Fiscal and Monetary
Policy Debates
CHAPTER
33
CHAPTER CHECKLIST
When you have completed your study of this
chapter, you will be able to
1
Discuss whether fiscal policy or monetary policy is
the better stabilization tool.
2
Explain the rules-versus-discretion debate and
compare Keynesian and monetarist policy rules.
3
Assess whether policy should target the price level
rather than real GDP.
33.1 FISCAL VERSUS MONETARY POLICY
Which tool does the better job of stabilizing short-run
economic fluctuations: fiscal policy or monetary policy?
We look at three aspects of the fiscal policy versus
monetary policy debate:
• Policy effects
• Goal conflicts
• Timing and flexibility
33.1 FISCAL VERSUS MONETARY POLICY
Policy Effects
The Effects of Monetary Policy
The two steps in the transmission of monetary
policy are
Step 1 A change in the money supply influences the
interest rate.
Step 2 A change in the interest rate influences
investment and other interest-sensitive
components of aggregate expenditure.
33.1 FISCAL VERSUS MONETARY POLICY
Step 1 Whether a given increase in the money supply
decreases the interest rate by a lot or a little depends
on the sensitivity of the demand for money to the
interest rate.
Step 2 Whether a given decrease in the interest rate
increases aggregate expenditure by a lot or a little
depends on the sensitivity of investment and other
components of aggregate expenditure to the interest
rate.
Figure 33.1 on the next slides illustrate these
propositions.
33.1 FISCAL VERSUS MONETARY POLICY
1. When the money supply increases from $1 trillion to
$1.2 trillion, the interest rate falls from 6 percent to 4
percent a year and
2. Investment increases from $2 trillion to $4 trillion.
33.1 FISCAL VERSUS MONETARY POLICY
3. The same change in the money supply lowers the
interest rate from 6 percent to 5 percent a year and
4. Investment from $2 trillion to $2.25 trillion.
Monetary policy is less powerful here than in the previous
case.
33.1 FISCAL VERSUS MONETARY POLICY
The Predictability of Monetary Policy
The two steps in the transmission of monetary policy
determine the predictability of monetary policy.
• At step 1, for a given change in the money supply
to have a predictable effect on the interest rate, the
demand for money must be predictable.
• At step 2, for a given change in the interest rate to
have a predictable effect on investment and
aggregate expenditure, the investment demand
must be predictable.
33.1 FISCAL VERSUS MONETARY POLICY
• So the more predictable the demand for money
and investment demand, the more predictable is
the effect of monetary policy.
33.1 FISCAL VERSUS MONETARY POLICY
The Effects of Fiscal Policy
The three steps in the transmission of fiscal policy are
Step 1 An increase in government expenditure or a tax
cut increases aggregate expenditure and
increases aggregate demand with a multiplier.
Step 2 A change in real GDP changes the demand for
money, which changes the interest rate.
Step 3 A change in the interest rate changes investment
and other components of aggregate expenditure
in a crowding- out effect.
33.1 FISCAL VERSUS MONETARY POLICY
The crowding-out effect is large and fiscal policy has a
weak effect on aggregate demand if
• A given change in the demand for money has a
large effect on the interest rate and
• A given change in the interest rate has a large
effect on aggregate expenditure.
33.1 FISCAL VERSUS MONETARY POLICY
The crowding-out effect is small and fiscal policy has a
powerful effect on aggregate demand if
• A given change in the demand for money has a
small effect on the interest rate and
• A given change in the interest rate has a small
effect on aggregate expenditure, then
33.1 FISCAL VERSUS MONETARY POLICY
Extreme Conditions
At one extreme, monetary policy is all-powerful and
fiscal policy is completely ineffective.
This extreme occurs if the quantity of money demanded
is independent of the interest rate.
33.1 FISCAL VERSUS MONETARY POLICY
At the other extreme, monetary policy is completely
ineffective and fiscal policy is all-powerful.
This extreme occurs if the quantity of money demanded
is infinitely sensitive to the interest rate.
