Advanced Macroeconomics Lecture: Stabilization policy Date: 22.06.2014

Advanced Macroeconomics

Lecture: Stabilization policyDate: 22.06.2014

Investment

• The value of that part of the economy’s output for any time period that takes the form of new structure, new producres’ durable equipment and change in inventories

• InventoriesStocks of goods held by business in production-Materials awaiting for use-Goods in process-Finished products awaiting sale to the distributors or

final users

Investment

The decision to invest depends on prospective profitability which is determined by three elements

- The expected income flow from the capital good

- Purchase price of that good- The market rate of interest

Investment function

• Investment demand functionI=e-dRWhere,I=InvestmentR=Rate of intereste=Autonomous Investmentd=Slope (Rate of change in investment due to

the percentage change in interest rate)

Investment function

• Investment FunctionInterest rate R

Investment I

∆I

∆R

Net export

• Net export= Export – Import• Net export is negatively related with the rate of interest• If interest rate is higher in the domestic economy then

say in BD, its attractive to put funds in taka, there will be appreciation of currency→ Higher exchange rate → export goods more expensive

• Imports become cheaper• Fall in net export• Hence net export depend negatively on the interest rate

Interest rate

• Nominal interest Rate• Real interest rate• Real interest rate=Nominal interest rate-

Expected rate of inflation• Nominal interest rate is 10 percent and

expected rate of inflation rate is 6 percent then real interest rate is 4 percent

• Implication large in the financial market???

Key macro relationships

• Macro variables• The endogenous VariablesIncome YConsumption, CInvestment, INet export, XInterest rate, R• The exogenous variablesGovernment purchases, G and Money supply, M(Decided by CB, Government)

Key macro relationships

• Five relationships• Y=C+I+G+X (Income identity)• C=a+ (1-t)Y(Consumption Function)• I=e-dR(Investment function)• X=Export-Import(Net export function)• M=(kY-hR)P (Money demand function where k

and h are constant)

Key macro variables

Dependent Variables Independent Variables

Consumption Tax , Income

Investment Interest rate

Export Interest rate

Money Supply Interest rate, Income

IS Curve

• Shows all the combinations of R and Y at which ex ante investment is equal to ex ante savings

• I stands for investment and S for savings• Downward sloping curve as higher interest rate reduces

investment and net export, hence reduces GDP through multiplier effect

R

GDP Y

IS curve

Effects

G↑

→

R

Y

IS Curve

LM Curve

• Shows different combinations of Y and R at which the ex ante demand for money holding, L is equal to the ax ante supply of money for a given level of the money balances M

• L stands for liquidity preference and M, for money supply• Slopes upward as increase in interest rate reduces money

demand, • As money supply is fixed, to offset the demand fall,

income must increase to push up the money demand for equilibrium in the money market

• Hence if interest rate increases income increases

LM Curve

• LM curve

R

Y

LM curve

Effects

• Nominal Money, M• Real money M/P• M/P= kY-hR• If money supply increases in the economy

then LM curve shits to the right

R

Y

LM curve→

Equilibrium in both money and product market

• Y and R that satisfies the equilibrium condition both in the money market and product market

R

Y

LM

IS

Monetary Policy

• IS curve shows all the combinations of Y and R that satisfy the spending balance

• LM curve shows all the combinations of Y and R that satisfy money market equilibrium

• Monetary expansion• M↑, More money in the economy, money supply

exceeds money demand, R ↓, demand for money increases

• Lower interest rate stimulates investment and net export

Monetary Policy

• Monetary Expansion

R1

R2

Y1

Y2

LM

IS

Fiscal policy

• Government decides to increase defense spending• G↑, increases GDP through multiplier, demand for

money is pushed up• More money is needed for transaction purpose• No change in money supply, to offset the excess money

demand, R↑• Increase in R reduces investment demand and net export• Thus offset some of the stimulus to GDP by government

spending• The offsetting negative effect is termed as crowding out

Fiscal Policy

Fiscal Expansion

R1

R2

Y1

Y2

LM

IS

Case Study (US)

• Expansionary policy in 1982• Booming in 1987• Inflationary pressure in the economy• Tighten monetary policy• Short term interest rate rose from 6 to 10% end

of 1989• High interest rate on business and consumer

loans• Businesses and purchases decline

Case Study (US)

• As a result in the drop of demand, economy slowed down

• Inflationary pressure eased• Fed lowered interest rate• Slow economic growth continued as monetary

policy works with a lag• Slow growth culminated recession started in July,

1990 Could avoided recession but oil price hike with Iraque’s invasions in Kuwait and loss of consumers confidence

Relative effectiveness of Fiscal policy and monetary policy

• Depend on the sensitivity of investment demand and net export to interest rate

• The sensitivity of money demand to interest rate

Effectiveness of fiscal policy

• Expansionary fiscal policy would have a relatively weaker effect on AD if

• Interest rate is considerably high• Large negative effect on investment and net export• Fall in investment and net export will offset

the positive effect of fiscal expansion

Effectiveness of fiscal policy

• There would be two circumstances:• If the sensitivity of investment demand and

net export to the interest is very large theni↑, there will be sharp decrease in investment

and net export

Effectiveness of fiscal policy

• If the sensitivity of money demand is very small to the change in interest rate

• Then the increase in money demand that arises as a result of the increased government expenditure

• Would cause a big rise in interest rate• If the economy has higher interest sensitivity to

investment and net export and low interest sensitivity to money demand even a large multiplier will not result in strong effects of fiscal policy

Effectiveness of fiscal policy

• Expansionary fiscal policy would have stronger effect on AD if investment demand and net export is less sensitive to the change in interest rate

• Explanation is just reverse of the previous two circumstances

Effectiveness of Monetary policy

• An expansionary monetary policy have weaker effect on AD if the drop in interest rate that occurs due to the increase in money, small influence on investment demand or net export

Effectiveness of monetary policy

• Effectiveness depend on two circumstances• The sensitivity of investment and net export to

interest rate is very small then investment is not stimulated by the decline in interest rate

• The sensitivity of money demand to interest rate is very large then the increase in money supply doesn't cause much of a drop in interest rate

Effectiveness of monetary policy

• Expansionary monetary policy would have large impact if interest rate fall by a large amount and stimulate investment and net export, explanation is just opposite of the previous explanation

The IS-LM interpretation

• IS curve is relatively flat if investment demand and net export are highly sensitive to interest rate

• Small changes in interest rate is associated with big change in demand

• If IS curves is relatively steep implies investment and net export are relatively insensitive to interest rate

The IS-LM interpretation

• The LM curve is relatively flat if money demand is much sensitive to interest rate

• Small change in interest rate is sufficient to reduce money demand when it increases with a change in income

• LM curve is relatively steep if money demand is very much insensitive to interest rate

The IS-LM interpretation

• Relative effectiveness of monetary policy

IS(Flat)

LM

Fed: Strong

IS(Steep)

LM

Fed: Weak

R

YY

R

The IS-LM interpretation

• Relative effectiveness of monetary policy

LM(Flat)

IS

LM(Steep)

IS

Fed: WeakFed: Strong

R

YY

R

The IS-LM interpretation

• Effectiveness of fiscal policy

LM

Fiscal: Strong

IS (Steep)

LM

IS (Flat)

Fiscal: Weak

R

YY

R

The IS-LM interpretation

• Effectiveness of fiscal policy

LM(Flat)

IS

LM(Steep)

IS

Fiscal: Strong Fiscal : Weak

R

YY

R