Money Demand and the Effects of Fiscal Policies: Reply

Abstract

Our paper Money Demand and Effects of Fiscal Policies challenged both theoretically and empirically standard practice of using income as scale variable in money demand function. We presented a variety of evidence indicating that consumption is a better scale variable. In paper's Elnal substantive section, we noted that this seemingly innocuous alteration in money demand function could crucially affect implied Elscal policy multipliers. In particular, we suggested that this change probably reverses traditional conclusion that tax cuts increase aggregate demaxld if money stock is held constant, though we cautioned that the uncertainty is necessarily large. James McGibany and Farrokh Nourzad and Darrel Cohen appear to accept our conclusion that consumption is appropriate scale variable in money demand function, but seek to reElne and challenge our assessment of effects of Elscal policy on aggregate demand. While further research on this question is clearly needed, we are not persuaded by calculations presented in these two comments. To derive our conclusion that a tax cut could be contractionary, we used a textbook IS-LM model with a modiEled money demand function. As in standard analysis, a tax cut shifts outward IS curve. Yet if money demand depends on consumption rather than income, a tax cut also increases money demand and thus shifts inward LM curve. The IS shift is expansionary while LM shift is contractionary net effect of tax cut is thus ambiguous. We provided a simple formula showing conditions under which tax cuts are contractionary: