Wealth Effects and the Effectiveness of Monetary and Fiscal Policies: Comment

Abstract

In a recent article [1 ] Laurence H. Meyer presents an interesting pedagogical note in which he illustrates and explains the impact of various wealth effects upon the potency of monetary and fiscal policies. Included in his analysis is a discussion of the interest-induced wealth effect. According to Meyer, this wealth effect flattens the slope of the IS curve, which increases the impact of an open market operation while decreasing the effectiveness of bond-financed fiscal policy. This impact of the interest-induced wealth effect is in the right direction, but its magnitude is incorrect because allowance is not made for the resulting change in the asset portfolio of the private sector. Whenever the money supply increases through an open market operation, private holdings of interest-bearing debt issued by the government are reduced. Since fewer bonds are now contained in private portfolios, a larger change is required of the interest rate in order to offset any given change in income. In other words, a decrease in the total amount of bonds outstanding reduces the potency of the interest-induced wealth effect and causes the IS curve to rotate clockwise.l Expanding the money supply through an open market operation therefore causes the IS curve to become more interest inelastic, and the impact of monetary policy is reduced below that level shown by Meyer. In the case of bond-financed fiscal policy, the interest-induced wealth effect again causes the IS curve to rotate. An expansion in government expenditures fmanced through the issuance of interest-bearing debt causes an increase in the bond holdings