In this section, I want to introduce four possibilities for the effectiveness of policy instruments in helping to reach a target for the unemployment rate. In the classical model, neither instrument is effective. In the crude Keynesian model, deficit spending is effective, but changes in the Fed Funds rate are not. In the textbook AS-AD model, both instruments are effective. In the crude monetarist model, changes in the Fed Funds rate are effective, but changes deficit spending is not. We can summarize this in a table.
| Model | Fed Funds Rate Effective? | Deficit Spending Effective? | |
|---|---|---|---|
| Classical | No | No | |
| Crude Keynesian | No | Yes | |
| Textbook AS-AD | Yes | Yes | |
| Crude Monetarist | Yes | No |
…First, a purely classical theory would say that employment is determined by productivity and workers’ preferences for labor and leisure… There is nothing left for macroeconomic policy to do, other than determine the price level…
In the crude Keynesian model, the budget deficit affects real output, because a larger deficit raises the interest rate, which increases the velocity of money…However, the Fed Funds rate has no effect on output. A decline in the Fed Funds rate raises the money supply, but this leads to an offsetting decline in the velocity of money…
In the textbook model, both instruments affect real GDP. As in the crude Keynesian model, a larger budget deficit raises the interest rate and increases the velocity of money. However, unlike in the crude Keynesian model, in the textbook AS-AD model when the Fed Funds rate goes down and consequently the money supply increases, there is not an offsetting decline in the velocity of money…
Finally, we have a variation on textbook AS-AD called the crude monetarist model…Monetary policy is powerful, because with velocity fixed, aggregate demand depends entirely on the money supply. Since the Fed can raise the money supply by lowering the Fed funds rate, and conversely, the Fed controls aggregate demand. However, with velocity fixed, there is nothing that fiscal policy can affect. An increase in interest rates does not increase velocity. Instead, it leads to reduced investment spending by businesses, offsetting the increased spending by consumers and government. Such an offset is called “crowding out.”
Very helpful. Thanks.
Very nice!
I think the classical view you describe deserves much more attention. More pointedly, it is dividing out two classes of unemployed people: those that are temporarily unemployed, and those that fit the classical view you describe. There are many facets to that perspective, not the least that many people in the long-term unemployed have low productivity.
In the last paragraph, I believe you meant to strike “and conversely”.
“There is nothing left for macroeconomic policy to do, other than determine the price level…”
There is nothing macroeconomic involved, other than policies to influence prices.
Does the “velocity of money” concept require a macro space for the movement?
Final para: “. . . it leads to reduced investment spending by businesses,”
Does this not depend on the “value” of capital, its capacity to improve or innovate production or distribution?
Uh, lots of stuff wrong with this table. First there are implicit monetary policy and fiscal rules. Second, it omits the dominate paradigm of the great moderation: neo-keynesianism. Third, several of these answers depend on what the unemployment target is. If the target is the natural rate of unemployment, and you pose the question in terms of volatility, your answers will change.
That’s a more serious discussion since we concluded thirty years ago that monetary and fiscal policy could not target real variables. That point is true for all of those models.