Shortterm stabilisation policy

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Short-term stabilisation policy
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Overview

• How can a rise in consumers confidence cause a
  short term boom?
• The effect of government monetary policy
• Using monetary policy to avoid recession
• How monetary policy can create a short-term boom
• The inflation-unemployment trade off

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How can a rise in consumer confidence cause a
short-term boom?

• Say C increases due to a rise in consumers
  confidence
• This leads to a fall in saving and a reduction in
  the supply of loanable funds
• This leads to a rise in the interest rate and a
  fall in the quantity of loanable funds demanded
  (I NFI)
• The fall in NFI leads to an appreciation in the
  real exchange rate and a fall in NX
• So the rise in C has led to a fall in INX.
  Overall no change in aggregate demand but the
  interest rate and the real exchange rate have
  risen

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How a rise in C affects the loanable funds market
As consumption increases, private savings falls
and the supply of loanable funds falls at any
interest rate. This pushes up the interest rate
and crowds out some investment (both domestic and
investment by Australians overseas)
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How a rise in C affects NX
As the rise in C leads to a rise in r and a fall
in NFI, this affects the foreign exchange
market. The fall in NFI reduces the supply of
AUD. As a result, the real exchange rate rises,
reducing net exports.
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So

• A rise in consumer confidence that increases
  consumption but reduces savings and tends to
• Raise real interest rates and crowd out I
• Raise real interest rates and crowd out NFI. But
  this leads to an appreciation of the AUD and a
  fall in NX

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But what about the money market?

• The interest rate has risen and this leads to a
  fall in the demand for less liquid assets. In
  other words, money demand falls
• If the supply of money has not changed then
  something else must change to bring the money
  market back to equilibrium
• This something else is the price level. Given
  the new higher interest rate, the aggregate price
  level P must rise in order to raise money demand
  back to money supply
• Overall, the rise in C has been offset by a fall
  in I NX. But interest rates, the real exchange
  rate AND the price level have all risen.

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Shift in Aggregate demand due to increase in
consumers confidence
The rise in C leads to a rise in interest rates.
For any given level of the money supply this
means that money demand has fallen. P must rise
to offset this change and return the money market
to equilibrium. But this means for any level of
GDP, the price level P must have risen
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This change leads to a short term boom
The shift in aggregate demand leads to a rise in
the price level. GIVEN PRICE EXPECTATIONS,
producers and workers respond to the higher price
by raising output. e.g. workers see nominal wages
moving up and work more overtime, even though
their real wage has not risen
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What happens in the longer term?
In the longer term, peoples price expectations
change. As this occurs, the short run supply
curve moves up and the economy moves back to long
run equilibrium. The boom corrects itself
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The effect of government monetary policy

• Suppose the economy starts to go into a recession
  (e.g. due to a fall in investor confidence and a
  fall in I)
• Can the Reserve Bank help protect the economy
  from recession?
• If so , how?

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Monetary policy and a recession

• As I falls, this reduces the demand for loanable
  funds. This tends to reduce the interest rate.
• As the interest rate falls, this increases money
  demand.
• If nothing happens to money supply then to
  restore equilibrium in the money market P must
  fall to reduce money demand. This reduces
  aggregate demand at any level of output and
  causes a downturn in the economy.

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The effect of a fall in investment
As investment falls, this leads to a fall in
interest rates and a fall in P to maintain money
market equilibrium
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But

• Suppose as interest rates start to fall, the
  Reserve Bank raises the money supply?
• Now as r falls, money demand rises, but money
  supply rises to meet it.
• Money demand rises and the money supply rises.
  There is no disequilibrium in the money market
  and the aggregate demand curve doesnt change
• The Reserve Bank has stopped the recession by
  raising the money supply

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More generally changing the money supply shifts
aggregate demand

• Suppose the Reserve Bank increases the money
  supply. For any given interest rate, money demand
  is now less than money supply the price level P
  has to rise to return the money market to
  equilibrium.
• But this means that a rise in the money supply
  tends to raise the aggregate demand curve.
  Similarly, a fall in the money supply pushes the
  aggregate demand curve down.

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Short term effect of a rise in money supply
A rise in the money supply tends to raise
aggregate demand. In the short term, this leads
to greater output, lower unemployment and higher
prices. In the long term, the rise in the money
supply just tends to lead to higher prices the
boom is short lived.
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The inflation-unemployment trade off

• In the short-term raising the money supply leads
  to a fall in unemployment below the natural rate.
• But note that this only works because the rise
  in prices caused by the monetary expansion is
  unexpected.
• As expectations change, the short-term reduction
  in unemployment goes away.

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• More generally, the Reserve Bank can lower
  unemployment if it increases the rate of growth
  of the money supply
• In the short term, this leads to higher than
  expected inflation, and lower unemployment
• There is a trade off between inflation and
  unemployment so long as people expect a lower
  level of inflation
• As people adjust their expectations about
  inflation, the short term benefit goes away and
  we are just left with higher inflation.
• The short term relationship between inflation and
  unemployment is called the Phillips curve.

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The cost of reducing inflation

• Suppose that inflation is at 15 and the economy
  is growing at 2 per annum
• The money supply is growing at 17 per annum
• Everyone expects a 15 rate of inflation
• Unemployment is at the natural rate.
• How can the Reserve Bank lower the inflation
  rate?
• Easy just reduce the rate of growth of the
  money supply
• But this reverses the Phillips curve effect. In
  the short term, people do not expect the lower
  inflation. The economy contracts and unemployment
  rises.
• So short term unemployment is the cost of
  reducing inflation

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Lessons

• In the short term changes in consumer confidence
  (or investor confidence) can cause a boom or a
  recession
• The effect operates (1) through the money market
  and (2) due to people making errors in their
  supply decisions.
• The Reserve Bank can use monetary policy to
  smooth out recessions and booms
• The Reserve Bank can also use monetary policy to
  lower unemployment in the short term but this
  leads to long run inflation.