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CHAPTER 11: CHAPTER 11: FISCAL FISCAL

& & MONETARY POLICYMONETARY POLICY

Y Y Td

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11.1 MULTIPLIER EFFECT11.1 MULTIPLIER EFFECT

11.2 11.2 FISCAL POLICY FISCAL POLICY

11.3 11.3 MONETARY POLICY MONETARY POLICY

11.411.4 CROWDING-OUT EFFECT CROWDING-OUT EFFECT

CHAPTER OUTLINE

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11.1 Multiplier Effect11.1 Multiplier Effect

• Multiplier – Ratio of the change in the equilibrium level of

output to a change in some autonomous variable.

• Autonomous variable is a variable that is assumed not to depend on the state of the economy that is, it does not change when the economy changes.

• Example: planned investment, government spending and taxes.

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• Multiplier effect– The equilibrium expenditure increases by

more than the increase in autonomous expenditure.

– It is always greater than one.

Autonomous variable (I, G, T)

Multiplier

(direct or indirect impact)

Effect to Aggregate

Expenditure / Output / Income

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Basic MultiplierY = C + I + GY = (a + bY) + I + GY (1 – b) = a + I + GY = (a + I + G) [1/(1 – b)]

Since, b = MPCY = (a + I + G) [1/(1 – MPC)]

orY = (a + I + G) [1/MPS]

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Planned Investment Multiplier

• Definition:– The impact of an initial change

(increased/decreased) in planned investment (I) on production, income, consumption spending and equilibrium income.

• The size of the multiplier depends on the slope of the planned aggregate expenditure line (MPC).

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Y = C + I + GY = [a + bY] + I + GY = [a + b(Y- T)] + I + GY = a + bY – bT + I + GY (1 – b) = a – bT + I + GY = (a – bT + I + G) [1/(1 – b)] ---Equation 11.1∆Y/ ∆I = 1/(1 – b)

Planned Investment Multiplier

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If planned investment (I) increase by the amount of ∆I, income (Y) will increase by:∆Y = ∆I X [1/(1 – b)]

Since b = MPC, and MPS = 1 – MPC, the expression become:∆Y = ∆I X [1/(1 – MPC)]∆Y = ∆I X [1/MPS]

Therefore, the multiplier for planned investment is ????

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Government Spending Multiplier

• Definition:– The ratio of the change in the equilibrium level of

output to a change in government spending.– The impact of an initial change

(increase/decrease) in government spending (G) on production, income, consumption spending and equilibrium income.

• The size of multiplier depends on the slope of the planned aggregate expenditure line.

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• From Equation 11.1:– If government spending increase by the amount

of ∆G, income (Y) will increase by:

∆Y = ∆G X [1/(1 – b)]

– Since b = MPC, and MPS = 1 – MPC, the expression become:

∆Y = ∆G X [1/(1 – MPC)]∆Y = ∆G X [1/MPS]

Thus, the multiplier for government spending is ????

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Figure: Government Spending Multiplier

Example:∆Y = ∆G X [multiplier] = ∆G X [1/(1 – MPC)] = 50 X [1/(1 – 0.75)] = 50 X [4] ∆Y = RM200 billion

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Tax Multiplier

• Definition:– The ratio of change in the equilibrium level of

output to a change in taxes.– The impact of an initial change

(increased/decreased) in taxes on production, income, consumption spending and equilibrium income.

• The multiplier for a change in taxes is not the same as the multiplier for a change in planned investment, government spending and others.

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Y = C + I + GY = [a + bY] + I + GY = [a + b(Y- T)] + I + GY = a + bY – bT + I + GY (1 – b) = a – bT + I + GY = (a – bT + I + G) [1/(1 – b)]∆Y/ ∆T= -b/(1 – b)

Tax Multiplier

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If taxes increase by the amount of ∆T, income will increase by:

∆Y = (-b) (∆T) X [1/(1 – b)]∆Y = (∆T) X [-b/(1 – b)]

Since b = MPC, and MPS = 1 – MPC, the expression become:

∆Y = ∆T X [-MPC/(1 – MPC)]∆Y = ∆T X [-(MPC/MPS)]

Therefore, the multiplier for taxes are:-MPC/(1 – MPC) or

-MPC/MPS

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Taxes (T):In an economy with a MPC of 0.75, a RM50 billion of tax cuts magnifies the aggregate expenditure three times higher through the multiplier effect.

∆Y = ∆T X [multiplier] = ∆T X [-MPC/(1 – MPC)] = 50 X [-0.75/(1 – 0.75)] = 50 X [-3] ∆Y = -RM150 billion

Example

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Balanced- Budget Multiplier

• Definition:– The ratio of change in the equilibrium level of

output to a change in government spending where the change in government spending is balanced by a change in taxes so as not to create any deficit.

