Chapter 25 Monetary 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 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 25.1 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 25.2 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 25.3 The life-cycle hypothesis A theory of consumption developed by Ando and Modigliani Actual income Permanent income Income varies over an individual's lifetime Individuals try to smooth their consumption, based on expected lifetime income Savings occur during middle age Death and dissaving in youth Age and old age Thus wealth and interest rates may influence consumption 25.4 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 25.5 Investment demand  Investment spending includes: – fixed capital   Machinery & other equipment  Dwellings  Other buildings  – Transport equipment Intangibles working capital    stocks (inventories) work in progress and is undertaken by private and public sectors 25.6 Other mc/eq Dwellings Other build 95 19 85 19 19 19 Trans 75 160 140 120 100 80 60 40 20 65 £ billion Analysis of fixed investment in the UK by type of asset 1965-1998 Intangible Source: Economic Trends Annual Supplement, Monthly Digest of Statistics 25.7 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  25.8 The investment demand schedule … shows how much investment firms wish to undertake at each interest rate At relatively high interest rates, less investment projects are viable At r0, I0 projects are viable r1 r0 I1 I0 II but if the interest rate rises to r1, desired investment falls to I1 Investment demand 25.9 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 25.10 Monetary policy Aggregate demand when aggregate demand depends upon the interest rate I1 I0 Y0 Suppose the economy starts with consumption 45o line AD1 at CC0, investment at I0 and equilibrium at Y0 AD0 CC1 A fall in interest rates shifts the consumption CC function to CC , and leads to higher investment at I1 Aggregate demand rises Y1 Income to AD1, and the new equilibrium is at Y1 25.11 Aggregate demand Fiscal policy and crowding out 45o line Suppose an increase in government spending shifts the AD curve to AD1 AD1 Initially, equilibrium AD2 moves to Y AD0 But higher income raises money demand, so interest rates rise Y0 Y2 Y1 Income and consumption and investment fall, shifting AD back to AD2 and equilibrium income to Y2 25.12 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 25.13 The IS schedule 45o line AD1 AD0 r r0 Y0 Y1 Income r1 IS Y0 Y1 Income At a relatively high interest rate r0, consumption and investment are relatively low – so AD is also low Equilibrium is at Y0 At a lower interest rate r1 Consumption, investment and AD are higher Equilibrium is at Y1 The IS schedule shows all the combinations of real income and interest rate at which the goods market is in equilibrium 25.14 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 25.15 The LM schedule r r LM r1 r1 r0 LL1 r0 LL0 L0 Real money balances Y0 Y1 Income At income Y0, money demand is at LL0 and equilibrium in the money market requires an interest rate of r0 At Y1, money demand is at LL1,and equilibrium is at r1 The LM schedule traces out the combinations of real income and interest rate in which the money market is in equilibrium 25.16 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) 25.17 Equilibrium in goods and money markets Bringing together the LM IS schedule (showing goods market equilibrium) r and the LM schedule (showing money market equilibrium) r* IS Y* Income We can identify the unique combination of real income and interest rate (r*, Y*) which ensures overall equilibrium 25.18 Fiscal policy in the IS-LM model Y0, r0 represents the initial equilibrium r LM r1 r0 Y0 Y1 A bond-financed increase in government spending shifts the IS schedule to IS1 IS1 Equilibrium is now at IS0 r1, Y1 Some private spending has been crowded out Income by the increase in the rate of interest 25.19 Monetary policy in the IS-LM model Y0, r0 represents the initial equilibrium r LM0 r0 r1 IS0 Y0 Y1 An increase in money LM1 supply shifts the LM schedule to the right Equilibrium is now at r1, Y1 Income 25.20 The composition of aggregate demand Demand management is the use of monetary and fiscal policy to stabilize the level of income around a high average level r LM1 Income level Y* can be attained by: ‘Tight’ fiscal policy (IS0) LM0 with ‘easy’ monetary policy (LM 0) r1 r2 IS1 IS0 Y* Income OR with ‘easy’ fiscal policy (IS1) with ‘tight’ monetary policy (LM1) This affects the private: public balance of spending in the economy 25.21 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 25.22 ... during middle age Death and dissaving in youth Age and old age Thus wealth and interest rates may influence consumption 25.4 Ricardian equivalence  Individuals will react to a shock such as a. .. 25.11 Aggregate demand Fiscal policy and crowding out 45o line Suppose an increase in government spending shifts the AD curve to AD1 AD1 Initially, equilibrium AD2 moves to Y AD0 But higher income... 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