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 25.1 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. 25.2 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. 25.3 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. 25.4 Savings occur during middle age and dissaving in youth and old age. The life-cycle hypothesis A theory of consumption developed by Ando and Modigliani. Age 0 Death Individuals try to smooth their consumption, based on expected lifetime income.Permanent income Thus wealth and interest rates may influence consumption. Income varies over an individual's lifetime.Actual income 25.5 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. 25.6 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 25.7 Analysis of fixed investment in the UK by type of asset 1965-1998 0 20 40 60 80 100 120 140 160 19 65 19 75 19 85 19 95 £ b illi on Trans Other mc/eq Dwellings Other build Intangible Source: Economic Trends Annual Supplement, Monthly Digest of Statistics 25.8 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. 25.9 The investment demand schedule … shows how much investment firms wish to undertake at each interest rate. Investment demand II At relatively high interest rates, less investment projects are viable. At r0, I0 projects are viable. r0 I0 but if the interest rate rises to r1, desired investment falls to I1. r1 I1 25.10 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 25.11 Monetary policy when aggregate demand depends upon the interest rate Income A g g re g a te d e m a n d 45o line AD0 Y0 CC 0 Suppose the economy starts with consumption at CC0, investment at I0 and equilibrium at Y0. I0 A fall in interest rates shifts the consumption function to CC1, and leads to higher investment at I1. CC1I1 Aggregate demand rises to AD1, and the new equilibrium is at Y1. AD1 Y1 25.12 Fiscal policy and crowding out Income A g g re g a te d e m a n d 45o line AD0 Y0 Suppose an increase in government spending shifts the AD curve to AD1.AD1 Initially, equilibrium moves to Y1. Y1 But higher income raises money demand, so interest rates rise and consumption and investment fall, shifting AD back to AD2 and equilibrium income to Y2. AD2 Y2 25.13 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. 25.14 The IS schedule Income 45o line Income r AD0 r0 At a relatively high interest rate r0, consumption and investment are relatively low – so AD is also low. Y0 Y0 Equilibrium is at Y0. Y1 Y1 Equilibrium is at Y1. IS The IS schedule shows all the combinations of real income and interest rate at which the goods market is in equilibrium. AD1 At a lower interest rate r1 Consumption, investment and AD are higher. r1 25.15 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. 25.16 The LM schedule r r IncomeReal money balances L0 LL0 r0 r0 Y0 At income Y0, money demand is at LL0 and equilibrium in the money market requires an interest rate of r0. r1 Y1 r1 LL1 At Y1, money demand is at LL1,and equilibrium is at r1. LM The LM schedule traces out the combinations of real income and interest rate in which the money market is in equilibrium. 25.17 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) 25.18 Equilibrium in goods and money markets Income r IS Bringing together the IS schedule (showing goods market equilibrium) LM and the LM schedule (showing money market equilibrium). Y* r* We can identify the unique combination of real income and interest rate (r*, Y*) which ensures overall equilibrium. 25.19 Fiscal policy in the IS-LM model Income r IS0 LM Y0 r0 Y0, r0 represents the initial equilibrium. IS1 A bond-financed increase in government spending shifts the IS schedule to IS1. r1 Y1 Equilibrium is now at r1, Y1. Some private spending has been crowded out by the increase in the rate of interest. 25.20 Monetary policy in the IS-LM model Income r IS0 LM0 Y0 r0 Y0, r0 represents the initial equilibrium. LM1 An increase in money supply shifts the LM schedule to the right. Y1 r1 Equilibrium is now at r1, Y1. 25.21 The composition of aggregate demand Income r Demand management is the use of monetary and fiscal policy to stabilize the level of income around a high average level. Y* Income level Y* can be attained by: LM0 IS0 r2 ‘Tight’ fiscal policy (IS0) with ‘easy’ monetary policy (LM0) IS1 LM1 r1 OR with ‘easy’ fiscal policy (IS1) with ‘tight’ monetary policy (LM1). This affects the private: public balance of spending in the economy. 25.22 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