Chapter 25 Monetary and fiscal policy in a closed economy

1
Chapter 25Monetary and fiscal policy in a closed
economy

• MIS 112
• Sping 2004

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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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Wealth effect

• Upward (downward) shift of consumption when
  households wealth increases (decreases) and
  people spend more (less) at each level of
  personal disposable income
• The autonomous part the intercept of the
  consumption function is function of wealth
• Y ACMPCYD
• AC f(W,i,..)
• Financial wealth
• Money
• Interest rates

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Wealth effect

• Financial wealth
• Money
• M/P??Wealth?
• Interest rates
• Bonds are part of wealth
• PB FV .
• int. rate
• i??bond prices?

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Consumer Credits

• Households borrow money to spend on durable
  goods
• cars, houses, furniture
• Amount of credits
• When increased ?shifts the consumption function
  upwords
• Money supply
• M/P??deposits? ?loans? ?consumer
  credits??consumption function up

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Consumer Credits

• Cost of credits
• Interest rates
• i ? ? credits? ? consumption function?
• Money supply
• M/P??i?? ?consumer credits??consumption function
  CF up

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Moneyin cir.?
wealth?
Wealth effect
Interest rates
i?
PB?
CF ?
ls?
Cost of credits?
deposits? loans ?
Consumer credits
Amount of credits ?
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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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The demand for fixed investment

• Investment is a trade off between present
  sacrifice for future gains
• firms incur costs in the short run
• but expects gains (profit) in the long run
• Expected returns must be greater then the return
  on market interest rate if a project is to be
  undertaken
• so at relatively high interest rates, less
  investment projects are viable.

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Benefits expected in the future
Costs or investment at present
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• There is a candidate project
• initial Investment 1000
• market interest rate 20
• expected future benefits 1400
• If the firm invests the 1000 worth of funds on
  bonds it will earn
• 1000(10.2) 1200
• if the firm invests to the project
• it will earn 1400
• so the return of the project is greater then the
  that of the bond

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• If the interest rate increases to
• i 50
• gain from bond
• 1000(10.5)1500
• the firm will not invest on the project but buy
  the bond

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• In real life there are so many alternative
  investment projects
• firms rank these in decreasing order of
  profitability
• at high interest rates few of these have higher
  gains then the return on the market interest rate
• at low interest rates many projects have higher
  returns then the market interest rate

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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
18

• CB increases Ms ??interest rates?
• ?CF?,investment demand?
• ?AD? ?Yeq? ?
• in the money market Md?
• excess demand in money market
• interest rates i?
• ?CF, ? investment demand ?
• ?AD ? ?Yeq ?
• new Y is higher then the initial one
• but lower then the intermedita4e Yeq

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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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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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Crowding out

• Reduction in private demand for consumption and
  investment caused by an increase in government
  spending
• Which increases AD and int. rates
• G??AD?or Y??MD??i??CF?,IF?,AD?
• Raise in AD is higher then the fall in AD so
  there is an overall raise in AD
• Question
• What is the effect of a tax cut?

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IS-LM Model

• Developed by John Hicks in 1937
• Extension of the basic Keynesien income
  determination model
• Aims at finding equilibrium value of income and
  interest rate
• Examining simulaneous equilibrium in both
• Good and money markets

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Goods market equilibrium

• The goods market is in equilibrium when the
  aggregate demand and actual income are equal
• AD Y
• AD C(Y,r) I(r) G Y
• 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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An illustrative example

• C 0.8(1-0.25)Y - 10r 100
• I 200 - 5r
• G 300
• AD CIG Y in equilibrium
• 0.6Y-10r100 200-5r 300 Y
• (1-0.6)Y 600 -15r
• Y 1500 - 37.5r IS schedule or
• r

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Slope of the IS schedules

• IS schedule is downward sloping
• As r??AD??Yeq?
• The slope of the IS schedule depends upon
• sensitivity of AD to r
• the more AC or I are reduced by an increase in r
• the more the equilibrium Y will be reduced
• the flatter will be the slope of IS
• if changes in r will not affect AD then
• IS schedule is steeper
• If components of AD C and I are not affected
  form r , IS is vertical

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Position of IS schedule

• 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 G() IS up
• Movements along the IS
• change is equilibrium y as a result of
• changes in interest rates
• any other change in AD results in
• shifting the position of IS schedule

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• IS cureve is the equilibrium Y and r when all
  other effects are constant
• Governmet expenditures
• As G up AD C(r)I(r)G up
• For every interest rate r
• AD curve up so
• Eq. Y is higher at each interest rate r

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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.
• MS MD f(Y,r)
• 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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Slope of LM

• The LM schedule slopes upwards
• for a higher level of Y
• a higher r is required
• to establish equilibrium in money the market

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Slope of the LM schedule

• MS MD
• along an LM curve ? MS 0 ? MD
• MDf(r,Y)
• ?MD response ?r response ?Y
• of r to MD of Y to MD
• 0
• slope of LM ?r/?Y or
• change in r for a unit increase in Y

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• Ms Md aY br
• Money demand is a linear function of income and
  interest rates
• a infront of Y indicates the sensitivity of
  money demand on income
• The higher the value of a
• The more transaction money demand is affected
  from changes in income
• b infront of interest rate indicates sensitivity
  of money demand on int rates
• The higher the value of b
• The more the speculative demand of money drops
  upon an increase in tnterest rates

