INTRODUCTION

The Assets-Augmented System, ISLM

The simplified Keynesian cross model we looked at in the previous session contains only a goods market. It is a real model (the price level is assumed constant), and it is demand driven (changes of the model are brought about entirely through changes in components of aggregate demand). Crucially for this session, the Keynesian cross model contains no money market (or more generally, no assets market). Keynes thought money important; indeed his General Theory starts with the topic. Modern macroeconomic textbooks develop bring the assets market into the analysis by introducing the ISLM model. This model was first formalized by John Hicks at Oxford University in 1937, and subsequently was popularized in the United States by Alvin Hansen at Harvard and, after the war, by Paul Samuelson in his famous textbook. In reality the assets market contains many different monetary instruments, but for the sake of simplification, we can think of a stylised market as comprising only money and bonds. Money supply and demand determines the interest rate, and thus bond prices---bond prices move inversely to interest rates. The ISLM model thus contains a real and a monetary side, thus enabling the economist to analyse the impact of fiscal and monetary policy respectively. However, the model cannot be used to analyse inflation; in the ISLM model, the general price level is assumed fixed. Below we develop both sides of the
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model. However, the reader should note at the outset that the IS side of the model contains a crucial new relationship. Unlike the Keynesian cross model where I is assumed exogenous (I*), in the ISLM the money market feeds back into the real sector by making I-demand depend partly on irk; i.e.,

I = I* - bi

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LM derivation
Let us start with the expression for money supply (Ms) and money demand (Md).

Ms = M*/P* Md = KY - hi

The money supply (Ms) is exogenous and though shown in nominal terms, the general price level is assumed to be fixed (P*). Expression 4.3 says that money demand is positive function of Y (transactions) and negative function of the interest rate. What does Md = KY mean? It means that the higher our level of income, the more money we want in our pocket (or equivalently our debit card) to finance our everyday purchases of goods and services; is our transactions demand. Equally what does Md = hi mean? It means that the higher the rate of interest, the higher is the opportunity cost of being liquid; i.e., holding cash as opposed to yield-bearing securities. The accompanying figure shows the derivation of the LM curve. In simple terms, an LM curve described by drawing different Md curves (each for a different Y level) through a vertical Ms Curve; i.e., assuming the money supply to be fixed and invariant to the interest-rate.

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LM Curve Derivation

The accompanying figure shows how the LM curve is derived. The right hand quadrant shows a fixed (vertical) money supply curve (Ms*) and two money demand curve, the lower one corresponding to the initial level of national income (You) and the higher curve corresponding to the higher income-level, Y1. These intersect the Ms Curve at points 0 and 1 respectively, corresponding to interest-rates io and i1 respectively. We can now map the co-ordinates (Y0, i0) and (Y1, i1) to the left-hand quadrant to produce two points. The line passing through these two points is the LM curve. (We could repeat this exercise for

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many different levels of Y and equilibrium i, thus yielding many different points defining the LM curve.)

IS DERIVATION
I = I* - bi In the simple Keynesian cross system, investment (I) was autonomous. In the ISLM system, I is in part autonomous and in part inversely dependent on the rate of interest

IS Curve Derivation

The derivation of the IS curve is more easily understood than that of the LM curve. All one needs to remember is that a fall in the interest rate stimulates I, thus driving up Y to some new level of equilibrium.
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The top quadrant of Figure 4-2 depicts a Keynesian-cross system while the lower quadrant depicts an IS system; note that in the latter the interest-rate is on the Y-axis. To understand the top quadrant, assume the initial level of aggregate demand is AD, the interest rate is i and the corresponding level of national income is Y. If i now rises to i', this rise causes investment (I) to fall reducing aggregate demand to level AD and national income to level Y. The interest rates i and i' together with the corresponding levels of national income, Y and Y, can be plotted on the bottom quadrant and the line passing through these points is the IS curve. Further changes in i could be used to define further combinations of (i, Y) to improve the definition of the IS curve.

