Baumol & Blinder MACROECONOMICS (11th ed)

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THE DEBATE OVER MONETARY

AND FISCAL POLICY

The love of money is the root of all evil.

THE NEW TESTAMENT

Lack of money is the root of all evil.

GEORGE BERNARD SHAW

U p to now, our discussion of stabilization policy has been almost entirely objective and technical. In seeking to understand how the national economy works and how government policies affect it, we have mostly ignored the intense economic and

political controversies that surround the actual conduct of monetary and fiscal policy. Chapters 14 through 16 are precisely about these issues.

We begin this chapter by introducing an alternative theory of how monetary policy affects the economy, known as monetarism. Although the monetarist and Keynesian theories seem to contradict one another, we will see that the conflict is more apparent than real. However, important differences do arise among economists over the appropriate design and execution of monetary policy. These differences are the central concern of the chapter. We will learn about the continuing debates over the nature of aggregate supply, over the relative virtues of monetary versus fiscal policy, and over whether the Federal Reserve should try to control the money stock or interest rates. As we will see, the resolution of these issues is crucial to the proper conduct of stabilization policy and, indeed, to the decision of whether the government should try to stabilize the economy at all.

C O N T E N T S

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We have suggested several times in this book that well-timed changes in fiscal or monetary policy can mitigate fluctuations in inflation and unemployment. For example, when the U.S. economy sagged after the terrorist attacks in September 2001, both fiscal policy and monetary policy turned more expansionary. Congress cut taxes and the Federal Reserve cut interest rates. These actions might be called “textbook responses” to the threat of recession. Similarly, when the finan-

cial crisis of 2007–2008 threatened to throw the economy into recession, the Fed cut interest rates again and the government enacted a large “stimulus package.” These policy decisions were all consistent with the lessons you have learned in Chapters 11 and 13.

But some economists argue that these lessons are best forgotten. In practice, they claim, attempts at macroeconomic stabilization are likely to do more harm than good. Policy makers are therefore best advised to follow fixed rules rather than use their best judgment on a case-by-case basis.

Nothing we have said so far leads to this conclusion. But we have not yet told the whole story. By the end of the chapter you will have encountered several arguments in favor of rules, and so you will be in a better position to make up your own mind.

VELOCITY AND THE QUANTITY THEORY OF MONEY

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You will undoubtedly notice the stark difference in the behavior of V1 versus V2. V1 is nowhere near constant; it displays a clear downward trend from 1929 until 1946, a pronounced upward trend until about 1981, and quite erratic behavior since then. V2 is much closer to constant, but it has risen noticeably since the 1980s. Furthermore, closer examination of monthly or quarterly data reveals rather substantial fluctuations in velocity, by either measure. Because velocity is not constant in the short run, predictions of nominal GDP growth based on assuming constant velocity have not fared well, regardless of how M is measured. In a word, the strict quantity theory of money is not an adequate model of aggregate demand.

Some Determinants of Velocity

Because it is abundantly clear that velocity is a variable, not a constant, the equation of exchange is useful as a model of GDP determination only if we can explain movements in velocity. What factors decide whether a dollar will be used to buy goods and services four or five or six times per year? While numerous factors are relevant, two are important enough to merit discussion here.

Efficiency of the Payments System Money is convenient for conducting transactions, which is why people hold it. But money has one important disadvantage: Cash pays no interest, and ordinary checking accounts pay very little. Thus, if it were possible to convert interest-bearing assets into money on short notice and at low cost, rational individuals might prefer to use, say, credit cards for most purchases, making periodic transfers to their checking accounts as necessary. That way, the same volume of transactions could be accomplished with lower money balances. By definition, velocity would rise.

The incentive to limit cash holdings thus depends on the ease and speed with which it is possible to exchange money for other assets—which is what we mean by the “efficiency of the payments system.” As computerization has speeded up banks’ bookkeeping procedures, as financial innovations have made it possible to transfer funds rapidly between checking accounts and other assets, and as credit cards have come to be used instead of cash, the need to hold money balances has declined and velocity has risen.

