Transcript D and S side policies wiki - uwcmaastricht-econ

Demand-side policies
(demand management)
 Focus: shift AD in the AD/AS model to achieve the
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goals of price stability, FE and economic growth.
Based on the idea that short-term fluctuations of Real
GDP are due to actions of firms and consumers that
affect AD, causing inflationary and recessionary gaps.
They try to counteract the effect of those actions and
bring AD to the FE level of real GDP.
D-side policies can also impact on economic growth,
that is, increase potential GDP (shift LRAS curve to the
right). IB exam question last year!!
Discretionary and non-discretionary policy.
Stabilization policies
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Discretionary policy: active and purposeful
government intervention to influence AD (the policy
is at the discretion of the gov). Two types:
Fiscal Policy
2. Monetary Policy
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Non-discretionary policy. AD is also influenced by
automatic stabilisers, which work to reduce the size
of economic fluctuations.
 Fiscal and monetary policies intended to reduce the
size of short-run economic fluctuations are called
stabilisation policies.
The government budget
 Sources of government revenue
1. Taxes, both direct and indirect (T).
2. Sales of goods and services (transportation, electricity,
water, …)
3. Sale of state-owned enterprises (privatisation).
 Types of government expenditure
1. Current (day-to-day) expenditures
2. Capital expenditures, including public investments or
the production of physical capital (building roads,
airports, harbours,…)
3. Transfer payments for the purpose of income
redistribution
 Current and capital expenditures are included under
G. Transfer payments do not represent value of new
output produced.
 Government budget: a plan of a country’s tax revenues
and expenditures over a period of time (a year).
 If G=T: balanced budget
 If G>T: budget deficit Gov needs to borrow
 If G<T: budget surplus
 Public/Government Debt is the gov’s accumulation of
deficits minus surpluses.
The role of Fiscal Policy (FP)
 Definition: manipulations by the government of its
own expenditures and taxes in order to influence the
level of AD.
 FP can affect AD through 3 components:
 G. Direct impact on AD
 C. FP, through changes in income taxes, affects the
disposable income of consumers, which affects their
consumption expenditures.
 I. Through changes in business taxes, FP affects the after
tax profits of firms, which has an impact on their level of
investment expenditures.
Expansionary Fiscal Policy
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In a recessionary gap (Y<YFE), the gov can increase
AD with expansionary FP, which works to expand
the level of economic activity.
Expansionary FP can consist of:
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↑G
↓ personal income taxes
↓ business taxes
a combination of the three.
An increase in G has a direct impact on AD
 A decrease in T affects AD in a 2-step process:
↓T → ↑Disposable income Yd / ↑After-tax businesses
profits → ↑C / ↑I → ↑ AD
 The gov can increase G and lower taxes at the same
time by borrowing to finance the excess of spending
over tax revenues.
 The increase in real GDP will be smaller in the
neoclassical model than in the Keynesian one, because
of the upward sloping neoclassical AS curve.
 The increase in the PL will be smaller in the Keynesian
model, where the increase in AD may result in no
increase in the PL at all if the AD shift occurs entirely
within the horizontal segment of the Keynesian AS
curve.
Contractionary Fiscal Policy
 In an inflationary gap (Y>YFE), the gov can decrease
AD with contractionary FP, which works to contract
AD and the level of economic activity.
 Contractionary FP can consist of:
1. ↓ G
2. ↑ personal income taxes
3. ↑ business taxes
4. a combination of the three.
 A decrease in G has a direct impact on AD
 An increase in T affects AD in a 2-step process:
↑ T → ↓ Disposable income Yd / ↓ After-tax businesses
profits → ↓ C / ↓ I → ↓ AD
 Figures 12.1 (expansionary FP) and 12.2 (contractionary
FP).
 Keynesian model with the ratchet effect (Fig 12.2 c)
The role of automatic stabilisers
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Definition: factors that automatically, without any action
by government authorities, work toward stabilising the
economy by reducing the short-term fluctuations of the
business cycle. They represent non-discretionary policy.
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Progressive income taxes
Unemployment benefits
 Progressive taxation. As income increases, the
fraction of income paid as taxes increases (increasing
tax rate).
 Proportional taxation. As income increases, the
fraction of income paid as taxes remains constant
(constant tax rate).
