CHALLENGES TO KEYNESIAN ECONOMICSModule 35

Problems of Fiscal Policy

•Problems of timing•recognition lag•administrative lag•operational lag

• Political problems• Political business cycles - fiscal policy may be corrupted for political purposes and may cause economic fluctuations

• Complications• Crowding Out – expansionary fiscal policy (deficit spending) will increase the interest rate and reduce consumer and business spending, thereby weakening or canceling the stimulus of expansionary policy.

Fiscal Policy and Crowding Out

EFFECTIVENESS OF MONETARY POLICY

Strengths•The Federal Open Market Committee can act swiftly.

•Isolation from political pressure•No Crowding Out

Monetary Policy and Crowding Out

Problem of Monetary Policy

•Monetary Neutrality• In the long-run an increase in the money supply raises price level, but does not affect output or employment

Monetarism

• Monetarist advocate increases in the money supply should match increases in GDP

• If GDP is increasing by 3 % the money supply should increase by only 3%

• This is reasonable given the equation of exchange and a constant money velocity.

Monetary Equation of Exchange (MV=PQ)

Monetarists adhere to this equation: money times velocity = price times quantity.

(M) Money is the stock of money, M1; currency in circulation, traveler’s checks, and checkable deposits.

 

(V) Velocity means the income (GDP) velocity of circulation; the average number of times a dollar is spent on final goods and services per time period (usually one year). V = GDP/M = PQ/M

(P) Price is the average price level of the final goods and services in GDP.

(Q) Quantity is the real output; the quantity of goods and services in GDP.

Problems with Monetarism

Although the velocity of money had been fairly constant, starting in the 1980s it became very erratic.

This led the Federal Reserve to drop monetarism as a means of controlling the money supply and to adopt targeting the Federal Funds rate.