Liquidity trap
An interest rate at which people are willing to hold any
quantity of money.
33.1 FISCAL VERSUS MONETARY POLICY
In a liquidity trap, a change in the money supply
changes the quantity of money held but has no effect on
the interest rate and so it has no effect on aggregate
expenditure.
But a change in government expenditure leaves the
interest rate unchanged, so there is no crowding out
and fiscal policy has a large multiplier effect on
aggregate expenditure.
33.1 FISCAL VERSUS MONETARY POLICY
Reality
Neither extreme occurs in real economies.
33.1 FISCAL VERSUS MONETARY POLICY
Goal Conflicts
Stabilization policy actions have side effects.
Goal conflict is more serious for fiscal policy than for
monetary policy.
33.1 FISCAL VERSUS MONETARY POLICY
Fiscal Policy Goal Conflicts
Fiscal policy has three goals:
• To provide public goods and services
• To redistribute income
• To stabilize aggregate demand
These goals can come into conflict.
One aspect of the government’s budget that does not
create conflict is its automatic stabilizer effect.
33.1 FISCAL VERSUS MONETARY POLICY
In contrast, discretionary fiscal policy actions create
goal conflicts.
The main source of conflict is the very large number of
spending programs and tax arrangements in place and
the difficulty of changing them to balance the costs and
benefits of one against the costs and benefits of others.
33.1 FISCAL VERSUS MONETARY POLICY
Monetary Policy Goal Conflicts
Monetary policy has three main goals:
• Price level stability
• Real GDP stability
• Stability of the financial system.
There is less conflict among these goals than among
those of fiscal policy.
First, stability of the financial system and aggregate
demand stability go together. Each contributes to the
other. So there is no conflict here.
33.1 FISCAL VERSUS MONETARY POLICY
Second, stability of real GDP and stability of the price
level are both served by stabilizing aggregate demand.
There is a conflict about how much weight to place on
price level stability versus real GDP stability.
But this conflict is also present for fiscal policy.
So fiscal policy does not outperform monetary policy in
this area.
33.1 FISCAL VERSUS MONETARY POLICY
 Timing and Flexibility
The ability to forecast the near future state of the
economy and act at the appropriate time to counteract
any unwanted recession or inflation is a crucial part of a
successful stabilization policy.
33.1 FISCAL VERSUS MONETARY POLICY
Inflexible Fiscal Policy
Fiscal policy is political.
The election cycle dominates fiscal policy making.
Fiscal policy is inflexible and incapable of the rapid-fire
response.
Flexible Monetary Policy
Stabilization is the purpose of monetary policy.
Monetary policy effects are long and drawn out, but
actions can be taken quickly.
33.1 FISCAL VERSUS MONETARY POLICY
 And the Winner Is?
There is no clear winner.
Automatic fiscal stabilizers do an important part of the
job of maintaining macroeconomic stability.
Discretionary fiscal policy is sometimes a vital part of
the policy mix, especially if the economy is in a deep
recession or in a seriously overheated condition.
But for dealing with normal fluctuations, monetary policy
is the preferred stabilization tool because it is more
flexible in its timing.
33.2 RULES VERSUS DISCRETION
 Discretionary Policy
Discretionary monetary policy is monetary policy
that is based on the judgments of the policy makers
about the current needs of the economy.
Discretionary monetary policy is setting the discount
rate and determining open market operations on the
basis of the expert opinions of the members of the
FOMC and their advisors.
33.2 RULES VERSUS DISCRETION
 Fixed-Rule Policies
A fixed-rule policy specifies an action to be pursued
independently of the state of the economy.
Milton Friedman: keep the quantity of money growing at
a constant rate year in and year out, regardless of the
state of the economy, to make the average inflation rate
zero.
Fixed rules are rarely followed in practice.
33.2 RULES VERSUS DISCRETION
 Feedback-Rule Policies
A feedback-rule policy specifies how policy actions
respond to changes in the state of the economy.