Progressive income taxes
 During an expansion, real GDP increases and tax
revenues automatically increase, causing disposable
income to be lower than otherwise. This acts to
dampen AD, counteracting the economic expansion.
In a recession, with real GDP and incomes falling,
government tax revenues decrease, causing disposable
income to be higher than it would otherwise be. This
exerts upward pressure on AD, reducing the severity of
the recession.
 The more progressive an income tax system, the
greater the stabilising effect on economic activity.
Unemployment benefits
 In a recession, as real GDP falls and UE increases, UE
benefits rise. The presence of UE benefits allows
unemployed workers to maintain their consumption to
some extent, as their benefits partially replace their
lost income, lessening the downward pressure on AD.
 In an expansion, UE benefits are reduced as UE falls.
Therefore, consumption increases less than it would in
the absence of UE benefits.
Fiscal policy and long term growth
D-side policies can contribute to ↑ the level of potential
GDP in two ways:
1. Indirectly, by providing a stable macroeconomic
environment in which consumers and firms can
plan and carry out their economic activities.
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Firms must make decisions on investment in capital
goods and whether, how and in what areas to pursue
R&D and technological innovations.
Both the formation of capital goods and technological
changes are important factors in increasing potential
GDP.
In order to be able to plan over long periods of time,
firms need economic stability, ie, avoidance of sharp
economic upturns (inflation) and downturns
(recession and UE).
Directly (Figure 9.15):
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By encouraging investment through lower business
taxes, thereby contributing to new capital formation
and technological innovations.
By directing a portion of G
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b.
to the development of physical capital goods, such as
infrastructure (roads, telecommunications,...), as well as
on R&D, which improves technology and therefore the
quality of capital goods. This improves the productivity of
labour.
to the development of human capital, such as training and
education programmes that increase the quality of the
labor force and improve the productivity of labour.
All these factors work to increase potential output,
thus supporting long-term economic growth.
Evaluating Fiscal Policy
Strengths of Fiscal Policy
Pulling an economy out of a deep recession.
Combating rapid and escalating inflation.
Ability to target sectors of the economy. Changes in
the composition of gov spending depending on gov
priorities can affect specific sectors:
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Education
Health care, focusing on particular social groups that may be in
greater need.
Infrastructure and its location, focusing if necessary on
economically depressed regions.
Other merit goods
4. Direct impact of gov spending (G) on AD. Changes in
taxes are less direct, as they work by changing
consumers’ disposable income and firms’ after-tax
profit.
5. Ability to affect potential output. FP can affect Yp
and long-term economic growth indirectly (by
creating a stable economic environment) and
directly through investments in human capital and
physical capital and through offering incentives to
firms to invest.
Weaknesses of Fiscal Policy
Problems of timing. FP is subject to time lags:
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A lag until the problem is recognized .
A lag until the appropriate policy is decided upon by
the gov.
A lag until the policy takes effect in the economy.
By the time the policy has taken effect the problem may
have become less or more severe, so that the policy
is no longer the appropriate one.
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Political constraints. Gov spending and taxation are
subject to numerous pressures that are unrelated to
fiscal policy considerations. Spending in public and
merit goods is undertaken for its own sake and
cannot easily be cut. Taxes are politically unpopular
and might be avoided even though they might be
necessary.
Crowding-out effect. The increase in interest rate
caused by deficit spending can lead to lower
investment spending by private firms. A greater G is
offset by a lower I.
Inability to deal with supply-side causes of
instability. Ex: FP is unable to deal with stagflation.
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In a recession, tax cuts may not be very effective in
increasing AD. Part of the increase in after-tax
income is saved. If this share becomes larger due to
pessimistic future expectations, the impacts of tax
cuts on AD will be even weaker. Increases in G are
more powerful.
Inability to fine tune the economy. FP can lead the
economy in a general direction of smaller or larger
AD, but it cannot be used to reach a precise target
with respect to the level of output, employment and
the price level. It is not possible to use FP to keep
real GDP at or very close to its potential level. There
are many factors affecting AD that the gov cannot
control.
Monetary Policy (MP)
 Carried out by the Central Bank (CB) of each country.
 Commercial banks are financial institutions whose
main functions are to hold deposits for their customers
(consumers and firms), to make loans to their
customers, to transfer funds by cheque and
electronically from one bank to another and to buy
government bonds.
