Transcript Lecture 11 - Har Wai Mun

UBEA 1013: ECONOMICS
CHAPTER 11:
FISCAL & MONETARY POLICY
11.1 The Multiplier Effect
11.2 The Fiscal Policy
11.3 The Monetary Policy
11.4 Fiscal versus Monetary
11.5 Crowding-out Effect
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UBEA 1013: ECONOMICS
11.1 The Multiplier Effect
Multiplier is the ratio of the change in the equilibrium
level of output to a change in some autonomous
variable.
An autonomous variable is a variable that is assumed
not to depend on the state of the economy that is, it
does not change when the economy changes.
Autonomous
variable
(I, G, T)
Multiplier
(direct or indirect
impact)
Effect to
Aggregate
Expenditure /
Output /
Income
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UBEA 1013: ECONOMICS
Y=C+I+G
Y = (a + bY) + I + G
Y (1 – b) = a + I + G
Y = (a + I + G) [1/(1 – b)] ………… Equation 11.1
Since, b = MPC
Y = (a + I + G) [1/(1 – MPC)]
Y = (a + I + G) [1/MPS]
or
Multiplier:
Planned Investment: [1/(1 – MPC)] or [1/MPS]
Government Spending: [1/(1 – MPC)] or [1/MPS]
Autonomous Consumption: [1/(1 – MPC)] or [1/MPS]
Tax multiplier???
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UBEA 1013: ECONOMICS
Y=C+I+G
Y = [a + b(Y-T)] + I + G
Y = [a + bY – bT] + I + G
Y (1 – b) = a – bT + I + G
Y = (a – bT + I + G) [1/(1 – b)] ………… Equation 11.2
Since, b = MPC
Y = (a – bT + I + G) [1/(1 – MPC)]or
Y = (a – bT + I + G) [1/MPS]
Multiplier:
Tax multiplier = – b / (1 – b)
= – MPC / (1 – MPC)
= – MPC / MPS
or
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UBEA 1013: ECONOMICS
11.2 The Fiscal Policy
Keynesian school of thought.
Fiscal tools: Spending & taxes (Government budget)
Two categories of fiscal policy:
i. Expansionary fiscal policy:
 Increase G and/or cut down T
To stimulate economy
Could cause inflation
May lead to budget deficit (need debt to
finance the deficit – burden the next generation)
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UBEA 1013: ECONOMICS
Two categories of fiscal policy:
ii. Contractionary fiscal policy:
 Decrease G and/or increase down T
To slow down economy or reduce demand-pulled
inflation
Could cause unemployment
Usually lead to surplus budget
Government
spending /
Taxes
Multiplier
(G: direct /
T: indirect impact)
Effect to
Aggregate
Expenditure /
Output /
Income
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UBEA 1013: ECONOMICS
Government Spending (G):
In an economy with a MPC
of 0.75, a $50 billion
increase in government
spending (G) magnifies the
aggregate expenditure four
times higher through the
multiplier effect. It is
illustrated numerically and
graphically as follow:
∆Y = ∆G X [multiplier]
= ∆G X [1/(1 – MPC)]
= 50 X [1/(1 – 0.75)]
= 50 X [4]
∆Y = $200 billion
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UBEA 1013: ECONOMICS
Taxes (T):
In an economy with a MPC of 0.75, a $50 billion of tax
cuts magnifies the aggregate expenditure three times
higher through the multiplier effect.
∆Y = ∆T X [multiplier]
= ∆T X [MPC/(1 – MPC)]
= 50 X [0.75/(1 – 0.75)]
= 50 X [3]
∆Y = $150 billion
Compare to government spending effect:
Increase $50 billion in G causes increase of
$200 billion in Y
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UBEA 1013: ECONOMICS
Balance Budget:
Increase in G = Decrease in T
Decrease in G = Increase in T
∆ = $50 billion
+∆G = – ∆T
∆Y = + G effect –T effect
= + $200 billion – $150 billion
= + $50 billion (= ∆)
Why????
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UBEA 1013: ECONOMICS
T multiplier + G multiplier
= [– (MPC) / (MPS)] + [1 / (MPS)]
= (1 – MPC) / (MPS)
= MPS / MPS
=1
If both G & T increase by (∆G =
∆T):
∆Y = (∆T)[– (MPC/MPS)] +
(∆G)[1/MPS]
= (∆G)[– (MPC/MPS)] +
(∆G)[1/MPS]
= (∆G)[1/MPS][1 – MPC]
= (∆G)[1/MPS][MPS]
∆Y = ∆G = ∆T
If both G & T increase by $50 billion
(∆G = ∆T), MPC = 0.75:
∆Y = (∆T)[– (MPC/MPS)] +
(∆G)[1/MPS]
∆Y = (50)[– (0.75/0.25)] +
(50)[1/0.25]
= (50)[– (3)] + (50)[4]
= – 150 + 200
= 50
∆Y = ∆G = ∆T = $50 billion
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UBEA 1013: ECONOMICS
11.3 The Monetary Policy
Monetarist of thought.
Monetary tools: Money supply (M) & Interest rate (r)
(Central Bank)
Two categories of monetary policy:
i. Easy/Expansionary monetary policy:
 Increase M – interest rate will drop
Effect investment
Effect local currency and net export
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UBEA 1013: ECONOMICS
ii. Tight/Contractionary monetary policy:
 Decrease M – interest rate will rise
Effect investment
Effect local currency and net export
The central bank can affect the equilibrium
interest rate by changing the supply of money
using one of its three monetary tools:
i) Reserve ratio
ii) Discount rate
iii) Open market operation (buy or sell government
securities from banks and public)
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UBEA 1013: ECONOMICS
r0
r1
r0
r1
• An increase in the supply of money lowers the rate of
interest.
• As investment has a negative relationship with
interest rate (refer Chapter 10), lower interest rates,
will increase investment (from I0 to I1).
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UBEA 1013: ECONOMICS
C + I1 (r1) + G
C + I0 (r0) + G
MS up,
Interest rate down,
Investment up,
AE up
(AE curve shift up),
Y up.
Y0
Y1
At the initial equilibrium
level of national income,
Y0, planned aggregate
expenditures are now
more than national
output.
Firms begin to
experience an
unexpected reduced
in their stocks.
This signals them to
increase output,
generating higher
income.
Higher income results
in higher spending
(multiplier process).
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UBEA 1013: ECONOMICS
International Sector (Export & Import):
Increase in M
Exchange
rate fall
(depreciate)
Local (foreign)
product cheaper
(more expensive)
Interest rate fall
Sell local
currency
Buy foreign
currency
Investor earning
lower IR
Seek better
investment
abroad
Net export
increase
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UBEA 1013: ECONOMICS
Crowding out Effect
Initial at Y0
G increase,
Y increase
Y1 fall back
to Y*
Planned AE
shift down
Md increase,
r increase,
Investment fall
Y increase,
Md increase
End
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