Money, Banking, and Monetary Policy ❮ 155FISCAL MONETARY KEEP
THE POLICY BUDGET POTENTIAL POLICY AN EYE
PROBLEM: SOLUTION IMPACT CONSEQUENCE COMPLEMENT ON...
Deep Tax cuts and Large Higher interest Expand MS to Higher
recessionary increased Deficit rates, crowding keep interest Inflation
gap and high spending to out private rates from
unemployment rapidly investment, lower rising. Increases
increase AD net exports, and AD to assist
even weaker AD fiscal policy
Mild Tax cuts or Moderate Rising prices, Contract MS to Rising
recessionary increased Deficit mild crowding keep inflation Interest
gap and spending to out, lower from rising. Rates
moderate gradually net exports, Decreases AD,
unemployment increase AD weakening AD offsetting fiscal
and real GDP policy
Inflationary Tax hikes Surplus Lower interest Contract MS Higher
gap and/or rates “crowding to keep Unem-
decreased in” private interest rates ployment
spending to investment, from falling.
rapidly decrease higher net Decreases AD
AD and real exports, and even to assist fiscal
GDP stronger AD policyTIP
• In a deep recessionary gap, expansionary monetary policy could be used to assist expan-
sionary fiscal policy to quickly move to full employment. The risk then becomes a burst
of inflation.
• In a mild recessionary gap, contractionary monetary policy could be used to offset
expansionary fiscal policy to gradually move to full employment. The risk then becomes
rising interest rates.
• In an inflationary gap, contractionary monetary policy could be used to assist contrac-
tionary fiscal policy to put downward pressure on the price level. The risk then becomes
a rising unemployment rate.Are There Critics of Monetary Policy?
Some economists disagree with the effectiveness of monetary policy, particularly the expan-
sionary policies that are designed to eliminate a recessionary gap. One group of economists,
which has come to be known as the “monetarists,” argues against active open market
purchases of Treasury securities on the grounds that such expansions of the money supply
will not create more economic growth in the long run and will only create inflation. How
would this happen?
Figure 11.9 shows an economy with a mild recessionary gap as real GDP (GDPr) falls
below full employment output (GDPf). Suppose the central bank takes aggressive action
and buys Treasury securities to expand the money supply. With a lower interest rate in
the money market, aggregate demand increases to AD 2 , increasing real GDP beyond full
employment. While the unemployment rate falls in the short run, the aggregate price levelTable 11.2