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ISLM CURVE

An ISLM system show overall equilibrium of the goods market (IS) and the bond (or assets) market (LM). Algebraically, the IS side can be written: Y = C + I + G + NX The only difference is that when substituting the full expressions for C, I, G and NX, I must be written I = I* - bi. The LM side is of course:
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Ms = Md Md = kY hi Since for IS = LM, i and Y must be the same, a simultaneous solution for the two unknows (i, Y) is required. The point about the ISLM system is is not merely that it includes an asset side. The key point is that the interest rate feedback from the assets to the goods market tends to stabilise the system. In a slump, a cut in the interest rate can stimulate investment and get economy moving! In other words, feedback from assets to goods market is entirely via the interest rates impact on investment. Any increase in the money supply (Ms) shifts LM to the right; ie, it leads to excess demand for bonds driving down the interest rate and stimulating investment. Note indirectness of mechanism; excess money is assumed not to be spent directly on consumption goods, but on investment goods.

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The "Keynesian" and "Monetarist or Classical" Cases

The above figure conveniently depicts both curves as lying at 45 degrees from the horizontal. Shifts in the curves brought about by fiscal (IS) or monetary (LM) policy can thus be analysed. For example, if we wish to raise national income but leave the interest rate unchanged, we must use both fiscal and monetary policy; expansionary fiscal policy alone would tend to raise interest rates (leading to possible crowding out) while expansionary monetary policy alone would tend to lower the interest rate (leading to possible capital outflow). In reality, economists disagree fundamentally about the slope of the above curves. Keynesians generally think the IS curve to be relatively interest-inelastic and the LM curve to be relatively interestelastic. Monetarists generally believe the LM curve to be interestinelastic (nearly vertical), either in the medium to long term. For members of the new classicist or rational expectations school of thought, the LM curve is always vertical at a level of national income coincident with the natural rate of unemployment.

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The Keynesian and Classical Cases

These contrasting positions are sometimes stylised (ie, simplified to their essentials) by introducing extreme assumptions about the elasticity of the LM curve. The accompanying diagram contrasts an ISLM system where LM is perfectly interest elastic (the so-called Keynesian case) with one in which the LM curve is
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perfectly interest inelastic (the so-called Classical case). Because the model can be used to represent both the Keynesian and Classical positions, the ISLM model is sometimes called the synthesis model.

The Keynesian LM, which is perfectly elastic (horizontal). Note that the use of monetary policy (as represented by a shift in LM) has not effect on the equilibrium level of national income. In short, monetary expansion cannot cure a depression. This depiction of LM as perfectly elastic is sometimes called the liquidity trap. In reality, the trap can only exist as less that full employment when demand is depressed and the real interest rate cannot fall any further. Keynes believed that at some low (but positive) interest rate---or equivalently at some high level of bond prices---investors would begin to feel that interest rates could fall no lower (or bond prices could rise no higher). Such a floor on interest rates would prevent real investment from being stimulated and national income from rising. In consequence, even if the Central Bank expanded the money supply, the non-bank public would absorb the extra liquidity. In reality, Keynes also believed that long-term investment depended far more on entrepreneurs expectations about aggregate demand and long-term profits than on interest rate movements; is, he believed the IS curve was relatively interest inelastic, something which is not shown in the diagram. In short, the IS-LM depiction of the Keynes-Classical debate, because it
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focuses exclusively on the LM curve, simplifies matters greatly--some would say far too greatly. Nevertheless, the analysis is not irrelevant. In the USA, the Federal Reserve Bank (the US Central Bank) has relied strongly on monetary policy. In 2001 alone, Alan Greenspan has cut the interest rate repeatedly in an attempt to prevent the economy from going into a serious slump (or making a hard landing). The Japanese economy has for some year operated at a rate of interest close to zero in order to stimulate investment, while in the EU the European Central Bank has criticised repeatedly for refusing to loosen monetary policy. So monetary policy is important, particularly in the way it affects sentiment in world financial markets. At the same time, on should not lose sight of the fact that fiscal policy is important in the real world. Japan has repeatedly introduced fiscal stimuli to economic growth in the recent past. In the EU, the Delors plan for an EU-wide high-speed railway network is an example of a large fiscal boost---unfortunately rejected by the EU Counsel of Ministers. In the US, The Bush administrations tax cut and repackaged star wars initiatives constitute a very large pumppriming package for the economy, however dubious their merits on other grounds.

