Aggregate demand, fiscal policy, and foreign trade

Chapter 22 Aggregate demand, fiscal policy, and foreign trade David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith 22.1 Some key terms  Fiscal policy – the government’s decisions about spending and taxes  Stabilization policy – government actions to try to keep output close to its potential level  Budget deficit – the excess of government outlays over government receipts  National debt – the stock of outstanding government debt 22.2 Government in the income-expenditure model  Direct taxes – affect the slope of the consumption function – and hence the slope of the AD schedule.  Government expenditure affects the position of the AD schedule 22.3 Fiscal policy? Income, output 45o line AD0 Y0 But this ignores some important issues – prices, interest rates, and the need to fund the government spending. AD1 This seems to suggest that the government could influence aggregate output in the economy by raising AD from AD0 to AD1, Y1 thus raising equilibrium output from Y0 to Y1. 22.4 but in surplus at high levels then the budget will be in deficit at low levels of income The government budget The budget deficit equals total government spending minus total tax revenue. If government spending is independent of income G Income, output but net taxes depend on income, The balanced budget multiplier states that an increase in government spending plus an equal increase in taxes leads to higher equilibrium output. Balanced budget 22.5 Deficits and the fiscal stance  The size of the budget deficit is not a good measure of the government’s fiscal stance.  The structural budget shows what the budget would have been if output had been at the full-employment level.  The inflation-adjusted budget uses real not nominal interest rates to calculate government spending on debt interest. 22.6 Automatic stabilizers  mechanisms in the economy that reduce the response of GNP to shocks – for example, in a recession: – payments of unemployment benefits rise – and receipts from VAT and income tax fall 22.7 Limits on active fiscal policy  Time lags: it takes time – to diagnose the problem – to take action – for the multiplier process to operate  Uncertainty – the size of the multiplier is not known – aggregate demand is always changing  Induced effects on autonomous demand – changes in fiscal policy may induce offsetting effects in other components of aggregate demand Why can’t shocks to aggregate demand immediately be offset by fiscal policy? 22.8 Limits on active fiscal policy (2)  The budget deficit – concern about inflation if the budget deficit grows  Maybe we’re at full employment! – unemployment may be (at least partly) voluntary Why doesn’t the government expand fiscal policy when unemployment is persistently high? 22.9 Foreign trade and income determination  Introducing exports (X) & imports (Z)  TRADE BALANCE – the value of net exports (X - Z)  TRADE DEFICIT – when imports exceed exports  TRADE SURPLUS – when exports exceed imports  Equilibrium is now where – Y = C + I + G + X - Z 22.10 At higher income levels, there is a trade deficit. At relatively low income, exports exceed imports – there is a trade surplus. Exports, imports and the trade balance Income but that imports increase with income Imports Assume that exports are independent of income, Exports There is trade balance at income Y*, but there is no guarantee that this corresponds to full employment. Y* 22.11 Foreign trade and the multiplier  The marginal propensity to import – is the fraction of additional income that domestic residents wish to spend on additional imports.  The effect of foreign trade is to reduce the size of the multiplier – the higher the value of the marginal propensity to import, the lower the value of the multiplier. 22.12 Chapter 23 Money and modern banking David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith 23.14 Some key questions  Why does society need money?  Why do governments wish to influence money supply?  How do financial markets interact with the “real” economy?  What is the relationship between money and interest rates? 23.15 Money  Any generally accepted means of payment for delivery of goods or the settlement of debt  Legal money – notes and coins  Customary money – IOU money based on private debt of the individual  e.g. bank deposit. 23.16 Money and its functions  Medium of exchange – money provides a medium for the exchange of goods and services which is more efficient than barter  Unit of account – a unit in which prices are quoted and accounts are kept  Store of value – money can be used to make purchases in the future  Standard of deferred payment – a unit of account over time: this enables borrowing and lending 23.17 Modern banking  A financial intermediary – an institution that specializes in bringing lenders and borrowers together  e.g. a commercial bank, which has a government licence to make loans and issue deposits  including deposits against which cheques can be written  Clearing system – a set of arrangements in which debts between banks are settled 23.18 A beginner’s guide to the financial markets  Financial asset – a piece of paper entitling the owner to a specified stream of interest payments over a specified period  Cash – Notes and coin, paying no interest – the most liquid of all assets.  Bills – financial assets with less than one year until the known date at which they will be repurchased by the original owner – highly liquid 23.19 A beginner’s guide to the financial markets (continued)  Bonds – longer term financial assets – less liquid because there is more uncertainty about the future income stream  Perpetuities – an extreme form of bond, never repurchased by the original issuer, who pays interest forever  e.g. Consols  Gilt-edged securities – government bonds in the UK  Industrial shares (equities) – entitlements to receive corporate dividends – not very liquid 23.20 Credit creation by banks  Commercial banks need to hold only a proportion of assets as cash reserves – this enables them to create credit by lending  EXAMPLE: – suppose the public needs a fixed £10m for transactions – and the commercial bank maintains a 10% cash reserve 23.21 Credit creation – example Commercial bank : Liabilities Assets Deposits Cash Loans Total Cash ratio % Public cash holding Money supply Initial position: 100 10 90 100 Central bank issues £10m extra; the public deposits it 10 10 110 110 20 90 1101 18.2 10 120 110 11 99 1102 10 19 129 119 20 99 1193 16.8 10 129 200 20 180 200n 10 10 210 23.22 The monetary base and the money multiplier  The monetary base or stock of high- powered money – the quantity of notes and coin in private circulation plus the quantity held by the banking system  The money multiplier – the change in the money stock for a £1 change in the quantity of the monetary base 23.23 The money multiplier Suppose the banks wish to hold cash reserves R as as fraction (cb) of deposits (D), and the private sector wish to hold cash (C) as a fraction (cp) of bank deposits (D). Then R = cbD and C = cp D Monetary base H = C + R = (cb + cp) D Money supply = C + D = (cp + 1) D So M = (cp + 1) (cp + cb) H Money supply = money multiplier × monetary base