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KEYNESIAN MONETARY AND FISCAL POLICIES
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Chapter 1
General Economic Concepts
Chapter 2
What is Policy?
Chapter 3
History of Macroeconomic Policies in the United States
Chapter 4
Policy Goals: Maximum Employment
Chapter 5
Policy Goals: Maximum Production
Chapter 6
Policy Goals: Price Stability
Chapter 7
Policy Goals: External Balance
Chapter 8
Subsidiary Policy Goals
Chapter 9
Conflicting Policy Goals
Chapter 10
The Policy Makers
Chapter 11
The Policy Instruments
Chapter 12
The Decision-Making Processes
Chapter 13
The Policy Indicators
Chapter 14
The General Economic Model
Chapter 15
Monetarist Monetary and Fiscal Policies
Chapter 16
Keynesian Monetary and Fiscal Policies
Chapter 17
Debt Management Policies
Chapter 18
Incomes Policies
Chapter 19
Supply Management Policies
Chapter 20
The Long Wave
Chapter 21
Contemporary Issues
"A man's habitual standard of life usually has the first claim on his income, and he is apt to save the difference which discovers itself between his actual income and the expense of his habitual standard; or, if he does adjust his expenditure to changes in his income, he will over short periods do so imperfectly. Thus, a rising income will often be accompanied by increased saving at first, and a falling income by decreased saving, on a greater scale at first than subsequently.... For the satisfaction of the primary needs of a man and his family is usually a stronger motive than the motives towards accumulation, which only acquire effective sway when a margin of comfort has been attained."

John Maynard Keynes
British Economist
The General Theory of Employment, Interest and Money (1936)

  1. Introduction
  2. Structural Equations of the Keynesian Model
  3. The Keynesian General Equilibrium Model
  4. Households and Consumption
  5. Businesses and Investment
  6. Government Spending
  7. Foreigners and Net Exports
  8. Equilibrium in the Products Markets
  9. The Demand for Money
  10. The Supply of Money
  11. Determination of National Income
  12. The Multiplier and Changes in National Income
  13. Fiscal Policy: The Transmission Mechanism
  14. Monetary Policy: The Transmission Mechanism
  15. Keynesian International Macroeconomic Theory
  16. Monetarist Policy Implications Revisited Through the Keynesian Model
  17. Lags in Monetary and Fiscal Policies
  18. Summary
    Readings
    Websites
top    I. Introduction

In order for policy to be effective, the links between the policy tools and the subsequent targets must be known, stable, and predictable. In this chapter, the Keynesian model links are explained, while in the next chapter the Monetarist model links are explained.

The Keynesian model is based on the circular flow model of economic activity. It presumes that the behavior of flow variables (income and spending) is more stable and predictable than that of stock variables (assets and liabilities). Furthermore, any disturbances are rectified through changes in the flow variables, while stock variables adjust passively. Keynes development of spending "at the margin" — the marginal propensity to consume (MPC), the marginal efficiency of capital (MEI), the marginal propensity to invest (MPI), the marginal propensity to import (MPH), and marginal government expenditures and tax collections — allowed him to substitute the consumption function for Say's Law, the marginal efficiency of investment schedule for the marginal product of capital, and fiscal policy for the monetary prescriptives of the Classical school.

top    II. Structural Equations of the Keynesian Model

THE STRUCTURAL EQUATIONS FOR THE KEYNESIAN GENERAL EQUILIBRIUM MODEL
General Equilibrium Y identity E
Causation Y = f(Ep)
Products Markets Equations Ep = C + Ig + G + X - H
C = Ca + bYd = Ca + bY - btY - bTa = (Ca - bTa) + b(1-t)Y
Ig = Ia - di + cY - zµ
G = Ga
X = Xa
H = Ha + hY
Xn = Xa - Ha - hY = Xna - hY
P = k
Money Market Equilibrium Ms = Md
Money Market Equations Md = kY - li - zµ
Ms = f(OMO, d, r; Md)
General Equilibrium Equation Y = {1/(1 - b(1-t) - c + h + dk/l)}(Ca + Ia + Xna + Ga - bTa + (d/l)Ms - zµ)|P
General Equilibrium Multipliers ΔY = {1/(1 - b(1-t) - c + h + dk/l)}(ΔCa + ΔIa + ΔXna - Δzµ)|P
ΔY = {-1/(1 - b(1-t) - c + h + dk/l)}(ΔHa)|P
ΔY = {1/(1 - b(1-t) - c + h + dk/l)}(ΔGa|P
ΔY = {-b/(1 - b(1-t) - c + h + dk/l)}(ΔTa)|P
ΔY = {(d/l)/(1 - b(1-t) - c + h + dk/l)}(ΔMs)|P

top    III. The Keynesian General Equilibrium Model

The Keynesian General Equilibrium model starts with the National Income Accounting identity as an ex post realization of economic activity:

Total Income (Y) identity Total Output (E identity PQ).

It then turns the identity into a functional equation by assuming a one-way causation between spending on total output and total income to determine the volume of employment associated with a given amount of expenditure on newly produced goods and services:

Y = f(Ep)
"The ultimate objective of the analysis is to discover what determines the volume of unemployment....the volume of employment is determined by the point of intersection of the aggregate supply function with the aggregate demand function. The aggregate supply function, however, which depends in the main on the physical conditions of supply involves few considerations which are not already familiar."
According to the Keynes, the part played by aggregate demand had been overlooked and knowledge of the pattern of the division of income between spending and saving and of spending plans by the various economic participants was important in explaining the level of income and the volume of employment.
"The aggregate demand function relates any given level of employment to the 'proceeds' which that level of employment is expected to realize. The 'proceeds' are made up of the sum of [spending by all economic participants]."
Economic participants can be divided into four groups whose spending and saving behavior is more or less homogeneous within the group: households, businesses, governments, and foreigners. Household spending plans are called consumption, business spending plans are called investment, government spending plans are called government expenditure, and international spending plans are called net exports. If the theorist can appropriately identify the spending and saving behavior of the groups individually, then the level of income and output will be known.

top    IV. Households and Consumption

Households "consume" or buy final goods and services for direct satisfaction. The amount that households spend on consumption depends
"partly on the amount of its income, partly on other objective attendant circumstances, and partly on the subjective needs and the psychological propensities and habits of the individuals composing it and the principles on which the income is divided between them."
Objective Factors

The objective factors are the primary reasons that households spend.
  1. a change in the 'wage-unit' or real income (Y/P),
  2. a change in the difference between income and net income (Yd = Y - T - tY),
  3. windfall changes in capital values not calculated income (P1 - P0),
  4. changes in the time-preference discount rate between present and future consumption (i),
  5. changes in fiscal policy (G, T), and
  6. changes in expectations of the relation between present and future income (e).
Subjective Factors

The subjective factors are the primary reasons that households save or refrain from spending.
  1. provision of a reserve against unforeseen contingencies (Md = f(µ), where µ is uncertainty),
  2. provision for the future when income and consumption needs of the household will differ from the present (Md = f(µ), where µ is uncertainty),
  3. enjoyment from interest and appreciation of a larger real consumption at a later date (i, C/P),
  4. enjoyment of a gradually increasing expenditure and standard of living (C/P),
  5. enjoyment of independence and a sense of power (non-quantifiable),
  6. provision for speculative or business projects (i, π),
  7. bequeathal of a large fortune (Md = f(µ), where µ is uncertainty) and
  8. satisfaction of pure miserliness (non-quantifiable).
The Consumption Function

THE CONSUMPTION FUNCTION

C



Ca - bTa
consumptionfn C = Y

C = (Ca - bTa) + b(1-t)Yd
  Ylow          Yb        Yhigh Yd
D = Dissaving = (Y - C) < 0      S = Saving = (Y - C) > 0
Consumption is partly autonomous (independent of income) and partly induced (by changes in income). Of all of the objective and subjective factors governing consumption, Keynes concluded that real disposable income is the most important determinant of consumption:
"For whilst the other factors are capable of varying (and this must not be forgotten), the aggregate income measured in terms of the wage-unit [real disposable income] is, as a rule, the principle variable upon which the consumption-constituent of the aggregate demand function will depend:"
C = f(Yd)|P = Ca + bYd

where Yd is the independent variable, b is the slope of the consumption function, and Ca is the amount of autonomous consumption which occurs, based on non-income factors. The objective factors determine the slope of the consumption function (b), while the subjective factors determine its position (Ca). The slope of the consumption function (b) is called the marginal propensity to consume.

