Monetary and Fiscal Policy

Walter W. Heering Monetary Economics: Theory and Policy Coursework Matthew C. Bell

Classical Model vs. Keynesian ModelMonetary and Fiscal Policy

Introduction

More than 50 years ago, a huge debate between two types of economists took place and is still going on in this modern age. This was the different views between the classical economists and a man named John Maynard Keynes (1883-1946) who led the debate. They both argued that unemployment and inflation had costs involved and had macroeconomic implications. On one hand the “activists” such as Keynes believed that it was `necessary for the government to control and manage the economy, whereas the classical economists felt that there was no need for government intervention and control in a free capitalist market whereby automatic stabilizers would be sufficient (Vitez, 2009).

Classical Model

Classical economists such as Milton Friedman (1912-2006) and Friedrich Hayek (1889-1992), believed in the idea of a “laissez-faire” economic market whereby the economy is a “free market” that does not require intervention of the government and that everyone should act in their own interest regarding economic decisions. They believed in “Say’s Law”, this is when supply creates its own demand (Madeiras, 2008).

In the Classical model, the economy is always operating at “full capacity”, whereby all resources (land, labour, capital, entrepreneurship) are used efficiently and assuming no unemployment level above the natural rate of unemployment of 5%. Any deviation of output from full capacity results in wages and prices to adjust “immediately” to bring output back to operating at “potential output”. Workers are willing to work at the prevailing wage rather than be unemployed. The adjustment of Monetary Policy and Fiscal Policy only affects prices and not output, which is always at “full capacity”.

The central bank, the Bank of England always has a target level of inflation that it wishes to maintain. This “target level”, is best described as being a benchmark used for a price-index of a basket of consumer goods (Begg et al, 2011). Generally speaking, it should be maintained at a level of 2% (inflation) and should never be negative (deflation), such as the case in Japan. In England, the central bank, The Bank of England sets the “nominal-interest rate” after forecasting the inflation rate to achieve the level of “real-interest rate” in accordance to the desired target inflation rate.

Aggregate demand (AD), shows us how higher inflation causes AD to fall (shift in AD downwards) by the way in which the central bank reacts by “tightening” monetary policy known as contractionary monetary policy, hence adjusting nominal interest rates to increase real interest rates. This in turn increases AD and there is a shift upwards, bringing AD back to the target level of inflation. We can now assume that there is an equilibrium, whereby goods and services, money and the labour market are in equilibrium. The AD is a downward sloping curve. Aggregate demand is composed of the sum of aggregate expenditures:


Expenditures = C + I + G + (X - IM)Where: C = total spending by consumers I = total investments by businesses G = total spending by the government

(X - IM) = net exports (exports - imports)

Fiscal Policy controlled by the government can also affect AD when it is “loosened”. This means that AD would increase. Therefore, if the government wanted to reduce AD, it would have to “tighten” Fiscal Policy known as contractionary monetary policy. This would be done by increasing the level of taxation and government spending. However in the classical model, demand does not change the level of “potential output”. Potential output depends on the level of technology and the different amount of inputs available, such as land, labour, capital and entrepreneurship. It can also be affected by the “efficiency” of inputs available and the level of technology used (Begg et al, 2011).

The Long-run Aggregate Supply Curve (LAS), represents the level of potential output and is a vertical line. When the LAS is in equilibrium, the potential output is equal to AD whereby equilibrium output does not get affected by inflation.

Figure 1: Classical Model Graph showing an increase in AD (Aggregate Demand) (Medler, 2012).

In the classical model if there is a shift upwards in AD, from point A-B, this means there is an increase in AD and an increase in inflation and the price level of goods, this could also mean that the money supply is reduced as it would be more expensive to borrow money. The inflation level would be higher than the required target level which we will assume is at point A, ceteris paribus. The cause of this shift could be due to a rise in public investments and public spending.

This could be managed by the central bank by adjusting nominal interest rates to in turn increase the real interest rates by tightening monetary policy. By increasing real interest rates it reduces spending as the purchasing power is less for consumers resulting in AD to shift downwards returning AD back to the equilibrium point A, whereby the inflation rate is at its target level. Another way in which AD could be brought back to equilibrium presuming a shift upwards in AD to point B, would be for the government to tighten fiscal policy. This


would cause a downward shift in AD back to point A. The impact that this would have on the economy would be higher taxes and a huge change in government spending. If AD increases because of an increase in government spending, then the central bank would then again adjust nominal interest rates, causing higher real interest rates. The overall effect would only be brought back to equilibrium when public spending would decrease as much as the government spending had increased. Faster nominal money growth means higher inflation but however leaves real output and potential output constant in this model (Goolsbee, 2013).

