Monetary and fiscal Monetary and fiscal policy in a closed policy in a closed

economyeconomy

2

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4

Bringing together the real and financial sectorsBringing together the real and financial sectors

Having seen equilibrium in the goods Having seen equilibrium in the goods

and money markets separately,and money markets separately,

it is now time to explore the links it is now time to explore the links

between thembetween them

and to look at simultaneous equilibrium and to look at simultaneous equilibrium

in both.in both.

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Consumption revisitedConsumption revisited

► Income is a key determinant of consumptionIncome is a key determinant of consumption► but other factors shift the consumption but other factors shift the consumption

functionfunction household wealthhousehold wealth availability of creditavailability of credit cost of creditcost of credit

► These create a link between the financial These create a link between the financial and real sectorsand real sectors because interest rates can be seen to influence because interest rates can be seen to influence

consumption.consumption.

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The permanent income The permanent income hypothesishypothesis

►A modern theory of consumption A modern theory of consumption developed by Milton Friedmandeveloped by Milton Friedman argues that people like to smooth planned argues that people like to smooth planned

consumption even if income fluctuatesconsumption even if income fluctuates

►Consumption depends upon Consumption depends upon permanentpermanent not transitory income. not transitory income.

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Savings occur duringmiddle ageand dissaving in youthand old age.

The life-cycle hypothesisThe 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

8

Ricardian equivalenceRicardian equivalence

► Individuals will react to a shock such as Individuals will react to a shock such as a tax change in different ways, a tax change in different ways, depending on whether changes are depending on whether changes are seen to be temporary or permanent.seen to be temporary or permanent.

► If the government cut taxes today, but If the government cut taxes today, but individuals realise this will have to be individuals realise this will have to be balanced by higher taxes in the future, balanced by higher taxes in the future, then present consumption may not then present consumption may not adjust.adjust.

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Investment demandInvestment demand

► Investment spending includes:Investment spending includes: fixed capitalfixed capital

► Transport equipmentTransport equipment► Machinery & other equipmentMachinery & other equipment► DwellingsDwellings► Other buildingsOther buildings► IntangiblesIntangibles

working capitalworking capital► stocks (inventories)stocks (inventories)► work in progresswork in progress

► and is undertaken by private and public sectorsand is undertaken by private and public sectors

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Analysis of fixed investment in the Analysis of fixed investment in the UK by type of asset 1965-1998UK by type of asset 1965-1998

02 04 06 08 0

1 0 01 2 01 4 01 6 0

£ b

illi

on

T r a n s O t h e r m c / e q D w e l l i n g s O t h e r b u i l d I n t a n g i b l eSource: Economic Trends Annual Supplement, Monthly Digest of Statistics

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The demand for fixed The demand for fixed investmentinvestment

► Investment entails present sacrifice for Investment entails present sacrifice for future gainsfuture gains firms incur costs in the short runfirms incur costs in the short run but reap gains in the long runbut reap gains in the long run

►Expected returns must outweigh the Expected returns must outweigh the opportunity cost if a project is to be opportunity cost if a project is to be undertakenundertaken

►so at relatively high interest rates, less so at relatively high interest rates, less investment projects are viable.investment projects are viable.

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The investment demand The investment demand scheduleschedule

… 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

13

Interest rates and aggregate Interest rates and aggregate demanddemand

►The position of the AD schedule is now The position of the AD schedule is now

seen to depend upon interest rates seen to depend upon interest rates

through the effects on through the effects on

consumptionconsumption

investmentinvestment

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Monetary policyMonetary policywhen aggregate demand depends upon the interest ratewhen 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

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Fiscal policy and crowding Fiscal policy and crowding outout

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

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Goods market equilibrium Goods market equilibrium

►The goods market is in equilibrium The goods market is in equilibrium when the aggregate demand and when the aggregate demand and actual income are equalactual income are equal

►The The IS scheduleIS schedule shows the different shows the different combinations of income and interest combinations of income and interest rates at which the goods market is in rates at which the goods market is in equilibrium.equilibrium.

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The IS scheduleThe 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

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Money market equilibrium Money market equilibrium

►The money market is in equilibrium The money market is in equilibrium when the demand for real money when the demand for real money balances is equal to the supply.balances is equal to the supply.

►The The LM scheduleLM schedule shows the different shows the different combinations of income and interest combinations of income and interest rates at which the money market is in rates at which the money market is in equilibrium.equilibrium.

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The LM scheduleThe 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.

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Shifting IS and LM schedulesShifting IS and LM schedules

►The The positionposition of the IS schedule of the IS schedule depends upon:depends upon: anything (other than interest rates) that anything (other than interest rates) that

shifts aggregate demand: e.g.shifts aggregate demand: e.g.►autonomous investmentautonomous investment►autonomous consumptionautonomous consumption►government spendinggovernment spending

►The The positionposition of the LM schedule of the LM schedule depends upondepends upon money supplymoney supply (the price level)(the price level)

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Equilibrium in goods and money marketsEquilibrium 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.

22

Fiscal policy in the IS-LM modelFiscal 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.

23

Monetary policy in the IS-LM modelMonetary 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.

24

The composition of aggregate The composition of aggregate demanddemand

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.

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But...But...

►The IS-LM model seems to offer The IS-LM model seems to offer government a range of options for government a range of options for influencing equilibrium income.influencing equilibrium income.

►But…But… there are other issues to be consideredthere are other issues to be considered

►the price level and inflationthe price level and inflation►the supply-side of the economythe supply-side of the economy►the exchange ratethe exchange rate

26

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