Neo-Keynesian Approach on Monetary Policy

Under most circumstances in modern industrial economies, neither the extreme Classical nor the extreme Keynesian conditions are likely to prevail. Wages do not decline readily in response to moderate amounts of unemployment-this rigidity of wages gives monetary policy a significant amount of influence over real income and employment.

Indeed, expansion stimulated by monetary policy is normally divided between an increase in employment and real output and an increase in the price level in proportions that depend on the existing volume of unutilized resources; the closer the economy is to full employment, the greater will be the increase in prices and the smaller will be the increase in output for a given expansionary impulse.

Moreover, the demand for money is responsive to interest rates but not infinitely elastic, as the ultra-Keynesian position implies. The conditions just described constitute the environment of the neo- Keynesian approach described by Smith in his article, "A Neo-Keynesian View of Monetary Policy," in which both monetary and fiscal policy can affect aggregate demand, and changes in aggregate demand can affect both real output and the price level.

The Smith paper is devoted largely to a detailed exposition of the various channels and mechanisms through which both kinds of policy affect output, employment, and so on, and the discussion is carried on with an eye toward the Keynesian-monetarist debate.

Neo-Keynesians think of monetary policy as working through several different channels; in fact, the channels are the same ones as those seen by the monetarists. It is on the efficacy of fiscal policy that the two sides diverge. Smith examines carefully the effects of pure fiscal policy changes on both flows of income and stocks of wealth, and the further implications of these effects for spending decisions.

He concludes that most of the available evidence indicates that fiscal policy is capable of having substantial effects on economic activity. Up to this point, most of the discussion of stabilization policy has taken place within the framework of a static, deterministic model-that is, one in which the intertemporal aspects of decisions play no role, and in which there are no random elements or any lack of knowledge concerning the structure of the system.

Unfortunately, this is not the framework in which the policy maker operates. He must make decisions concerning targets to be pursued and the amount of policy action needed, even though these decisions must be made in a context of considerable uncertainty about the exact structure of the economic system.

In his paper, "The Theory of Monetary Policy under Uncertainty," William Poole examines the implications of the presence of uncertainty for the choice of a monetary policy target. Poole's analysis is, of course, based on a number of simplifying assumptions - he takes income stabilization as the only ultimate policy goal, and assumes that the uncertainty concerns only the intercepts of the behavioral relationships in the structure, and not their slopes.

Nonetheless, he demonstrates quite convincingly that the choice of policy targets should be influenced by the relative degree of uncertainty present concerning the structure of different sub sectors of the economy, and not merely by opinions or evidence on the sizes of various elasticities in the structure.