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ISLaMic Economics: Monetary and Fiscal Policy


ISLaMic Economics: Monetary and Fiscal Policy What is the goal of the Fed? Officially to target unemployment and inflation Their main thrust has been to limit ... – PowerPoint PPT presentation

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Title: ISLaMic Economics: Monetary and Fiscal Policy

ISLaMic Economics Monetary and Fiscal Policy
What is ISLM economics?
  • Discussed real sector of economy production and
  • 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

Macroequilibrium in Real Sector
(No Transcript)
Equilibrium in Monetary Sector
  • Levels of income (Y) and interest (r) at which
    demand for money supply of money

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.

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
  • You have to learn the model yourself from text
    and lecture notes

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)
  • 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
  • Would you be more likely to start your own
    business with interest rates at 1 or 20? (Both
    rates exist today)

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

(No Transcript)
IS Curve
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.

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?

How is Demand for Money Related to Income and
  • 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

LM Curve
Why does LM slope upwards?
  • More income greater demand for money. Less
    money available to lend. Higher r required for

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
  • Lower r lower opportunity cost of holding
    money, higher demand for money
  • Lower r greater Y higher demand for money

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

Combining IS and LM
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

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

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
  • Shift upward
  • Same thing occurs from decrease in M (monetary

Monetary Policy 3 tools Fed can use
  • Reserve requirements (within bounds set by
  • 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)

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

Monetary Policy
  • Increase in M shifts LM curve downwards (to
  • 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'

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

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

(No Transcript)
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

Is this true? Real World Fiscal Policy the
Federal deficit
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)

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

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

  • 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.

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

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

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?

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

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.

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

  • 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
  • But Mr. Bernanke had what many outsiders wanted
    a world-class reputation among economists
    credibility on Wall Street

Impact of Policies on Scale, Distribution and
  • 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?

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

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

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

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