Transcript Chapter 25 Monetary and fiscal policy in a closed economy

Chapter 25
Monetary and fiscal policy in a
closed economy
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
6th Edition, McGraw-Hill, 2000
Power Point presentation by Peter Smith
Bringing together the real and financial sectors
Having seen equilibrium in the goods
and money markets separately,
it is now time to explore the links
between them
and to look at simultaneous
equilibrium in both.
25.1
Consumption revisited


Income is a key determinant of
consumption
but other factors shift the consumption
function
–
–
–

household wealth
availability of credit
cost of credit
These create a link between the financial
and real sectors
–
because interest rates can be seen to influence
consumption.
25.2
The permanent income hypothesis

A modern theory of consumption
developed by Milton Friedman
–

argues that people like to smooth
planned consumption even if income
fluctuates
Consumption depends upon
permanent not transitory income.
25.3
The life-cycle hypothesis
A theory of consumption developed by Ando and Modigliani.
Actual
income
Permanent
income
0
Income varies over an
individual's lifetime.
Individuals try to smooth
their consumption, based
on expected lifetime
income.
Savings occur during
middle age
Death and dissaving in youth
Age
and old age.
Thus wealth and interest rates may influence consumption.
25.4
Ricardian equivalence

Individuals will react to a shock such
as a tax change in different ways,
depending on whether changes are
seen to be temporary or permanent.

If the government cut taxes today,
but individuals realise this will have
to be balanced by higher taxes in the
future, then present consumption
may not adjust.
25.5
Investment demand

Investment spending includes:
–
–

fixed capital

Transport equipment

Machinery & other equipment

Dwellings

Other buildings

Intangibles
working capital

stocks (inventories)

work in progress
and is undertaken by private and public sectors
25.6
Other mc/eq
Dwellings
Other build
95
19
85
19
19
19
Trans
75
160
140
120
100
80
60
40
20
0
65
£ billion
Analysis of fixed investment in the UK
by type of asset 1965-1998
Intangible
Source: Economic Trends Annual Supplement, Monthly Digest of Statistics
25.7
The demand for fixed investment

Investment entails present sacrifice
for future gains
–
–
firms incur costs in the short run
but reap gains in the long run
Expected returns must outweigh the
opportunity cost if a project is to be
undertaken
 so at relatively high interest rates,
less investment projects are viable.

25.8
The investment demand schedule
… shows how much investment firms wish to
undertake at each interest rate.
At relatively high interest
rates, less investment
projects are viable.
At r0, I0 projects are viable.
r1
r0
I1
I0
II but if the interest rate
rises to r1, desired
investment falls to I1.
Investment demand
25.9
Interest rates and aggregate demand

The position of the AD schedule is
now seen to depend upon interest
rates through the effects on
–
consumption
–
investment
25.10
Monetary policy
Aggregate demand
when aggregate demand depends upon the interest rate
I1
I0
Y0
Suppose the economy
starts with consumption
45o line
AD1 at CC0, investment at I0
and equilibrium at Y0.
AD0
CC1 A fall in interest rates
shifts the consumption
CC 0 function to CC , and
1
leads to higher
investment at I1.
Aggregate demand rises
Y1 Income
to AD1, and the new
equilibrium is at Y1.
25.11
Aggregate demand
Fiscal policy and crowding out
45o line
Suppose an increase in
government spending
shifts the AD curve to AD1.
AD1
Initially, equilibrium
AD2 moves to Y .
1
AD0 But higher income raises
money demand, so
interest rates rise
Y0 Y2 Y1 Income
and consumption and
investment fall, shifting AD
back to AD2 and equilibrium
income to Y2.
25.12
Goods market equilibrium

The goods market is in equilibrium
when the aggregate demand and
actual income are equal

The IS schedule shows the different
combinations of income and interest
rates at which the goods market is in
equilibrium.
25.13
The IS schedule
45o line
AD1
AD0
r
r0
Y0
Y1
Income
r1
IS
Y0
Y1
Income
At a relatively high interest
rate r0, consumption and
investment are relatively
low – so AD is also low.
Equilibrium is at Y0.
At a lower interest rate r1
Consumption, investment
and AD are higher.
Equilibrium is at Y1.
The IS schedule shows all
the combinations of real
income and interest rate
at which the goods market
is in equilibrium.
25.14
Money market equilibrium

The money market is in equilibrium
when the demand for real money
balances is equal to the supply.

The LM schedule shows the different
combinations of income and interest
rates at which the money market is in
equilibrium.
25.15
The LM schedule
r
r
LM
r1
r1
r0
LL1
r0
LL0
L0
Real money
balances
Y0
Y1
Income
At income Y0, money demand is at LL0 and equilibrium
in the money market requires an interest rate of r0.
At Y1, money demand is at LL1,and equilibrium is at r1.
The LM schedule traces out the combinations of real income
and interest rate in which the money market is in equilibrium.
25.16
Shifting IS and LM schedules

The position of the IS schedule
depends upon:
–
anything (other than interest rates) that
shifts aggregate demand: e.g.
 autonomous
investment
 autonomous consumption
 government spending

The position of the LM schedule
depends upon
–
–
money supply
(the price level)
25.17
Equilibrium in goods and money markets
Bringing together the
LM IS schedule (showing
goods market equilibrium)
r
and the LM schedule
(showing money market
equilibrium).
r*
IS
Y*
Income
We can identify the
unique combination of
real income and interest
rate (r*, Y*) which ensures
overall equilibrium.
25.18
Fiscal policy in the IS-LM model
Y0, r0 represents the
initial equilibrium.
r
LM
r1
r0
Y0 Y1
A bond-financed
increase in government
spending shifts the IS
schedule to IS1.
IS1 Equilibrium is now at
IS0 r1, Y1.
Some private spending
has been crowded out
Income
by the increase in the
rate of interest.
25.19
Monetary policy in the IS-LM model
Y0, r0 represents the
initial equilibrium.
r
LM0
r0
r1
IS0
Y0 Y1
An increase in money
LM1 supply shifts the LM
schedule to the right.
Equilibrium is now
at r1, Y1.
Income
25.20
The composition of aggregate demand
Demand management is the use of monetary and fiscal policy
to stabilize the level of income around a high average level.
r
LM1
Income level Y* can
be attained by:
‘Tight’ fiscal policy (IS0)
LM0 with ‘easy’ monetary
policy (LM0)
r1
r2
IS1
IS0
Y*
Income
OR with ‘easy’ fiscal
policy (IS1) with ‘tight’
monetary policy (LM1).
This affects the private:
public balance of spending
in the economy.
25.21
But...
The IS-LM model seems to offer
government a range of options for
influencing equilibrium income.
 But…

–
there are other issues to be considered
 the
price level and inflation
 the supply-side of the economy
 the exchange rate
25.22