Referat Monetary Policy And Fiscal Policy2

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Monetary Policy and Fiscal Policy The policy arsenal Economic policy makers have access to a variety of policy instruments. The challenge is to choose the right tools at the right time. The mix of tools required may vary from problem to problem. Type of policy Policy instruments Fiscal -changes in government spending -tax cuts and increases Monetary -open market operations -reserve requirements -discount rates Supply side -tax incentives -deregulation -skill training and other labour-market aid -wage-price controls -free trade The choice between monetary and fiscal policy as tools stabilisation policy is an important and controversial topic. One basis for decision is the flexibility with which these policies can be implemented and take effect. Here we do not discuss speed and flexibility, but rather look at what these policies do to the aggregate demand. In that respect, there is a sharp difference between monetary and fiscal policy. Monetary policy operates by stimulating interest, responsive components of aggregate demand, primarily investment spending. There is strong evidence that the earliest and strongest effect of monetary policy is on residential construction. Fiscal policy, by contrast, operates in a manner that depends on precisely what gods the government buys or what taxes and transfers it changes. Here we might be talking of government purchases of goods and services such as defense spending or a reduction in the corporate profits tax, sales taxes, or social security contributions. Each policy affects the level of aggregate demand and causes an expansion in output, but the composition of the output increase depends on the specific policy. An investment subsidy increases investment spending. An income tax cut has a direct effect on consumption spending. All expansionary fiscal policies will raise the interest rates if the quantity of money is unchanged. When we speak of fiscal policy, we are referring to these public tax and expenditure activities; more particularly, fiscal policy is the use of the government’s taxation and spending powers to alter macroeconomic outcomes. An increase in government spending has a multiplied impact on total spending. The government expenditures in product markets create additional income. This added income finances increased consumption. These income and spending cycles continue until total income (spending) has increased. Stimulus to the circular flow of income is made of: increased employment additional income increased consumption increased sales receipts increased govern spending which are represented in the next figure. Fiscal policy will not always be used to increase aggregate spending. Just as the expenditure decisions made by consumers and investors may result in deficient aggregate spending, so too may they result in excessive aggregate spending. In situations where excessive spending threatens to erode price stability or is already doing so, the objective of fiscal policy is to decrease total spending rather than to increase it. In this sense, fiscal policy is a two-edged sword, which may be used either to stimulate or to suppress aggregate spending; but a major objective of this policy is to close inflationary and recessionary gaps. Income Interest rate Fiscal policy affects aggregate demand and thus has an impact on output and income; but changes in income affect the demand for money and thereby equilibrium interest rates in assets markets; these interest rates change feed back to the goods market and dampen the impact of fiscal policy. ALTERNATIVE FISCAL POLICIES Interest rate Consumption Investment GNP Income tax cut + + - + Government spending + + - + Investment subsidy + + + + POLICY EFFECTS ON INCOME AND INTEREST RATES Policy Equilibrium income Equilibrium interest rate Monetary expansion + - Fiscal expansion + + The recognition that monetary and fiscal policy changes have different effects on the composition of output is important. It suggest that policy makers can choose a policy mix that will only get the economy to full employment but also make a contribution to solving policy problems. The use of fiscal policy to alter the level of GNP is commonly referred to as the stabilisation function of the budget. The basic objective of such activity is to stabilise total spending at a rate that is consistent with the goals of full employment and price stability. (The Keynesian theory of instability leads directly to a mandate for government policy. From a Keynesian perspective, an insufficiency of aggregate spending causes unemployment; an excess of aggregate spending causes inflation. Since the market itself will not correct these imbalances, the government must. How is possible that fiscal policy has no effect at all on income? After all, of the government were to spend more, how is it possible that the increased spending should not raise income? The reasoning is as follows: an increase in government spending does lead to an incipient rise in aggregate demand and income, but that immediately raises the demand for money; with the money supply unchanged, interest rates will shoot up to clean the money market; as interest rates rise because of the excess demand for money, investment spending declines; the fall in investment spending compensates exactly for the higher government spending and the level of income is unchanged. Does it matter how much money is available? Will the money supply affect our ability to achieve full employment, price stability or any other macroeconomic goal? Vladimir Lenin thought so. The first communist leader of the Soviet Union once remarked that the best way to destroy a society is to destroy its money. If a society’s money became valueless, it would no longer be accepted in exchange for goods and services in product markets. As a consequence, people would resort to barter, and the economy’s efficiency would be severely impaired. Adolf Hitler tried unsuccessfully to use this weapon against Great Britain during the Second World War. Although all economists recognise that money is important, they have different opinions on just how the supply of money affects prices and output. John Maynard Keynes was primarily concerned about aggregate spending in the economy; money was a secondary concern; it mattered only if it could alter desired investment, consumption or government spending; as a consequence, Keynesians regard monetary policy as less important than fiscal policy. They concede that changes in the money supply may affect prices and output (employment), but would rather use tax and budget policies to influence the macroeconomy. Not anyone shares the Keynesian view of money. Monetarists think money has direct and powerful effects, particularly on the price level. From their perspective, neither fiscal nor monetary policy significantly affects real output levels. But monetary policy at least has a direct influence on prices (inflation). From Keynes’ perspective, the supply of money has a potentially important but indirect impact on the macroeconomy. His view of money starts with a simple proposition: money is simply a commodity that is traded in the market place. Like other goods, there is a supply of money and a demand for money. Together, they will determine the “price” of money, or the interest rate. In his model, changes in the money supply affect macroeconomic outcomes only through the intermediary of interest-rates. Members of another school of economists, the Monetarists, claim that Keynes’ explanation of monetary policy is unduly complex. In their view, monetary policy has little impact on real output and employment levels, but has a far more powerful and certain impact on the price level than Keynes surmised. Monetarists assert the potential of monetary policy can be expressed in a simple equation called the equation of exchange. It is written as MV=PQ, where M refers to the quantity of money in circulation and V to its velocity of circulation; total spending in the economy is equal to the average price (P) of goods times the quantity(Q) of goods sold in a period; this spending is financed by the supply of money(M) times the velocity of its circulation(V). Notice that the velocity of MV and PQ says nothing about which dimensions of the economy will change. Monetarists use the equation of exchange to simplify the explanation of how monetary policy works. There is no need, they argue, to follow the effects of changes in M through the money markets to interest rates and further to changes in aggregate spending. Keynesians worry about how the money supply affects interest rates, how interest rates affect spending, and how spending affects output. By contrast, Monetarists point to a simple equation(MV=PQ) that produces straight forward responses to monetary policy. There are fundamental differences between the two schools here, not only about how the economy works, but also about how successful macro policy might be. The equation of exchange –there is no disagreement about the equation itself: aggregate spending(MV) must equal the value of total sales(PQ). What Keynesian and monetarist economists argue about is which of the policy levers– M or V –is likely to be effective in altering aggregate spending. Monetarists point to changes in the money supply(M) as the principal lever of macro policy. Keynesian fiscal policy must rely on changes in the velocity of money(V) because tax and expenditure policies have no direct impact on the money supply. Monetarists assert that changes in government spending(G) and taxes(T) do not alter yhe velocity of money (V). As a result, fiscal policy alone cannot alter total spending. Keynesians reject this view, arguing that V is changeable. They claim that tax cuts and increased government spending increase the velocity of money and so alter total spending. Table 1.How fiscal policy matters: monetarist versus Keynesian views. Do changes in G or T affect Monetarist view Keynesian view 1.Aggregate spending? No (stable V causes crowding out) Yes (V changes) 2.Prices? No (aggregate spending not affected) Maybe (if at capacity) 3.Real output? No (aggregate spending not affected) Yes (output responds to demand) 4.Nominal interest rate? Yes (crowding out) Maybe (may alter demand for money) 5.Real interest rate? No (determined by real growth) Yes (real growth and expectations may vary) Because Monetarists believe that V is stable, they assert that changes in the money supply(M) must alter total spending. But all of the monetary impact is reflected in prices and nominal interest rates; real output and interest rates are unaffected. Keynesians think that V is variable and thus that changes in M might not alter total spending, however, Keynesians expect all outcomes to be affected. Table 2. How money matters: monetarist versus Keynesian views. Do changes in M affect Monetarist view Keynesian view 1.Aggregate spending? Yes (V stable) Maybe (V may change) 2.Prices? Yes (V and Q stable) Maybe (V and Q may change) 3.Real output? No (rate of unemployment determined by structural forces) Maybe (output responds to demand) 4.Nominal interest rates? Yes (but direction unknown) Maybe (liquidity trap) 5.Real interest rates? No (depends on real growth) Maybe (real growth may vary) These 2 tables provide many insights into how fiscal and monetary policy can do work. The velocity of money plays a key role in the debate over the relative effectiveness of these 2 policies levers. The critical question appears to be whether V is stable or not. To understand the persistence of the debate over V thus over the question of whether fiscal or monetary policy “works” –we must distinguish between the long run and the short run- the velocity of money turn out, in fact, to be quite stable over long periods of time and velocity might fluctuate in the short run. Economic policy would be most effective if it incorporates the insights of both Monetarists and the Keynesians. Of course, monetary policy and fiscal policy could be used to cancel each other out, but a much more intelligent course of action would be to combine monetary and fiscal policy in such a way as to approach more closely all of our economic goals. This is what a policy synthesis is all about. The issue is not really whether monetary policy is more effective than monetary policy or vice versa. We must seek the combination of policies that is best suited to deal with a specific set of problems in a specific economic context. This kind of debate may be less exciting, but it is also more likely to contribute to improvements in economic performance. “Money, which represents the prose of life, and which is hardly spoken of in parlours without an apology, is, in its effects and laws, as beautiful as roses.” Ralph Waldo Emerson “General monetary controls are a mirage and a delusion.” Keynesian Warren Smith “Money does matter and matters very much. Changes in the quantity of money have important, and broadly predictable, economic effects… Substantial contradictions in the quantity of money over short periods have been a major factor in producing severe economic contradictions. And cyclical variations in the quantity of money may well be an important element in the ordinary mild business cycle.” Monetarist Milton Friedman Crowding out Whenever governments run a budget deficit, borrowing to pay for the excess of their spending over the tax revenue they receive, the talk turns to it. It occurs when expansionary fiscal policy causes interest rates to rise, thereby reducing private spending, particularly investment. Policy mix Policy mix is the combination of monetary and fiscal policy(for instance, monetary policy may be easy, with rapid monetary growth, and fiscal policy may be tight or restrictive, with taxes being increased). Monetary Policy and Fiscal Policy PAGE PAGE 2 5 3 2 Consumers 4 1 Business firms Product market Factor market Initial stimulus Goods market Assets markets 쥁`