Lecture 11: Monetary & Fiscal Policy

Influencing the state of the economy

Purpose of the lecture

• Briefly review the main macroeconomic models

• Bring together the main macroeconomic models to show the effect of selected macroeconomic policies

• Briefly discuss the trade-off between employment and inflation

The purpose of policy

• Maintain long-term growth

• Stabilise the economy– Moderating the business cycle

• Maintain employment levels where possible

• Control inflation

Policy options for recessions

• Do nothing – Lower costs and wages will result in an

eventual increase in output.

• Stimulate aggregate demand with monetary policy

• Stimulate aggregate demand with fiscal policy

Do nothing (market correction)

Quantity ofOutput

PriceLevel

0

AS1

Long-runAS

AD1

A

B

C

P1

P2

P3

Y1Y2

AD2

AS2

The limits of self-correction

• Hardship for some households

• Adds to long-term unemployment

• Adds to consumer & producer pessimism

• Political unrest

Monetary Policy and Aggregate Demand

The process of monetary policyExpansionary & Contractionary

• Central bank buys securities

• O’night cash rate increases

• Interest rates increase• Increase in

consumption & investment

• Increase in aggregate demand

• Central bank selld securities

• O’night cash rate decreases

• Interest rates decrease• Decrease in

consumption & investment

• Decrease in aggregate demand

The result of expansionary monetary policy

Quantity ofOutput

PriceLevel

0

AS1

Long-runAS

AD1

A

B

P1

P2

Y1 Y2

AD2

When to use expansionary policy

• Growth rate is low; and

• Consumer and investor sentiment is pessimistic; but

• Inflation should also be low– Stimulation increases prices

Fiscal Policy & Aggregate Demand

Fiscal Policy

• Fiscal policy refers to the government’s choices regarding the overall level of government purchases or taxes.

• Fiscal policy influences saving, investment, and growth in the long run.

• In the short run, fiscal policy primarily affects the aggregate demand.

Fiscal Policy

• The Federal government’s control of the economy is both direct and indirect.– Its expenditures have a direct effect on

aggregate demand.– Taxes and tax policy have an indirect effect on

consumer spending.

The Multiplier Effect of Government Purchases

• Government purchases are said to have a multiplier effect on aggregate demand.– Each dollar spent by the government can raise

the aggregate demand for goods and services by more than a dollar.

• The total impact on the quantity of goods and services demanded can be much larger than the initial change in government spending.

The Multiplier Effect of Government Purchases

AD1

AD2

Quantity of Output0

PriceLevel

1. An increase in government purchases of $5 billion initially increases aggregate demand by $5 billion…

AD3

2. …but the multiplier effect can amplify the shift in aggregate demand.

A Formula for the Government Purchases Multiplier

• The formula for the multiplier is:

Multiplier = 1/(1 - MPC)• An important number in this formula is the

marginal propensity to consume (MPC).– It is the fraction of extra income that a

household consumes rather than saves.– eg if households spend 80 cents out an extra $1

they earn, then the MPC is 0.8

An Example of the multiplier effect

• MPC = 0.9• Multiplier = 1/(1-0.9) = 1/0.1 = 10• Government spends $200,000• Extra activity = 10 x $200,000 = $2,000,000• NB same mathematical principle as the

money multiplier– Size of increase is determined by how much is

‘kept back’

Changes in Taxes

• When the government cuts taxes, it increases households’ take-home pay.– Households save some of this additional

income.– Households also spend some of it on consumer

goods.– Increased household spending shifts the

aggregate-demand curve to the right.

Changes in Taxes

• The size of the resulting shift in aggregate demand is also affected by the multiplier and crowding-out effects.

• The size of the shift in the aggregate demand is also determined by the households’ perceptions about the permanency of the tax change.

Automatic Stabilisers

• Automatic stabilisers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action.

Examples of automatic stabilisation

• Taxes automatically decline in a recession– Helps maintain disposable income

• Government welfare payments– Increase in total in recessions

The Crowding Out Effect

The Crowding-Out Effect

• Fiscal policy may not affect the economy as strongly as predicted by the multiplier.– An increase in government purchases

causes the interest rate to rise.– A higher interest rate reduces investment

spending.

The Crowding out effect of fiscal stimulation

AD1

AD2

Quantity of Output0

PriceLevel

1. An increase in government purchases initially increases aggregate demand

AD3

2. …but higher interest rates lead to a decrease in investment and a decrease in aggregate demand.

The Employment/Inflation Trade-off

• Society faces a short-run trade-off between unemployment and inflation.– If policymakers expand aggregate demand, they

can lower unemployment, but only at the cost of higher inflation.

– If we reduce aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment.

The Phillips Curve

• The Phillips curve illustrates the short-run relationship between inflation and unemployment.

• It shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve.

Aggregate Demand, Aggregate Supply, and the Phillips Curve

• The greater the aggregate demand for goods and services, the greater is the economy’s output, and the higher is the overall price level.

• A higher level of output results in a lower level of unemployment.

Phillips Curve

Unemployment Rate (percent)0 4 7

Inflation Rate

(percent per year)

B

A

6

2

Phillips curve

Policy Impact

• Monetary and fiscal policy can shift the aggregate demand curve, thus moving the economy along the Phillips curve.– The Phillips curve illustrates the trade-off between

inflation and unemployment faced by policymakers.