Consumption is an increasing function of real disposable income.
"The psychology of the community is such that when aggregate real income is increased consumption is increased but not by as much.... The fundamental psychological law, upon which we are entitled to depend with great confidence both a priori from our knowledge human nature and from the detailed facts of experience, is that men are disposed, as a rule and on average, to increase their consumption as their income increases, but not by as much as the increase in their income."
The marginal propensity to consume (MPC = b) is the change in spending that results from a change in income. The MPC is positive but less than one (0 < b < 1). This relationship is especially true in short periods of so called cyclical fluctuations during which habits, as distinct from the more permanent psychological propensities, are not given enough time to adapt themselves to changed objective circumstances. In other words, man prefers comfort to security.

Taxes paid by households are partly autonomous (independent of income) (Ta) and partly induced (dependent on the level of income) (tY):

Yd = Y - tY - Ta

Therefore, the complete consumption function is

C = Ca + bY - btY - bTa
= (Ca - bTa) + b(1 - t)Y
.

The consumption function shows the relationship between consumption (C) and disposable income (Yd). Consumption is an increasing function of disposable income, assuming that all other factors which impact consumption are constant. As disposable income increases, households consume more, but they also save (S) more. As disposable income falls, households consume less, but they also save less. At the break-even point (Yb), households spend all of their disposable income. Below the break-even level of income , households dissave (D), either by using up previously accumulated assets or by borrowing. If a non-income factor or taxes change, then the consumption function shifts up and down in response to the non-income or tax change. A change in autonomous taxes shifts the consumptions function parallel. A change in income taxes changes the slope of the consumption function and it rotates around its y-axis.

top    V. Businesses and Investment

Businesses spend on capital goods for indirect satisfaction. The amount spent on the acquisition of new capital
"depends on the rate of return expected to be obtained on money if it were invested in a newly produced asset; not on the historical result of what an investment has yielded on its original cost if we look back on its record after its life is over."
Expected Profitability

Expected profitability depends upon the expected total receipts or revenues (TR) from the sale of output from the capital minus all costs associated with owning and operating the capital (TC) minus corporate profits taxes (T = t[TR - TC]) plus any tax credits (TC):

E(π) = E(TR) - E(TC) - E(t[TR - TC]) + E(TC)

Expected total revenue consists of the price at which the output is expected to be sold and the quantity or number of units that can be sold at the expected price:

E(TR) = E(P)E(Q)

Expected quantity to be sold differs from the potential output of the capital. Each unit of capital comes with a potential or technical capability. This technical capability sets the upper limit to the quantity of units that can be sold from each piece of capital. At a given price, the firm may or may not be able to sell all of the technical output. Alternatively, as more units are produced and made available for sale, the increased supply to the market puts downward pressure on prices. The firm must estimate both how many units it can and at what price to determine expected total revenue.

Expected total cost consists of all expenses expected to be incurred in the ownership and operation of the capital. Explicit expenses include expected labor expenses, utility and energy bills, the costs of raw materials and semi-finished goods, rent, interest, maintenance, and insurance. Implicit expenses include a normal or minimum acceptable profit and the user cost. The user cost is the difference between the value of the capital at the beginning of the year and its value at the end of the year — the net cost of using the capital throughout the year. The user cost is akin to capital consumption allowance or, in modified version, depreciation (the latter an accounting method for estimating capital consumption allowance). If a machine is bought, but not used, its value at the end of the year will depend principally upon the degree of technological obsolescence. The faster technology is changing, the greater will be the technological obsolescence, the less will be the machine's value at the end of the year, and the larger the user cost. If the machine is used during the year, wear and tear from operation will further reduce the value of the machine. The faster or harder the machine is used during the year, the greater will be the physical obsolescence, the less will be the machine's value at the end of the year, and the larger its user cost. If the machine is maintained or improved during the year, then the value will be somewhat enhanced at the end of the year and the user cost will be smaller.

Expected taxes and tax credits depend on the current tax structure as well as any pending modifications to the tax law. The tax structure is more or less permanent and difficult to emend. Tax rates are fairly stable and certain. Tax credits, on the other hand, can be increased and decreased annually and are, therefore, subject to much more uncertainty.

The expected economic life of a unit of capital is the number of years over which the capital is expected to produce quantities for sale. Each year, then, the capital is expected to return profits to the business. However, a dollar today is worth more than a dollar tomorrow, so each successive annual profit flow must be discounted to determine the net present value of the capital (NPV) or the marginal efficiency of the capital (MEC).

Determination of the Profitability of the Capital

Method 1: Net present value

The net present value (NPV) of a capital project is the discounted stream of expected profits (E(π)) over the economic life of the capital (n). The discount rate is the opportunity cost of capital (i), e.g., the rate of financing for the capital. Subtract the current cost of capital (PK) to determine profitability:

n
NPV = E(π)t / (1 + i)t - PK
t = 1

Compare the NPV with 0. If NPV > 0, the decision is to accept and to buy the capital. If NPV < 0, then the decision is to reject and not to buy the capital.

Method 2: Marginal efficiency of capital

The marginal efficiency of capital (MEC) is the expected profitability (expected rate of return) from spending on additional the capital. Set the stream of expected profits from the capital (excluding interest payments) equal to the current supply price of capital and solve for the marginal efficiency of capital (k):

n
PK = E(π)t/(1 + k)t
t = 1

Compare the MEC (k) with the rate of interest or cost of financing the capital. If k > i, the decision is to accept and to buy the capital. If k < i, then the decision is to reject and not to buy the capital.

Investment Demand

THE MARGINAL EFFICIENCY OF INVESTMENT

k, i


i0
mei
          I2      I0       I1            I
Marginal Efficiency of Investment (MEI) The marginal efficiency of investment function (MEI) shows the relationship between investment (I), the marginal efficiency of capital (k), and interest rates (i). In any given year, businesses have many capital projects under consideration. If these are ranked by their marginal efficiency of capital (k) from most profitable to least profitable, the resulting schedule is the MEI. The position of the MEI is influenced by income (Y) and businessmen's expectations about an uncertain future (µ).

Investment and the interest rate Investment (I) is a decreasing function of both the marginal efficiency of capital (k) and the interest rate (i). The slope of the MEI is negative.

I = f(i) = Ia - di

where d is the slope of the MEI schedule. At higher interest rates, fewer capital projects meet the profitability criteria. At lower interest rates, more capital projects meet the profitability criteria. Therefore, as interest rates rise, ceteris paribus, investment falls. As interest rates fall, ceteris paribus, investment rises. Total investment will be the sum of all capital projects up to the margin where k = i.

Investment and expectations about an uncertain future (µ). The position of the MEI depends on whether businesses are optimistic or pessimistic and how confident they are in their expectations about the future.

