[MUSIC] Now, there is at least one more important point to note about using open operations, to close recessionary and inflationary gaps. From a purely mechanistic Keynesian point of view, Monetary Policy Is conducted with Less Precision Than Fiscal Policy. To see this, recall from our lesson on the Keynesian multiplier model, that if we knew the size of a recessionary gap, and the value of the multiplier, we could calculate exactly how much we would have to increase government expenditures, or cut taxes, to close the gap. In the case of monetary policy, however, it is a bit more of a guessing game. Because the link between the money supply, and shifts in the Aggregate Expenditure curve, is much more complex. Relying on changes in the interest rate, and the responsive investment, consumption and net exports. This observation leads us to the major paradox of the Keynesian-Monetarist Debate. Namely, that it is the Keynesian economist, not the Monetarist, who support and activist role for monetary policy, in fighting recessions and inflation. In defining an activist role for monetary policy, Keynesians believe that monetary policy is most effective as a fine tuning policy instrument, when the economy is near full employment. Either in a mild recession, or in a mild inflation. In this narrow band of output. Keynesians believe that investment in aggregate expenditures will respond relatively swiftly to changes in the interest rate which are brought about by changes in the money supply. This is particularly true when there is an inflationary gap in the economy. In such a case, Keynesians see the use of contractionary monetary policy as pulling on a string. However, Keynesians also believe, that in a severe recession, or depression, monetary policy is largely ineffective, equivalent to, pushing on a string. That is, in a sever economic downturn, Keynesians believe, that an increase in the money supply may well lead to a reduction in interest rates. However, these lower rates will have little or no success, in encouraging additional investment, and shifting the aggregate expenditures curve upward. Thus in the recessionary and depressionary ranges, Keynesians believe, that expansionary fiscal policy is much more appropriate. In contrast, the Monetarist School doesn't believe in an activist fiscal and monetary policy at all. According to the father of Monetarism, Milton Friedman, the problems of both inflation and recession may be traced to one thing, the rate of growth of the money supply. Inflation happens when the government prints too much money, and recession happens when it prints too little. In fact, Milton Friedman totally rejects the Keynesian view of the origins of the Great Depression, as well as the Keynesian fiscal policy cure. Instead, Friedman blames the nation's economic collapse in 1929 on bad monetary policy by the Federal Reserve rather than any inherent Keynesian instability with the system. As Friedman has argued, the Federal Reserve contracted the money supply, plunging a private economy that would otherwise have been pretty stable into a depression. And in fact, there is much truth in Friedman's argument. In the wake of numerous bank failures immediately preceding and then following the 1929 stock market crash, people began hoarding cash, rather than leaving it in banks. The same time, the banks themselves dramatically increase their reserves in case nervous depositors triggered a bank run. This fall in demand deposits coupled with an increase in the banks own self imposed reserved requirements led to a sharp contraction of the money supply. And Friedman faults the Federal Reserve for not stepping in to the monetary policy breach to stabilize the situation. Moreover to Friedman, if the Fed had acted promptly and injected enough currency to stabilize the money supply, an activist fiscal policy, as embodied in Franklin Roosevelt's New Deal, would never have been necessary. More broadly, monetarists like Friedman liken the Federal Reserve to a bad driver, constantly either accelerating too fast or braking to hard on the money supply. This analogy describes quite well the behavior of the Federal Reserve during the 1970s, as it tried to cope alternatively with the recession and inflation and then both at the same time. As the Keynesian successes in the 1960s, gave way to a soaring inflation in the early 1970s, the Federal Reserve stomped on the monetary brakes, and watched as interest rates climbed dramatically. Predictably, investment slowed and the economy plunged into a recession until 1975. The government stomped back on the accelerator using a Keynesian-style tax cut to stimulate the economy. To accommodate this tax cut, the Federal Reserve reluctantly increased the money supply, and then stood by as a new and ugly macroeconomic phenomenon called stagflation, simultaneous high unemployment and high inflation, began to tighten its deadly grip on the nation. This video provides a simple example of stagflation brought about by cost push inflation, here we started full employment output Y star however a supply shot shifts the aggregate supply curve back to AS prime this leads to a recessionary depth of Y star minus Y sub r But note also that the price level has also risen from P star to P sub R. In other words, we've got both recession and inflation. Prior to the 1970s, economists didn't believe you could even have both high inflation and high unemployment at the same time. One went up, the other had to go down. But the nineteen seventies proved economists wrong on this point, and likewise exposed Keynesian economics as being incapable of solving the new stagflation problem. Now, you see the Keynesian dilemma. Put another way, how would you use Keynesian fiscal policy to fight Stagflation? The Keynesian dilemma was simply this. Using expansionary policies to reduce unemployment, simply created more inflation. While using contractionary policies to curb inflation only deepened the recession. That meant that the traditional Keynesian tools could solve only half of the stagflation problem, at any one time, and only by making the other half worse. It was this inability of Keynesian economics to cope with stagflation that set the stage for professor Milton Friedman's monetarist challenge to what had become the Keynesian orthodoxy. To fight stagflation and to, more broadly, prevent the roller coaster ride of economic booms and busts, the Monetarist solution is to set monetary targets and stick with them. For example, if we want economic growth to proceed at an annual rate of 3%, then we should simply increase the money supply by 3%. This monetary targets approach was precisely the policy prescription embraced by the Fed in 1979, after almost a decade of fruitless battling against inflation. In October of that year, federal reserve chairman Paul Volcker, announced that the Fed would no longer focus on holding interest rates stable. Instead, it would simply adopt monetary growth targets, and stick by them. Unfortunately, the Fed's Monetarist cure proved to be almost as bad as the stagflation disease. Interest rates soared to above 20%. Inflation remained in the double digits. And the economy entered into the beginning of a severe 3 year recession. While chairman Volcker stuck to his monetarist guns and watched as both tight money and a deep recession, eventually helped wring inflation out of the economy, the cost in human terms was high. Finally, in the summer of 1982 the Fed relaxed its monetarist rules and by late fall, the recession had ended, just in time to try the latest evolution in economic theory supply side economics. [MUSIC]