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Financial and Non-Financial Crowding Out

Financial Crowding Out

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Above it was said that when the LM curve is less than perfectly elastic (flat), expansionary fiscal policy will lead to some degree of financial crowding out. In essence, the steeper the LM curve, the more crowding out will take place. Figure 4-5 depicts what happens when a rightward shift in the IS curve (expansionary fiscal policy) takes place under different assumptions about the elasticity of the LM curve (the nature of the money-demand function).

Financial crowing out occurs where a rise in the interest rate leads to a reduction in private investment. How much crowding out occurs depends on the slope of the LM curve (and slope of IS too) To analyse this situation, imagine that Government increases fiscal spending, as shown by a rightward shift from IS to IS. In the figure, three possible LM curves are shown. If the LM curve (LM) is horizontal (or "Keynesian" at less than full-N) then no crowding out takes place and national income rises from Yn to Y 1. In the classical case however where LM is vertical (shown by LM), there is full crowding out; i.e., fiscal policy is totally ineffective and national income does not rise. In the intermediate case (shown by LM), national income will rise from Yu to Y 2 and there is partial financial crowding out . What is happening in the diagram is that increased fiscal spending, unless accompanied by a loosening of monetary policy, leads to a rise in interest rates. This rise causes private
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investment to contract. Thus, fiscal expansion by the public sector is offset by a contraction of investment in the private sector, an effect which results in national income growing less than it would have had the rate of interest not raised. In general the steeper the LM curve, the more crowding out takes place. "Crowding out" will be strongest close to full-employment where the LM segment is steepest. Full crowding out (or a vertical LM curve means that an increase in aggregate demand brought about by increased Government spending causes such a rise in the interest rate that private investment falls by an amount that exactly offsets the expansionary effect of the initial change in G.

The reader should bear three further points in mind. First, financial crowding out via the interest-rate mechanism is only one potential form of crowding out. If foreign exchange is scarce or rationed and if private and public investment, more public spending might use up foreign exchange thus limiting its availability to the private sector; ie, foreign exchange crowding out. Again, if an investment licensing system exists, more public investment might mean a reduction is the licences available to the private sector; i.e., administrative crowding out. In general, crowding out can take place in different ways. Secondly, the full financial crowding out scenario depicted in the classical case above seems unlikely to occur in practice. Whether increased fiscal expenditure leads to an interest-rate
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rise depends on how it is financed (a matter to which we return). Even if G is financed by borrowing from the non-bank public, rising domestic interest rates may serve to attract overseas capital. More generally, full crowding out is unlikely because the private sector investment decision does not depend on the interest rate alone but on a variety of factors including; crucially, it depends on entrepreneurial expectations about the buoyancy of future demand. Increased public spending, as Keynes argued, may serve to stimulate aggregate demand, raise incomes and improve the economic outlook in a manner leading entrepreneurs to invest more, not less. This is called the crowding in argument. The argument for crowding in gains greater force where public spending is directed at improving the economic and social infrastructure in a manner which complements private investment, an argument put forward in the early economic development Gershenkron. literature by such writers as Nurkse and

If the crowding out argument has been examined in some detail, it is because is has become all too common to hear economic journalists and policy makers (including these from multilateral institutions) use the argument as a strong reason for limiting public spending. While there may be good reasons for limiting public spending---particularly where it is likely to contribute to inflation---in the authors view, the argument for strong crowding out is not terribly convincing. Worse still, policy makers often use the concept in contradictory ways. One
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example is that of the European Central Bank (ECB). The ECB currently argues (a) that public spending must not be increased because it might lead to crowding out; and (b) that interest rates must remain high because of the danger of inflation. The contradiction should be apparent to any student studying economics.

MONETARY POLICY
Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest, in order to attain a set of objectives oriented towards the growth and

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stability of the economy.[1] Monetary theory provides insight into how to craft optimal monetary policy. Monetary policy is referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy, and a contractionary policy decreases the total money supply. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interest rates in order to combat inflation. Monetary policy is contrasted with fiscal policy, which refers to government borrowing, spending and taxation.

