The economy's apparently sluggish response to lower interest rates during 1991 has led some analysts to speculate that monetary policy may be less effective than in the past. These analysts argue that fiscal stimulus is necessary to combat the recent slow growth of the economy. In response, the President and Congress are debating the shape of a fiscal stimulus package.
Questions about the relative effectiveness of monetary and fiscal policy are not new. The issue was at the heart of the Monetarist-Keynesian debate of the 1960s and early 1970s. The monetarists held that monetary policy was much more important to the economy than fiscal policy, while the Keynesians argued that fiscal policy was dominant.
Evidence from this debate, however, is of limited help to today's policymakers. First, the debate was never fully resolved. Moreover, numerous changes in the U.S. economy have occurred in the last two decades.
This article revisits the monetary-fiscal policy debate. The first section reviews the dispute between the monetarists and the Keynesians. The second section discusses how the effects of monetary and fiscal policy on the economy may have changed in recent years. The final section presents evidence indicating that while monetary policy has become less effective over the years, it is still relatively more effective than fiscal policy.
THE MONETARY-FISCAL POLICY DEBATE
The debate over the relative importance of monetary and fiscal policy was originally waged by two philosophically opposed groups of economists. The monetarists believed the money supply played a central role in determining economic performance. They used evidence from their empirical studies to show that changes in the money supply had a larger effect on the economy than changes in fiscal variables. The Keynesians believed that to stabilize the economy, fiscal policy was essential. They claimed that methodological problems invalidated the conclusions of the monetarist studies.
The first empirical study that attempted to determine which of the two positions was correct was conducted by Milton Friedman and David Meiselman in 1963. They examined simple correlations between consumption and money and between consumption and fiscal variables. Friedman-Meiselman found that consumption was correlated to a much larger extent with money than with the fiscal variables. They interpreted this piece of evidence as consistent with the monetarist belief that monetary policy is more important than fiscal policy.
In 1965, Keynesians Albert Ando and Franco Modigliani argued that Friedman and Meiselman's evidence failed to show that monetary policy was more important than fiscal policy. First, Ando-Modigliani attacked Friedman-Meiselman's choice of sample periods on the grounds that the results may be sensitive to the inclusion of the World War II years. Second, Ando-Modigliani criticized Friedman-Meiselman's focus on contemporaneous relationships, reasoning that any complete study of the effectiveness of policy must account for lags in the effect of policy changes.
Ando-Modigliani's most serious criticism, however, was that Friedman-Meiselman failed to allow for feedback from the economy to the measures of monetary and fiscal policy. One example of this problem arose in the way in which Friedman-Meiselman measured their fiscal variable (called autonomous expenditures). Ando-Modigliani pointed out that the monetarists' measure of autonomous expenditures included the fiscal deficit, which moves inversely with economic activity. To see why this is a problem, suppose the government increases autonomous expenditures to increase economic activity. The increase in economic activity will reduce the deficit by generating tax revenue, thereby offsetting part of the initial rise in autonomous spending. As a result, the correlation between economic activity and autonomous spending would appear weak even if the initial increase in spending had a strong effect on output. …