Chapter 25 Monetary and fiscal policy in a closed economy

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Chapter 25Monetary 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

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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.

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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.

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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.

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The life-cycle hypothesis
A theory of consumption developed by Ando and
Modigliani.
Income, consumption
0
Death
Age
Thus wealth and interest rates may influence
consumption.
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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.

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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

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Analysis of fixed investment in the UK by type of
asset 1965-1998
Source Economic Trends Annual Supplement,
Monthly Digest of Statistics
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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.

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The investment demand schedule
shows how much investment firms wish
to undertake at each interest rate.
Interest rate
Investment demand
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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

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Monetary policywhen aggregate demand depends
upon the interest rate
45o line
Aggregate demand
AD0
Income
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Fiscal policy and crowding out
45o line
Aggregate demand
AD0
But higher income raises money demand, so
interest rates rise
Y0
Income
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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.

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The IS schedule
45o line
AD
Income
r
Income
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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.

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The LM schedule
r
r
Real money balances
Income
L0
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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)

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Equilibrium in goods and money markets
r
Income
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Fiscal policy in the IS-LM model
Y0, r0 represents the initial equilibrium.
Some private spending has been crowded out by
the increase in the rate of interest.
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Monetary policy in the IS-LM model
Y0, r0 represents the initial equilibrium.
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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
This affects the private public balance of
spending in the economy.
Income
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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