Classical economics and supply-side approaches lead to the conclusion that Aggregate Demand matters little, if at all, in the long run. Keynesians and monetarists alike, however, focus on Aggregate Demand. Monetarists and contemporary Keynesians clearly have different views on some things, but this should not cloud their areas of agreement. Their differences lie in different views about (a) how important monetary policy is relative to fiscal policy, not that one alone matters to the exclusion of the other, and (b) how quickly and effectively government policies can adjust to reverse momentum towards an excessively inflationary expansion or into a recession.
Relative Effectiveness Arguments
Keynesians and monetarists agree that money matters but differ as to how much it matters. Keynesians argue that monetary growth will not raise spending or cut interest rates very much in a slump. Figure 13 shows why. Keynesians view investment as relatively insensitive to interest rates, depending instead primarily upon business expectations. This suggests that slight drops in interest rates when the money supply grows (Panel A) will affect investment and output very little (Panel B). Fiscal policy, on the other hand, is extremely powerful in a slump. Adding government purchases to investment in Panel B boosts autonomous spending and, via the multiplier, massively raises national production and income.
Monetarists see the demand for money as relatively insensitive to interest rates but perceive investment as highly dependent on interest. Even a small increase in the money supply drives interest rates down sharply in the monetarist view (Panel A in Figure 14), which in turn strongly stimulates investment (Panel B). Monetarists also see expansionary monetary policy as bolstering consumer spending, both because extra money burns holes in people’s pockets and because lower interest rates make buying on credit easier and cheaper. Thus, monetarists view money as a powerful tool.
Fiscal policy has only a negligible effect, according to monetarist reasoning, because new government spending does not raise injections (I + G) nearly as much as does even a small decline in interest rates. Moreover, monetarists object that government spending may crowd out investment. Careful study of Figures 13 and 14 will enable you to understand the fundamental reasons why Keynesians advocate fiscal policy to regulate Aggregate Spending, while monetarists prefer monetary policy.
Keynesians and monetarists agree that when an economy is at full employment, growth of Aggregate Demand raises the price level. Both would agree that, when an economy is in a severe slump, increases in Aggregate Demand will restore full employment. They would, however, disagree on the appropriate way to expand Aggregate Demand. Monetarists favor expansionary monetary policy to increase private consumption and investment, while Keynesians view that approach as ineffective because of widespread pessimism on the parts of workers, consumers, and business firms. Keynesians, therefore, favor expansionary fiscal policy.
Rules vs. Discretionary Policies
Most economists who draw ideas heavily from the classical school believe that designing discretionary monetary and fiscal policies to buffer business cycles is an impossible task. They favor doing away with all discretion in policymaking and adopting stable and permanent monetary and fiscal rules. These critics believe that the market system is inherently stable and that severe swings in business activity inevitably follow ill-advised discretionary policies. One mechanism to eliminate discretion in monetary policymaking is a monetary growth rule.
A monetary growth rule would dictate that the money supply be increased at a rate compatible with historical growth of GDP, say 3% annually.
Suppose you are driving a high-powered car on a fairly straight highway that is banked slightly along the edges to keep you on the road. Unfortunately, someone has blackened the front and side windows—you cannot see where you are or what lies ahead. To make matters worse, your gas pedal sticks at times, the steering wheel is loose, and your brakes alternate between pure mush and grabbing so sharply that you skid. You can vaguely see where you have been through a fogged-over rearview mirror. What is your best strategy?
If you press the gas pedal too hard, you may go so fast that the curbs at the edge of the road will fail to keep you on course. If you try to steer, you may guide yourself over the side. Your best strategy will be to carefully adjust the accelerator to maintain a slow but steady speed and let the car steer itself away from the road’s edges.
The economists who blame cyclical swings on erratic monetary or fiscal policies perceive macroeconomic policymakers as being in our economy’s driver’s seat. Attempts to fine-tune the economy through discretionary policies are viewed as the fumblings of people who barely deserve learners’ permits playing with the controls of an Indianapolis 500 racecar. They tend to oversteer and to jump back and forth from the accelerator to the brake. The resulting stop-and-go economic pattern might resemble your path when you were learning to drive, and, unlike policymakers, you knew what you were passing and could see what lay ahead. We also hope that the steering, braking, and acceleration of the car you drove responded more precisely than the cumbersome tools available to monetary and fiscal policymakers.
In addition to a monetary growth rule, most economists opposed to discretion in policymaking advocate certain fiscal rules:
1. Government spending should be set at the amounts of government goods and services that the public would demand if the economy were at full employment; no make-work projects should be permitted.
