Compare and contrast the views of new classical economists and mainstream economists on the issue of policy rules versus the use of discretionary monetary and fiscal policy.

Question

What will be an ideal response?

Answer 1

Monetarists and new classical economists argue for policy rules to reduce government intervention in the economy that they believe cause macroeconomic instability. In regard to monetary policy, monetarists have proposed a monetary rule that the money supply be increased at the same annual rate as the potential annual rate of increase in the real GDP. A monetary rule would shift aggregate demand rightward to match a shift in the long-run aggregate supply curve that occurs because of economic growth, thus keeping the price level stable over time.
Monetarists and new classical economists question the value of fiscal policy and some extreme proposals have called for a required balanced federal budget over time. The reason that monetarists and new classical economists dislike fiscal policy is that it will tend to crowd-out investment and only cause a temporary increase in output. RET economists also think that fiscal policy is ineffective and that people will anticipate it and their acts will counteract its intended effects.
Mainstream economists think that discretionary fiscal and monetary policy can be effective and are opposed to a monetary rule and a balanced budget requirement. They see velocity as relatively unstable and a loose link between changes in the money supply and aggregate demand. This means that a monetary rule might produce too great a shift in aggregate demand (and demand-pull inflation) or too small a shift (and deflation) to match the shift in aggregate supply. Such a rule would contribute to price instability, not price stability. They support the use of fiscal policy during a recession or to counter growing inflation. Fiscal policy, however, should be reserved for those situations where monetary policy is relatively ineffective. They also oppose a balanced budget amendment because its effects would be procyclical and reinforce recessionary or inflationary tendencies, rather than being countercyclical. Mainstream economists also note that there has been greater stability in the macro economy since 1946 when discretionary monetary and fiscal policy was being more actively used to moderate the effects of the business cycle.