Prof. Bryan Caplan

Econ 311

Fall, 1999

Week 10: Monetary Policy, Fiscal Policy, and Aggregate Demand

  1. Nominal Rigidities and the Market for Loanable Funds
    1. Suppose the price level is totally fixed due to high menu costs. The government then increases the money supply. What happens?
    2. Simple answer: Surplus of money.
    3. But note: Adjustments may take place along other dimensions to eliminate the surplus.
      1. Ex: Price controls on meat - quality can fall if price can't rise.
    4. If P is fixed, what else can adjust to eliminate the surplus of money? The interest rates! As interest rates fall, money demand increases until the surplus disappears.
    5. How? One way to think of it is that people try to lend their surplus money in the market for loanable funds. This reduces interest rates, shifting the money demand curve up.
    6. Empirically, when the money supply unexpectedly increases, there is initially a LARGE effect on the nominal interest rate, and hardly any effect on the price level. It takes a year or more before the price level responds much to money supply increases.
    7. Journalistically, this is why people say "the Fed sets interest rates." It would be more accurate to say that they pick the money supply necessary to make interest rates be what they want. When the Fed announces a cut in interest rates, this is normally equivalent to increasing the rate of money supply growth.
    8. If the nominal rate falls when the money supply increases, and if people know that the price level will be higher in a year or so due to the money supply increase, what must the effect on real interest rates be? Real rates fall even more than nominal rates!
  2. Aggregate Demand Policy
    1. With Keynesian AS, AD shifts can affect output as well as the price level.
    2. Why would governments want to shift AD if they could?
      1. Efficiency rationale: Compensate for fluctuations that exist due to menu costs and money illusion.
      2. Political reasons: Try to improve economic performance during election years.
      3. Mixed: Compensate for problems created by other government policies, such as minimum wage.
    3. Main tools governments try to use to move AD:
      1. Money supply
      2. Spending and taxation
    4. Key concept: lags. Some effects happen quickly, others take more time to unfold.
      1. Recognition lag. When events happen, it takes time for the government to find out what happened.
      2. Decision lag. Once the government finds out what has happened, it takes time to decide what, if anything, to do differently.
      3. Transmission lag. Once the Fed decides to do something differently, this decision affects some aspects of the economy quickly, others more slowly.
    5. Due to lags, policies may in principle be helpful, but in practice still unworkable. You may wind up responding to problems that will have solved themselves by the time your policies take effect.
  3. Monetary Policy, Interest Rates, Demand, and Output
    1. In the U.S., monetary policy is controlled by the Fed. The Fed uses considerable resources to gather information on economic developments and decide what to do. But these still take time.
    2. For some aspects of the economy, the transmission lags are extremely short: Nominal (and real) interest rates fall as soon as people find out that the money supply will increase. This can even occur before the money supply increases, since people are speculating about future developments.
      1. This is why statements by the Fed - the U.S. government bureau that controls the money supply - immediately affect interest rates, and thus financial markets.
    3. It takes longer for increases in the money supply to actually increase AD. Usually about 1 year.
    4. It then takes 2-3 years for the short-run AS curve to shift back to the long-run AS curve.
    5. In the long-run, then, the Classical view of the effect of money creation still holds. But there are some surprising short-run effects that must also be noted.
  4. Fiscal Policy, Interest Rates, Demand, and Output
    1. In the U.S., fiscal policy (spending and taxation) is controlled by Congress and the President. As a rule, these decision-makers spend relatively little effort to gather objective information on economic developments, and take a long time to decide what to do.
    2. As with monetary policy, changes in fiscal policy quickly affect interest rates. As soon as speculators learn more about how much the government will borrow, interest rates respond in the market for loanable funds.
    3. In a Keynesian world, will fiscal policy affect AD? As in a Classical world, it is hard to see why it would. If the money supply does not increase, then spending must be paid for with taxes, and borrowing, both of which reduce private demand.
    4. But increases in government spending do change the composition of output. This too happens with a lag.
  5. Interest-Rate Targeting and Fiscal-Monetary Interaction
    1. If fiscal policy doesn't matter for AD, why do so many think it does?
    2. Simple answer:
      1. Many central banks vary money supply growth to "target" a given nominal interest rate.
      2. Increases in government borrowing tend to raise interest rates.
      3. To prevent interest rates from rising above the targeted rate, the central bank has to increase the growth rate of the money supply.
    3. In other words, fiscal policy seems to increase AD because given interest-rate targeting, fiscal and monetary policy move in the same direction.
    4. Application: The U.S. experience in WWII. The Fed pegged U.S. interest rates at 1.0% nominal. The U.S. government engages in massive deficit spending to pay for the war. What happens to money supply growth (as always, "money"="base money"):


Money Supply

Growth (Jan-Jan)













Wars years in italics.