Monetary and Fisical Policy

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CHAPTER 11

MONETARY AND FISCAL POLICY

Chapter Outline:

The effects of fiscal and monetary policy on output
Monetary policy and the transmission mechanism
The liquidity trap
The classical case
The quantity theory of money
Fiscal policy and crowding out
Monetary accommodation
The effects of alternative policies on the composition of output •The U.S. economy in the 1980s and 1990s
Anticipatory monetary policy
The policy mix during the German re-unification

Changes from the Previous Edition:

The material in this chapter has been updated, but its format is essentially the same. More emphasis is given to the economic expansion in the U.S. in the 1990s.

Introduction to the Material:

Chapter 11 uses the IS-LM model derived in Chapter 10 to show how monetary and fiscal policies can be used to dampen economic disturbances. The economic effects of various policy mixes are highlighted in discussions of actual events: the recession and recovery in the United States in the 1980s, the U.S. recession in 1990-91, the long economic expansion thereafter, and the policies enacted by Germany during the re-unification process in 1990-92. First, the Fed's conduct of monetary policy is discussed, with an explanation of how open market operations can be used to change nominal money supply. The effectiveness of monetary policy in changing the amount of output demanded depends on the steepness of the LM-curve. The transmission mechanism, that is, the process by which monetary policy changes affect the economy, occurs in several steps. First, a change in money supply leads portfolio holders to make adjustments in their asset holdings. As a result, asset prices and interest rates change. The change in interest rates subsequently affects intended spending and thus national income. Table 11-1 provides a summary of this process. Two extreme cases in the operation of monetary policy are given special attention. Monetary policy is powerless to affect interest rates (and thus the economy) in the liquidity trap (represented by a horizontal LM-curve). The polar opposite is the classical case (represented by a vertical LM-curve), in which a given change in money supply has the greatest effect on the level of income. The effectiveness of expansionary fiscal policy depends on the amount of crowding out that takes place, that is, on the reduction in private spending (most notably investment) caused by rising interest rates following fiscal expansion. It is important to state that crowding out is always a matter of degree. When output is close to the full-employment level, any increase in aggregate demand due to fiscal expansion will be reflected mainly in an increase in interest rates and the price level, with little effect on the level of output. But when the economy experiences high unemployment, fiscal expansion can stimulate the economy successfully, without much upward pressure on interest rates or prices. Since Chapter 11 deals only with the IS-LM model, the extent of the crowding-out effect depends on the slopes of the IS- and LM-curves. The flatter the IS-curve and the steeper the LM-curve, the larger the crowding-out effect. (Special attention is again given to the two extremes of the liquidity trap and the classical case). The factors that determine the slopes of the IS- and LM-curves have already been discussed in the previous chapter. Here, some additional examples are given to emphasize the effects of fiscal policy changes on the composition of output, including the effects of investment subsidies. While monetary and fiscal policy can both raise the level of output, their impacts on the composition of GDP can differ significantly. Monetary policy operates by affecting interest rates, which will first be felt by the most interest-sensitive sectors of the economy. In contrast, the effects of fiscal policy depend on which category of government expenditures and/or taxes are changed. Intended...
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