 The Central bank is usually a government financial
institution with a number of important
responsibilities:
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Banker to the gov. Among other, the CB manages the
government’s borrowing by selling bonds to
commercial banks and the public, and acts as an
adviser to the gov on financial and banking matters.
Banker to commercial banks, by holding deposits for
them and make loans to them in times of need.
Regulator of commercial banks, making sure they
operate with appropriate levels of cash and according
to rules that ensure the safety of the financial system.
Conduct monetary policy, through changes in the
supply of money or the rate of interest. It usually also
responsible for the determination of exchange rates.
 In the countries which form the European Monetary
Union (EMU), monetary policy is carried out by the
European Central Bank (ECB), located in Frankfurt.
The money market and the rate of interest
 MP impacts AD indirectly through the rate of interest.
 Interest is the payment (per unit of time) for the use
of borrowed money. Usually expressed as % of the
principal to be paid per year. This % is called the rate
of interest.
 Money is anything that is acceptable as payment for
g&s (ie, coins and paper money as well as checking
accounts)
 The money market is a market where the demand for
money and the supply of money determine the
equilibrium rate of interest. The horizontal axis
measures the quantity of money in the economy, and
the vertical axis measures the rate of interest.
 The rate of interest is the price of money services.
 The Demand for money, Dm, shows the relationship
between the rate of interest and the quantity of money
demanded. Dm is downward sloping.
Rate of
interest
Sm
i
Dm
Qe
Quantity
of money
 Why is Dm downward sloping?
 Money allows economic agents to carry out their buying
and selling exchanges.
 Money can be used as a form of saving when used to buy
bonds (a certificate issued by the gov or a firm that
promises to pay interest at various intervals until the
date when the money is repaid to the bond holder).
 So, interest is the opportunity cost of holding money, as
you could have received that interest if you had saved
the money instead of holding it.
 The higher i, the higher the opportunity cost of holding
money and the lower the quantity of money demanded.
 The Supply of money, Sm, is fixed at a level that is
decided upon by the CB. does not depend on i.
 The point of intersection between Dm and Sm
determines the equilibrium rate of interest.
 Monetary policy is carried out by the CB, through
changes in the money supply, which shift the Sm curve.
Rate of
interest
Sm3
Sm1
↑Sm → ↓ie
Sm2
↓Sm → ↑ie
i3
i1
i2
Dm
Q3
Q1
Q2
Quantity
of money
 In practice, the CB can target either the money supply
or the interest rate. Most central banks target the
interest rate: decide upon i and then adjust Sm so that
the actual ie will become equal to the target i.
 In the real world there are many interest rates and it
varies from country to country which one central
banks target.
 In the UK, the CB targets the ‘base rate’, which is the interest
rate at which the Bank of England lends to commercial banks.
 In the US, the Federal Reserve targets the ‘federal funds rate’,
the interest rate at which commercial banks borrow and lend
from each other over a 24-hour period.
 The ECB targets the ‘minimum refinancing rate’, which is the
interest rate paid by commercial banks when they borrow
from their respective national central banks.
The role of Monetary Policy
 Changes in i affect two components of AD:
 C, as some consumption is financed by borrowing.
 I, as firms borrow money in order to finance their
investment expenditures.
 Therefore:
↑ i → ↓ C , ↓ I → ↓ AD and AD shifts left
↓ i → ↑ C , ↑ I → ↑ AD and AD shifts right
Expansionary (easy money) Policy
 In a recessionary gap (Y<YFE), the CB increases Sm,
causing the interest rate to decrease.
 A lower i means a lower cost of borrowing, so
consumers and firms are likely to borrow and spend
more: ↓ i → ↑ C and ↑ I → ↑ AD.
PL
LRAS
K-AS
PL
SRAS
AD1
Yrec
YP
AD2
AD1
Real
GDP
Yrec
YP
AD2
Real
GDP
 The effects of the AD increase are different depending
on the shape of the AS curves:
 In the monetarist model there is a smaller increase in
real GDP and a larger increase in the price level
compared to the Keynesian model.
Contractionay (tight money) Policy
 In an inflationary gap (Y>YFE), the CB decreases Sm,
causing the interest rate to increase.
 A higher i means a higher cost of borrowing, so
consumers and firms are likely to borrow and spend
less: ↑ i → ↓ C and ↓ I → ↓ AD.