In practice, improvements in the payments system pose severe practical problems for analysts interested in predicting velocity. A host of financial innovations, beginning in the 1970s and continuing right up to the present day (some of which were mentioned in Chapter 12’s discussion of the definitions of money), have transformed forecasting velocity into a hazardous occupation. In fact, many economists believe the task is impossible and should not even be attempted.

Interest Rates A second key determinant of velocity is the rate of interest. The reason is implicit in what we have already said: The higher the rate of interest, the greater the opportunity cost of holding money. Therefore, as interest rates rise, people want to hold smaller cash balances—which means that the existing stock of money circulates faster, and velocity rises.

It is this factor that most directly undercuts the usefulness of the quantity theory of money as a guide for monetary policy. In the previous chapter, we learned that expansionary monetary policy, which increases bank reserves and the money supply, also decreases the interest rate. But if interest rates fall, other things being equal, velocity (V) also falls. Thus, when the Fed raises the money supply (M), the product M 3 V should increase by a smaller percentage than does M itself.

Thus, we conclude that

Velocity is not a strict constant but depends on such things as the efficiency of the financial system and the rate of interest. Only by studying these determinants of velocity

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From here, careful study of the determinants of money growth (which we provided in the previous two chapters) and of changes in velocity (which we just sketched) can be used to predict the growth rate of nominal GDP. Similarly, given an understanding of movements in V, controlling M can give the Fed excellent control over nominal GDP. These ideas are the central tenets of monetarism.

The monetarist and Keynesian approaches can be thought of as two competing theories of aggregate demand. Keynesians divide economic knowledge into four neat compartments marked C, I, G, and (X 2 IM) and then add them all up to obtain aggregate demand. In Keynesian analysis, as we have learned, money affects the economy by first affecting interest rates. Monetarists, by contrast, organize their knowledge into two alternative boxes labeled M and V and then multiply the two to obtain aggregate demand. In the monetarist model, the role of money is not necessarily limited to working through interest rates.

The bit of arithmetic that multiplies M and V to get P 3 Y is neither more nor less profound than the one that adds up C, I, G and (X 3 IM) to get Y, and certainly both are correct. The real question is which framework is more useful in practice. That is, which approach works better as a model of aggregate demand?

Although there is no generally correct answer for all economies in all periods of time, a glance back at Figure 1 (page 279) will show you why most economists had abandoned monetarism by the early 1990s. During the 1960s and 1970s, velocity (at least V2) was fairly stable, which helped monetarism win many converts—in the United States and around the world. Since then, however, velocity has behaved so erratically here and in many other countries that there are few monetarists left.

Nonetheless, as we will see later in this chapter, some faint echoes of the debate between Keynesians and monetarists can still be heard. Furthermore, few economists doubt that there is a strong long-run relationship between M and P. They just question whether this relationship is useful in the short run. (See the box “Does Money Growth Always Cause Inflation?” on the next page.)

FISCAL POLICY, INTEREST RATES, AND VELOCITY

As we learned in the previous chapter, Keynesian economics provides a powerful and important role for monetary policy: An increase in bank reserves and the money supply reduces interest rates, which, in turn, stimulates the demand for investment. But fiscal policy also exerts a powerful influence on interest rates.

To see how, think about what happens to real output and the price level following, say, a rise in government spending. We have learned that both real GDP (Y) and the price level (P) rise, so nominal GDP certainly rises. But the previous chapter’s analysis of the market for bank reserves taught us that rising prices and/or rising output—by increasing the money volume of transactions—push the demand curve for bank reserves outward to the right. If there is no change in the supply of reserves, the rate of interest must rise. So expansionary fiscal policy raises interest rates.

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P O L I C Y D E B AT E

DOES MONEY GROWTH ALWAYS CAUSE INFLATION?

If the government uses its spending and taxing weapons in the opposite direction, the same process works in reverse. Falling output and (possibly) falling prices shift the demand curve for reserves inward to the left. With a fixed supply curve, equilibrium in the market for bank reserves leads to a lower interest rate. Thus:

Monetary policy is not the only type of policy that affects interest rates. Fiscal policy does, too. Specifically, increases in government spending or tax cuts normally push interest rates up, whereas restrictive fiscal policies normally pull interest rates down.

