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Milton Friedman, “inflation is always and everywhere a monetary cent U.S. history as an illustration. In the scatter diagram on the left,
phenomenon.” By this statement, Friedman meant that changes in each point records both the growth rate of the M2 money supply and
the growth rate of the money supply (%DM) are far and away the the inflation rate (as measured by the Consumer Price Index) for a
principal cause of changes in the inflation rate (%DP)”in all places particular year between 1979 and 2007. Because of the years
and at all times. 1979“1981, there seems to be a weak positive relationship be-
Few economists question the dominant role of rapid money tween the two variables. But no relationship at all appears for the
growth in accounting for extremely high rates of inflation. During years 1982“2007.
the German hyperinflation of the 1920s, for example, money was Monetarists often argue that this comparison is unfair because
being printed so fast that the printing presses had a difficult time the effect of money supply growth on inflation operates with a lag
keeping up the pace! But most economists question the words “al- of perhaps two years. So the right-hand scatter diagram compares
ways and everywhere” in Friedman™s dictum. Aren™t many cases of inflation with money supply growth two years earlier. It tells essen-
moderate inflation driven by factors other than the growth rate of tially the same story. More sophisticated versions of scatter plots
the money supply? like these have led most economists to reject the monetarist claim
that inflation and money supply growth are tightly linked.


14 14
80 80
12 12




SOURCE: Federal Reserve System and Bureau of Labor Statistics.
79 79
81 81
10 10
Inflation Rate




Inflation Rate




8 8
82 82
6 6
90 90
84
89 89
84 91
91 88 88
93 92 05 06 87 00 83
4 4
87
92 85 85
05 06 00 01 83 96 95
93 95 96 04 07 0701 04
94 94 03
99 97 99
2 2
86 86
03 97 98 02
98
02
2.5 5 7.5 10 12.5 2.5 5 7.5 10 12.5
Money Growth Rate Money Growth Rate
(a) (b)


NOTE: All figures are in percent.




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 in-
terest 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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Chapter 14 283
The Debate over Monetary and Fiscal Policy



some private demand (I) provides another reason why the oversimplified multiplier for-
mula 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 lan-
guage 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 equa-
tion 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 ig-
nored questions of timing and pretended that the authorities noticed the need for stabi-
lization 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 govern-
ment 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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Licensed to:
Part 3
284 Fiscal and Monetary Policy



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, con-
sumers may increase their spending by only 30 to 50 cents for each $1 of additional in-
come 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 cor-
poration 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 in-
terest 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, prob-
ably 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 de-
cisions 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 nor-
mally 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 threat-
ened 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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Licensed to:

Chapter 14 285
The Debate over Monetary and Fiscal Policy



monetary policy up to now. But others, especially mone- S
M1
10% M0
tarists, insisted that the Fed should concentrate on con-
trolling bank reserves or some measure of the money W
9
supply (M) instead. This debate echoes even today in
8 For given
Europe, where the European Central Bank (ECB), unlike Fed policy
the Fed, claims to pay considerable attention to the A
7
growth of the money supply. (Many skeptics doubt that




Interest Rate
6
it actually does so, however.)
To understand the nature of this debate, we must first Z
5 Money
E
demand
understand why the Fed cannot control both M and r at
4 shifts out
the same time. Figure 2 will help us see why. It looks just
like Figure 8 of the previous chapter (on page 274), except 3
that the horizontal axis now measures the money supply
2
instead of bank reserves. The switch from reserves to
money is justified by something we learned in earlier 1 D1
D0
M
chapters: that the money supply is “built up” from the 0
Fed™s supply of bank reserves via the process of multiple 830 840 850
expansion. As you will recall, this process leads to an ap-
1 Money Supply (in billions of dollars)
proximately proportional relationship between the two”
F I GU R E 2
meaning that if bank reserves go up by X percent, then
the money supply rises by approximately X percent, too. Because M is basically propor- The Federal Reserve™s
2

Policy Dilemma
tional to bank reserves, anything we can analyze in the market for reserves can be analyzed
in just the same way in the market for money”which is the market depicted in Figure 2.
The diagram shows an initial equilibrium in the money market at point E, where
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

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