I = f(µ) = Ia - zµI
    Optimistic expectations and increased confidence about the future. When businesses are optimistic about the future, their perception of uncertainty falls (µ decreases). They feel more confident about a prosperous future and they will tend to overvalue expected revenues and undervalue expected costs. Thus, optimistic expectations and increased confidence about the future increases the expected rate of return on capital and shifts the MEI0 to the right to MEI1. More investment occurs at each and every rate of interest, ceteris paribus

    Pessimistic expectations and decreased confidence about the future. When businesses are pessimistic about the future, their perception of uncertainty rises (µ increases). They feel less confident about a prosperous future and they will tend to undervalue expected revenues and overvalue expected costs. Thus, pessimistic expectations and decreased confidence about the future decreases the expected rate of return on capital and shifts the MEI0 to the left to MEI2. Less investment occurs at each and every rate of interest, ceteris paribus.
Investment and income As income increases, consumption increases. As production increases to meet the increased consumer demand, businesses spend more on raw materials and semi-finished goods (variable capital). As production continues to increase, eventually businesses reach capacity limitations and must consider spending more to increase their fixed stock of capital. The marginal propensity to invest (MPI = c) is the willingness of businesses to change capital spending in response to changes in income:

I = Ia + cY.

Changes in income may arise as a result of changes in demand (changes in expected revenues), changes in costs, and changes in tax liabilities (corporate profits taxes and tax credits) and will change the valuation of NPV and k. As income increases, the MPI shifts the MEI to the right from MEI0 to MEI1. As income decreases, the MPI shifts the MEI to the left from MEI0 to MEI2.

Total investment demand for new capital depends on interest rates, income, and uncertainty about the future:

I = f(i, Y, µ) = Ia - di + cY - zµI.


top    VI. Government Spending

How much government spends does not depend on many endogenous economic variables. While automatic stabilizers tend to increase government spending during a recession (with a decline in income and employment) and decrease it during a boom (with an increase in income and employment), on the whole, the amount government spends depends upon the political motives of elected officials in conjunction with societal goals. In addition, spending on many programs (legal entitlements) and interest payable on the debt are fiduciary commitments that cannot be reduced, regardless of the state of the economy. Therefore, most government spending is considered exogenous or autonomous:

G = Ga.

top    VII. Foreigners and Net Exports

Exports

How many goods and services a home country sells to foreigners depend upon relative prices, the foreign exchange rate, incomes of foreigners, the geographic, climatic, and technological constraints that prohibit foreigners from producing certain goods and services or from producing them in sufficient quantities at world prices, the home country's reputation for quality and back-up services, and any monopoly production. Through monetary and fiscal policies, the home country may control its prices and, perhaps, its foreign exchange rate. However, the home country has virtually no control over the rest of these factors. Therefore, exports may be considered exogenous or autonomous:

FOREIGN DEMAND: NET EXPORTS

X, H, Xn netexports H

X



Xn
  Xn > 0        Xn = 0        Xn < 0  
  Trade Surplus ←⇒ Trade Deficit  
X = Xa

Imports

How many goods and services a home country buys from foreigners depend upon relative prices, the foreign exchange rate, domestic incomes, the geographic, climatic, and technological constraints that prohibit the home country from producing certain goods and services or from producing them in sufficient quantities at world prices, the foreign country's reputation for quality and back-up services, and any monopoly production by foreigners. Through monetary and fiscal policies, the home country has some control over its income, its prices and its foreign exchange rate. However, the home country has virtually no control over the rest of these factors. Since income is endogenous to the model, imports are considered to be partly autonomous and partly an increasing function of income.

H = f(Y) = Ha + hY.

Net Exports

The combination of exports and imports is the home country's net exports. Net exports is a decreasing function of income:

Xn = f(Y) = Xa - (Ha + hY) = Xa - Ha - hY = Xna - hY.

top    VIII. Equilibrium in the Products Markets

Equilibrium in the products markets occurs when planned expenditure (Ep) equals income (Y0). When planned expenditure (Ep) is less than income (Y), a deflationary gap appears. When planned expenditure (Ep) is greater than income (Y), an inflationary gap appears. The line, 45o from the horizontal axis, shows all points of potential equilibrium, where E identity Y, ex post. Ex ante, planned expenditure (Ep) is the planned expenditure of households (C), businesses (I), governments (G), and foreigners (Xna) on domestic output.

EQUILIBRIUM IN THE PRODUCTS MARKETS

productsmarkets
Deflationary Gap

When income is Y1, which is greater than Y0, Ep is less than Y. The difference between income and planned expenditure is called the deflationary gap. There is a disequilibrium with an excess of income over planned expenditure, which implies an excess of saving over investment or withdrawals over injections. Because economic participants plan to spend less than the amount of income earned, inventories accumulate. This unwanted accumulation of inventories means that businesses will cut back on production. As labor is laid off, income falls. As income falls, consumption falls, and businesses are stuck with additional unwanted inventories. The process of production cutbacks, labor layoffs, and consumption declines reduce income by some multiple of the deflationary gap until actual inventories are once again equal to planned inventories and planned spending is equal to income at Y0.

Inflationary Gap

When income is Y2, which is less than Y0, Ep is greater than Y. The difference between planned expenditure and income is called the inflationary gap. There is a disequilibrium with an excess of planned expenditure over income, which implies an excess of investment over saving or injections over withdrawals. Because economic participants plan to spend more than the amount of income earned, inventories decumulate. This unwanted decumulation of inventories means that businesses will step up production. As more labor is hired, income rises. As income rises, consumption rises, and businesses are still short the requisite inventories. The process of production speedups, labor hires, and consumption increases raise income by some multiple of the inflationary gap until actual inventories are once again equal to planned inventories and planned spending is equal to income at Y0.

top    IX. The Demand for Money

Money balances are demanded for several reasons.

Transactions Motive

The most obvious reason for holding money balances is to spend them. Thus, every time money income is received, a portion will be held in money balances to make ordinary disbursements. Since spending increases as income increases, transactions balances are an increasing function of income:

Md = f(Y) = k1Y

Precautionary Motive

PRECAUTIONARY MONEY DEMAND FUNCTION





imin
liquiditypreffn
What is not spent or held in money balances for transaction purposes is saved. Such saving will be directed to alternative assets depending on income, interest rates or yields on the assets, expectations about the future, and the degree of uncertainty (or lack of confidence in our expectations) about the future.

Precautionary money balances will be held in some ratio to income to provide for a given standard of living in an emergency. This is akin to saying that the average family of four living in an urban area should have on hand six months income in liquid assets as a contingency. If income increases, then the money demand function increases from Md0 to Md1. If income decreases, then the money demand function decreases from Md0 to Md2.

Additional precautionary balances will be held depending on the state of expectations about the future and the degree of uncertainty. Keynes said that the demand for precautionary money balances is a measure of the public's uncertainty about the future. Only after a sufficient provision for future liquidity has been attained will individuals willingly forego liquidity for increasing yields on less liquid assets. If uncertainty increases, then the money demand function increases from Md0 to Md1. If uncertainty decreases, then the money demand function decreases from Md0 to Md2.

