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