ISLaMic Economics: Monetary and Fiscal Policy

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ISLaMic EconomicsMonetary and Fiscal Policy
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What is ISLM economics?

• Discussed real sector of economy production and
  income
• Discussed monetary sector
• How do the consumers, savers, lenders, borrowers,
  and monetary authorities interact to determine
  level of national income and rate of interest?
• Rough model. Economics is a two-digit science

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Macroequilibrium in Real Sector
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Equilibrium in Monetary Sector

• Levels of income (Y) and interest (r) at which
  demand for money supply of money

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Reality Check

• Do you think Ben Bernanke and Henry Paulson know
  what the hell is going on?
• I will try to explain the model that they more or
  less follow.

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What do you want to learn?

• Explanation of complex model that you will need
  to review carefully (lecture mode), followed by
  discussion of applications (current crisis,
  ecological economics)
• Simple summary of results of model (brief lecture
  mode), followed by more detailed discussion of
  applications
• You have to learn the model yourself from text
  and lecture notes

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What Determines S and I?

• What happens to savings as income (Y) increases?
• Who saves more, the poor or the rich?
• What happens to savings as interest rates (r)
  increase?
• Would you save more in a hedge fund at 20 or in
  government bonds at 2?
• What happens to investment as income increases?
• Will firms invest more when people are buying
  lots of stuff or nothing?
• What happens to investment as interest rates
  increase?
• Would you be more likely to start your own
  business with interest rates at 1 or 20? (Both
  rates exist today)

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What Determines S and I?

• SS(r,Y)
• II(r,Y)
• Equilibrium in real sector occurs when
  S(r,Y)I(r,Y)
• One equation, two unknowns
• Multiple solutions
• Depicted by IS curve
• Assumption is that economy is always moving
  towards equilibrium

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Equilibrium?
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IS Curve
r
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Why downward sloping?

• Low interest more profitable investment
  opportunities gt more investment gt more income
• Higher income more savings
• Higher interest more savings?
• Do poor people carry credit card debt at 20?
• When savings are high, interest rates must be low
  for sectors to balance.

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Why do people demand money instead of real assets?

• Avoids inconvenience of barter
• Transactions demand for money
• More income more transactions more
  transactions demand for money
• Liquidity preference we prefer liquid assets to
  frozen one. Cash is most liquid
• What is the cost to holding cash?
• What is the cost of holding non-liquid assets?

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How is Demand for Money Related to Income and
Interest?

• What happens to your demand for cash money as
  interest rates increase?
• As income increases?
• DML(r,Y)
• Equilibrium occurs when DMSM
• What determines SM?
• Discoveries of silver and gold?
• Ben Bernanke?
• Equilibrium occurs when L(r,Y)M

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LM Curve
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Why does LM slope upwards?

• More income greater demand for money. Less
  money available to lend. Higher r required for
  equilibrium

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Moving Towards Equilibrium in LM

• MgtL
• More money available than people want
• Use excess to buy non-liquid interest bearing
  assets, e.g. Bonds
• Demand for bonds increases, price increases,
  interest rate on bond goes down.
• Increase in supply of money drives interest rate
  down
• Lower r lower opportunity cost of holding
  money, higher demand for money
• Lower r greater Y higher demand for money

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Combining IS and LM

• Two simultaneous equations with two unknowns
• One unique combination of r and Y for which IS,
  LM
• Equilibrium in real and monetary sector
• We do not assume that economy is in equilibrium,
  but rather that it is moving towards it

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Combining IS and LM
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How do we use this?

• Comparative statics How do r and Y respond to
  exogenous changes?
• Changes include monetary and fiscal policy as
  well as liquidity preferences, propensity to
  save, efficiency of capital investment, etc.
• How does the economy move towards equilibrium
  when policy pushes it away?
• Doesn't look at dynamic path

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Non-Policy Changes IS

• Propensity to Save
• What has happened to US propensity to save?
• SltI for all I, injection into economy (I) gt
  leakage (S) for all Y and r on old equilibrium
• Income increase until IS again, new equilibrium
• Lower savings rate, but higher income.
• IS curve shifts to right
• More expenditure stimulates investment. IS curve
  shifts to right
• Paradox of thrift
• Increase in productivity of capital

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Non-Policy changes LM

• Increase in liquidity preference
• LgtM
• Higher r required to induce lending
• Each level of Y associated with higher r on new
  LM
• Shift upward
• Same thing occurs from decrease in M (monetary
  policy)

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r
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Monetary Policy 3 tools Fed can use

• Reserve requirements (within bounds set by
  congress)
• Allows private banks to create more or less money
• Interest rates (discount window)
• Rate at which Fed loans money to banks
• Open market operations buying and selling
  government securities (bonds)
• Changes money supply.
• Goal typically is to increase or decrease
  overnight interest rates for banks loaning to one
  another (Fed funds rate)

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Current Monetary Policy

• Discount window from 5.75 August 2007 to 1.25
  today Fed funds rate shows similar plunge to 1
• NYT Headlines
• A Rate of Zero Percent From the Fed? Some
  Analysts Say It Could Be Coming

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Monetary Policy

• Increase in M shifts LM curve downwards (to
  right)
• Higher income, lower interest
• Decrease in M shifts LM curve upwards (to left)
• Why would we want to decrease M?
• Real Mnominal M/P
• Any other reasons?
• Liquidity trap
• When demand is inadequate, firms have excess
  capacity, increasing money supply (reducing r)
  has no impact on investments.
• 'Pushing on a string'