Figure 2: Classical Model Graph showing how an increase in Long-Run Aggregate Supply (LAS) increases overall output (Collie, 2014).

If there is an increase in Long-Run Aggregate Supply there will be an increase in overall output, whereby LAS0 shifts to the right to LAS1. The new equilibrium moves from point A to point B. However there now is a problem, whereby the economy is producing more output, at the cost of a deviation from the target level of inflation set by the Bank of England. This means the central bank and government would have to loosen monetary and fiscal policy to cause a rise in AD, bringing the new equilibrium at point B whilst still incorporating the target level of inflation and the increase in overall output.

Keynesian Model

In the Keynesian Model wages and prices are fixed. Wages take time to adjust and are referred to as “sticky”. Pay contracts are not negotiated daily and the amount of pay reflects the workers motivation and ability to produce output. Output is demand determined unless it falls below potential level of output. When AD falls, firms respond by reducing hours available to work, stop overtime and lay workers off rather than reduce wages and prices. Employment is demand-determined in the short-run. In the Keynesian Model we use the Short-Run Aggregate Supply curve which slopes upwards to the right and shows how desired output varies with inflation, if wages do not adjust immediately (Nash, 2003).

Figure 3: Keynesian Model Graph showing how Short-Run Aggregate Supply (SAS) affects output by a change in the real wage rate (Collie, 2014).

In The Keynesian model if the inflation rate is above target level which stands at point A, firms raise output prices. The real wage is lower and the inherited nominal wage is higher. Firms produce more output by taking on more staff and paying for workers


to work overtime. These costs are substituted for a rise in output prices (Keynes, 2006). However if inflation is below the target level, labour is more expensive and firms produce less output. Workers are laid off and hours are cut down. This is because real wage is higher and inherited nominal wage is lower, we can observe this on the graph, the movement from point A to point B along the SAS0 curve.

At point B we call this “involuntary unemployment”, this is where workers are willing to work at the prevailing wage but are unable to find employment. This could be because there is a surplus in the labour force at the current real wage. We can compare this to “voluntary unemployment”, whereby people will refuse to work at the given real wage rate (Nash, 2003).

If demand and output remain low, the inherited nominal wage growth falls whereby firms will not need to raise output prices so rapidly. As nominal wage growth decreases, the SAS0 curve shifts downwards to SAS1 until the labour market is cleared at given point C on the graph. At this point output increases and the level of unemployment falls. Output may diverge from its potential level in the short run because prices and wages are fixed and “sticky” as they do not adjust instantaneously. As real wage rises in the long-run it leads to point D where the economy is producing at potential output again, this is shown by the movement of the SAS1 to SAS2 (Keynes, 2006).

As potential output is achieved at point D in the long-run, the level of inflation is far below the target level. This would cause the central bank to loosen monetary policy, whereby adjusting nominal interest rates to reduce the real interest rates, causing an increase in public expenditure leading to an increase and shift upwards in AD. This would lead back to point A (equilibrium), where the target level of inflation is reached and also the level of output is at full potential. Likewise the government could also loosen fiscal policy, by reducing taxes and increasing spending whereby boosting AD back to point A (Begg et al, 2011). However this does not always have a positive multiplier effect on the economy as the UK has borrowed over £1Trillion to try and reduce unemployment and boost AD according to Anderson, (2014).

Conclusion

We can observe that the classical model is rather outdated compared to the current situation in the UK. The Keynesian model and is a more true and fair reflection of what is happening right now. If we look closely at figure 3, we can see the recession of 2008 could best be described at point B, where there was high levels of unemployment and where people were being laid off. Slowly we moved to point C where the economy was recovering and more jobs were being made available as the real wage was rising in the short-run. We are now at point D, ceteris paribus, where we are slowly working at full potential again. The next stage is to move back to point A where we are still operating at full capacity in line with the target level of inflation of 2%, thereby boosting AD, hence why David Cameroon/Nick Clegg have decided to keep real interest rates so low.


References

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Goolsbee, A, Levitt, S, Syverson, C. (2013). Macroeconomics. New York: Worth Publishers.

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Keynes, J (2006). General Theory Of Employment, Interest And Money. New York: Atlantic

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Monetary and Fiscal Policy