Thus, precautionary balances are positively related to income and uncertainty:

Md = f(Y, µ) = k2Y + zµ

Speculative Motive

SPECULATIVE MONEY DEMAND FUNCTION FUNCTION





imin
liquiditypreffn
Speculation in the Keynesian system involves shifting assets between money balances and bonds based on current interest rates and expectations of future interest rates. When interest rates are low, bond prices are high. Since no additional capital gains can be made from holding bonds, individuals will sell bonds and accumulate money balances. As interest rates rise, bond prices fall and the opportunity cost of holding idle money balances increases. When individuals believe interest rates have peaked (bond prices are lowest), they will economize on cash balances and buy bonds. Holding bonds affords individuals both high interest income and future capital gains (when interest rates fall). In the Keynesian system, where individuals have a choice only between cash and bonds, they hold either all cash or all bonds and the demand for money is perfectly elastic at imin.

In the real world, not all individuals think alike or hold identical expectations. As interest rates rise, various individuals will begin to think rates have peaked and that bond prices have reached bottom. Different individuals with different interest rate expectations will gradually decumulate money balances and buy bonds. As interest rates fall (bond prices rise), various individuals will begin to think interest rates have fallen to their lowest levels and will begin to sell bonds, take capital gains, and accumulate cash balances for the next interest rate cycle.

In the real world, individuals are not limited to just two alternatives: cash and bonds. They have a variety of financial assets with varying degrees of risk from which to choose. Varying risk-return preferences draw individuals through the spectrum of interest-bearing assets. This variety smooths out the demand for money function and makes it more interest-inelastic. To the extent that switching involves transaction costs — transportation to and from the bank, brokers commissions, etc.— and some element of risk, nominal interest rates will have to be higher; but the same principles for the speculative motive hold. The higher the return from other financial assets, the smaller money balances will be. The lower the return from other financial assets, the larger money balances will be. Thus, speculative balances are negatively related to interest rates:

Md = f(i) = - l1i.

Finance Motive

When individuals want to buy something beyond their current means, they must borrow to finance the purchase. This desire to spend in excess of current income results in an increase in the demand for money from financing. The demand for finance is positively related to income (from which repayment is made) and negatively related to interest rates (the opportunity cost of financing):

Md = f(Y, i) = k3Y - l2i

KEYNESIAN LIQUIDITY PREFERENCE FUNCTION





imin
liquiditypreffn
The Keynesian Liquidity Preference Function

The Keynesian money demand function is really a demand for liquidity at alternative interest rates with income and uncertainty about the future playing a key role in shifting the function:

Md = f(i)|Y, µ = (kY + zµ) - li.

As income and uncertainty increase, the money demand function also increases, from Md0 to Md1. As income and uncertainty decrease, the money demand function also decreases, from Md0 to Md2.

The Liquidity Trap

Because the demand for money is a liquidity preference, Keynes postulated that at some low interest rate (imin), individuals would be indifferent between holding idle (non-interest-bearing) money balances and interest-bearing assets. This perfectly elastic segment of the money demand function he called the "liquidity trap."

top    X. The Supply of Money

The supply of money is determined partly exogenously or autonomously by the central monetary authority and partly endogenously or induced by economic activity and economic participants.

Exogenous Determination

The central monetary authority (the Federal Reserve) has the ability through use of its policy tools to determine the amount of money supply in circulation. Federal reserve credit — open market operations and lending at the discount window — determines the monetary base (high powered money) and reserve requirements determine the amount of loans banks can make to expand the base.

Ms = f(OMO, QE, d, CFs, r).

Given the regulation of these policy tools, the money supply is perfectly inelastic at some maximum amount (Ms0) from base B0.

KEYNESIAN MONEY SUPPLY FUNCTION

i-rate
          moneys
Federal Reserve Credit (OMO, QE, d, CFs) When the Fed expands the base to B1 (by buying T-bills or other securities or increasing lending at the discount window or any of the credit facilities), the money supply expands to Ms1 (solid line ___). When the Fed contracts the base to B2 (by selling securities or decreasing lending at the discount window), the money supply contracts to Ms2 (solid line ___).

Reserve requirements (r) When the Fed lowers reserve requirements, base B0 can be expanded all the way to Ms1 (dotted line —). When the Fed raises reserve requirements, base B0 can be expanded only to Ms2 (dotted line —).

Endogenous Determination

Although the central bank has much control over the amount of money in circulation, that control is not total. The Treasury can change the base from B0 to B1 or B2 and the amount of money supply from Ms0 to Ms1 or Ms2 by circulating its own coin and currency. Commercial banks can expand the base from B0 to B1 or B2 and the money supply from Ms0 to Ms1 or Ms2 by borrowing at the discount window and abroad in the Eurodollar market. Commercial banks can alter the multiplier and the money supply with their excess reserves and lending policies. Individuals can change the multiplier by altering the composition of the money supply — shifting from cash to demand deposits to time deposits and money market mutual funds and back again. In both of the latter cases, any base (B0) can be expanded to either Ms1 or Ms2. This effect of economic activity and the actions of economic participants on the money supply is called reverse causation, where the demand for money determines the supply of money.

top    XI. Determination of National Income

EQUILIBRIUM IN THE PRODUCTS MARKETS

productsmarkets
National income is determined when the products markets and the money markets are in equilibrium.

The Products Markets

GNP is specifically defined so that all spending (by households (C), businesses (I), governments (G), and foreigners (Xn)) must generate an equal and offsetting amount of income. Therefore, the amount of expenditure (E0) determines income (Y0). If total expenditure is higher (E1), total income will be higher (Y1). If total expenditure is lower (E2), total income will be lower (Y2).



The Money Markets

EQUILIBRIUM IN THE MONEY MARKETS
moneymarket
Total expenditure will be higher or lower depending on the level of interest rates as determined by the money markets. If the money markets are in equilibrium at interest rate i0, then expenditure E0 will generate income Y0. If the money markets are in equilibrium at a lower interest rate i1, then higher expenditure E1 will generate higher income Y1. If the money markets are in equilibrium at a higher interest rate i2, then lower expenditure E2 will generate lower income Y2.



top    XII. The Multiplier and Changes in National Income

Equilibrium

The products markets are in equilibrium when planned spending (E0) equals planned income (Y0).

Disequilibrium

THE PRODUCTS MARKETS

productsmarkets
Excess spending over income If planned spending rises from E0 to E1, when income is Y0, an inflationary gap is created at Y0. Inventories will be decumulated and businesses will have to hire more labor and buy more raw materials and semi finished goods to replace inventories. This increased production increases income. Because consumption increases as income increases, inventories will be further decumulated and businesses will have to repeat the hiring and buying process. Subsequent rounds of consumption, production, and income increases will raise income by some multiple of the original increase in spending. Income rises to Y1.

Excess income over spending If planned spending falls from E0 to E2, when income is Y0, a deflationary gap is created at Y0. Inventories will be accumulated and businesses will cut back on their work force and purchases of raw materials and semi-finished goods. This decrease in production decreases income. Because consumption decreases as income decreases, inventories will be further accumulated and businesses will have to repeat their cutbacks and layoffs. Subsequent rounds of consumption, production, and income reductions will cause income to fall by some multiple of the original decrease in spending. Income falls to Y2.

The Multipliers

By what multiple income changes depends, depends upon the multiplier. The relevant multiplier depends upon the type of autonomous change.

The spending multiplier If there is an increase (decrease) in autonomous consumption (C), autonomous investment (I), autonomous government spending (G), or autonomous net exports (Xn), income will increase (decrease) by

                 1                 
1 - b(1-t) - c + h + (dk/l)

because income is positively related to autonomous spending (C, I, G and Xn).

The tax multiplier If there is an increase (decrease) in autonomous taxes (T), income will decrease (increase) by

                 -b                
1 - b(1-t) - c + h + (dk/l)

because taxes and income are negatively related. Also, the tax multiplier is smaller than the spending multiplier, because the numerator, b, is between 0 and 1. The tax multiplier is smaller because a change in taxes affects only disposable income, not total income, and the first round of spending is induced only out of the change in disposable income. Because b is between 0 and 1, any change in spending will be less than the change in income from the tax change.