The employment growth trade-off

6

Unemployment rate (%)0

3. …Unemployment decreases but inflation increases.

(a) AD/AS Model

1. Output = $5 b & Unemployment = 8 percent

Output ($b)0

AD1

AS1

106102

2. Demand increases to output of $6b

(b) The Phillips Curve

3 8

Inflation rate

2

Price level (deflator)

*

*

**

5 6

AD2

The Phillips Effect in Australia1960s-1990s

The Phillips Curve in the 1960s Include figure 18.8 here

Generally low inflation rate and low unemployment rate

The Phillips Curve in the 1970s and early 1980s

Include figure 18.11 here

Generally high inflation and medium to high unemployment rate

The Phillips Curve in the late 1980s and early1990s

Insert Figure 18.12

Generally low inflation rate and medium to high unemployment rate

Policy trends

• Growth a priority in the 1960s• Wage control in the mid-1980s reduced supply-

side wage pressures on inflation. • Restrictive monetary policy in the late 1980s

– Inflation fell but unemployment rose.

• Current RBA policy is generally keeping inflationary expectations low.– Medium unemployment rate

MACROECONOMIC POLICY MACROECONOMIC POLICY DEBATESDEBATES

Should Policymakers try to stabilise the economy?YES Vs NO

• The economy is inherently unstable.

• Monetary and fiscal policy can influence aggregate demand and offset this.

• No reason for society to suffer through the booms and busts of the business cycle.

• Stabilising aggregate demand will boost production and employment.

• There are time lags between decision & response for both monetary & fiscal policy

• This means intervention will be largely ineffective in the short run and may be harmful by exacerbating downturns or upswings

Monetary PolicyRules’ vs ‘Discretion

• Discretionary policy can easily be mismanaged

• Policy is manipulated in the political business cycle

• Policy makers don’t follow through on announcements

• Economic actors are sceptical about announcements

• Need moderate and steady growth of the money supply to limit the problems

• The problems of discretionary policy are not proven

• Need flexibility for changing circumstances

• Leave it to the experts

• What rules are valid anyway?

The central bank should aim for zero inflationYES Vs NO

• No benefits but many costs to inflation– eg shoeleather, menu, etc

• Reducing inflation is a policy with temporary costs and permanent benefits.– Once the disinflationary

recession is over, the benefits of zero inflation would persist.

• Zero inflation is probably unattainable and output and unemployment costs from policy are too high.

• Instead aim for a low inflation.

• Policymakers can reduce many of the costs of inflation without actually reducing inflation.

The Government should balance the budgetYES Vs NO

• Deficits are a burden on future generations– Need more taxes or

less spending

• Deficits reduce savings & therefore investment in capital & therefore lower growth

• The problem of deficits is often exaggerated.

• Current govt spending may produce benefits well into the future.

• Need flexibility in spending for emergencies etc

• Govt debt can increase because population growth and technological progress increase the nation’s ability to pay the interest on the debt.

Tax laws should be reformed to encourage savingYES

• A nation’s productive capability is determined largely by how much it saves and invests for the future.

• A nation’s saving rate is a key determinant of its long-run economic prosperity.

• When the saving rate is higher, more resources are available for investment in new plant and equipment.

Tax laws should be reformed to encourage savingYES

• We heavily tax the income from capital and reduce benefits for those who have accumulated wealth.

• This reduces saving, capital accumulation, lower labour productivity and economic growth.

Tax laws should be reformed to encourage savingYES

• An alternative to income tax policies advocated by many economists is a consumption tax.

• With a consumption tax, a household pays taxes based on what it spends not on what it earns.– Income that is saved is exempt from taxation

until the saving is later withdrawn and spent on consumption goods.

Tax laws should be reformed to encourage savingNo

• Such changes in tax laws would primarily benefit the wealthy.– High-income households save a higher fraction

of their income than low-income households.– Any tax change that favours people who save

will also tend to favour people with high incomes.

Tax laws should be reformed to encourage savingNo

• Reducing the tax burden on the wealthy would lead to a less egalitarian society.

• Raising public saving by eliminating the government’s budget deficit would provide a more direct and equitable way to increase national saving.

Conclusion

• The study of economics does not always make it easy to choose among alternative policies.

• Few if any policies come with benefits but no costs.

• The study of economics should make you a better participant in our national debates.

Self-Test (Hakes & Parry): Chapter 17

• Match all Terms & Definitions• Answer questions 2 & 3 of the Practice Problems• Answer Short Answer questions 6, 8 & 10• Do all True/False Questions• Answer Multiple Choice Questions 6, 8, 9, 10, 15,

& 18• Check answers in guide and revise accordingly

Self-Test (Hakes & Parry): Chapter 18

• Answer question 3 of the Practice Problems• Answer Short Answer question 7• Answer Multiple Choice Questions 1, 2, 4, 5 & 8• Check answers in guide and revise accordingly

Self-Test (Hakes & Parry): Chapter 19

• Match all Terms & Definitions• Answer question 1 of the Practice Problems• Answer Short Answer questions 1, 3, 5 & 8• Do all True/False Questions• Answer Multiple Choice Questions 1, 2, 3, 5, 7, 8

& 11• Make notes on the Advanced Critical Thinking

questions 1 & 2• Check answers in guide and revise accordingly

Reading

• This week: Text and Study Guide Chapters 17 & 19 and the main points from 18

• Revision