A feedback-rule for monetary policy is one that changes
the quantity of money or the interest rate in response to
the state of the economy.
 Stabilizing Aggregate Demand Shocks
We’ll study an economy that starts out at full
employment and has no inflation.
33.2 RULES VERSUS DISCRETION
Figure 33.2 shows a
decrease in aggregate
demand brings recession.
Aggregate demand
decreases from AD0 to AD1.
Real GDP decreases to
$9.8 trillion, and the GDP
deflator falls to 107—the
economy goes into
recession.
33.2 RULES VERSUS DISCRETION
Fixed Rule: Monetarism
A monetarist is an economist who believes that
fluctuations in the quantity of money are the main
source of economic fluctuations and who advocates that
the quantity of money grow at a constant rate.
The fixed rule that we’ll study here is one in which the
quantity of money remains constant.
33.2 RULES VERSUS DISCRETION
Figure 33.3(a) shows a
monetarist stabilization
policy in the face of an
aggregate demand shock.
A fixed-rule policy leaves
real GDP and the price level
to fluctuate from A to B, to
C, to D and back to A.
33.2 RULES VERSUS DISCRETION
Feedback Rule: Keynesian Activism
A Keynesian activist is an economist who believes
that fluctuations in investment are the main source of
economic fluctuations.
And who advocates interest rate cuts when real GDP
falls below potential GDP and interest rate hikes when
real GDP exceeds potential GDP.
33.2 RULES VERSUS DISCRETION
Figure 33.3(b) illustrates a
Keynesian activist policy.
As aggregate demand
fluctuates around AD0.
A feedback-rule policy tries to
restores full employment as
quickly as possible by
keeping aggregate demand
at AD0.
33.2 RULES VERSUS DISCRETION
The Two Rules Compared
Under a fixed-rule policy, a decrease in aggregate
demand puts real GDP below potential GDP, where it
remains until either a fall in the money wage rate or a
subsequent increase in aggregate demand restores full
employment.
Under a feedback-rule policy, a policy action pulls the
economy out of a recessionary gap or an inflationary
gap.
There is no need to wait for an adjustment in the money
wage rate for full employment to be restored.
33.2 RULES VERSUS DISCRETION
Real GDP decreases and increases by the same
amounts under the two policies, but real GDP stays
below potential GDP and above potential GDP for
longer with a fixed rule than it does with the feedback
rule.
33.2 RULES VERSUS DISCRETION
Are Feedback Rules Better?
Despite the apparent superiority of a feedback rule,
many economists remain convinced that a fixed rule
stabilizes aggregate demand more effectively than
does a feedback rule.
These economists assert that fixed rules are better
than feed-back rules because
• Potential GDP is not known.
• Policy lags are longer than the forecast horizon.
• Feedback-rule policies are less predictable than
fixed-rule policies.
33.2 RULES VERSUS DISCRETION
Knowledge of Potential GDP
It is necessary to determine whether real GDP is
currently above or below potential GDP.
But potential GDP is not known with certainty.
As a result, there is often uncertainty about the direction
in which a feedback policy should be pushing the level
of aggregate demand.
33.2 RULES VERSUS DISCRETION
Policy Lags and the Forecast Horizon
The effects of policy actions taken today are spread out
over the following two years or even more.
But no one is able to forecast accurately that far ahead.
So feedback-rule policies that react to today’s economy
might be inappropriate for the state of the economy at
that uncertain future date when the policy’s effects are
felt.
33.2 RULES VERSUS DISCRETION
Predictability of Policies
To forecast the inflation rate, it is necessary to forecast
aggregate demand.
And to forecast aggregate demand, it is necessary to
forecast the Fed’s policy actions.
If the Fed sticks to a rock-steady, fixed rule for money
growth rate, then policy is predictable and it does not
contribute to unexpected fluctuations in aggregate
demand.
33.2 RULES VERSUS DISCRETION
In contrast, if the Fed pursues a feedback rule, there is
more scope for the policy actions to be unpredictable.
