Answer to Question #127006 in Macroeconomics for Muhammad Mohsin

Question

Explain the relationship between the effectiveness of monetary policy and the interest elasticity of money demand. Will monetary policy be more or less effective the higher the interest elasticity of money demand? Now explain the relationship between fiscal policy and the interest elasticity of money demand. Why do the two relationships differ?

Answer 1

Depending on the current general economic tasks, the central bank can pursue different monetary policies.

A tight monetary policy ("expensive money" policy) involves maintaining a constant supply of money in circulation and the possibility of interest rate fluctuations. If the goal of monetary policy is to keep the mass of money in circulation at a constant level, then the money supply will be represented by a vertical line. In this case, a change in the demand for money leads to a change in the interest rate with a constant supply of money.

Flexible (soft) monetary policy ("cheap money" policy) assumes that the interest rate remains unchanged with a perfectly elastic supply of money. If the central bank pursues a monetary policy that aims to keep the rate of interest at a fixed level, then the money supply will be represented by a horizontal line. In this case, when the demand for money changes, the supply will change at a constant interest rate.

The central bank cannot simultaneously fix both the mass of money and the interest rate, so it has, as a rule, to resort to intermediate versions of soft or tight monetary policy, allowing more or less change in one of the parameters of the money market.

The choice of this or that policy depends on the goals set. If there is a recession in the economy, unemployment and the goal of the state is to expand production, then the central bank pursues a policy of "cheap" money: it increases the supply of money, which leads to their reduction in price and at the same time to a fall in the rate of interest, expansion of aggregate demand and production.

On the contrary, during inflation, the central bank pursues a policy of "expensive" money; reduces their supply, which contributes to the growth of their value, interest rates and, consequently, holding back investment and aggregate demand.

The degree to which changes in money supply affect production and employment depends on the elasticity of the demand for money and the demand for investment. The less elastic the demand for money and the more elastic the demand for investment, the greater the effect of a change in supply and vice versa.

Fiscal policy pursued by the state is based on the provision that changes in tax exemptions and the volume of government spending affect aggregate demand and, therefore, the value of GNP, employment and prices. In the short term, tax cuts and increases in government spending have an upward impact on aggregate demand, and conversely, tax increases and government spending cuts reduce aggregate demand. In the long run, fiscal policy can have a negative impact on economic growth. The peculiarity of fiscal policy is that all changes in taxes and government spending are reflected in the volume of GNP with a multiplier effect. The balanced budget multiplier is equal to one.

Changes in taxes and government spending can occur either automatically (without special legislative decisions) using built-in stabilizers that maintain economic stability on the basis of self-regulation, or as a result of targeted government decisions (discretionary policy). Depending on the objectives pursued, fiscal policy can be stimulating or restrictive. Stimulus fiscal policy is aimed at expanding aggregate demand and involves lowering taxes and increasing government spending. The consequence of this policy is the budget deficit. Restraining fiscal policy is aimed at narrowing aggregate demand, involves increasing taxes and reducing government spending, and is accompanied by a decrease in the budget deficit or the appearance of a budget surplus. Although fiscal policy is an effective tool for state regulation of a market economy, it has some drawbacks that reduce its effectiveness. Fiscal policy is effective only in the short term. Contradictions may arise between the directions of changes in taxes and government spending, carried out in order to achieve macroeconomic stability, and other goals facing society (defense, ecology, social problems).