The money supply multiplier If there is an increase (decrease) in the money supply (Ms), income will increase (decrease) by

                d/l                
1 - b(1-t) - c + h + (dk/l)

because the money supply and income are positively related. The size of the multiplier, however, depends on the slope of the investment (MEI) function (d) and the slope of the money demand (Md) function (l). The multiplier will be larger as the slope of the MEI is flatter and more elastic ((d) is larger) and the slope of the Md function is steeper and more inelastic ((l) is smaller). The multiplier will be smaller as the slope of the MEI schedule is steeper and more inelastic ((d) is smaller) and the slope of the Md function is flatter and more elastic ((l) is larger).

The tax rate multiplier If there is a change in tax rates (t), then all of the multipliers are changed (in the denominator):

1 - b(1 - Δt) - c + h + (dk/l).

An increase in tax rates reduces the multiplier and a decrease in tax rates increases the multiplier.

In addition to tax rate changes, all of the multipliers are affected equally by parameters in the denominator — the MPC (b), the slope of the MEI (d), the slopes of the money demand functions (k and l), the marginal propensity to invest (c), and the marginal propensity to import (h).

General Conclusions

The multiplier is positively related to changes in the following parameters:
  1. The larger the marginal propensity to consumer (b), the larger the multiplier and vice versa. A large MPC indicates high levels of household spending out of additional income, which forces a larger decumulation of inventories and requires a larger increase in production at each successive round of spending. A small MPC indicates low levels of household spending out of additional income, which forces a smaller decumulation of inventories and requires a smaller increase in production at each successive round of spending.

  2. The larger the marginal propensity to invest (c), the larger the multiplier and vice versa. A large MPI indicates high levels of business spending out of additional income, which forces a larger decumulation of inventories and requires a larger increase in production at each successive round of spending. A small MPI indicates low levels of business spending out of additional income, which forces a smaller decumulation of inventories and requires a smaller increase in production at each successive round of spending.

  3. The larger the slope of the demand for money (related to interest rates) function (l), the larger the multiplier and vice versa. As the value of the slope (l) increases, the money demand function becomes more interest-insensitive. Small changes in the supply of money induce large changes in interest rates. As the value of the slope (l) decreases, the money demand function becomes more interest-sensitive. Large changes in the supply of money induce very small changes in interest rates. In the limit, when interest-sensitivity is zero (0), the economy is in a "liquidity trap" where changes in the money supply will have no impact on interest rates.
The multiplier is negatively related to changes in the following parameters:
  1. The larger the slope of the marginal efficiency of investment function (d), the smaller the multiplier and vice versa. As the value of the slope (d) increases, investment becomes more interest-insensitive. It takes very large changes in interest rates to induce a little more or less investment. As the value of the slope (d) decreases, investment becomes more interest-sensitive. Very small chances in interest rates induce large changes in investment.

  2. The larger the slope of the demand for money (out of income) function (k), the smaller the multiplier and vice versa.

  3. The larger the marginal propensity to import (h), the smaller the multiplier and vice versa. When income is spent abroad, rather than at home, it becomes a leakage by which income is reduced. As the MPH rises, current spending generates more income abroad and less at home. As the MPH falls, current spending generates more income at home and less abroad.
In the Keynesian model, the autonomous spending multiplier is the strongest and most certain, because the links are direct — from a change in spending to a change in income. The tax multiplier is the next most effective, depending on the size and stability of the MPC. The money supply multiplier is the weakest and least effective, because it has two links. First, a change in the money supply must change interest rates in the money markets and second the change in interest rates must cause a change in interest-sensitive spending (especially investment). If either or both links are unstable or if the money demand function is elastic (flat) and the MEI schedule inelastic (steep), the money supply multiplier will break down and have no effect on real output, income, or employment.

top    XIII. Fiscal Policy: The Transmission Mechanism

Government Spending

Government spending is the most effective macroeconomic policy weapon of the federal government, because it changes aggregate income immediately and then subsequently aggregate income and employment are adjusted through the MPC and MPI in the multiplier. Also, it bypasses the money markets by increasing the velocity of existing money balances without any change in the money supply.

ΔG ⇒ (ΔS,ΔB,ΔD) ⇒ ΔY ⇒ ΔC,ΔI ⇒ ΔY ⇒ ΔP,ΔQ ⇒ Δu

A change in government spending changes the budget balance and then income directly. As income changes, consumption changes in the same direction by an amount determined by the marginal propensity to consume. As consumption changes, inventories are either decumulated (with an increase in spending) or accumulated (with a decrease in spending).

THE PRODUCTS MARKETS

productsmarkets
Assume that the economy is in equilibrium at Y0. When the government increases spending, aggregate expenditure increases from E0 to E1. Income increases by the amount of the spending. As income increases, consumption increases. Inventories are involuntarily decumulated and businesses must hire more labor to replenish inventories. As businesses step up production and invest in inventory accumulation, capacity utilization increases. The expected rate of return on new capital (the marginal efficiency of investment) rises as plant and equipment wear out faster and must be replaced. Other firms bump up against capacity limitations and must invest in new plant and equipment. New investment depends on the marginal propensity to invest out of income. This additional investment increases income, real output, and employment through the multiplier. Increased employment means reduced unemployment.

When the government decreases spending, aggregate expenditure decreases from E0 to E2. Income decreases by the amount of the spending. As income decreases, consumption decreases. Inventories are involuntarily accumulated, businesses must lay off labor to reduce redundant inventories. As businesses slow down production to divest unwanted inventories, desired capital falls below actual capital. Capacity utilization falls and excess capacity increases. The expected rate of return on new capital (the marginal efficiency of investment) fells. Less investment in both inventories and plant and equipment occur. This reduction in investment decreases income, real output, and employment through the multiplier. Decreased employment means more unemployment.

Tax Revenues

Changing tax revenues is the second most effective macroeconomic policy weapon of the federal government, because it changes disposable income immediately. A change in tax revenues changes disposable income for both households and/or businesses, depending on the target of the tax cuts. If personal income taxes are changed, then aggregate economic activity is initially influenced through the marginal propensity to consume. If corporate profits taxes are changed, then aggregate economic activity is initially influenced through the marginal propensity to invest out of income. Subsequently, aggregate income and employment are influenced by the multiplier.

(ΔT,Δt) ⇒ (ΔS,ΔB,ΔD) ⇒ ΔYd ⇒ ΔC,ΔI ⇒ ΔY ⇒ ΔP,ΔQ ⇒ Δu

THE PRODUCTS MARKETS

productsmarkets
Assume that the economy is in equilibriium at Y0. A decrease in taxes increases disposable income for households. Consumption increases by the marginal propensity to consume out of disposable income. Aggregate expenditure increases from E0 to E1. A decrease in taxes for businesses, raises the expected rate of return on new capital (the marginal efficiency of investment). The MEI curve shifts out and investment increases by the marginal propensity to invest out of income. Aggregate expenditure increases from E0 to E1. In either case, private sector spending is stimulated. Increased spending increases income and real output, puts more labor to work, and reduces unemployment.

An increase in taxes decreases disposable income for households. Consumption decreases by the marginal propensity to consume out of disposable income. Aggregate expenditure decreases from E0 to E2. An increase in taxes for businesses, reduces the expected rate of return on new capital (the marginal efficiency of investment). The MEI curve shifts in and investment decreases by the marginal propensity to invest out of income. Aggregate expenditure decreases from E0 to E1. In either case, private sector spending falls, reducing income and real output, idling labor, and increasing unemployment.

