Question

i)Explain why monetarists would argue that control of inflation is the most effective
method of achieving growth in the economy.
ii)Mention four reasons why a government may have difficulty in implementing
discretionary stabilisation successfully.

Answer 1

Answer i)

Monetarists are those economists who give emphasis on the argument that the money supply (physical currency, deposits and credit), is the fundamental factor affecting demand and price levels in an economy. Consequently, the economy's growth or contraction, can be regulated by changes in the money supply over a period of time. Some of the famous monetarists are Milton Friedman, Marshall and Pigou, Fisher etc.

The purchasing power of money, depends on the price level which in turn determines the general inflation level. The monetarists always argued that quantity of money or supply of money is prime cause of fluctuations in the price levels. This theory was first put forward by Irving Fisher, who was a monetarist.

Quantity Theory of Money (Fishers) says that level of prices varies directly with quantity of money / supply of money in economy.

1. Money only Matters - This is the fundamental principle of monetarism, which says that aggregate demand is influenced by changes in money supply. Changes in money supply lead to changes in GNP/ Nominal Income. Therefore Monetarists were of view that controlling the supply of money directly influences inflation and that by overcoming inflation with the supply of money, interest rates can be controlled in the future.

2. Emphasis on Money Supply - Monetarists stresses the importance of controlling the money supply to keep inflation low. They place emphasis on reducing inflation than keeping unemployment low.

3. Demand Pull Inflation The monetarists emphasize the role of money as the principal cause of demand-pull inflation. They contend that inflation is always a monetary phenomenon that arises from a more rapid expansion in the quantity of money than in total output. The monetarists employ the familiar identity of Fisher’s Equation of Exchange. Arithmetically, MV= PQ

Where M is the money supply, V is the velocity of money, P is the price level, and Q is the level of real output.

To sum up, Monetarists argued that if the Money Supply rises faster than the rate of growth of national income, then there will be inflation.. Therefore money supply is prime cause of inflation. To control the rate of inflation, rise in money supply rate must be kept below the rate of growth of National Income. In that scenario there will be no inflation and growth rate of economy will be higher than the money supply rate.

Answer ii)

Before answering the question, it is important to understand the concept of "Stabilization". The term Stabilization means a policy adopted by a government or its central bank which is aimed at maintaining a healthy level of economic growth and minimal price changes. Thus, stabilization is the result of the use of direct and indirect controls to maintain and stabilize the economy by the government.

The discretionary Stabilizers are actions taken in response to changes observed in the economy. These acts do not follow a strict set of rules; instead, they use subjective judgmental approach to treat each economic situation in a unique manner. For example, Discretionary fiscal policy represents changes in government spending and taxation. Examples include increases in public expenditure on roads, bridges, stadiums, and other public works. They come into effect when the government passes new laws that change tax or spending levels.

The 4 reasons why a government may have difficulty in implementing discretionary stabilization (Discretionary Fiscal Policy as well as Monetary Policies) successfully can be discussed as under

1. Non - Alignment between Monetary and Fiscal Policies -

An expansionary fiscal policy, with tax cuts or spending increases, is intended to increase aggregate demand. If an expansionary fiscal policy also causes higher interest rates, then firms and households are discouraged from borrowing and spending (as occurs with tight monetary policy), thus reducing aggregate demand.

Even if the direct effect of expansionary fiscal policy on increasing demand is not totally offset by lower aggregate demand from higher interest rates, fiscal policy can end up less powerful than was originally expected. We refer to this as crowding out, where government borrowing and spending results in higher interest rates, which reduces business investment and household consumption.

Therefore, government must coordinate fiscal and monetary policy. If expansionary fiscal policy is to work well, then the central bank can also reduce or keep short-term interest rates low. Conversely, monetary policy can also help to ensure that contractionary fiscal policy does not lead to a recession.

2. Long and Variable Time Lags

The government can change monetary policy several times each year, but it takes much longer to enact fiscal policy. In a slowdown, it often takes some months before the economic statistics signal clearly that a downturn has started, and a few months more to confirm that it is truly a recession and not just a one- or two-month blip. Economists often call the time it takes to determine that a recession has occurred the recognition lag.

After this lag, policymakers become aware of the problem and propose fiscal policy bills. The bills go into various congressional committees for hearings, negotiations, votes, and then, if passed, eventually for the president’s signature. Many fiscal policy bills about spending or taxes propose changes that would start in the next budget year or would be phased in gradually over time. Economists often refer to the time it takes to pass a bill as the legislative lag.

Finally, once the government passes the bill it takes some time to disperse the funds to the appropriate agencies to implement the programs. Economists call the time it takes to start the projects the implementation lag.

3. Structural Economic Change Takes Time

When an economy recovers from a recession, it does not usually revert to its exact earlier shape. Instead, the economy’s internal structure evolves and changes and this process can take time. Many of the people who lost work from the various sectors in recession will never return to the same jobs in the same sectors of the economy. Instead, the economy will need to grow in new and different directions. Discretionary policy can increase overall demand, but the process of structural economic change—the expansion of a new set of industries and the movement of workers to those industries—inevitably takes time.

4. Political Realties -

A final problem for discretionary policy arises out of the difficulties of explaining to politicians how counter cyclical policy that runs against the tide of the business cycle should work. Countercyclical policy says that when the economy has slowed, it is time for the government to stimulate the economy, raising spending, and cutting taxes. This offsets the drop in the economy in the other sectors. Conversely, when economic times are good and tax revenues are rolling in, politicians often feel that it is time for tax cuts and new spending. However, countercyclical policy says that this economic boom should be an appropriate time for keeping taxes high and restraining spending.