ECO2013 Fall 03 Cobbe Chapter 18Page 1 of 18<When you have completed your study of this chapter, you will be able toC H A P T E R C H E C K L I S TDiscuss whether fiscal policy or monetary policy is the better stabilization tool.1Explain the rules-versus-discretion debate and compare Keynesian and monetarist policy rules.2Assess whether policy should target the price level rather than real GDP.318.1 FISCAL VERSUS MONETARY POLICY<Policy EffectsThe Effects of Monetary PolicyThe two steps in the transmission of monetary policy are:Step 1A change in the money supply influences the interest rate.Step 2A change in the interest rate influences investment and other interest-sensitive components of aggregate expenditure.Step 3A change in the interest rate influences short-term international capital flows and thus the exchange rate of the dollar, and therefore exports and imports.
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ECO2013 Fall 03 Cobbe Chapter 18Page 2 of 1818.1 FISCAL VERSUS MONETARY POLICYStep 1Whether a given increase in the money supply decreases the interest rate by a lot or a little depends on the sensitivity of the demand for money to the interest rate.Step 2Whether a given decrease in the interest rate increases aggregate expenditure by a lot or a little depends on the sensitivity of investment and other components of aggregate expenditure to the interest rate.Step 3 Whether a given decrease in the interest rate reduces the exchange rate by a lot or a little depends on the sensitivity of the exchange rate to the interest rate; and whether this increases net exports by a little or a lot depends on the sensitivity of exports and imports to changes in the exchange rate. These ‘sensitivities’ are empirical questions that are hotly disputed. 18.1 FISCAL VERSUS MONETARY POLICYIn this figure, when the money supply increases from $1 trillion to $1.2 trillion, the interest rate falls from 6 percent to 4 percent a year and investment increases from $2 trillion to $4 trillion.18.1 FISCAL VERSUS MONETARY POLICYHere, the same change in the money supply lowers the interest rate from 6 percent to 5 percent a year and increases investment from $2 trillion to $2.25 trillion.Monetary policy is less powerful here than in the previous case.