MONETARY POLICY-INEFFECTIVENESS DEBATE : ISSUES AND EVIDENCE

Abstract

There are many literature covering the New Classical Policy Ineffectiveness Proposition (PIP). However, there is no general consensus regarding the effectiveness of stabilization policies and whether should the government follow a simple monetary rule or practice policy discretion. The Keynesians followers, strongly disagree with the New Classical proposition. They attacked the basic assumptions of the New Classicists. The New Classicists assumes that markets are in the Walrasian general equilibrium where markets clears and firms are perfectly competition. Information are imperfect but expectations are rationally formed. At the initial stage of the debate, criticisms are mistakenly directed towards the rational expectations hypothesis. However, it was later found that rational expectations is a necessary but insufficient condition to validate the New Classicists' Proposition. Many new Keynesians also incorporated rational expectations into their models and found the results consistent with that of the traditional Keynesians. The strongest criticisms of the New Classicists are perhaps the assumptions of market equilibrium, and flexible prices and wages. New Keynesians offered many reasons for sluggishness of wages and prices. They argued that due to non-market clearing situation, stabilization policies will be effective in achieving policy objectives.

Nevertheless, Tobin (1993) expressed skepticism over the new Keynesians emphasis on price and wage rigidity. Stabilization policies, especially fiscal policies are potent not merely because of market imperfections and rigidities.

The PIP states that only unanticipated monetary policy is able to affect real macro aggregates such as output and unemployment. Anticipated monetary growth are only able to affect the price level. Thus, they predicted that announced disinflationary policies will be painless to the economy, i.e. achieving its objective of lower inflation rate without any sacrifice in output and employment. The main objective of this study is to investigate the relationship between the anticipated and unanticipated components of monetary growth, and economic activity (approximated by income). The test is conducted on data for 19 countries from the Asia-Pacific region. Many empirical tests have been conducted for the Western developed countries such as the United States and United Kingdom, but few were made with data of the less developed countries. Furthermore, the most tests are also on single country data, such multi-country based studies are rare. The importance of this study, and hence its contribution, stems from the review of some related literature, application of Barre's methodology with certain modifications to 19 developed as well as developing countries in the Asia - Pacific region and the empirical findings.

Prior to testing the PIP, a brief discussion will be done in the first two chapters. Chapter 3 looks at the state monetary policy in Singapore. It is known that Singapore is a small and open economy with huge foreign direct investments. Thus, theoretically, domestic monetary policy is ineffective in achieving the country's policy goals. Chapter 4 presents the methodology and results of the test. Finally, in Chapter 5, a general summary and appraisal of the test will be discussed.

Due to time constraint, the study focuses on the impact of monetary policy on income. The money - unemployment rate relationship is not tested.