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April 24, 1981 PolicyDebate A major debate within the economics profession has now been reflected in the financial press and in policy circles. The debate concerns the appropriate role for monetary policy and, to a lesser extent, fiscal policy in the Reagan economic game plan. A March 23 Wall Street Journal editorial, entitled "Money Doesn't Matter," sets forth one point of view with the following propositions: 1) the Federal Reserve, through its monetarypolicy tools, can control the money supply and thus the inflation rate; 2) the Federal government, through its fiscal-po!icy tools (tax rates and government spending) can affect productivity and employment; 3) monetary policy has little effect on employment and growth; 4) fiscal pol icy has Iittle effect on inflation. If these four propositions correctly describe the world, then the implementation of monetary and fiscal pol icy wou Id be rather easy and straightforward. Monetary policy should be directed towards lowering inflation, because of its lack of consequences for real output. Fiscal policy should be directed towards loweri ng taxes and government spending to encourage productivity, because of its lack of consequences for inflation. Rebirthof classicalview Some critics have labeled the Journal's argument as new, radical, and untested. That is misleading. Indeed, the Journal's editorial simply garbs in modern clothes the classicai view of economics, which dominated the economics profession from the time of Adam Smith (The Wealth of Nations, 1776) to the time of Lord Keynes (General Theory, 1936). This classical economic theory focused policy attention on the long run, where money was a veil, so that changes in the money supply only affected prices. Short-run business-cycle problems, in this view, simply reflected random economic events, which policymakers could not anticipate and thus cou Id not offset. But because private markets were efficient and flexible, the economy quickly returned to a new equilibrium value following any external shock. Policymakers' attempts to stabilize the economy in the short-run thus would be both unnecessary and undesirable. Rather, government policy should be directed toward long-run considerations-monetary policy to stabilize prices and fiscal policy to encourage economic growth. The Great Depression of the 1 930's-a worldwide traumatic event -seemed to undermine one of the major assumptions of the classical theory, however. With the unemployment rate over 10 percent for a decade, economists could no longer reasonably assume that the business cycle was due to random shocks which would be selfcorrecting by the efficient and flexible response of private markets. The "Keynesian Revolution" in economic thinking arose as a direct response to the Great Depression. It shifted the focus of policy analysis to the short run from the long run-"when we are all dead," in Keynes' words. It provided a theoretical rationale for the failure of private markets to adjust effectively to an outside shock (such as a decl i ne in aggregate demand) and for the need for government "stabilization" policy to offset these influences. But although the Keynesian approach provided a theory for deal i ng with the short-run business cycle, it did not incorporate a long-run theory of either inflation or economic growth. (Keynes himself had strong, even classical, views on these topics, but they were not incorporated into his General Theory.) This turned macroeconomic policy on its head. While the classical theory focused on the long run and assumed away the short run, the Keynesian theory did just the reverse. In recent years, the classical model has revived in response to the accelerating inflation Inflation (Personal consumption deflator) ....... ...:....a...a.....&..!b..I!.....&..&....I.....II....L-I!...Il...dI-2I!-:&...b..IbdI..........,,"""'1952 1960 1968 1976 1980 1948 1956 19 For 1981, dots reprE -_. _---_ ....-._.......--..... -_ __-.....----_.__._-_.__.._ __.....- - - - _ ...._-_..._--- _._._----_.. .._.. ... .. of the 1970s, which forced policymakers to focus more on reducing inflation and less on stabilizing income. Because of the Keynesian model's failure to provide a theory of inflation, economists began to return to a classical model-in its purest form, a "rational expectations" approach -which did provide such a theory. -- ..--_. nf rI",ht ::>nrl hro",t orr ................._ .............. .....··0 ...... 