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Fiscal Policy

• Taxation
• Reduces demand, contracts economy, drives down
  interest rates
• Government expenditure
• Stimulates investment, expands economy
• Drives up interest rates
• Crowding out
• When economy is at full capacity, government
  expenditure simply displaces private sector
  expenditure

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3 Ways for Government to Spend

• Tax and spend
• Spending more than counteracts equal tax
• Surplus taxes gt expenditures
• Borrow and spend
• Greater short term impact than tax and spend
• Deficit expenditures gt taxes
• Borrowing now taxes in future
• Print money and spend
• Does not increase interest rates
• Threat of inflation
• We could increase reserve requirements, give
  government more control

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NYT description

• The Federal Reserve, through its power to raise
  and lower interest rates, exercises more
  influence over economic growth and the level of
  employment than any other government entity. That
  unusual role dates from the 1970s, when the
  executive branch and Congress pulled back from
  the use of fiscal tools vast New Deal spending
  and targeted tax cuts as a means of regulating
  prosperity.

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Is this true? Real World Fiscal Policy the
Federal deficit
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Who Controls the Fed?

• The governors appointed by the president,
  approved by Congress
• Chair appointed for 14 years
• Regional bank presidents selected by leaders of
  their communities, particularly bankers. (NYT)

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What is the goal of the Fed?

• Officially to target unemployment and inflation
• Their main thrust has been to limit inflation,
  even at the risk of a recession although they
  have cut rates when the nation seemed in danger
  of one, as the Bernanke Fed has recently done.
• The Task Ahead First on To-Do List Tame
  Inflation by DAVID LEONHARDT

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Inflation, Disinflation, Deflation

• Is inflation a problem?
• Good for debtors, bad for creditors
• 2 inflation x 7 trillion debt (at fixed
  interest) 140 billion inflation tax
• Also tax on those who hold money (reduce L).
• Facilitates price adjustments
• Predicted vs. unpredicted
• Moderate inflation vs. hyperinflation
• Disinflation
• Predicted vs. unpredicted
• Deflation
• More feared than inflation
• Creates incentive not to spend money

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Deflation

• NYT Headline (Nov. 1) Fear of Deflation Lurks as
  Global Demand Drops
• NYT 2005, calling Bernanke a safe choice The
  lessons of the Depression sometimes seem to hover
  behind much of his thinking. Shortly after
  becoming a Fed governor in 2002, for example, Mr.
  Bernanke argued forcefully for tough action to
  head off a possible epidemic of deflation, or
  downward spiraling prices.

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Fighting Deflation

• Bernankes remedies
• Buying treasury securities with longer maturities
• Buy up privae debt, e.g. corporate bonds
• In effect, the Federal Reserve would be printing
  more money and injecting it into the economy a
  strategy of quantitative easing, in Fed
  jargon.

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Fighting Inflation

• Increase supply
• Reduce demand (typical approach)
• Fiscal policy
• Increase taxes
• Decrease spending
• Can be targeted
• Monetary policy
• Raise interest rates bad for debtors, good for
  creditors, bad for farming, construction
• Decrease money supply
• Blunt instrument
• Either one can increase unemployment, reduce wages

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Unemployment and Inflation

• Decreasing Y increases unemployment
• NAIRU and Phelps
• Bargaining power of labor vs. capital
• Black death
• Wage push or Profit push inflation?
• Impact on wages
• Does this work in global economy?

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Unemployment and National Income

• Positive feedback loops (vicious circles)
• Fiscal policies and stability
• Welfare payments
• Unemployment insurance

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What Does Fed Target?

• Bernanke
• he is trying to establish himself as an
  inflation fighter
• speaking out on a wide array of topics about the
  economy as well as about the central bank's need
  to become more open and to peg policy to publicly
  stated inflation targets.
• As both an academic and former Fed governor, he
  focused on the importance of the Fed's
  anti-inflation credibility.

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Why does Fed Target Inflation?

• Who are the Fed's constituents?
• Not elected
• Where do Fed reserve governors come from?
• Why do stock markets dislike inflation?
• Inflation increases uncertainty
• Fear of higher interest rates

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• In settling on Mr. Bernanke, President Bush ...
  chose a candidate who would satisfy others --
  investors on Wall Street, lawmakers in Congress
  -- more than himself or his Republican base.
• ''They needed somebody that everybody, including
  the financial markets, would react positively
  to.''
• But Mr. Bernanke had what many outsiders wanted
  a world-class reputation among economists
  credibility on Wall Street

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Impact of Policies on Scale, Distribution and
Allocation

• What should our goals be?
• Sustainable Scale
• Just Distribution
• Efficient allocation
• Stability
• How do we reduce consumption without increasing
  unemployment, while making poor better off?
• What is appropriate balance between market goods
  and public goods?

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Monetary Policy

• Only affects market goods directly
• Difficult to simultaneously address scale and
  distribution
• Poor at dealing with public goods, including
  ecosystem services
• Changing reserve requirements
• Blunt instrument

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Fiscal Policy

• Taxes
• Can be targeted 'tax bads, not goods' 'tax what
  we take, not what we make'
• Reduces overall consumption
• Stabilize economy
• Can have important impact on scale

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Fiscal Policy

• Subsidies
• Research and development
• Activities that provide positive externalities
  'subsidize goods, not bads'

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Fiscal Policy

• Government expenditures
• Can be targeted welfare for corporations or for
  the poor?
• Public goods or private goods? What offers
  highest marginal benefits?
• Investments in human made vs. natural K
• Crowding out in a full world