Overview

Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (in order to achieve policy goals). The beginning of monetary policy as such comes from the late 19th century, where it was used to maintain the gold standard. A policy is referred to as contractionary if it reduces the size of the money supply or raises the interest rate. An expansionary policy increases the size of the money supply, or decreases the interest rate.
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Furthermore,

monetary

policies

are

described

as

follows:

accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or tight if intended to reduce inflation. There are several monetary policy tools available to achieve these ends: increasing interest rates by fiat; reducing the monetary base; and increasing reserve requirements. All have the effect of contracting the money supply; and, if reversed, expand the money supply. Since the 1970s, monetary policy has generally been formed separately from fiscal policy. Even prior to the 1970s, the Bretton Woods system still ensured that most nations would form the two policies separately. Within almost all modern nations, special institutions (such as the Bank of England, the European Central Bank, Reserve Bank of India, the Federal Reserve System in the United States, the Bank of Japan, the Bank of Canada or the Reserve Bank of Australia) exist which have the task of executing the monetary policy and often independently of the executive. In general, these institutions are called central banks and often have other responsibilities such as supervising the smooth operation of the financial system. The primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various credit instruments, foreign currencies or commodities. All of these purchases or sales result in more or less base currency entering or leaving market circulation.

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Usually, the short term goal of open market operations is to achieve a specific short term interest rate target. In other instances, monetary policy might instead entail the targeting of a specific exchange rate relative to some foreign currency or else relative to gold. For example, in the case of the USA the Federal Reserve targets the federal funds rate, the rate at which member banks lend to one another overnight; however, the monetary policy of China is to target the exchange rate between the Chinese renminbi and a basket of foreign currencies. The other primary means of conducting monetary policy include: (i) Discount window lending (lender of last resort); (ii) Fractional deposit lending (changes in the reserve requirement); (iii) Moral suasion (cajoling certain market players to achieve specified outcomes); (iv) "Open mouth operations" (talking monetary policy with the market).

Price level targeting

Price level targeting is similar to inflation targeting except that CPI growth in one year is offset in subsequent years such that over time the price level on aggregate does not move. Something similar to price level targeting was tried by Sweden in the 1930s, and seems to have contributed to the relatively good performance of the Swedish economy during the Great Depression. As of 2004, no country operates monetary policy based on a price level target.

Interest rates

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The contraction of the monetary supply can be achieved indirectly by increasing the nominal interest rates. Monetary authorities in different nations have differing levels of control of economy-wide interest rates. In the United States, the Federal Reserve can set the discount rate, as well as achieve the desired Federal funds rate by open market operations. This rate has significant effect on other market interest rates, but there is no perfect relationship. In the United States open market operations are a relatively small part of the total volume in the bond market. One cannot set independent targets for both the monetary base and the interest rate because they are both modified by a single tool open market operations; one must choose which one to control. In other nations, the monetary authority may be able to mandate specific interest rates on loans, savings accounts or other financial assets. By raising the interest rate(s) under its control, a monetary authority can contract the money supply, because higher interest rates encourage savings and discourage borrowing. Both of these effects reduce the size of the money supply.

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FISCAL POLICY
In economics, fiscal policy is the use of government spending and revenue collection to influence the economy.Fiscal policy can be contrasted with the other main type of economic policy, monetary policy, which attempts to stabilize the economy by controlling interest rates and the supply of money. The two main instruments of fiscal policy are government spending and taxation. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy:

Aggregate demand and the level of economic activity; The pattern of resource allocation; The distribution of income.

Fiscal policy refers to the overall effect of the budget outcome on economic activity. The three possible stances of fiscal policy are neutral, expansionary and contractionary:

A neutral stance of fiscal policy implies a balanced budget where G = T (Government spending = Tax revenue). Government
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spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.