0· .... _------_ high money growth was associated with a high inflation rate in the post-1 965 period. Specifically, the inflation rate averaged about one percentage point below the moneygrowth rate before 1965, and about one percentage point higher in later years. Non-monetary factors-such as the upsurge in OPEC oil prices-can also affect the inflation rate in the short run. The oil crisis pushed the inflation rate above that related to underlying monetary factors in 1974 and again in 1 979-80. Weather-caused food shortages have caused similar price shocks on several other occasions. This approach in effect asserts that monetary policy should be directed in the long run towards lowering the inflation rate. It asserts also that in the short run, the business cycle is largely due to random fluctuations, which policy authorities can neither anticipate nor do anything systematic to offset. I f policy is systematic, it can also be anticipated by the public, who will actto offset its influence. For example, if the Fed announces as-percent faster growth in the money supply in response to a rise in unemployment, the public will revise its inflation expectations by 5 percent, so that there wou Id be no favorable impact on real growth or unemployment. Fiscalpolicy andinflation Does fiscal policy affect inflation? Apparently not, at least in any significantly direct way. For example, 'an increase in the government deficit increases the demand for credit and therefore tends to push up interest rates. However, it does not necessarily increase the demand for goods, and thus does not push up the inflation rate. This is because the deficit's pressure to raise interest rates tends to "crowd out" a roughly equal amount of private interest-sensitive spending, so that the total demand for goods fails to rise significantly. This suggeststhatthe deficit, even in the short run, will not systematically affectthe inflation rate. Markets are rational in the sense that they use all information available in a systematic way, and they are efficient in the sense that they respond to external shocks in the least-cost way. Thus, there is no role for stabilization policy in this rational-expectations worldthe world of the Wall Street Journal editorial. Because of the current importance of that approach, the major propositions stated in the Journal editorial deserve further analysis. However, fiscal policy and the government deficit can affect the inflation rate indirectly, through money-supply effects. The rate of change in the government deficit is closely related in most years to the rate of change in the money supply (see Chart 2). This close statistical association is not based on any basic behavioral relationship; in fact, the relationship is not nearly as close in other countries as it is in the United States. Monetarypolicy and inflation Does monetary policy affect the inflation rate? Apparently yes. Monetary policy, measured by the annual rate of change in the money supply, is a good predictor of the inflation rate, with approximately a two-year lag (seeChart 1). For example, money-supply growth in 1 978 was a majorfactor explaining the inflation rate in 1 980. The close historic relationship between deficits and money in this country reflects a number of potential factors: • Even-keel considerations. Until the mid1970's, the Federal Reserve tended to hold interest rates steady during periods of large The trends of money and prices over long periods of time are closely related. Low money growth was associated with a low inflation rate in the pre-1 965 period, while 2 .. _---- Change(%) 8 , 6 ;=1221Ci\lP/ 4 \ r '; 2 I .;/. \. '\(./': -2 -4 changes (annual averages) 1972 estimatedgrowth of money, -6 1962 __ 1965 1970 1975 1980 Monetary policy and GN P Does monetary pol icy affect real output (GNP)? Economists generally recognize that the growth in real output, in the long run, depends on the growth of capital, labor and technology, and that fiscal policy can affect those variables importantly through government taxing and spending decisions. However, in the short run, the growth in real GN P is largely a function of incentives to utilize the existing stock of capital and labor. These incentives depend upon the level of aggregate demand, which can be influenced by monetary policy. Treasury financing. The reserves and money created during such "even-keel" periods may not all have been offset in periods. " Federal Reserve operating procedures. Until October 1979, the Fed controlled the money supply via an