In this article we will discuss about Monetarists and Keynesians view on monetary and fiscal policy.
The Monetarist View on Monetary and Fiscal Policy:
The monetarists hold that changes in the money supply have a direct influence on aggregate expenditure and thus on income. Let us analyse an expansionary monetary policy followed by monetarists. To begin, suppose the central bank purchased securities in the open market.
It raises the price of securities and lowers the rate of interest. People will, therefore, start selling securities and hold more money. People spend their excess money balances on financial assets and durable consumer goods. Others attracted by low interest rates borrow from banks for expenditure on houses, durable consumer goods, plants and equipment’s, etc. These forces tend to increase aggregate expenditure and income.
This is illustrated in Fig. 3. MD is the demand for money curve and M the money supply curve. Both the curves are interest inelastic. Initially both are in equilibrium at OR interest rate. The increase in money supply to Ms1 reduces the interest rate from OR to OR1. The demand for money being relatively insensitive to the interest rate, it increases from OQ to OQ. But the aggregate expenditure is very sensitive to this fall in interest rate so that it increases from OE to OE1 in Panel (B) of the figure where EC represents the expenditure curve.
Thus an expansionary monetary policy is highly successful in increasing aggregate expenditure and income. Now consider the fiscal policy in Fig. 4 (A) and (B). An increase in aggregate expenditure leads to expansion in the economy which shifts the expenditure curve upward from EC to EC, in Panel (B) of the figure. As aggregate expenditure increases from OE to OE, national income also rises.
This leads to greater demand for money for transactions purposes. In order to meet this increased demand for money, households and firms sell securities which they have and also borrow from banks and other financial institutions. These tendencies have the effect of raising the interest rate. As the demand for money is relatively insensitive to interest rate changes, a very high rate of interest is required to equate the supply of money to the demand for money.
This is shown in Panel (A) of Fig. 4 where the increased demand for money is shown by the MD, curve and the rise in the interest rate by RR1 .But such a large increase in interest rate has the effect of reducing private expenditure from OE1 to OE, so the net effect on aggregate expenditure of an expansionary fiscal policy is only EE2.
Thus according to the monetarists, an increase in government expenditure as a result of an expansionary fiscal policy leads to an increase in government expenditure and income which leads to a large rise in the rate of interest that, in turn, reduces private expenditure almost equal to the increase in government expenditure.
The Keynesian View on Monetary and Fiscal Policy:
In contrast to the monetarists, the Keynesians regard monetary policy relatively less effective because of the relative interest inelasticity of aggregate expenditure. To illustrate, consider an expansionary monetary policy.
Suppose the central bank purchases securities in the open market. As a result, the price of securities rises and the interest rate falls. People will, therefore, start selling securities in order to hold more money. As the demand for money is highly interest elastic in the Keynesian system, even a small fall in the rate of interest will induce people to sell securities and hold more money.
This is illustrated in Fig. 5. Panel (A) of the figure shows that in the initial situation, OR is the interest rate and OQ the money demanded and supplied. Now the money supply increases due to the central bank’s action. This is shown by the Ms1 curve. When the money supply rises to OQ, the interest rate falls from OR to OR1. This small fall in the interest rate by RR1increases aggregate expenditure by only EE1 as shown in Panel (B) of the figure. Thus an expansionary policy is not successful in raising aggregate expenditure and income much.
Though monetary policy is relatively less effective under the Keynesian system, fiscal policy is relatively more effective. Consider Fig. 6. An increase in aggregate expenditure for raising national income leads to expansion in the economy. This shifts the expenditure curve EC upward to EC, in Panel (B) of the figure. As aggregate expenditure increases from OE to OE1, national income rises. This leads to greater demand for money by the people for transactions purposes. To meet this increased demand for money, householders and firms sell securities they possess, and also borrow funds from the banks and other financial institutions.
These moves tend to raise the rate of interest. Higher interest rates and the demand for more loans induce commercial banks to reduce their excess reserves, thereby increasing the supply of money from OQ to OQ1 in Panel (A) of the figure. Further, high interest rates induce bond holders to reduce the amount of money held for speculative purposes because high interest rates mean fall in the price of bonds. As the demand for money is highly interest elastic only a small rise in the interest rate from OR to OR1 is required to equate the money supply curve Ms with the new money demand curve MD1 at E1, in Panel (A) of Fig. 6. But this small increase in interest rate by RR1, has a very small effect in reducing private expenditure from OE1 to OE2, as shown in Panel (B) of the figure.
This is because aggregate expenditure is relatively – interest inelastic in the Keynesian system. Thus the effect of an expansionary fiscal policy is that there is a net increase in aggregate expenditure by EE2 and only a small amount of private expenditure is reduced by E1E2 due to a rise in the rate of interest by RR1. Thus the Keynesians regard fiscal policy more effective than monetary policy.
The above analysis about monetarism and Keynesianism reveals that both hold almost the opposite views. The monetarists argue that only money matters, and that economic recessions and expansions are caused by decreases and increases of the money supply. They, therefore, advocate control of the money supply to stabilise cyclical fluctuations.
They emphasise that the growth rate of money is the principal determinant of the behaviour of national income. This view is based on a number of historical studies carried out by Friedman and Schwartz, Friedman and Meiselman, and Anderson and Jordan of the Federal Reserve Bank of St. Louis. These studies reveal that there is a very close relation between money supply and national income than between national income and any of the Keynesian variables like aggregate expenditure.
Though the monetarists have tried to enforce their position on the basis of empirical studies yet they are themselves skeptical about the success of monetary policy in contrast to fiscal policy. They agree that as economic stabilizer, monetary policy may do more harm than good because of the operation lag.
The operation lag refers to the time elapsing between the taking of action and the effective impact of that action on the economic situation. On an average, it takes a long time for a change in the money supply to affect national income, so the operation lag is long. Friedman himself admits that the time lag involved is so large that contra-cyclical monetary policy might actually have a destabilising effect on the economy.
The monetarists, therefore, hold that the economy is basically stable and when disturbed by some change in basic conditions, will quickly revert to its long-run growth path. That is why, they advocate an annual fixed percentage growth in the money supply and an end to discretion in monetary policy. Friedman, therefore, believes that fiscal policy does not have any potent influence on the economy except that it affects the behaviour of money.
On the other hand, the Keynesians are not diehards like the monetarists. They take a more realistic view of monetary and fiscal policy in contrast to the latter. They do not regard the two as competitive but complementary to each other. They do not deny that money does matter, for they believe that monetary policy does influence national income but via changes in the interest rate.
But they find monetary policy ineffective in controlling severe depressions and therefore depend upon fiscal policy for this. On the other hand, they combine monetary policy with fiscal policy for controlling booms and inflations.
In this connection, the views of Walter Heller merit consideration: “The ‘new economies’… assigns an important role to both fiscal and monetary policy. Indeed, the appropriate mix of policies has been the cornerstone of the argument… To anyone who fears that the ‘new economics’ is all fiscal policy, the record offers evidence, and the new economics assurance, that money does matter.”
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