Changing taxes is not so effective as changing government spending because it requires private sector initiative to change spending habits in response to changes in disposable income. If the marginal propensities to consume and invest are zero, a change in taxes will have no effect on income, output, and employment. If the tax change is only temporary, saving or dissaving, rather than spending, may be the adjusting mechanism. For example, a temporary tax decrease may be saved and a temporary tax increase may be paid for out of saving.

Tax Credits

Changing tax credits is the third most effective macroeconomic policy weapon of the federal government, because it has the effect of changing the expected profitability of new capital. A change in tax credits changes the expected rate of return on new capital, directly; that is, an increase in the tax credit increases expected profitability and a decrease in the tax credit reduces expected profitability. The MEI shifts out in response to an increase in the tax credit and it shifts down in response to a decrease in the tax credit. Subsequently, aggregate income and employment are influenced, through investment spending, by the multiplier. However, it will only be effective for businesses with positive tax liabilities. Many companies can reduce their tax liabilities to zero through ingenious accounting methods, deductions, and depreciations. Companies with losses pay no taxes any way. Therefore, changing tax credits is less effective that either of the above budgetary methods.

top    XIV. Monetary Policy: The Transmission Mechanism

Money Supply

UNSTABLE MONEY DEMAND FUNCTION





imin
liquiditypreffn
Changing the money supply is the least effective macroeconomic policy weapon, because it has too many "loose links". A change in the money supply influences income, output, and employment through its effect on the money markets.

(ΔOMO, ΔQE, Δd, ΔCFs, Δr) ⇒ ΔRe ⇒ Δloans ⇒ Δdeposits ⇒ ΔMs ⇒ ΔC,ΔI ⇒ ΔY ⇒ ΔP,ΔQ ⇒ Δu

To be effective, a change in the money supply must change interest rates, which, in turn, must influence interest-sensitive spending. If changes in the money supply are matched by changes in the demand for money or if the economy is in a "liquidity trap" and the elasticity of the money demand function is infinite, an increase or decrease in the money supply will not change interest rates. If interest rates cannot fall, or if interest rate ceilings prevent their rising, then changes in the money supply are ineffective. If private sector spending is interest-insensitive, or if other factors, especially expectations about the future, are preventing spending from changing, then changes in the money supply will be ineffective.

(ΔOMO, ΔQE, Δd, ΔCFs, Δr) =/=> ΔRe =/=> Δloans =/=> Δdeposits =/=> ΔMs =/=> ΔC,ΔI =/=> ΔY =/=> ΔP,ΔQ =/=> Δu

Interest Rates

KEYNESIAN LIQUIDITY PREFERENCE FUNCTION





imin
liquiditypreffn
Changing interest rates is a more effective macroeconomic policy weapon than changing the money supply, because changes in interest rates bypass the link between money supply and interest rates.

(ΔOMO, ΔQE, Δd, ΔCFs, Δr) ⇒ Δiff ⇒ Δis/t ⇒ Δil/t ⇒ ΔC,ΔI ⇒ ΔY ⇒ ΔP,ΔQ ⇒ Δu

However, to be effective, changes in interest rates must change spending. A change in interest rates is effective, if private sector spending is interest-sensitive. A change in interest rates is ineffective, if spending is interest-insensitive, or if other factors, especially expectations about the future, are preventing spending from changing.

(ΔOMO, ΔQE, Δd, ΔCFs, Δr) =/=> Δiff =/=> Δis/t =/=> Δil/t =/=> ΔC,ΔI =/=> ΔY =/=> ΔP,ΔQ =/=> Δu

top    XV. Keynesian International Macroeconomic Theory

Basic Assumptions

In the Keynesian macroeconomic model, prices are assumed to be constant. Since the foreign exchange rate of a country's currency is simply another price, Keynesians assume a fixed exchange rate system and then assume exchange rates are constant.

Policy Implications for a Trade Deficit

The trade deficit is represented by the excess supply dollars at the fixed exchange rate. A trade deficit in the Keynesian macroeconomic system would be the result of an over-valued currency or expansive domestic macroeconomic policies. The government can either devalue the currency or engage in more restrictive monetary and fiscal policies.

Devaluation

A devaluation will cheapen the country's currency relative to foreign currencies and make the country's exports more competitive, while its imports become more expensive. Initially, following a devaluation, the terms of trade (the price adjustment) move against the country and its trade deficit worsens, as it pays more for its imports and receives less for its exports. After several months, contracts can be renegotiated and the quantity adjustment will reverse the deterioration in the trade balance (the J-curve).

A devaluation will work only so long as other countries are willing to have their currencies revalued upward. If other countries had been satisfied with the previous exchange rates, or if other countries are experiencing depressed economic activity and high rates of unemployment, then a series of devaluations by other countries will occur, canceling the positive effects of the initial devaluation.

Restrictive Monetary Policy

The monetary authority must contract (or slow the growth rate) of the money supply. This action raises interest rates to deflate the economy. Higher interest rates reduce spending (aggregate demand), income, and employment. Reduced income and employment decrease the demand for imports. Less spending on imports, assuming exports and the foreign exchange rate stay the same, reduces the trade deficit. Less spending reduces the demand for money and interest rates fall.

The impact on the capital account depends on the net effect of rising interest rates from reduction of the money supply and falling interest rates from decreasing money demand. The effectiveness of a restrictive monetary policy depends on the interest-sensitivity of the money demand function. If the money demand function is interest-insensitive, monetary policy will be effective. However, if the money demand function is interest-sensitive, then interest rates will not rise very much and monetary policy will not work. Since Keynesians presume an interest-sensitive money demand function, they conclude that monetary policy will be ineffective.

Further, a fall in the demand for imports without a corresponding increase in the demand for foreign securities, will create an excess demand for the country's currency on world markets. Eventually, the home country may be forced to revalue. At the higher exchange rate, import demand increases, export demand declines, the trade balance worsens, and the circle starts over.

Restrictive Fiscal Policy

A reduction in government spending or an increase in taxes reduces aggregate demand, income, and employment. Reduced income and employment decrease the demand for imports. Less spending on imports, assuming exports and the foreign exchange rate stay the same, reduces the trade deficit. Less spending reduces the demand for money and interest rates fall. Lower interest rates, ceteris paribus, may start a capital outflow. The positive effect is that the home country will soon become a net creditor to the rest of the world.

The effectiveness of fiscal policy does not depend on the interest-sensitivity of the money demand function. Fiscal policy has a direct impact on income, employment, and spending, bypassing the money markets altogether.

Policy Implications for a Trade Surplus

The trade surplus is represented by the excess demand for dollars at the fixed exchange rate. A trade surplus is the envy of most nations. More often than not, the surplus country does not want to reverse its positive trade balance. However, no country can run a surplus indefinitely, without draining the reserves of all other nations and bringing world trade to a halt. Therefore, periodically, a surplus country must evaluate the costs and benefits of its surplus position. A trade surplus in the Keynesian macroeconomic system would be the result of an under-valued currency or restrictive domestic macroeconomic policies. The government can either revalue the currency or engage in more stimulative monetary and fiscal policies.

Revaluation

A revaluation will strengthen the country's currency relative to foreign currencies and make the country's exports more expensive, while its imports become cheaper. Initially, following a revaluation, the terms of trade (the price adjustment) move in favor of the country and its trade surplus increases, as it pays less for its imports and receives more for its exports. After several months, contracts can be renegotiated and the quantity adjustment will reverse the surplus in the trade balance (the reverse J-curve).