interest-rate targeting procedure. A large deficit could put upward pressures on interest rates, which would tend to induce monetary accommodation. CDPol icy coi ncidence. Government deficits were usually associated with businesscycle recessions, when monetary policy was typically eased and the money supply increased. As we have seen, monetary policy tends to affect inflation with a lag. In the meantime, a change in the nominal money stock affects the real (or inflation adjusted) money stock, which tends to change aggregate demand with about a two-quarter lag (Chart 3). Many other factors are involved, of course, but real money and real GN P have maintained a systematic cyclical relationship over time. The one major break in the link between large deficits and rapid money growth occurred in 1 975-76, when money growth stabilized in the face of a record increase in the deficit. But Administration policymakers expect that experience to be repeated in the 1 981 -82 period. The Federal Reserve is targeting a 31/2-to-6 percent growth rate in the (M-1 B) money supply in 1 981 -considerably below the 1 980 rate-and presumably it will target even less in subsequent years. On the other hand, the Government deficit may remain high this year and next, as tax revenue reductions are expected to outpace planned spending cuts. In summary, economists widely accept the long-run relationships between monetary policy and inflation, and between fiscal policy and real output. But it also seems true that monetary policy can affect real income in the short run. In addition, fiscal policy appears to influence the inflation rate, at least indirectly, through its impact on the growth of the money supply. We might encounter difficulty repeating the 1 975-76 experience in the 1 981 -82 period. The 1 975-76 deficit was associated with the 1 974-75 recession -the most severe since the 1 930's-which sharply reduced private demands for credit. Therefore, financial markets were able to finance an unusually large government deficit with relatively little strain, with little pressure on the Fed to monetize that deficit. But no one expects a recession of 1 974-75 magnitude over the next year or so, which means that financial markets could feel considerable strain under the conflicting pressures of a high government deficit and a slowdown in money-supply targets. Policymakers cannot ignore the short-run costs involved in the necessary attack of monetary policy on inflation. These costs are of two kinds. First, there are the costs in terms of pressures on financial markets when tight money is associated with large government deficits. Second, there are the costs of tight money associated with a decline in real output and a rise in unemployment. Recognizing these costs shou Id not paralyze action to fight inflation. But being forewarned about costs, one can be forearmed to deal with them. MichaelW.,Keran 3 SS\11:J .lSl::ii:J U018U!4seM • 4eln • uo8aJO• epeAaN• o4epi !!eMPH 0 e!uJoj!lP:) euoz! J\'. e>jselV (\J) <§y J( <r)) JJ, WJJ,CU'Wd[ BANKINGDATA-TWELfTH FEDERAL RESERVE DISTRICT (Dollaramountsin millions) SelectedAssetsandliabilities largeCommercialBanks Loans(gross,adjusted) andinvestments* Loans(gross,adjusted) - total# Commercialandindustrial Realestate Loansto individuals Securities loans U.s.Treasury securities* Othersecurities* Demanddeposits- total# Demanddeposits- adjusted Savings deposits- total Timedeposits- total# Individuals,part.& corp. (Largenegotiable CD's) WeeklyAverages of Daily Figures MemberBankReserve Position Excess Reserves (+ )/Deficiency(- ) Borrowings Netfreereserves (+ )/Netborrowed( -) Amount Outstanding Change from 4/8/81 4/1/81 146,216 123,851 36,486 51,552 22,695 1,497 6,617 15,748 42,931 30,677 31,588 75,411 66,677 28,995 - - - 456 504 122 44 57 66 36 12 487 329 572 488 422 83 Changefrom yearago Dollar Percent 6,681 6,114 1,837 5,708 - 1,641 774 92 475 - 2,216 - 2,553 4,529 12,460 12,245 6,533 Weekended Weekended 4/8/81 4/1/81 n.a. n.a. 2 118 n.a. n.a. 4.8 5.2 5.3 12.5 - 6.7 107.1 1.4 3.1 - 4.9 - 7.7 16.7 19.8 22.5 29.1 Comparable year-ago period 35 200 165 * Excludes tradingaccountsecurities. # Includesitemsnotshownseparately. Editorialcommentsmaybeaddressro to theeditor(WilliamBurke)or to theauthor.... Freecopiesof this andotherFederalReserve publications canbeobtainedbycallingor writingthePublicInformationSection, FederalReserve Bankof SanFrancisco, P.O.Box7702, SanFrancisco 94120. Phone(415) 544-2184. <tdI
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