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The Mix of Monetary and Fiscal Policies: Conventional Wisdom Vs

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The Mix of Monetary and Fiscal Policies: Conventional Wisdom Vs The Mix of Monetary and Fiscal Policies: Conventional Wisdom Vs. Empirical Reality KEITH M. CARLSON I, HE current economic situation of high interest stance in the coming years. By contrast, the budget rates, high unemployment and large federal deficits measures enacted last summer will provide consider- has prompted a call for a change in the mix of stabiliza- able stimulus to economic activity over the next few years. This suggests the possibility of a clash between tion policies. The current mnix seems to be one of “easy” monetar and fiscal policy unless the Congress emmacts fiscal policy and “tight” monetary policy. Many further spending cuts and tax increases to reduce analysts feel the mix should be shifted toward “tighter” federal borrowing or the Federal Reserve adopts a less fiscal policy and “easier” monetary policy, ostensibly restrictive monetary policy. If the clash materializes, it for purposes of putting the economy on the path to will he reflected in high real interest rates that crowd out private investment.‘~ recovery. The notion of policy mix is well-known and has been Jamnes Toiin, for example, recently stated that: a part ofthe macroeconomics literature for a nummber of the mix of policies is unhealthy. To achieve a solid years, hut seldom has it generated controversy as it has recovery, such as the administration projects, and to now. Despite its recognition, however, little is known achieye it withommt astronomical interest rates and se- rious crowding out, we need an easier monetary policy about the exact terms of the mnix or what indicators of comhined with a tighter fiscal policy.’ monetary and fiscal policy are most appropriate to umse in defining it. For example, neither Tobin, the Brook- Economists at the Brookings Institution have ex- ings econoniists, nor the Congressional Budget Office pressed a similar view: state by how much fiscal policy should be tightened Beyond 1982, the key to an improved economicsitu- and to what extent monetary policy should be eased. ation must lie in a realigmument of economic policy— a shift in the mix of fiscal and monetary policy, by The gravity of the current economic situation re- matching reductions of future budget deficits with quires that the notion of policy mix” ie given a more an easier monetary policy. As presently constituted, precise interpretation. Is cmmrrentpolicy what it seems? fiscal and monetary policies appear to he on a collision How does one measure the ease and tightness of course 2 monetary and fiscal policies? What measures of eco- The Congressional Budget Office talks of the clash nomic performance are relevant to the mix argu- between mnonetary and fiscal policy: ment—interest rates, GNP, the ratio of investment to CNP? What horizon is pertinent—short-run, long- Statements from the Federal Reserve suggest that monetary policy will continue its anti-inflationary run, a specific number ofyears? Can policies really be traded off to achieve a specific economic objective? These are the types of questions that are given short ‘James Tohin, “The wrong Mix lbr Recovery,” Challenge (May-’ shrift when the mix of policies is discussed. June 1982), p. 25, tm Joseph A, Pechmanand Barry P. I3oswomth, “The Budget and the 3 Economy,” in Joseph A. Pechmnan, ed,, Setting Nationa/ Priorities: Congressional Budget Office. The Prospects for Economic Recor- The 1983 Budget (The Brookings Institution, 1982), p. 43’ cry (US’ Government Printing Office, 1982), p. 27. 7 FEDERAL RESERVE BANK OF ST. LOUIS OCTOBER 1982 The purpose of this article is to provide some spec- Labeling momuetary’ policy as easy’ or tight is, of ificity to the policy mix question. As a point of de- course, quite arbitrary. The procedure followed here is parture, some indicators of monetary’ and fiscal policy to examimue the historical record of Ml and develop a are examined, amud a historical classification of policy classification of relatively easy and relatively tight mix is developed. A conventional macroeconomic policy on the basis of this record. To make this classifi- treatment of polic~’mix is then presented, providing cation mneaningfml, one mimst accoumut fUr changes in the the basis for developmnent of testable hypotheses. trend ofmonetary growth, particularly ifone intends to These hypotheses are tested, and somne policy implica- ficus on the imnpact of monetary’ policy’ on real vari- tiomus are derived. ables. Consumers and investors come to expect certaimu groxvth rates of the mnonetarv aggregates, basing such expectations on past experience. It is the deviation of DEFIPS INC EASE AND TIGHTNESS 2 the monetary aggregate around this expected growth OF i. OLICY rate that a,ffeets real economic activity. Many sumnnsary measures of nionetary and fiscal Table 1 summarizes monetary policy since 1956. policy have been developed over the years. The mnaimi The first column shows the four-quarter rate ofchange reason fUr seeking such a measure is toprovide a quick of Nil minus its trend (20-quarter rate of change) fUr interpretation of current policy stamuce. The criteria for the period ending in the fourth quarter of each year selection are that the nieasure primnarily reflect move- (except for 1982).’ The second column, which classifies ments in the instruments of policy’ andl that it not he monetary policy as easy, tight or neutral, follows from a influenced greatly by the pace of economic activity.4 In three-part division of the observations in the first col- other words, the indicator should reflect the thrust of umn. The mean plus or minus ½standard deviation the policy on the economy rather than the reverse. serve as points of demarcation. The classification is relative and also approximate. Rigidly adhering to the four-quarter rate of change can mnask changes in policy )%:Icasurcmcnt oj 1~Uo~.atiu’u ,~i.trans that occur within the year. A more exhaustive study Measuring the stance of monetary policy revives would not be tied to periods of fixed length. Nonethe- many controversial issues, one of the oldest of which less, the classification seems to accord with commnon centers on the choice between interest rates and interpretation of economicexperience; for example, all monetary aggregates Although the level of interest of the observations labeled as “tight” occurred near rates is often alluded to as an indicator of monetary recession periods. policy, most analysts have fhund it tohe unreliable as a ~1Jf1/ u;-’en.i.eri.t at Fiscal ,~‘1cn•an,s policy measure, since a great mnany forces influmenee interest rates besides mnonetary actions. The monetary The measurement of fiscal actions, also has beemu ag,gregates, on the other hand, tend to reflect more researched extensively over the years.5 The chiefcon- accurately changes in the policy imustrnments—open clusion from this research is that recorded surpluses or market operations, reserve requiremnents and the dis- deficits do not provide an accurate measure of fiscal count rate—without being influenced undumly by out- actions. The reason is that a considerable amotmnt ofthe side forces.’ movement of receipts and expenditures reflects an Chief among the candidates for a monetary policy automatic response to the pace of economic activity indicator are the money stock (Ml) and the monetary rather than policy actions, Consequently, only fiscal measures on a high-emuployment basis are con- base. The mnonetary base has appeal because it reflects sidered.9 These high-employment budget measures more accurately changes in the instrumnents of policy than does Ml. The Ml measure, however, tends to be 7 more closely related to CNP.6 Justiflcation for a 20-quarter rate of change as a measure oftrend is found in Denis S. Karnosky. “The Link Between Money and Prices,” this Review (June 1976), pp. 17—23. See also Keith M. 4 See, for example, Albert E. Burger, “The Implementation Prob- Carlsom,, “The Lag from Money to Prices,” this Review (October lem of Monetary Policy,” this Review (Nlarch 1971), pp. 20—30, 1980), pp. 3—10. 5 5 ‘ See R. w. Hafer, “selecting a Monetary Indicator: A Test of the Alan S. Blinder and Robert M. Solow, “Analytical Foundations of New Momietary Aggregates,” this Review (Fehruary 1981), pp. Fiscal Policy,” in Alan S. Blinder and Robert M. Solow, eds., The 12—18. Economics ofPublic Finance (The Brookings Institution, 1974), pp. 3—115. °Forreferences to the literature, along with a contrasting inter- pretation, see William E. Cullison, “Money, the Monetary Base, °Frauk de Leeuw and Thomas M. Holloway, “The High- and Nominal GNP,” Federal Reserve Bank ofRichmond Economic Employment Bmmdget: Revised Estimates and Automatic Inflation Review (May/June 1982), pp. 3—13, Effects,” Survey of Current Business (April 1982), pp. 21—33. 8 FEDERAL RESERVE BANK OF ST LOUIS OCTOBER 1982 Table I Classification of Ease and Tightness of Monetary and Fiscal Policy Monetary 1 Measure Fiscal Measure EF~ En E Ml ~ Ml 4 20 A’~ 2 Year Value Class Value Class Value Class Value Class 1958 119 T 584 E 215 N 0.52 T 1957 1.67 T GSa E 463 E 069 E 1958 149 5 1012 5 1005 E 173 5 1959 033 N 671 T 948 T 172 T 1960 039 T 289 P 547 T 107 1 198 119 5 288 N 634 5 1.02 5 1962 030 N 1.75 N 202 N 032 N 1963 175 122 T 151 N 0.33 N 1964 171 582T 196 P4 038 N 1985 091 N 435 5 834 1.48 5 1966 069 1 846 5 201 N 0,48 N 1967 188 5 249 N 346 5 079 5 1968 231 008 N 7S9 1 131 1 1968 tUB T 633 1 5,69 T 14 T 1970 016 N 198 1 659 5 13 5 1971 087 N 1.28 T 129 N 029 N 1972 226 E 683 E 534 515 1973 01 N 273 T 760 1 35 T 1974 135 ‘1’ 632 5 343 T 058 T 1975 116 T 293 N 819 16 5 1976 06 N 402 T 209 N 030 N 1977 221 5 022 N 162 N 045 N 1978 177 5 158 T 482 1 081 1 979 041 N 088 N02N 00 N 1980 014 N 556 506N00 N 981 220 T 031 N 124 N 033 N 198 211 1 314 1 482 5 —10 Mean 0 127 047 01 Mean zu 04 106 34 06 Mean 092 354 220 038 Easy N Neutal T Tigh For definitions of variables see te Ease is associated with relatively large positive v uese cept for the ight hand pair of fiscal measures For these measu e ease is associated Wi h relatively large negative values Al alues are or year endin fourth quarte emtcept for 1982 which is for year ending second quarter can h’ ~s nhled i diffe ent say houes.er.
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