The apparently banal fact that changes in fiscal policy move interest rates up and down has several important consequences. Here are two.

Application: The Multiplier Formula Revisited

We have just noted that expansionary fiscal policy raises interest rates. We also know that higher interest rates deter private investment spending. So when the government raises the G component of C 1 I 1 G 1 (X 2 IM), one side effect will probably be a reduction in the I component. Consequently, total spending will rise by less than simple multiplier analysis might suggest. The fact that a surge in government demand (G) discourages

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some private demand (I) provides another reason why the oversimplified multiplier formula of earlier chapters, 1/(1 2 MPC), exaggerates the size of the multiplier:

Because a rise in G (or, for that matter, an autonomous rise in any component of total expenditure) pushes interest rates higher, and hence deters some investment spending, the increase in the sum C 1 I 1 G 1 (X 2 IM) is smaller than what the oversimplified multiplier formula predicts.

Combining this observation with our previous analysis of the multiplier, we now have the following complete list of

REASONS WHY THE OVERSIMPLIFIED FORMULA OVERSTATES THE MULTIPLIER

1.It ignores variable imports, which reduce the size of the multiplier.

2.It ignores price-level changes, which reduce the size of the multiplier.

3.It ignores the income tax, which reduces the size of the multiplier.

4.It ignores the rising interest rates that accompany any autonomous increase in spending, which also reduce the size of the multiplier.

With so many reasons, it is no wonder that the actual multiplier, which is estimated to be less than 2 for the U.S. economy, is so much less than the oversimplified formula suggests.

Application: The Government Budget and Investment

One major argument for reducing the government’s budget deficit is that lower deficits should lead to higher levels of private investment spending. We can now understand why. To reduce its budget deficit, the government must engage in contractionary fiscal policies: lower spending or higher taxes. But as we have now just learned, any such measure should reduce real interest rates. These lower real interest rates should spur investment spending. This simple insight—that lower budget deficits should lead to more private investment—will play a major role in the next chapter.

DEBATE: SHOULD WE RELY ON FISCAL OR MONETARY POLICY?

The Keynesian and monetarist approaches are like two different languages. But it is well known that language influences attitudes in subtle ways. For example, the Keynesian language biases things toward thinking first about fiscal policy simply because G is a part of C 1 I 1 G 1 (X 2 IM). By contrast, the monetarist approach, working through the equation of exchange, M 3 V 5 P 3 Y, puts the spotlight on M. In fact, years ago economists engaged in a spirited debate in which extreme monetarists claimed that fiscal policy was futile, whereas extreme Keynesians argued that monetary policy was useless. Today, such arguments are rarely heard.

Instead of arguing over which type of policy is more powerful, economists nowadays debate which type of medicine—fiscal or monetary—works faster. Until now, we have ignored questions of timing and pretended that the authorities noticed the need for stabilization policy instantly, decided on a course of action right away, and administered the appropriate medicine at once. In reality, each of these steps takes time.

First, delays in data collection mean that the most recent data describe the state of the economy a few months ago. Second, one of the prices of democracy is that the government often takes a distressingly long time to decide what should be done, to muster the necessary political support, and to put its decisions into effect. Finally, our $14 trillion economy is a bit like a sleeping elephant that reacts rather sluggishly to moderate fiscal and monetary prods. As it turns out, these lags in stabilization policy, as they are called, play a pivotal role in the choice between fiscal and monetary policy. Here’s why.

The main policy tool for manipulating consumer spending (C) is the personal income tax, and Chapter 8 documented why the fiscal policy planner can feel fairly confident that each $1 of tax reduction will lead to about 90 to 95 cents of additional spending eventually. But not all of this extra spending happens at once.

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First, consumers must learn about the tax change. Then they may need to be convinced that the change is permanent. Finally, there is simple force of habit: Households need time to adjust their spending habits when circumstances change. For all these reasons, consumers may increase their spending by only 30 to 50 cents for each $1 of additional income within the first few months after a tax cut. Only gradually will they raise their spending up to about 90 to 95 cents for each additional dollar of income.