An expansionary stance of fiscal policy involves a net increase in government spending (G > T) through rises in government spending or a fall in taxation revenue or a combination of the two. This will lead to a larger budget deficit or a smaller budget surplus than the government previously had, or a deficit if the government previously had a balanced budget. Expansionary fiscal policy is usually associated with a budget deficit.

contractionary

fiscal

policy

(G

<

T)

occurs

when

net

government spending is reduced either through higher taxation revenue or reduced government spending or a combination of the two. This would lead to a lower budget deficit or a larger surplus than the government previously had, or a surplus if the government previously had a balanced budget. Contractionary fiscal policy is usually associated with a surplus. Fiscal policy was invented by John Maynard Keynes in the 1930s.

Methods of funding
Governments spend money on a wide variety of things, from the military and police to services like education and healthcare, as well as transfer payments such as welfare benefits. This expenditure can be funded in a number of different ways:
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Taxation Seignorage, the benefit from printing money Borrowing money from the population, resulting in a fiscal deficit. Consumption of fiscal reserves. Sale of assets (e.g., land).

Funding the deficit

A fiscal deficit is often funded by issuing bonds, like treasury bills or consols. These pay interest, either for a fixed period or indefinitely. If the interest and capital repayments are too large, a nation may default on its debts, usually to foreign creditors.

Consuming the surplus

A fiscal surplus is often saved for future use, and may be invested in local (same currency) financial instruments, until needed. When income from taxation or other sources falls, as during an economic slump, reserves allow spending to continue at the same rate, without incurring a deficit.

Economic effects of fiscal policy

Fiscal policy is used by governments to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment and economic growth. Keynesian economics suggests that adjusting government spending and tax rates are the best ways to stimulate aggregate demand. This can be used in times of recession or low economic activity as an essential tool in providing the framework for strong economic growth
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and working toward full employment. The government can implement these deficit-spending policies due to its size and prestige and stimulate trade. In theory, these deficits would be paid for by an expanded economy during the boom that would follow; this was the reasoning behind the New Deal. During periods of high economic growth, a budget surplus can be used to decrease activity in the economy. A budget surplus will be implemented in the economy if inflation is high, in order to achieve the objective of price stability. The removal of funds from the economy will, by Keynesian theory, reduce levels of aggregate demand in the economy and contract it, bringing about price stability. Some classical and neoclassical economists argue that fiscal policy can have no stimulus effect; this is known as the Treasury View, and categorically rejected by Keynesian economics. The Treasury View refers to the theoretical positions of classical economists in the British Treasury who opposed Keynes call for fiscal stimulus in the 1930s. The same general argument has been repeated by neoclassical economists up to the present day. From their point of view, when government runs a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing or the printing of new money. When governments fund a deficit with the release of government bonds, an increase in interest rates across the market can occur. This is because government borrowing creates higher demand for credit in the financial markets, causing a lower aggregate demand (AD), contrary to the objective of a budget deficit. This concept is called crowding out.

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Other possible problems with fiscal stimulus include the time lag between the implementation of the policy and detectable effects in the economy and inflationary effects driven by increased demand. In theory, fiscal stimulus does not cause inflation when it uses resources that would have otherwise been idle. For instance, if a fiscal stimulus employs a worker who otherwise would have been unemployed, there is no inflationary effect; however, if the stimulus employs a worker who otherwise would have had a job, the stimulus is increasing demand while labor supply remains fixed, leading to inflation.