With a feedback-rule policy, it is necessary to predict the
variables to which the Fed reacts and the extent to
which it reacts.
Consequently, a feedback rule for monetary policy can
create more unpredictable fluctuations in aggregate
demand than a fixed rule can.
33.2 RULES VERSUS DISCRETION
Stabilizing Aggregate Supply Shocks
To see the effects of supply shocks and the policy to
stabilize them, we’ll again start out at full employment
with no inflation.
33.2 RULES VERSUS DISCRETION
Figure 33.4 shows how a
decrease in aggregate supply
brings recession.
Aggregate supply decreases
from AS0 to AS1.
Real GDP decreases to
$9.9 trillion, and the GDP
deflator rises to 113—the
economy goes into
recession.
33.2 RULES VERSUS DISCRETION
Fixed Rule
Under a fixed-rule policy, the decrease in aggregate
supply has no effect on aggregate demand.
Feedback Rule
Under a Keynesian activist feedback rule, when
aggregate supply decreases, policy actions increase
aggregate demand.
Figure 33.5 on the next slides show the effects of these
policy actions.
33.2 RULES VERSUS DISCRETION
A decrease in aggregate
supply brings recession as
the economy moves from
A to B.
A fixed-rule policy leaves real
GDP and the price level to
gradually return from B to A
as the money wage rate falls.
33.2 RULES VERSUS DISCRETION
A decrease in aggregate
supply brings recession as
the economy moves from
A to B.
A feedback-rule policy tries
to restores full employment
as quickly as possible,
moving the economy from
B to C.
33.3 ALTERNATIVE POLICY TARGETS
Real GDP Versus Inflation
How should monetary policy try to influence aggregate
demand when aggregate supply changes?
Two possible targets for monetary policy are
• Real GDP
• The price level
33.3 ALTERNATIVE POLICY TARGETS
Real GDP Target
If monetary policy targets real GDP, it seeks to
neutralize the effects of aggregate supply shocks on
real GDP.
That is,
• An increase in aggregate supply is met by
decrease in aggregate demand.
• And a decrease in aggregate supply is countered
by an increase in aggregate demand.
33.3 ALTERNATIVE POLICY TARGETS
Figure 33.6(a) shows a
monetary policy that targets
real GDP.
The blue band is the real
GDP target.
As aggregate supply
fluctuates between AS1 and
AS2, monetary policy aims
to change aggregate
demand to keep real GDP
on target at $10 trillion.
33.3 ALTERNATIVE POLICY TARGETS
Price Level Target
If monetary policy targets the price level, it seeks to
neutralize the effects of aggregate supply shocks on the
price level.
That is,
• An increase in aggregate supply is met by an
increase in aggregate demand.
• And a decrease in aggregate supply that is
countered by a decrease in aggregate demand.
33.3 ALTERNATIVE POLICY TARGETS
Figure 33.6(b) shows a
monetary policy that targets
the price level.
The blue band is the price
level target.
As aggregate supply
fluctuates between AS1 and
AS2, monetary policy aims
to change aggregate
demand to keep the price
level on target at 110.
33.3 ALTERNATIVE POLICY TARGETS
Inflation Targeting
Inflation targeting
A monetary policy framework that combines an
announced target range for the inflation rate with the
publication of the central bank’s economic forecasts and
analysis.
Despite its name, inflation targeting is an attempt to
stabilize output and employment while maintaining an
unwavering commitment to keeping inflation firmly
inside an announced target range.
Policy Debates in YOUR Life
Recently Ben Bernanke succeeded Alan Greenspan as
Fed chairman.
Chairman Greenspan was credited with keeping inflation
in check and avoiding serious recession.
Will Chairman Bernanke be as successful?
Before his appointment, Ben Bernanke said he wanted
the United States to set an inflation target.
What do you think is best for the United States?
Should the Fed announce an inflation target?
Do you think that Chairman Bernanke will push for an
inflation target for the Fed?