Lags are much longer for investment (I), which provides the main vehicle by which monetary policy affects aggregate demand. Planning for capacity expansion in a large corporation is a long, drawn-out process. Ideas must be submitted and approved, plans must be drawn up, funding acquired, orders for machinery or contracts for new construction placed. And most of this activity occurs before any appreciable amount of money is spent. Economists have found that much of the response of investment to changes in either interest rates or tax provisions takes several years to develop.

The fact that C responds more quickly than I has important implications for the choice among alternative stabilization policies. The reason is that the most common varieties of fiscal policy either affect aggregate demand directly—because G is a component of C 1 I 1 G 1 (X 2 IM)—or work through consumption with a relatively short lag, whereas monetary policy primarily affects investment. Therefore:

Conventional types of fiscal policy actions, such as changes in G or in personal taxes, probably affect aggregate demand much more promptly than do monetary policy actions.

So is fiscal policy therefore a superior stabilization tool? Not necessarily. The lags we have just described, which are beyond policy makers’ control, are not the only ones affecting the timing of stabilization policy. Additional lags stem from the behavior of the policy makers themselves. We refer here to the delays that occur while policy makers study the state of the economy, contemplate which steps they should take, and put their decisions into effect.

Here monetary policy has a huge advantage. The Federal Open Market Committee (FOMC) meets eight times each year, and more often if necessary. So monetary policy decisions are made frequently. And once the Fed decides on a course of action, it executes its plan immediately by buying or selling Treasury bills in the open market.

In contrast, federal budgeting procedures operate on an annual budget cycle. Except in unusual cases, major fiscal policy initiatives can occur only at the time of the annual budget. In principle, tax laws can be changed at any time. But the wheels of Congress normally grind slowly and are often gummed up by partisan politics. For these reasons, it may take many months for Congress to change fiscal policy. That said, Congress has proven twice in this decade that it can act very quickly in a perceived emergency. First in 2001, and then again in 2008, both houses rapidly passed, and the president signed, fiscal stimulus bills that put checks into the hands of consumers when the economy was threatened by recession—even though, in the second case, the White House and Congress were controlled by different parties. This recent experience now has many observers rethinking the old conventional wisdom, which held that:

Policy lags are normally much shorter for monetary policy than for fiscal policy.

Could it be that this is no longer true?

So where does the combined effect of expenditure lags and policy lags leave us? With nothing very conclusive, we are afraid. In practice, however, most students of stabilization policy have come to believe that the unwieldy and often partisan nature of our political system make active use of fiscal policy for stabilization purposes quite difficult. Monetary policy, they claim, is the only realistic game in town and therefore must bear most of the burden of stabilization policy.

DEBATE: SHOULD THE FED CONTROL THE MONEY SUPPLY OR INTEREST RATES?

Another major controversy that raged for decades focused on how the Federal Reserve should conduct monetary policy. Most economists argued that the Fed should use its open-market operations to control the rate of interest (r), which is how we have portrayed

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money demand curve M0D0 crosses money supply curve MS. Here the interest rate is r 5 5 percent and the money stock is M 5 $830 billion. We assume that these are the Fed’s targets: It wants to keep the money supply and interest rates just where they are.

If the demand curve for money holds still, everything works out fine. But suppose the demand for money is not so obliging. Suppose, instead, that the demand curve shifts outward to the position indicated by the brick-colored line M1D1 in Figure 2. We learned in the previous chapter that such a shift might occur because output increases or because prices rise, thereby increasing the volume of transactions. Or it might happen simply because people decide to hold more bank deposits. But whatever the reason, once the shift occurs, the Fed can no longer achieve both previous targets.

If the Fed does nothing, the outward shift of the demand curve will push up both the quantity of money (M) and the rate of interest (r). Figure 2 depicts these changes as the move from point E to point A. In the example, if the demand curve for money shifts outward from M0D0 to M1D1, and monetary policy does not change (leaving the supply curve unchanged), the money stock rises to $840 billion and the interest rate rises to 7 percent.