Impacts of Monetary Policy and Fiscal Policy

Fiscal policy should not be seen is isolation from monetary policy. For most of the last thirty years, the operation of fiscal and monetary policy was in the hands of just one person the Chancellor of the Exchequer. However the degree of coordination the two policies often left a lot to be desired. Even though the BoE has operational independence that allows it to set interest rates, the decisions of the
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Monetary Policy Committee are taken in full knowledge of the Governments fiscal policy stance. Indeed the Treasury has a nonvoting representative at MPC meetings. The government lets the MPC know of fiscal policy decisions that will appear in the annual budget. The federal funds rate, or the interest rate that U.S. banks charge each other for overnight loans, is the benchmark rate for many short-term and long-term interest rates in the United States. A reduction in the federal funds rate, often times (though not always), decreases the interest rate on credit cards, automobile loans, and mortgages. Lower interest rates encourage consumers to spend and businesses to build new offices and purchase computers, machinery, and software. A boost in consumption (e.g. buying new clothes) and investment (e.g. building new offices) (with the added benefit of lowering the value of the dollar and thus boosting U.S. exports) spending are exactly what the economy needs when it is slipping into a recession caused by sudden drops in overall spending. Though the U.S. economy is NOT officially in a recession, the Federal Reserve forecasts slowed growth and would like to cut rates just-in-case. The previous explanation shows how the Federal Reserve could use monetary policy to minimize the depth and length of a recession. However, what is less well known is the process with which the Federal Reserve is able to manipulate the federal funds rate. Essentially, the Federal Reserve lowers the federal funds rate by expanding the money supply. This is easier said than done. First and foremost, the Federal Reserve does NOT print new dollar bills. So how is it able to create new money? There are two main forms of
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moneycash in circulation and checking deposits held in banks. Separate from the money supply are reserve accounts that commercial banks are required to have at the Federal Reserve. These reserve accounts hold cash for the commercial banks in case depositors cash-out some of their deposits. The Federal Reserve can expand the money supply by expanding the amount of deposits held in the U.S. commercial banking system. One way to do so is to purchase U.S. government bonds issued by the U.S. Treasury department. When the Federal Reserve purchases government bonds from commercial banks, it takes bonds out of circulation and electronically credits reserve accounts. U.S. commercial banks armed with more cash reserves will issue new loans which are then deposited back into the banking system. This method effectively increases the dollar amount of checking deposits in the economy, and hence, expands the money supply. As Greg Mankiw recently pointed out and Wall Street Journal reporter David Wessel was quick to observe nearly a month ago, the actual federal funds rate has been trading below the Feds target federal funds rate of 5.25%. The federal funds rate is the rate at which banks borrow from one another overnight, and it is the key benchmark interest rate for monetary policy. The Fed targets a relatively low, or loose, fed funds rate in order to encourage borrowing, speed up economic growth, and avoid recession. The Fed targets a neutral rate when it wants neither slower nor faster growth than the economy is currently experiencing. The Fed targets a relatively high, or tight, rate when it wants to discourage some borrowing, slow the pace of economic growth, and ensure price stability (low and stable inflation).
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According to Mankiw, the actual fed funds rate averaged 5.02% during August23 basis points lower than the targetwhile in the preceding 13 months, the Fed had never allowed the actual rate to deviate from the target by more than 1 basis point. Although we cant be sure until the next Federal Open Market Committee (FOMC) meeting on Tuesday, September 18, the behavior of the actual rate in August seems to suggest that the Fed will cut the target federal funds rate to at least 5.0%. A rate cut would mean that the Fed is backing away from a tighter policy stance associated with reducing inflation, and moving instead toward a more neutral monetary policy that will allow it to wait and see how the recent subprime and housing-market turmoil plays out in the broader economy. The prospect of a rate cut raises the issue of moral hazard. Some critics feel that any loosening by the Fed will bail out borrowers who have taken on risky subprime mortgages and investors who have purchased the assets backed by such mortgages. By cutting rates, the Fed may encourage borrowers, lenders, and investors to make similar gambles in the future on the assumption that the Fed will intervene if things turn sour. Tyler Cowens latest New York Times column argues that while the Fed should not go out of its way to help poor decision makers, the Feds mandateprice stability and full employment should not be sacrificed for fear of instigating moral hazard. But what, if anything, can the fiscal authorityCongress and the Presidentdo to assist the economy? According to Fed chair Ben Bernanke, Fiscal action could be helpful in principle, as fiscal and monetary stimulus together may provide broader support for the economy than monetary actions alone. (Read this New York Times
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article for more.) However, Bernanke is hedging a bit here. By saying that tax cuts or spending increases could be helpful in principle, he implicitly acknowledges that such measures may be ineffective, or even harmful, in practice. The process of agreeing on and passing legislation limits the usefulness of fiscal policy for stabilizing mild fluctuations in economic output. By the time our representatives haggle over and pass legislation, the downturn may be over or the resulting policy may reflect political rather than economic considerations. For this reason and others, recent commentaries by Greg Mankiw and Robert J. Samuelson argue that we should leave the Fed to address mild ups and downs in the business cycle, reserving fiscal policy for deep or prolonged recessions.