A revaluation will work only so long as other countries are willing to have their currencies devalued downward. If other countries had been satisfied with the previous exchange rates, or if other countries are experiencing full employment and inflation, then a series of revaluations by other countries will occur, canceling the positive effects of the initial revaluation.

Stimulative Monetary Policy

The monetary authority must increase the growth rate of the money supply. This action lowers interest rates to inflate the economy. Lower interest rates increase spending (aggregate demand), income, and employment. More income and employment increase the demand for imports. More spending on imports, assuming exports and the foreign exchange rate stay the same, reduces the trade surplus. More spending increases the demand for money and interest rates rise.

The impact on the capital account depends on the net effect of falling interest rates from increasing the money supply and rising interest rates from increasing money demand. The effectiveness of a stimulative monetary policy depends on the interest-sensitivity of the money demand function. If the money demand function is interest-insensitive, monetary policy will be effective. However, if the money demand function is interest-sensitive, then interest rates will not fall very much and monetary policy will not work. Since Keynesians presume an interest-sensitive money demand function, they conclude that monetary policy will be ineffective.

Further, a rise in the demand for imports without a corresponding decrease in the demand for foreign securities, will create an excess supply of the country's currency on world markets. Eventually, the home country may be forced to devalue. At the lower exchange rate, import demand decreases, export demand increases, the trade surplus increases, and the cycle starts over.

Stimulative Fiscal Policy

An increase in government spending or a decrease in taxes raises aggregate demand, income, and employment. Increased income and employment increase the demand for imports. More spending on imports, assuming exports and the foreign exchange rate stay the same, reduces the trade surplus. More spending increases the demand for money and interest rates rise. Higher interest rates, ceteris paribus, may start a capital inflow. The negative effect is that the home country will soon become a net debtor to the rest of the world to finance its trade deficit.

The effectiveness of fiscal policy does not depend on the interest-sensitivity of the money demand function. Fiscal policy has a direct impact on income, employment, and spending, bypassing the money markets altogether.

Conclusions

According to the Keynesians, monetary policy is not very effective in correcting a trade imbalance because of its dubious impact in the money markets. Furthermore, the use of monetary policy to correct a trade imbalance may actually worsen the country's trade position, if offsetting supply and demand forces leave interest rates unchanged and the country is forced to revalue when it has a deficit and to devalue when it has a surplus.

top    XVI. Monetarist Policy Implications Revisited Through the Keynesian Model

"We are all Keynesians now."

Milton Friedman

When Milton Friedman quipped that "We are all Keynesians now," he was referring to Monetarist Theory being recast within the Keynesian framework. However, even though the structural equations for the Monetarist Model were recast in terms of flow variables (income and expenditure), rather than stock variables (assets), the Monetarist flow analysis varies significantly with regard to the underlying assumptions about the flow variables. For example, the Monetarist investment function is considered to be very elastic, while the Keynesian investment function is considered to be inelastic. Also, the Monetarist money demand function is considered to be inelastic, while the Keynesian money demand function is considered to be elastic. Moreover, the Monetarist marginal propensity to spend still relies on relative prices to drive spending on newly produced goods and services. Depending on relative prices, the marginal propensity to spend may not be stable or predictable, even in the short-run, as Keynesians assume. Furthermore, the Monetarist direction of cause and effect — from income to spending (rather than from spending to income) — is not changed. Therefore, the policy conclusions of the Monetarist model, as recast in the Keynesian framework, remain the same.

THE MONEY DEMAND FUNCTION

moneydemandfnelasticity
Monetarist Implications for Monetary Policy

A change in the money supply changes interest rates along an insensitive money demand function (MdM), which change interest-sensitive consumption and/or investment spending (IM). The change in spending changes income, through the multiplier, and affects prices and/or output, employment, and unemployment, depending on the economy's current deviation from the natural employment level. Because Monetarists believe that the slope of the investment demand function (IM) is interest-sensitive and the slope of the money demand function (MdM) is interest-insensitive, (d) is very large and (l) is very small. The numerator for the money supply multiplier (d/l) is very large and the money supply multiplier is very large. In the limit, the money supply multiplier goes to infinity (oo), having a mega-impact on income.

A change in interest rates changes consumption and/or investment. The change in spending changes income, through the multiplier, and affects prices and/or output, employment, and unemployment, depending on the economy's current deviation from the natural employment level. Because Monetarists believe that the slope of the investment demand function (IM) is interest-sensitive and the slope of the money demand function (MdM) is interest-insensitive, (d) is very large and (l) is very small. The numerator for the money supply multiplier (d/l) is very large and the money supply multiplier is very large. In the limit, the money supply multiplier goes to infinity (oo), having a mega-impact on income.

Monetarist Implications for Fiscal Policy

THE INVESTMENT FUNCTION

investment
A change in government spending changes income, which changes consumption (through the marginal propensity to consume) and/or investment (through the marginal propensity to invest). The change in spending changes income, through the multiplier, and affects prices and/or output, employment, and unemployment, depending on the economy's current deviation from the natural employment level. Because Monetarists believe that the slope of the investment demand function (IM) is interest-sensitive and the slope of the money demand function (MdM) is interest-insensitive, (d) is very large and (l) is very small. The denominator for the government spending multiplier is very large and the government spending multiplier is very small. In the limit, the government spending multiplier goes to zero (0), having no impact on income.

A change in tax revenues changes disposable income, which changes consumption (through the marginal propensity to consume) and/or investment (through the marginal propensity to invest). The change in spending changes income, through the multiplier, and affects prices and/or output, employment, and unemployment, depending on the economy's current deviation from the natural employment level. Because Monetarists believe that the slope of the investment demand function (IM) is interest-sensitive and the slope of the money demand function (MdM) is interest-insensitive, (d) is very large and (l) is very small. The denominator for the tax multiplier is very large and the tax multiplier is very small. In the limit, the tax multiplier, like the government spending multiplier, goes to zero (0), having little or no impact on income.

The Keynesian Rebuttal

The presumption is that spending is interest-insensitive (IK) and the money demand is interest-sensitive (MdK-liquidity trap). Spending insensitivity makes the value of the slope of the investment demand function (d) very small and the value of the slope of the money demand function (l) very large. The numerator for the Therefore, the autonomous spending multipliers are the strongest and most certain, because the links are direct from a change in spending to a change in income. The links bypass the money markets and interest rates altogether.

From a policy standpoint, the government spending multiplier is the strongest and most effective. It has no links. A change in government spending directly changes income.

The tax multiplier is the next strongest and most effective, because it has only one link -- the marginal propensity to consume or invest. The tax multiplier will be more effective the larger the marginal propensities to consume and invest out of income. The tax multiplier will be less effective the smaller the marginal propensities to consume and invest out of income.

The money supply multiplier is the weakest and least effective, because it has two links. First, a change in the money supply must change interest rates in the money markets and, second, the change in interest rates must cause a change in interest-sensitive spending (especially investment). If either or both links are unstable or if the money demand function is elastic (l is very large) and the investment demand function is inelastic (d is very small), the money supply multiplier will be very small.