Now suppose the Fed is targeting the money supply and is unwilling to let M rise. In that case, it must use contractionary open-market operations to prevent M from rising. But in so doing, it will push r up even higher, as point W in Figure 2 shows. After the demand curve for money shifts outward, point E is no longer attainable. The Fed must instead choose from among the points on the brick-colored line M1D1, and point W is the point on this line that keeps the money supply at $830 billion. To hold M at $830 billion, the Fed must reduce bank reserves just enough to pull the money supply curve inward so that it passes through point W. (Pencil this shift in for yourself on the diagram.) But the interest rate will then skyrocket to 9 percent.

Alternatively, if the Federal Reserve is pursuing an interest rate target, it might decide that the rise in r must be avoided. In this case, the Fed would be forced to engage in expansionary open-market operations to prevent the outward shift of the demand curve for money

1If you need to review this process, turn back to Chapter 12, especially pages 252–258.

2For further details on this proportionality relationship, including some numerical examples, see Test Yourself

Question 5 at the end of this chapter.

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from pushing r up. In terms of Figure 2, the interest rate can be held at 5 percent by adding just enough bank reserves to shift the money supply curve outward so that it passes through point Z. But doing this will push the money supply up to $850 billion. (Again, try penciling in the required shift of the money supply curve.) To summarize this discussion:

When the demand curve for money shifts outward, the Fed must tolerate a rise in interest rates, a rise in the money stock, or both. It cannot control both the supply of money and the interest rate. If it tries to keep M steady, then r will rise even more. Conversely, if it tries to stabilize r, then M will rise even more.

Two Imperfect Alternatives

For years, economists debated how a central bank should deal with its inability to control both the money supply and the rate of interest. Should it adhere rigidly to a target growth path for bank reserves and the money supply, regardless of the consequences for interest rates—which is the monetarist policy? Should it hold interest rates steady, even if that requires sharp gyrations in reserves and the money stock—which is roughly what the Fed does now? Or is some middle ground more appropriate? Let us first explore the issues and then consider what has actually been done.

The main problem with imposing rigid targets on the supply of money is that the demand for money does not cooperate by growing smoothly and predictably from month to month; instead it dances around quite a bit in the short run. This variability presents the recommendation to control the money supply with two problems:

1.It is almost impossible to achieve. Because the volume of money in existence depends on both the demand and the supply curves, keeping M on target in the face of significant fluctuations in the demand for money requires exceptional dexterity.

2.For reasons just explained, rigid adherence to money-stock targets might lead to wide fluctuations in interest rates, which could create an unsettled atmosphere for business decisions.

But powerful objections can also be raised against exclusive concentration on interest rate movements. Because increases in output and prices shift the demand schedule for money outward (as shown in Figure 2), a central bank determined to keep interest rates from rising would have to expand the money supply in response. Conversely, when GDP sagged, it would have to contract the money supply to keep rates from falling. Thus, interest rate pegging would make the money supply expand in boom times and contract in recessions, with potentially grave consequences for the stability of the economy. Ironically, this is precisely the sort of monetary behavior the Federal Reserve System was designed to prevent. Hence, if the Fed is to control interest rates, it had better formulate flexible targets, not fixed ones.

What Has the Fed Actually Done?

For most of post–World War II history, the predominant view held that the interest rate was much the more important of the two targets. The rationale was that gyrating interest rates could cause abrupt and unsettling changes in investment spending, which in turn would make the entire economy fluctuate. Stabilizing interest rates was therefore believed to be the best way to stabilize GDP. If doing so required fluctuations in the money supply, so be it. Consequently, the Fed focused on interest rates and paid little attention to the money supply—which is more or less the Fed’s view today as well.

During the 1960s, however, this prevailing view came under withering attack from Milton Friedman and other monetarists. These economists argued that the Fed’s obsession with stabilizing interest rates actually destabilized the economy by making the money supply fluctuate too much. For this reason, they urged the Fed to stop worrying so much about fluctuations in interest rates and, instead, make the money supply grow at a constant rate from month to month and year to year.

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