Impact on the Composition of Output

Monetary policy is seen as something of a blunt policy instrument affecting all sectors of the economy although in different ways and with a variable impact Fiscal policy changes can be targeted to affect certain groups (e.g. increases in means-tested benefits for low income households, reductions in the rate of corporation tax for small-medium sized enterprises, investment allowances for businesses in certain regions) Consider too the effects of using either monetary or fiscal policy to achieve a given increase in national income because actual GDP lies below potential GDP (i.e. there is a negative output gap)

Monetary policy expansion

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Lower interest rates will lead to an increase in both consumer and fixed capital spending both of which increases current equilibrium national income. Since investment spending results in a larger capital stock, then incomes in the future will also be higher through the impact on LRAS.

Fiscal policy expansion

An expansion in fiscal policy (i.e. an increase in government spending) adds directly to AD but if financed by higher government borrowing, this may result in higher interest rates and lower investment. The net result (by adjusting the increase in G) is the same increase in current income. However, since investment spending is lower, the capital stock is lower than it would have been, so that future incomes are lower.

Differences in the Effectiveness of Monetary and Fiscal Policies

When the economy is in a recession (when business and consumer confidence is very low and perhaps where deflationary pressures are taking hold) monetary policy may be ineffective in increasing current national spending and income. The problems experienced by the Japanese in trying to stimulate their economy through a zero-interest rate policy might be mentioned here. In this case, fiscal policy might be more effective in stimulating demand. Other economists disagree they argue that short term changes in monetary policy do impact quite quickly and strongly on consumer and business behaviour. Consider the way in which domestic demand in both the United States and the UK has responded to the interest rate cuts introduced in the wake of the terror attacks on the USA in the autumn of 2001
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However, there may be factors which make fiscal policy ineffective aside from the usual crowding out phenomena. Future-oriented consumption theories hold that individuals undo government fiscal policy through changes in their own behaviour for example, if government spending and borrowing rises, people may expect an increase in the tax burden in future years, and therefore increase their current savings in anticipation of this

Differences in the Lags of Monetary and Fiscal Policies

Monetary and fiscal policies differ in the speed with which each takes effect the time lags are variable Monetary policy in the UK is extremely flexible (rates can be changed each month) and emergency rate changes can be made in between meetings of the MPC, whereas changes in taxation take longer to organize and implement. Because capital investment requires planning for the future, it may take some time before decreases in interest rates are translated into increased investment spending. Typically it takes six months twelve months or more before the effects of changes in UK monetary policy are felt. The impact of increased government spending is felt as soon as the spending takes place and cuts in direct and indirect taxation feed through into the economy pretty quickly. However, considerable time may pass between the decision to adopt a government spending
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programme and its implementation. In recent years, the government has undershot on its planned spending, partly because of problems in attracting sufficient extra staff into key public services such as transport, education and health.

Evaluation: Problems with the "demand-management" policies

use

of

active

(1) The measurement of output: Where are we in the cycle? Where are we going? How fast? Will we know when we get there? Inaccuracies in estimating the possible trade-offs in macroeconomic policy (2) Time lags in the policy process: measurement, decision, execution and then effectiveness of policy changes (3) What kind of fiscal policy? Spending (on what?) or tax cuts (for whom?) (4) Will spending (fiscal policy) crowd-out other spending, either directly or indirectly? (5) Will changes in fiscal or monetary policy affect other economic objectives - such as the exchange rate, the trade balance and the provision of public services? (6) Fiscal policy is weak (ineffective) when investment is very sensitive to interest rates and when consumers pierce the veil and attempt to offset the actions of the government (e.g. saving a tax cut, or
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increasing their saving when higher government spending leads to expectations of higher taxes in the future) (7) Monetary policy is weak (ineffective) when consumers are willing to hold large quantities of money rather than spend them even when interest rates are very low

BIBLIOGRAPHY
www.google.com www.wikipediea.com
www.econmodel.com www.investopedia.com www.wolfram.com www.dukeupress.edu www.economyprofessor.com

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