Effectiveness of the Fiscal and Monetary Policy - Coursework Example

EFFECTIVENESS OF THE FISCAL AND MONETARY POLICY The IS-LM model acts as important macroeconomic tool that graphically represent the IS and the LM curves. This model attempts to explain the investing decisions made by investors given the amount of money they have available and the interest rate they will receive. The IS curve represents the equilibrium in the goods market while the LM curve represents the equilibrium in the money market. In the short run, equilibrium is achieved where the IS curve intersects with the LM curve. Here, the goods market, the labor market, and the assets market are all at par. At this point, when aggregate demand for goods rises, the assumption is that firms are willing to hire more workers in the short run to produce the extra output and meet the expanded demand. The long run equilibrium is where labor market is in equilibrium and full employment. This means that if there is higher demand, firms will increase prices until they hire the optimal amount of workers that will produce the potential level of output. Keynesians and Monetarists have disagreed on many policy issues, one of them being the fiscal and monetary policies. Controversy exists between Keynesians and Monetarists as to the strength and effectiveness of fiscal & monetary policies with each having a differing point of view. The debate between Keynesian and Monetarist theories concerning fiscal and monetary policies might seem academic but its implications are actually relevant to both everyday investment decisions and economic policy. Keynesians claim that both are potent weapons and how much they affect the economy depends upon circumstances. They add that fiscal policy works faster than monetary policy. On the other hand, Monetarists1 claim that the effect of fiscal policy is weak while that of the monetary policy is strong. They further assert that monetary policy works faster. Therefore, a clear understanding the major contrasts in the two schools of thought in macroeconomics will help in the assessments of risk and expectations for economic growth. Keynesians View Keynesians say that the effect of pure fiscal policy depends upon the size of shift of IS and slopes of both IS and LM. Suppose the fiscal authorities pursue an expansionary policy by increasing government spending and uses bonds to finance it. An increase in the government spending will shift the IS curve to the right. Such a policy will be most effective if the IS curve intersects the LM curve in the liquidity trap range, where the LM curve is said to be perfectly elastic. It is somewhat effective if it occurs in the intermediate range, where the LM curve is somewhat elastic. However, the policy is completely ineffective if it occurs in the classic range, where the LM curve is said to be perfectly inelastic. In the liquidity trap range, such an action will be most effective because the shifting of the IS curve to the right will not increase the interest rate, thereby causing no adverse effects on private investment. However, in the classical range, similar actions cause an increase in the interest rate making private investment equal to the increase in government spending is crowded out. In the case of the intermediate range, similar action is somewhat effective because only a portion of its effect is offset by a decrease in private investment. Thus, the effect of the fiscal policy depends, among other things, upon LM curve’s slope. The steeper the slope of the LM curve, the less will be the effect. Regarding the monetary policy, Keynesians claim that it is completely ineffective where the LM curve is in the liquidity trap range, partially effective when it is in the intermediate range, and most effective when it is in the classical range. Suppose the monetary authority increases the money supply to stimulate the economy, this will make the LM curve to shift to the right. In cases when the LM curve is in the liquidity trap range, if the money supply increases, it will be fully absorbed by an increase in the demand for money. As a result, the interest rate will remain unchanged and hence investment will remain at the same level. This is illustrated in the figure below: On the other hand, an increase in money supply when the LM is in the intermediate range, the interest rate will fall slightly. As a result, investment and consequently income will rise. Therefore, the interest rate will fall because the increase in money supply is only partially absorbed by the increase in demand for idle cash balances. Monetary policy will be most effective situations where money supply increases when the LM curve is in the classical range. Since here, the demand for money is perfectly interest inelastic; when money supply increases, it will cause a significant reduction in the interest rate. This will in turn produce a large stimulative effect on investment. Consequently, income will rise. Monetarists View Monetarists maintain that pure fiscal policy has a weak impact on the economy. If government increases its expenditure to stimulate the economy and expenditure is financed by public borrowing, its effect will