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• Alohng a LM curve money supply is fized by
  definition
• And hence in equilibrium money demand is fixed
• So
• ? MS 0 ? MD
• MDf(r,Y)
• ?MD a?y- b?r
• 0
• slope of LM ?r/?Y or
• change in r for a unit increase in Y
• slope of LM ?r/?Y a/b

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continued

• ?MD 0 a ?y b?r
• In equilibrium or along an LM curve
• Change in transaction demand equals
• Change in speculative demand
• ?r - resp of Y a
• ?Y resp of r b
• resp of Y is high slope is steeper
• resp of r is low slope is steeper
• resp of Y is low slope is flatter
• resp of r is high slope is flatter

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Slope of LM curve depends on

• the more sensitive the quantity of money demanded
  to income
• the larger will be the increase in the interest
  rate required to maintain money market
  equilibrium
• and the steeper will be the LM schedule
• The less responsive quantity of the money
  demanded to a given rise in interest rates
• the larger will be the increase in interest rates
  required to choke off money demand for a given
  increase in income
• and the steeper will be the LM curve

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The position of LM curve depends on

• money supply
• (the price level)
• As MS??LM?
• for a given Y
• MS?? r?
• for every Y the eq. Interest rate in the money
  market decreases hence
• LM schedule shifts right or down
• conversely for a fixed Y
• As MS? ?r? ? LM?
• LM schedule shifts left

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Equilibrium in goods and money markets
r
Income
39
r1
Any point on the IS curve Good market is in
equilibrium YAD such as point A
A
C
B
r
IS
For any point on the right side of the IS
curve YgtAD firms cut output good market Good
market Comes equilibrium at A keeping interest
rate constant
Y
Y2
Y1
For any point on the left side of IS Curve such
as C YltAD firms increases output Good market
comes eq. At A Keeping interest rates constant
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LM
B
r1
Any point on the lM curve Money market is in
equilibrium MS MD such as point A
A
For any point on the upper side of the LM curve
such as B MDltMS interest rates falls to preserve
equ. In the money market For any point on the
lower side of the LM curve such as C MDgtMS
interest rates rises to preserve equ. In the
money market
C
Y
rB
MS
rA
rc
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LM
r1
Starting from a high interest r1 good market is
in eq at Y1 money market is in eq at Y2
r
IS
if the good market is in eq. There is an excess
money supply in the money market because at
Y1 the money demand is not high enough to
preserve eq in the money market
Y
Y2
Y1
r1
Y2
There is excess demand of bonds so bond price
raises or interest rates must fall towards the
eq value r
Excess money supply
Y1
MS
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LM
Starting from a lower interest r2 good market is
in eq at Y2 money market is in eq at Y1
r
r2
IS
if the good market is in eq. There is an excess
money demand in the money market because at
Y2 the money supply is not high enough to
preserve eq in the money market
Y
Y2
Y1
r1
Y2
There is excess supply of bonds so bond prices
falls or interest rates must raise towards the
eq value r
Y1
MS
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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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Treasury
First stage selling of bonds
Public
bonds
Stage 2 government makes spending so M returns
ot public
M
Treasury or government
M
public
Publics wealth increases to B
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• Note that
• increasing G by selling (issuing) new bonds by
  treasury is different from
• selling of existing bonds by CB by OMO to
  decrease money supply
• in the former
• the money is returned to economy by government
  spending
• in the later
• money is withdrawn from circulation by C.B.

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A vertical LM schedule
Crowding out is complete when LM is vertical
r
LM
r1
r0
Interest rates have no effect on the
quantity demanded of money
IS0
s
Income
Y0
No inrcease in income is possible interest rates
would raise until the increase in AD is
compansated by a downward shift of CF or IF
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• MS MD(Y)
• money demand is a function of output only so
• if output changes a new equilibrium is not
  attainable in the money market
• for a fixed money supply MS
• MS MD only when Y Yeq
• when G is raised
• Y will not increase
• r will increase only to compansate the shift in
  AD

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• in practice this is most unlikely
• MD is not completely insensitive to r
• LM is not completely vertical
• however,
• the less sensitive is MD to r
• the steeper will be the LM schedule
• the more a bond financed increase in G will lead
  to higher r rather than higher Y

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Fiscal policy in the IS-LM model(2)
If the increase in G is financed by printing
money
r
LM0
LM1
E0
r0
E1
At the same time LM schedule shifts to LM1
IS0
The money supply is increased to keep the
interest rate constant at r0
Y0
Income
Y1
Multiplier value is the same as we calculated in
the simple model with no financial markets there
is no crowding out effect
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Monetary policy in the IS-LM model
Y0, r0 represents the initial equilibrium.
E0
E1
E
Money market reachs equilibrium much faster than
the good market initially r drops to r
With such a low r, income starts to rise along
the IS0 curve
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Central Bank
CB sells bonds by OMO
Public
bonds
M increases bonds in the hand of public decrease
M
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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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• Fiscal P. Monetary P.
• easy tight
• G large,I,C low
• r high
• crowding out
• tight easy
• Glow, I,Chigh
• rlow
• no crowding out

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• Fiscal P. Monetary P.
• easy easy
• IS1 LM0
• Y very high
• tight tight
• IS0 LM1
• Y very low

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• in the long run
• economic growth
• high investment are desirable
• capital stock increases more quickly
• tight fiscal and easy monetary policy is chosen
• however
• G includes also
• roads hospitals education
• tight fiscal policy cuts back on such expending

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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
• unanticipated effects of fiscal and monetary
  policy
• the price level and inflation
• the supply-side of the economy
• the exchange rate