
both positive and normative analysis.
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• In short, the rule proposes a high interest rate
when “inflation is above its target rate and when
the economy is above its full employment level.”
Similarly, the rule proposes a low interest rate
when inflation is below its target and the
economy is below its full employment level
(current situation).
• The dilemma takes place when inflation is
above its target and the economy is below full
employment or inflation is below its target but
the economy is above full employment.
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• Alas, the Taylor rule depends on picking the
target inflation rate, the equilibrium real rate of
interest, and estimating the full employment
GDP. It also requires picking the coefficients.
_
it   t  r  a ( t   )  ay (y t  y t )
*
t
*
t
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