• The balanced-budget multiplier is equal to 1: – The change in Y resulting from the change in G

and the equal change in T is exactly the same size as the initial change in G or T itself.

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Balance of budget multiplier = 1

Tax multiplier + Government multiplier

= (-MPC)/MPS + 1/MPS

=1-MPC/MPS

= MPS/MPS

= 1

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Balance Budget:Increase in G = Decrease in TDecrease in G = Increase in T

∆ = RM50 billion

+∆G = – ∆T ∆Y = + G effect –T effect = + RM200 billion – RM150billion = + RM50 billion

Example

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11.2 Fiscal Policy11.2 Fiscal Policy

• Definition:– Government policy concerning taxes (T) and

expenditure (G).

• Tools:– Government expenditure (G) & taxes (T)

• Types:– Expansionary fiscal policy– Contractionary fiscal policy

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Expansionary Fiscal Policy

• Definition:– An increase in government spending or a

reduction in net taxes aimed at increasing aggregate output (income) (Y).

• Function:– To stimulate the economy.

• Problem: – Could lead to inflation– May lead to budget deficit because need debt

to finance the deficit, this will burden the next generation.

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Unemployment Vs. Fiscal Policy

• Solution:– Expansionary fiscal policy

Increase government expenditure and/or cut down taxes

Increase aggregate expenditureAggregate output increases

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Unemployment Vs. Fiscal Policy

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Contractionary Fiscal Policy

• Definition:– A decrease in government spending or an

increase in net taxes aimed at decreasing aggregate output (income) (Y).

• Function:– To slow down economy or demand-pulled

inflation.

• Problem:– Could cause unemployment– Usually lead to budget surplus.

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Inflation Vs. Fiscal Policy

• Solution:– Contractionary Fiscal Policy

Decrease government expenditure and/or increase taxes

Reduce aggregate expenditureAggregate output decreases

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Inflation Vs. Fiscal Policy

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11.3 Monetary Policy11.3 Monetary Policy

• Definition:– The behavior of the Federal Reserve

concerning the money supply.

• Tools:– Money supply (Ms) and Interest rate (r) by

central bank (CB).

• Types:– Expansionary monetary policy– Contractionary monetary policy

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Expansionary Monetary Policy

• Definition:– An increase in the money supply aimed at

increasing aggregate output (income) (Y).

• Function:– To stimulating the economy.

• Problem:– Could cause inflation.

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Unemployment Vs. Monetary Policy

• Solution:– Easy/Expansionary monetary policy:

• Increase money supply• Interest rate will drop• Effect investment• Effect local currency and net export

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Unemployment Vs. Monetary Policy

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Contractionary Monetary Policy

• Definition:– A decrease in the money supply aimed at

decreasing aggregate output (income) (Y).

• Function:– To slow down the economy.

• Problem:– Could cause unemployment.

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Inflation Vs. Monetary Policy

• Solution:– Decrease money supply – Interest rate will rise– Effect investment– Effect local currency and net export

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Inflation Vs. Monetary Policy

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Tools of Monetary Policy

• The central bank can affect the equilibrium interest rate by changing the supply of money using one of its three monetary tools:– Required reserve ratio (RRR)

– Discount rate

– Open market operation (OMO)

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Required Reserve Ratio (RRR)

• Definition:– The rule that specifies the amount of

reserved a bank must hold to back up deposits.

– Amount of a bank’s total reserves that may not be loaned out.

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• Decreases in the required reserve ratio allow banks to have more deposits with the existing volume of reserves. As banks create more deposits by making loans, the supply of money (currency + deposits) increases.

• If the Fed raise the required reserve ratio, in which case banks will find that they have insufficient reserves and must therefore reduce their deposits by “calling in” some of their loans. The result is a decrease in the money supply.

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Discount Rate

• Definition:– Interest rate that banks pay to the FED

to borrow from it.

– The interest rate the FED charges banks that borrow reserves.

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• The higher the discount rate, the higher the cost of borrowing, and the less borrowing banks will want to do.

• The lowest discount rate will encourage banks to borrow because of the lower cost of borrowing.

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Open Market Operation (OMO)

• Definition:– The purchase and sale by the Fed of

government securities in the open market.

– A tool used to expand or contract the amount of reserves in the system and thus the money supply

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• An open market purchase of securities by the FED results in an increase in reserves and an increase in the supply of money.

• An open market sale of securities by the FED results in a decrease in reserves and a decrease in the supply of money.

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11.4 CROWDING-OUT EFFECT

• Definition:– The tendency for increases in government

spending to cause reductions in private investment spending.

– Offset in AD that results when an expansionary fiscal policy raises interest rate and thereby reduces the investment spending.

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Crowding-out Effect

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