2. Tax rates should then be structured so that the federal budget would be roughly in balance if the economy were at full employment.
Although monetarists perceive some problems emerging from improper spending and tax policies (e.g., Hoover’s tax hike in 1930–1932, Johnson’s simultaneous wars on poverty and in Vietnam, and the enormous budget deficits of the Reagan years), they cast central bankers (the Fed) as the major villains in their explanations of cyclical chaos in market economies.
The Culpability of the Fed
Monetarists view the market system as largely self-stabilizing and predictable; they perceive erratic government policies as the leading cause of business cycles. Monetarists believe that rapid inflation is explained by excessive monetary growth, which results in “too much money chasing too few goods.” Alternatively, severe deflations, recessions, or depressions result when the money supply grows too slowly (or even falls), resulting in “too little money chasing too many goods.” Government can prevent macroeconomic convulsions by simply holding the rate of growth of the money supply roughly in line with our (slow growing) capacity to produce.
This sounds fairly easy. Why has government not learned these simple monetary facts of life and followed policies to achieve a stable price level and facilitate smooth economic growth? The monetarist answer to this question is that no one is able to predict precisely what will happen to our productive capacity in the near future. Moreover, instituting policies and having them take effect requires time. (We discuss the problems posed by time lags in a later chapter.) Monetarists also believe that the Fed tries too hard to control the economy. Finally, political considerations too often dominate sound policymaking. The solution, according to many monetarists, is to follow a rule of expanding the money supply at a fixed annual rate in the 2% to 4% range compatible with historical growth of our productive capacity.
The Failure of Discretionary Fine-Tuning
From the 1940s through the 1960s, most economists viewed the Great Depression as evidence that only Keynesian engineering can ensure a prosperous and stable economy. Keynesians recommended discretionary changes in taxes and spending as the proper fiscal tools. Other economists argue that the Fed can keep the economy on track by expanding or contracting the money supply as needed. Fiscal and monetary policies both have been frequently changed to try to fine-tune the economy by balancing Aggregate Demand with Aggregate Supply.
Tax rates were cut and the money supply was expanded to stimulate a previously sluggish economy during the early 1960s. Then, monetary restraint was applied in 1966 to curb mounting inflationary pressures. A temporary tax surcharge was imposed in 1969. The money supply grew rapidly in the early 1970s, screeched to a halt causing a short collapse during 1975–1976, accelerated from 1977 to 1979, and then slowed sharply in the early 1980s. Cuts in tax rates from 1981 to 1983 were coupled with a monetary slowdown to reduce inflation while expanding output, but resulted in rapidly rising government deficits.
Keynes believed that central banks tried to follow expansionary policies but failed to cure the Great Depression. This is, in part, why Keynes and his followers sought to replace passive monetary policy with activist fiscal policies. Milton Friedman and other monetarists question the widely held belief that the Great Depression occurred despite expansionary monetary policies. Collecting and reviewing monetary data for the United States for the past century, they discovered that the money supply fell considerably just before and during the Depression. Their interpretation is that the Federal Reserve System caused the Depression because (perhaps unwittingly) it followed contractionary policies.
In fact, most monetarists believe that improper monetary policy is the major cause of business cycles: when the money supply grows too slowly, economic downturns and stagnation soon follow; when the money supply mushrooms, increases in the price level are inevitable. These difficulties are the major reasons for monetarists’ advocacy of stable monetary growth rates. Table 2 summarizes crucial differences between fiscal and monetary policies according to the traditional theories of Keynesian, monetarist, and classical macroeconomics.
Classical theory, with its emphasis on Aggreg-ate Supply, provides some insights, but not a complete picture, of macroeconomic problems encountered in most modern economies (e.g., sustained high rates of unemployment). Nor does Keynesian theory, with its stress on variations in Aggregate Demand in a world beset by depression, systematically address such problems as naggingly high unemployment accompanied by persistent creeping inflation. Even monetarism, which treats Aggregate Supply from a classical perspective while recognizing the relevance of Aggregate Demand in the short run, has failed to explain economic events of recent years.
You may have the sense that these theories are so disparate that the prospects for economists ever reaching any consensus are practically nil. From the 1940s through the 1980s, the policies of the Federal Reserve System meandered back and forth between Keynesian, classical, and monetarist recipes, with results that, predictably, were mixed. Several things have become fairly clear, however. One is that frequent changes in both monetary and fiscal policy have confounded economic stability as often as they have helped dampen business cycles; extremely active fine-tuning does not work. Another is that all of these traditional theories have left a legacy, filling in pieces of the puzzle of how a mixed economy with substantial networks of both markets and government actually works.