be weak because it will crowd out private expenditure by increasing interest rate. In the IS and LM framework this will happen when LM is relatively interest inelastic. The effect will also be weak, if the increased expenditure is financed by taxes because it leaves taxpayers with less to spend. Monetarists recognize that the fiscal policy has a re-allocative effect on the long-run output. If an expenditure program re-allocates resources from consumption to investment, say it cuts down low-income subsidies and increase expenditure on education, long run output will rise. Output will also rise if a tax program is designed to encourage private investment. Nevertheless, they argue that such effects are minor and take a long time before they appear. On the other hand, monetary policy produces a strong impact, stronger than fiscal policy, because it does not cause any crowding out effect. As explained earlier, fiscal policy is completely ineffective when the LM curve is vertical, meaning demand for money is perfectly interest inelastic. Friedman2 says that though the LM curve is not vertical, it is steeper than what the Keynesians think. Furthermore, he asserts that there is a much broader category of interest sensitive private expenditure than Keynesians think, which reduce the size of shift of the IS curve caused by a fiscal action. In addition, Hamm3 says that the size of the shift of IS curve is reduced significantly, if consumption expenditure is highly sensitive to the interest rate because the interest sensitivity of business expenditure is already taken into account in the slope. Therefore a small shift in IS curve combined with a steeply sloped LM produces a weak impact on income. The St. Louis model, a major Monetarist model, shows that the effect of pure fiscal policy on income is not only minor but also short-lived. However, the MPS model, which is a major Keynesians model, shows that the same policy exerts a significance effect lasting for several years. This is illustrated in the figure below: Effectiveness of Economic Policies in the Short Run This entails a review of some reasons that lead to demand-side policies ineffective, or those that to some extent lead to effectiveness only in the short run. The point of the model was to show that, under certain conditions, active economic policies on the aggregate demand could lead the economy towards a desired outcome. Effectiveness of the Fiscal Policy in the Short Run In order to evaluate the effectiveness of the Fiscal policy we shall consider a scenario where the money demand is very interest inelastic making the LM curve almost vertical. This is because as income increases money demand also increase and thus it needs a huge increase in interest rate to take money demand back to where it was initially. In this case, the effectiveness of the fiscal policy is very limited: an increase in G will increase output and hence money demand. As firms struggle to raise funds, they will have to offer very high interest rates. In this case, the crowding out effect can be very strong, and almost no real effect produced. Monetary policy will be instead effective. The less interest-sensitive is money demand and the more effective is monetary relative to fiscal policy. This is illustrated in the figure below: Effectiveness of the Monetary Policy in the Short Run In this case we will consider a scenario where investments are very interest inelastic hence the IS curve is almost vertical. This is because as r decreases investments will increase by a small amount. Alternatively, a small increase in output will require a huge drop in interest rate. In this case, monetary policy effectiveness is very limited: an increase in money supply will reduce the interest rate. As firms will not take this as an extra incentive to borrow and invest, the level of investments will remain unchanged. In this case, monetary policy will be ineffective, while fiscal policy will be effective. The less interest-sensitive are investments and the more effective is fiscal relative to monetary policy. This is illustrated in figure 4 below: Effectiveness of Economic Policies in the Long Run An alternative source of prudence for an excessive reliance on demand-side policies is that in the long run prices are not fixed, as assumed by the IS-LM model. On this matter, we have to leave the Keynesians way of thinking and rely on Classical economic theory. This theory predicts that, the economy in the long run stays on the natural level of output, regardless of the level of the aggregate demand. This means that any difference between aggregate demand and the natural level of aggregate supply will be matched by price variations. The natural level of output is defined as the level of output where prices have no tendency to adjust, and reflects the potentials of the supply side of the economy. According to this theory, if output is above the natural level of output then prices will increase, and if output is below the natural level of output prices will decrease. This means that any economic policy that tries to boost output permanently above the natural level of output will run into inflationary pressures that will