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Chapter 25Monetary and fiscal policy in a closed economy
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
6th Edition, McGraw-Hill, 2000
Power Point presentation by Peter Smith
25.2
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.
25.3
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.
25.4
The permanent income hypothesis
A modern theory of consumption developed by Milton Friedman– argues that people like to smooth
planned consumption even if income fluctuates
Consumption depends upon permanent not transitory income.
25.5
Savings occur duringmiddle ageand dissaving in youthand old age.
The life-cycle hypothesis
A theory of consumption developed by Ando and Modigliani.
Age0
Inco
me ,
con
s um
p tio
n
Death
Individuals try to smooth their consumption, basedon expected lifetime income.Permanent
income
Thus wealth and interest rates may influence consumption.
Income varies over anindividual's lifetime.Actual
income
25.6
Ricardian equivalence
Individuals will react to a shock such as a tax change in different ways, depending on whether changes are seen to be temporary or permanent.
If the government cut taxes today, but individuals realise this will have to be balanced by higher taxes in the future, then present consumption may not adjust.
25.7
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
25.8
Analysis of fixed investment in the UK by type of asset 1965-1998
020406080
100120140160
1965
1975
1985
1995
£ b
illi
on
Trans Other mc/eq Dwellings Other build Intangible
Source: Economic Trends Annual Supplement, Monthly Digest of Statistics
25.9
The demand for fixed investment
Investment entails present sacrifice for future gains– firms incur costs in the short run– but reap gains in the long run
Expected returns must outweigh the opportunity cost if a project is to be undertaken
so at relatively high interest rates, less investment projects are viable.
25.10
The investment demand schedule
… shows how much investment firms wish toundertake at each interest rate.
Investment demand
Inte
rest
ra t
e
II
At relatively high interest rates, less investmentprojects are viable.
At r0, I0 projects are viable.r0
I0
but if the interest rate rises to r1, desiredinvestment falls to I1.
r1
I1
25.11
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
25.12
Monetary policywhen aggregate demand depends upon the interest rate
Income
Agg
rega
te d
eman
d
45o line
AD0
Y0
CC 0
Suppose the economy starts with consumptionat CC0, investment at I0and equilibrium at Y0.
I0
A fall in interest ratesshifts the consumption function to CC1, and leads to higher investment at I1.
CC1I1
Aggregate demand risesto AD1, and the newequilibrium is at Y1.
AD1
Y1
25.13
Fiscal policy and crowding out
Income
Agg
rega
te d
eman
d
45o line
AD0
Y0
Suppose an increase ingovernment spendingshifts the AD curve to AD1.AD1 Initially, equilibrium
moves to Y1.
Y1
But higher income raisesmoney demand, so interest rates rise
and consumption and investment fall, shifting AD back to AD2 and equilibriumincome to Y2.
AD2
Y2
25.14
Goods market equilibrium
The goods market is in equilibrium when the aggregate demand and actual income are equal
The IS schedule shows the different combinations of income and interest rates at which the goods market is in equilibrium.
25.15
The IS schedule
Income
AD
45o line
Income
r
AD0
r0
At a relatively high interestrate r0, consumption andinvestment are relatively low – so AD is also low.
Y0
Y0
Equilibrium is at Y0.
Y1
Y1Equilibrium is at Y1.
IS
The IS schedule shows allthe combinations of realincome and interest rateat which the goods market is in equilibrium.
AD1
At a lower interest rate r1
Consumption, investmentand AD are higher.
r1
25.16
Money market equilibrium
The money market is in equilibrium when the demand for real money balances is equal to the supply.
The LM schedule shows the different combinations of income and interest rates at which the money market is in equilibrium.
25.17
The LM schedule
r r
IncomeReal moneybalancesL0
LL0
r0 r0
Y0
At income Y0, money demand is at LL0 and equilibrium in the money market requires an interest rate of r0.
r1
Y1
r1
LL1
At Y1, money demand is at LL1,and equilibrium is at r1.
LM
The LM schedule traces out the combinations of real incomeand interest rate in which the money market is in equilibrium.
25.18
Shifting IS and LM schedules
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
The position of the LM schedule depends upon– money supply– (the price level)
25.19
Equilibrium in goods and money markets
Income
r
IS
Bringing together the IS schedule (showinggoods market equilibrium)
LM
and the LM schedule(showing money market equilibrium).
Y*
r*
We can identify theunique combination ofreal income and interestrate (r*, Y*) which ensuresoverall equilibrium.
25.20
Fiscal policy in the IS-LM model
Income
r
IS0
LM
Y0
r0
Y0, r0 represents the initial equilibrium.
IS1
A bond-financed increase in governmentspending shifts the ISschedule to IS1.
r1
Y1
Equilibrium is now at r1, Y1.
Some private spending has been crowded outby the increase in therate of interest.
25.21
Monetary policy in the IS-LM model
Income
r
IS0
LM0
Y0
r0
Y0, r0 represents the initial equilibrium.
LM1
An increase in money supply shifts the LMschedule to the right.
Y1
r1 Equilibrium is now at r1, Y1.
25.22
The composition of aggregate demand
Income
r
Demand management is the use of monetary and fiscal policy to stabilize the level of income around a high average level.
Y*
Income level Y* canbe attained by:
LM0
IS0
r2
‘Tight’ fiscal policy (IS0) with ‘easy’ monetary policy (LM0)
IS1
LM1
r1 OR with ‘easy’ fiscalpolicy (IS1) with ‘tight’monetary policy (LM1).
This affects the private:public balance of spendingin the economy.
25.23
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
the price level and inflation the supply-side of the economy the exchange rate