Empirical Conclusions

Monetarists argue that, if empirical analysis shows a strong correlation between fiscal policy measures and changes in income, it is not the fiscal policy measure, per se, that is responsible for changing income. Rather it is the accompanying change in the money supply that provides the stimulus. For example, if the government increases expenditures or reduces taxes, the resulting deficit must be financed. Since the government borrows in the same money markets as private individuals and businesses, the increased demand for money by the government will pull up interest rates. Thus, increased government financing will "crowd out" private expenditures. If, on the other hand, the central bank monetizes the debt by buying it either directly from the government or indirectly in the open market, then reserves and the money supply are increased. When the central bank is accommodative, private expenditures are not crowded out and income will rise by some multiple. By which multiple? By that multiple associated with an increase in the money supply — the money supply multiplier — not one of the fiscal policy multipliers.

top    XVII. Lags in Monetary and Fiscal Policies

The theoretical differences between Monetarists and Keynesians are more often than not trumped by practical considerations in policy making. The inside and outside lags differ for the various monetary and fiscal policies. In general, the inside lag for monetary policy is quick, while the outside lag is long, variable, and asymmetric. The inside lag for fiscal policy is long, variable, and asymmetric, while the outside lag is quick.

Inside Lags

The inside lag has three separate lags: the recognition lag, the decision-making lag, and the implementation lag.

Recognition Lag

The recognition lag is the time between when a problem first arises and when someone in a decision-making capacity officially recognizes the problem.

Monetary policy: The recognition lag is variable. The Chair of the Federal Reserve System is generally charged with the authority to identify problems in the economic and financial markets. Some Chairs, like Paul Volcker, have been quick to identify problems. Some Chairs, like Alan Greenspan, have been quick to anticipate problems before they occur. Other Chairs have been more lax in identifying problems. Hence, the great inflation of the 1970s.

Fiscal policy: The recognition lag is long and variable. The President is generally charged with leading the nation and, therefore, with the responsibility for identifying economic and financial problems. However, no President wants to admit that the economy is not doing well under his/her administration. Therefore, the President tends to postpone identification of a problem for as long as possible so that he/she can, hopefully, pass any problems along to his/her successor.

Decision-Making Lag

The decision-making lag is the time between when someone in a decision-making capacity officially recognizes the problem and when a decision is made to correct the problem.

Monetary policy: The decision-making lag is very short. The FOMC is charged with making monetary policy decisions. The committee meets eight (8) times each year. It also has the authority to act in between meetings, should an emergency arise.

Fiscal policy: The decision-making lag is very long and asymmetric. Fiscal policy decision-making is shared between the President and Congress. Before the government can spend or change tax collections, it must have the appropriate authorization. This authorization comes through the passage of laws. All spending and tax bills must pass through the House and Senate before the President can sign them into law. This process is long and tedious.

In addition, the fiscal policy decision-making lag asymmetric. Congress and the President are quicker to pass into law bills that increase spending and reduce taxes than they are to pass into law bills that reduce government spending and raise taxes. The latter legislation is not so politically appetizing as the former legislation.

Implementation Lag

The implementation lag is the time between when a decision is made to correct the problem and when a policy is implemented to correct the problem.

Monetary policy: The implementation lag is very short. Once the FOMC meets and decides on a strategy for monetary policy, it sends a directive to the Trading Desk to implement. The next day the Trading Desk is buying or selling U.S. government securities pursuant to the directive.

Fiscal policy: The implementation lag is variable depending on the fiscal measure. Once the President and Congress agree on a tax measure, employers can have new withholding schedules inside of two weeks. However, even when the President and Congress agree on a spending measure, it often takes much longer to implement. Implementation of spending on a public works job takes much longer than simply paying people to stay home.

Outside Lag

Effectiveness Lag

The outside lag has only one lag: the effectiveness lag.

The effectiveness lag is the time between when a policy is implemented to correct the problem and when the problem is corrected.

Monetary policy: The effectiveness lag is long, variable, and asymmetric. Monetary policy may take any where from six (6) months to two (2) years to become effective. Its effectiveness is also asymmetric. It is more effective in controlling inflation than for stimulating economic activity.

Fiscal policy: The effectiveness lag is short and quickly exhausted. Fiscal policy is effective the moment spending changes but is generally exhausted before one (1) year. Because changes in spending are simply changes the velocity of money balances, fiscal policy may require additional injections or reductions in order to accomplish the desired goal. It is more effective for stimulating economic activity than for controlling inflation.

top     Summary

Keynesian economic analysis is a flow analysis based in spending and saving by economic participants. In contrast to Say's Law, Keynesian economics states: "Demand creates supply." With fixed prices, quantity adjustments from changes in spending determine the amount of real income, output and employment. Changes in spending change the velocity of money (or its inverse, the demand for money) and thus change income, output, and employment. The supply of money is not so important, because of the loose linkages in its transmission to the real sector. In order for changes in the money supply to be effective, they must change interest rates, which, in turn, must change interest-sensitive spending. If the demand for money is either elastic or unstable, changes in the money supply will be ineffective. If spending is interest-insensitive, then changes in interest rates will be ineffective. Therefore, fiscal policy is most effective as it changes spending and the velocity of money to get the desired stimulus or restriction to influence macroeconomic aggregates.

top    Readings

The Grumbling Hive: or, Knaves Turn'd Honest, Bernard Mandeville (Ed. by Jack Lynch), 1705, reprinted in The Fable of the Bees; or, Private Vices, Public Benefits, 1724

The General Theory of Employment Interest and Money, John Maynard Keynes, Harcourt, Brace and Company, New York, 1936

New Dimensions of Political Economy, Walter W. Heller, W.W. Norton & Co., New York, 1967

Keynes and After, Michael Stewart, Penguin Books, Baltimore, 1972

Money and the Real World, Paul Davidson, Halsted, New York, 1972

Fiscal Policy in Theory and Practice, Alan Blinder, General Learning Press, 1973

How Dead is Keynes? James Tobin, Economic Inquiry, XV Oct 1977: 459-68

Some Aspects of the Development of Keynes's Thought, Richard Kahn, Journal of Economic Literature, XVI(2) Jun 1978: 545-59

A Revised Perspective of Keynes's General Theory, Ivan C. Johnson, Journal of Economic Issues, XII(3) Sep 1978: 561-82

Hick's Contribution to Keynesian Economics, Alan Coddington, Journal of Economic Literature, XVII(3) Sep 1979: 970-88

Monetary Theory, Laurence Harris, McGraw-Hill, New York, 1981

Keynes's General Theory: A Different Perspective, Allan H. Meltzer, Journal of Economic Literature, XIX(1) Mar 1981: 34-64

Monetarism, Keynesian, and New Classical Economics, Jerome L. Stein, American Economic Review, LXXI(2) May 1981: 139-44

Fiscal Policy and Aggregate Demand, David Alan Aschauer, American Economic Review, LXXV(I) Mar 1985: 117-27

Keynes and the Modern World: A Review Article, Walter S. Salant, Journal of Economic Literature, XXIII(3) Sep 1985: 1176-85

International Money and the Real World, 2nd ed., Paul Davidson, St. Martin's Press, 1992

Channels of Monetary Policy, Proceedings of the Nineteenth Annual Economic Policy Conference of the Federal Reserve Bank of St. Louis, October 20-21, 1994, in Review, ed. by Daniel L. Thornton and David C. Wheelock, 77(3) May/June 1995

Is There a Broad Credit Channel for Monetary Policy? Stephen D. Oliner and Glenn D. Redebusch, Economic Review (FRBSF), 1996(1)

In Bad Times, Consumers Might Simply Refuse to Spend, Louis Uchitelle, New York Times, 2 Jul 1999

Bush Team Sensed Economic Slump Early, Richard W. Stevenson, New York Times, 22 Apr 2001

Government Fiddles and the Economy Burns, Richard W. Stevenson, New York Times, 16 Dec 2001

Keynesian Economics, Alan S. Blinder, The Concise Encyclopedia of Economics, 2002

New Keynesian Economics, N. Gregory Mankiw, The Concise Encyclopedia of Economics, 2002

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