Natural Output Levels: Fiscal and Monetary Policy Impact

In this essay I discuss whether the fiscal and monetary policy has impact on the natural level of output. Natural level of output, in other words potential output is a total gross domestic product (GDP) that could be produced by an economy if all its resources were fully employed. This means if the economy is at natural level of output, the unemployment rate equals the NAIRU or the “natural rate of unemployment” and other factories, such as technology and capital are kept at optimal capacity level. We can derive the natural level of output function. It is given by:

Yn=Nn=L(1-un)

where natural level of output is equal to natural level of employment and it is equal to the labor force L times 1 minus the natural rate unemployment rate un.

In addition, the natural level of output satisfies this equation:

F((1-Yn)/L,z)=1/(1+μ)

The natural level of output is such that, at the associated rate of unemployment, the real wage chosen in wage setting – the left side of equation is equal to the real wage implied by price setting – the right side of equation.

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However, it is hard to change the natural level of output as it is difficult to change the natural level of unemployment. Let’s consider why natural unemployment rate cannot be changed by government policies. Famous economists Friedman and Phelps explained that using Phillips curve. They opposed this idea on theoretical grounds, as they noted that if unemployment was to be permanently lower, some real variable in the economy, like the real wage, would have changed permanently. Why this should be the case because inflation was higher, appeared to rely on systematic irrationality in the labor market. As Friedman remarked, wage inflation would eventually catch up and leave the real wage, and unemployment, unchanged. Hence, lower unemployment could only be attained as long as wage inflation and inflation expectations lagged behind actual inflation. This was seen to be only a temporary outcome. Eventually, unemployment would return to the rate determined by real factors independent of the inflation rate. According to Friedman and Phelps, the Phillips curve was therefore vertical in the long run, and expansive demand policies would only be a cause of inflation, not a cause of permanently lower unemployment.

The policy implication is that the natural rate of unemployment cannot permanently be reduced by demand management policies (including monetary policy), but that such policies can play a role in stabilizing variations in actual unemployment. So, we should find out what exactly impact the government policies have to the country’s economy.

Firstly, we should consider monetary policy and whether it has affect to the natural level of output.

Monetary policy is the process a government, central bank, or monetary authority of a country uses to control the supply of money, availability of money, and cost of money or rate of interest to attain a set of objectives oriented towards the growth and stability of the economy. Monetary policy is referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy, and a contractionary policy decreases the total money supply. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interest rates to combat inflation. Lets look how the monetary policy is working and that is then happening to equilibrium output. Suppose that government is running the expansionary monetary policy and increase the level of nominal money from M to M’. Assume that before the change in nominal money, output is at its natural level. So now we will try to find out does the monetary policy affect the natural level of output. In the Figure 1 we see that aggregate demand and aggregate supply cross at point A, where the level of output is equals Yn, and the price level equals P.

Figure 1.

Suppose the nominal money level increase. Remember the equation Y=Y(M/P,G,T). For a given price level P, the increase in nominal money M leads to an increase in the real money stock M/P leading to an increase in output. Aggregate demand curve shifts from AD to AD’. In the short run economy’s equilibrium goes from A to A’, output increases from Yn to Y’ and prices increases from P to P’. Over time, the equilibrium changes. As output is higher than the natural level of output, the price level is higher than was expected so the wage setters revise their expectations which cause AS curve to shift up. The economy moves up along the aggregate demand curve, AD’. The adjustment process stops when output is returned to the natural level of output. In the medium run the aggregate supply curve is AS”, the economy is at point A” and the price level have rose and is equal to P”.

So the only effect achieved by monetary policy in medium run is price level rise. The proportional increase in the nominal money stock is equal to the proportional increase in prices.

So we can see that expansionary monetary policy did not affect the natural level of output. We should consider why it did not succeed.

As we know that stabilizing inflation will also stabilize output at its natural level, so it suggest assumption that monetary policy does not affect natural level of output, but only changes real level of output and returns it to the position of natural level of output.