cause disequilibrium on the money market, increase interest rate, and discourage investment, taking income back to the natural level of output. Effectiveness of the Fiscal Policy in the Long Run We will consider a fiscal expansion that attempts to increase equilibrium output by shifting the IS curve to the right. We have seen that the increase in output will put upward pressure on the interest rate. If we start from a situation where output is equal to its natural level, the fiscal policy will take the economy above its natural level, causing inflationary pressures. This will reduce the real money supply, shifting the LM curve up, increasing equilibrium interest rate, and reducing output. This is illustrated in the figure below: Effectiveness of the Monetary Policy in the Long Run Let consider a monetary expansion that attempts to increase equilibrium output by shifting the LM curve to the right. We have seen that the increase money supply will put downward pressure on the interest rate thus increasing output. If we start from a situation where output is equal to its natural level, the monetary policy will take the economy above its natural level, causing inflationary pressures. This will reduce the real money supply, shifting the LM curve up, increasing equilibrium interest rate and reducing output, until the LM curve reaches its starting position. The long run effect is only on prices, as output gets back to his original level. This is illustrated in the figure below: Conclusion Keynesians and Monetarists differ, though, about the outside lag time, time required for the economy to respond to changes in policy after it is implemented. Keynesians claim that fiscal policy has a shorter lag than monetary policy while Monetarists claim just the opposite. Keynesians argue their position because most fiscal actions, such as government expenditure and changes in personal income tax, affect the economy almost immediately but this is not the case with monetary actions. It takes time for an action of the Bank of England to affect the money supply; for a change in money supply to affect the interest rates; and for any interest rate change to affect the economy. Monetarists disagree with this claims and support their position with empirical evidence such as the study of Andersen and Jordan4, which concludes that monetary actions affect the economy faster than fiscal ones. However, it is important to note that both the Keynesians and Monetarists agree that fiscal policy has a longer policy lag, time required to implement a change in policy after its need is recognized, than monetary policy. This is because most of the changes in fiscal policy have to be approved by the Parliament of the United Kingdom, and speed has never been one of the Parliament of the United Kingdom’ strong points. Monetary policy can be changed within a short time because the Bank of England has complete authority in such matters. Based on this therefore I can conclude that the most convincing school of thought is the fiscal policy due to its effectiveness in the short run since in the long run both policies are considered ineffective. Bibliography Arthur Okun M., 1972. ‘Fiscal-Monetary Activism: Some Analytical Issues,” Brookings Paper on Economic Activity, 1 p. 157 Beetsma, R. and Bovenberg, A.L. 2001. ‘The Optimality of a Monetary Union without a Fiscal Union’: Journal of Money, Creditand Banking, 33: 179-204. Bobby Hamm L., 1974. ‘Theoretical Controversy and Macroeconomic Policies: 1960’s and 1970’s. Ruston, Louisiana: Louisiana Tech University, p. 19. Chari, V. V., and Kehoe, P. J., 2004. ‘On the Desirability of Fiscal Constraints in a Monetary Union’, NBER Working Paper, No.10232. Dixit, A., and Lambertini, L., 2003. ‘Symbiosis of Monetary and Fiscal Policies in a Monetary Union’, Journal of International Economics, 60: p. 235-247 Eichengreen, B., and von Hagen, J., 1996), ‘Federalism, Fiscal Restraints, and European Monetary Union’, American Economic Review, 86: p. 134-138. Fischer, Stanley., 1997. “Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Rule.” Journal of Political Economy, 85(1), p. 191-205. Franco Modgiliani 1977, “The Monetarist Controversy or Should We Forsake Stabilization Policies?” American Economic Review, p.11 Giavazzi, F., and Pagano, M., 1996. ‘Non-Keynesian Effects of Fiscal Policy Changes: International Evidence and the Swedish Experience’, Swedish Economic Policy Review, 3: p. 67-103 Gandolfo, G., (2002). International Finance and Open-Economy Macroeconomics. Springer. Hemming, R., Kell, M., and Mahfouz, S., 2002. ‘The Effectiveness of Fiscal Policy in Stimulating Economic Activity – A Review of the Literature’, IMF Working Paper, WP/02/208. Leonall C., Andersens and Jerry L., Jordan 1968. “Monetary and Fiscal Actions: A Test of Their Relative Importance in Economic Stabilization,” Federal Reserve Bank of St. Louis, p 22 Milton, Friedman., 1968. “The Role of Monetary Policy,” American Economic Review, p. 15-16 Romer, D., 1996. Advanced Macroeconomics, McGraw-Hill. William, Poole., 1971. “Rule of Thumb for Guiding Monetary Policies,” (Washington, D.C.: Board of Governors of the Federal Reserve System), p. 139-140. Read More