PL
LRAS
SRAS
AD1
AD2
YP
Yinf
Real
GDP
 If AD falls within the downward sloping part of the AS
curve in the Keynesian model, the effects on the price
level and real GDP are similar to those in the
monetarist model. But if AD decreases in the
horizontal part of the AS curve, there would be a larger
fall in real GDP and a smaller fall in the price level in
the Keynesian model.
 The ratchet effect also applies here.
Monetary policy and inflation targeting
 As we have seen, MP can be used to achieve the goals
of FE and a low and stable rate of inflation.
 In recent years, more CBs (26 in total) around the
world pursue a kind of MP that aims at maintaining a
particular targeted rate of inflation. Examples: New
Zealand (first one, 20 years ago), Australia, Canada,
UK, EU, Brazil, Mexico, among others.
 Defined by IMF as ‘…the public announcement of
medium-term numerical targets for inflation with an
institutional commitment by the monetary authority
to achieve these targets.’
 Targets range between 1.6% and 2.5%, with one
percentage point as a ‘tolerance’ margin.
 Target set in terms of the consumer price index (CPI)
but usually based on forecasts of future inflation based
on the CPI.
 If predicted inflation is higher (lower) than the target,
they use contractionary (expansionay) policy to
increase (decrease) i and lower (increase) AD, thus
lowering (increasing) the rate of inflation.
Advantages of inflation targeting
1. A lower rate of inflation.
2. A more stable rate of inflation (less fluctuations in
the inflation rate)
3. Improved ability of economic decision-makers to
anticipate the future rate of inflation. Public
knowledge about the CB’s objectives on inflation
reduces uncertainty and facilitates economic
decision making.
4. Greater coordination between MP and FP. Gov can
plan its FP to complement the CB’s monetary policy.
5. Greater CB transparency and accountability.
Disadvantages of inflation targeting
 Reduced ability of the CB to pursue other macroeconomic
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objectives. MP can then not be used for other goals, such as
FE level of real GDP or exchange rate stability.
Reduced ability of the CB to respond to S-side shocks. This
might require expansionary MP, which may mean a higher
rate of inflation than the target.
Reduced ability of the CB to deal with unexpected events,
such as financial crises.
Finding an appropriate inflation target. If it is too low, it
may lead to higher UE; if it is too high, it could lead to the
problems resulting from high inflation.
Difficulties of implementation, as it is based on forecasts,
which are often highly unreliable.
Evaluating monetary policy
Strengths of Monetary Policy
Quick implementation. MP can be implemented
more quickly than FP because it does not have to go
through the political process.
No political constraints:
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Even if a CB is not independent from the government,
MP is not subject to the same kinds of political
pressures as fiscal policy since it does not involve
changes in gov budget.
CB in many countries is independent of the governing
political party.
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No crowding-out.
Ability to adjust interest rates incrementally (in
small steps). This makes monetary policy better
suited to ‘fine tuning’ the economy in comparison
with FP. However, also subject to limitations.
Central bank independence. CB can take decisions
that are in the best longer term interests of the
economy, having greater freedom in pursuing
policies that may be politically unpopular.
Weaknesses of Monetary Policy
Problems of timing. Although MP does not depend
on the political process, it is still subject to time
lags:
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A lag until the problem is recognized .
A lag until the policy takes effect in the economy.
Changes in interest rates can take several months to
have an impact on AD, Y and PL. This time lags
becomes longer if there is pessimism in the economy.
2.
Possible ineffectiveness in recession. A tight money
policy can effectively combat inflation. However, an
easy money policy is less effective in a deep
recession. In a recession, lower i would encourage C
and I, increasing AD. This is under the assumption
that banks will be willing to ↑ their lending to
households and firms and that these will be willing
to ↑ their borrowing and their spending. However, in
a severe recession banks may be unwilling to ↑ their
lending and if firms and consumers are pessimistic
about the future they may avoid taking new loans
and may even ↓ their I and C. This situation
occurred in the 1930s during the Great Depression
and in 2008.
3. Conflict between government objectives.
Manipulation of interest rates affects also variables in
the foreign sector of the economy, such as exchange
rates. The pursuit of domestic objectives may conflict
with the pursuit of objectives in the foreign sector.
4. Inability to deal with stagflation. MP is unable to
deal effectively with S-side causes of instability, just
like fiscal policy.
 Inflation requires a contractionary policy
 UE requires an expansionary policy