So, in the short run, monetary policy affects the level of real output as well as its composition: an increase in money leads to a decrease in interest rates and a depreciation of the currency. Both of these lead to an increase in the demand for goods and an increase in output. In the medium run and the long run, monetary policy is neutral: changes in either the level or the rate of growth of money have no effect on output or unemployment, so it cannot affect the natural level of unemployment and the natural level of output. Changes in the level of money lead to proportional increase in prices. Changes in the rate of nominal money growth lead to corresponding changes in the inflation rate.

Secondly, we should consider the fiscal policy and whether it affects the natural level of output.

Fiscal policy is the use of government expenditure and revenue collection to influence the economy. Fiscal policy can be contrasted with the other main type of economic policy, monetary policy, which attempts to stabilize the economy by controlling interest rates and the supply of money. The two main instruments of fiscal policy are government expenditure and taxation. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy: aggregate demand and the level of economic activity; the pattern of resource allocation; the distribution of income. Lets consider the fiscal policy impact to country’s economy and natural level of output. Take an example the government is running a budget deficit and decides to reduce it by decreasing it spending from G to G’ and leave taxes T unchanged.

Assume that output is initially at the natural level of output so that the economy is at point A in figure 2 and output equals Yn.

Figure 2.

The decrease in government spending from G to G’ shifts the aggregate demand curve from AD to AD’: for a given price level, output is lower. In the short run, the equilibrium moves from A to A’: output decreases from Yn to Y’, and the price level decreases from P to P’. As we can see the deficit reduction leads to lower output. In the medium run as long as output is below the natural level of output, the aggregate supply curve keeps shifting down. The economy moves down along the aggregate demand curve AD’, until the aggregate supply curve is given by AS” and the economy reaches point A”. By then, the recession is over, and output is back at Yn.

Like an increase in nominal money, a reduction in the budget deficit does not affect output forever. Eventually, output returns to its natural level. However there is an important difference between the effect of a change in money and the effect of a change in deficit. In this case output is back to the natural level of output, but the price level and the interest rate are lower than before the shift. So we can conclude that fiscal policy cannot affect the natural level of output – it only affects the real level of output which in the medium and long run comes back to its natural level.

Thirdly, we should consider whether government has any other policy that can affect the natural level of output. We have find out neither fiscal nor monetary policy cannot affect the natural level of output by itself. However, using both of these policies together in appropriate way can cause a desirable result and a change the natural level of output. Let’s look in Figure 3, which shows the mix of monetary and fiscal policy. There are two ways to stabilize income at Y*, which is the natural level of output. First, there is expansionary or easy fiscal policy. This leads to a high IS schedule IS1. To keep income in check with such an expansionary fiscal policy, tight monetary policy is needed. Government choose a low money supply target, which is represented by LM1 schedule in the Figure 3. Equilibrium E1 is at output Y*, but has the high interest rate r1. With high government spending, private demand must be kept in check. The mix of easy fiscal policy and tight monetary policy implies government spending G is a big part of national income Y* but private spending (C + I) is a small part.

Alternatively, government interested in long-run growth may choose a tight fiscal policy and easy monetary policy. In this case target income Y* is attained with a lower interest rate r2 at the equilibrium E2. With easy monetary policy and tight fiscal policy, the share of private expenditure (C + I) is higher, and the share of government expenditure lower, than at E1. With lower interest rates, there is less crowding out of private expenditure. It rises the investment level and high investment increases the capital stock more quickly, giving workers more equipment with which to work and raising their productivity. In the long run it will cause the growth of the natural output level.

Figure 3.

Income

Y*

Interest rates

r1

r2

E1

LM1

LM0

IS0

IS1

E4

E3

E2

So we can make a conclusion, that neither the fiscal nor the monetary policy can affect the natural level of output working separately. Though, if the government uses both policies, this mean use the mix of monetary and fiscal policies, for example for expanding the government spending on such things as basic research, public health, education, and infrastructure, this will cause the long-term growth of potential output.