ECN 111 Chapter 18 Lecture Notes
18.1 Fiscal Policy Versus Monetary Policy
A. Policy Effects
1. The Effects of Monetary Policy
a. Step 1: A change in the supply of money influences the interest rate.
b. Step 2: A change in the interest rate influences investment and other interestsensitive components of aggregate expenditure.
2. The Effects of Fiscal Policy
a. Step 1: A change in government purchases or a tax cut increases aggregate
expenditure directly and increases aggregate demand with a multiplier.
b. Step 2: A change in real GDP changes the demand for money, which changes the
interest rate.
c. Step 3: A change in the interest rate changes investment and other interestsensitive components of aggregate expenditure, which counteract the effects of the
initial increase in aggregate expenditure—a crowding-out effect.
3. Extreme Conditions
a. Case 1: 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.
b. Case 2: At another extreme, monetary policy is completely ineffective and fiscal
policy is all-powerful. This extreme occurs if there is one interest rate at which
people are willing to hold any quantity of money, a situation called a liquidity trap.
4. Reality is that empirical evidence suggests that neither extreme holds in real
economies.
B. Goal Conflicts
1. Fiscal Policy Goal Conflicts
Fiscal policy has three goals: to provide public goods and services, to redistribute
income, and to stabilize aggregate demand. These goals can come into conflict.
2. Monetary Policy Goal Conflicts
Monetary policy has three main goals: price level stability, real GDP stability, and
stability of the financial system. These is less conflict among these goals than among
those of fiscal policy.
C. Timing and Flexibility
1. Inflexible Fiscal Policy
Fiscal policy is political in nature and so concern about elections as well as long
debates are often required. Fiscal policy is inflexible and incapable of the rapid-fire
response that is often called for to keep aggregate demand growing smoothly.
2. Flexible Monetary Policy
Monetary policy effects are long and drawn out, but actions can be taken quickly.
D. And the Winner Is?
There is no clear winner. Discretionary fiscal policy might be better for deep recessions
and monetary policy might be better for normal fluctuations.
18.2 Rules Versus Discretion
A. Discretionary Policy
Discretionary monetary policy is monetary policy that is based on the judgments of
policy makers about the current needs of the economy.
B. Fixed-Rule Policies
A fixed-rule policy is a policy that is pursued independently of the state of the economy.
C. Feedback-Rule Policies
A feedback-rule policy is a policy that specifies how policy actions respond to changes
in the state of the economy.
D. Stabilizing Aggregate Demand Shocks
1. Fixed Rule: Monetarism
a. 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.
b. Under a rule that keeps the quantity of money constant, a decrease in aggregate
demand brings a recession that lasts until the money wage rate decreases and
aggregate supply increases.
2. Feedback Rule: Keynesian Activism
a. 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.
b. In the case of a decrease in aggregate demand, a feedback rule increases the
quantity of money. The interest rate falls, investment increases, and aggregate
demand increases, offsetting the initial decrease.
3. The Two Rules Compared
Real GDP decreases and increases by the same amounts under the two policies, but
real GDP takes longer to return to potential GDP with a fixed rule than with a feedback
rule.
4. Are Feedback Rules Better?
Many economists remain convinced that a fixed rule stabilizes aggregate demand
more effectively than does a feedback rule because:
a. Potential GDP is not known.
b. Policy lags are longer than the forecast horizon.
c. Feedback-rule policies are less predictable than fixed-rule policies.
E. Stabilizing Aggregate Supply Shocks
A decrease in aggregate supply increases the price level and decreases real GDP.
1. Fixed Rule
The decrease in aggregate supply has no effect on the Fed's actions and no effect on
aggregate demand. The economy remains in a recession until the money wage rate
falls and aggregate supply increases.
2. Feedback Rule
The decrease in aggregate supply leads to a policy that increases aggregate demand.
The result is that real GDP returns to potential GDP but the price level is higher.
18.3. Targeting Inflation
A. Real GDP Versus the Price Level
The two possible targets for monetary policy are real GDP and the price level.
1. Real GDP Target
a. 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 a
decrease in aggregate demand; and a decrease in aggregate supply is countered
by an increase in aggregate demand.
b. Stabilizing real GDP means destabilizing the price level.
2. Price Level Target
a. 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; a decrease in aggregate supply is
countered by a decrease in aggregate demand.
b. Stabilizing the price level means destabilizing real GDP.
3. More General Targets
a. Monetary policy can stabilize a combination of real GDP and the price level.
4. A Tradeoff or a Free Lunch?
Stabilizing the price level helps stabilize aggregate supply because it limits fluctuations
in the money wage rate. So stabilizing the price level also helps stabilize real GDP.
B. Zero Versus Positive Inflation
1. Labor Market Lubricant
a. The claim is that to maintain full employment, some real wage rates need to fall. But
money wage rates don’t fall, so a little bit of inflation is needed to make real wage
rates fall.
b. There is no evidence that money wages are stickier downward than upward and
there is no evidence that a long-run tradeoff between inflation and unemployment
exists.
3. The Zero Lower Bound
a. The claim is that expansionary monetary policy cannot be used to get the economy
out of recession if the nominal interest rate is zero, so in such a situation, recession
will last longer. Because the nominal interest rate will be zero more frequently the
lower the inflation rate, the economy will spend longer in recession, on the average,
the lower the inflation rate.
b. Even if monetary policy cannot lower the nominal interest rate, an increase in the
quantity of money still leads to more spending by way of an exchange rate and a
buying power of money effect, which increases aggregate demand.