Relative Effectiveness of Fiscal and Monetary Policy

Noted that the purpose of implementing fiscal and monetary policies is to influence economic outcomes i.e. income/output and employment The potency of these policies is therefore measured against their effect on income/output and employment A policy is considered effective if it results in a larger change in the equilibrium level of income/output and employment i.e. the greater the change in equilibrium income, the more effective the policy There are two key determinants used in measuring the relative effectiveness of fiscal and monetary policies (i) interest elasticity of demand for money (ii) interest elasticity of investment Interest elasticity of demand for money The elasticity of demand for money measures the responsiveness of the rate of interest to changes in the money supply Noted that monetary policy affects equilibrium income/output and employment indirectly through its effect on interest rate and investment An increase in the nominal supply of money reduces the rate of interest, therefore increasing investment and aggregate demand: equilibrium income/output therefore increase as a result

Relative Effectiveness Monetary Policy

of

Fiscal

and

Note however that the change in the rate of interest as a result of the increase in money supply will be smaller, the more elastic the demand for money i.e. if the demand for money function has a flatter slope The smaller change in the rate of interest also implies a smaller change in the level of investment and therefore aggregate demand, and income/output and employment [insert diagram] Note also that the change in the rate of interest will be larger if the demand for money is less interest elastic i.e. if the demand for money function has a steeper slope The larger the change in the rate of interest the larger the change in the level of investment and therefore aggregate demand and income/output Monetary policy is therefore considered less effective if the demand for money is more interest elastic: In the extreme, monetary policy will be completely ineffective when the economy is in a liquidity trap i.e. when the demand for money is perfectly elastic (when the demand for money function is flat) [insert diagram] Note that the interest rate remains unchanged with changes in the money supply In the liquidity trap, people choose to hold their wealth in the form of money with the hope that interest rates will increase in the future

Relative Effectiveness Monetary Policy

of

Fiscal

and

In contrast to monetary policy, which is less effective the more interest elastic the demand for money, fiscal policy is more potent, the more interest elastic the demand for money Noted that fiscal policy involves manipulating government spending and taxes to influence aggregate demand, and therefore output and employment Noted that expansionary fiscal policy (i.e. increase in government spending or reduction in taxes) results in higher aggregate demand, and therefore higher output and employment; but that output increases by a smaller amount due to crowding out resulting from the increase in the rate of interest (generated by the excess demand in the money market) as the level of income increases If the demand for money is more interest elastic however, the increase in the rate of interest will be smaller: this implies also a smaller effect on the level of investment as the rate of interest increases output thus falls by a smaller amount In totality therefore, government spending increases by a larger amount since the crowding out effect will be minimized by the smaller change in the rate of interest Conclude: the more interest elastic the demand for money, the more effective is fiscal policy

Relative Effectiveness Monetary Policy

of

Fiscal

and

Note that fiscal policy will even be more potent when the demand for money is perfectly interest elastic i.e. when the demand for money function is flat (liquidity trap) the interest rate remains unchanged in the liquidity trap when government spending increases, so there is no crowding out effect Interest elasticity of Investment The elasticity of investment measures the responsiveness of investment to changes in the rate of interest Noted that monetary policy influences output and employment indirectly through the rate of interest: where a fall in the rate of interest (due to an increase in money supply expansionary monetary policy) induces investment spending and produces a higher level of aggregate demand and therefore output and employment Monetary policy is considered less effective the more interest inelastic the investment this implies that a change in the money supply will result in a small change in the rate of interest and therefore a small change in the level of investment, aggregate demand and output and employment [insert diagram] Note that the change in the level of investment in response to a change in the rate of interest is larger for the investment function with a flatter slope In the extreme, monetary policy will be completely ineffective when the investment function is non responsive to changes in the rate of interest i.e. when the investment function is perfectly interest inelastic - when the investment function is perfectly interest inelastic there will be no change in investment even if the rate of interest changes, so that output and employment also remain unchanged

Relative Effectiveness Monetary Policy

of

Fiscal

and

In contrast, fiscal policy will be more effective the more interest inelastic the investment demand Noted that expansionary fiscal policy involves either an increase in government spending or a reduction in taxes: both of which increase aggregate demand and result in a higher level of income and interest rate Noted also that the increase in the rate of interest generated by the excess demand in the money market as the level of income increases, squeezes out some of the private investment, resulting in loss of some output If the investment function is interest inelastic, the change in the rate of interest will be small, so that the loss of output (i.e. crowding out) will be minimized, therefore a larger change in output when authorities embark on an expansionary fiscal policy Conclude: the more interest inelastic the investment, the more effective is fiscal policy Note: Fiscal policy will be even more effective when the investment is perfectly interest inelastic (implying no change in investment even if interest rate increases as a result of the expansionary fiscal policy): therefore output will change by a larger amount when investment is interest inelastic