Chapter 9 Monetary and Fiscal Policy in the Closed Economy Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Objectives Consider the effect of changes in monetary policy aggregate demand Explain the monetary policy transmission mechanism Consider the impact of fiscal policy on aggregate demand Analyse factors which may reduce the effectiveness of monetary and fiscal policy Review the policy mix in action Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Chapter Organisation 9.1 Monetary Policy 9.2 Fiscal Policy and Crowding Out 9.3 The Composition of Output and the Policy Mix 9.4 The Policy Mix in Action Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

9.1 Monetary Policy In Australia, the RBA is responsible for monetary policy. Monetary policy is conducted through open market operations (OMOs) to achieve a target short-term interest rate. OMOs involve the RBA buying and selling bonds. When the RBA buys bonds the money supply increases. When the RBA sells bonds the money supply decreases. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Monetary Policy Assume that the RBA conducts an open market purchase of bonds. When the RBA buys bonds, the quantity of bonds in the market decreases, which raises their price or lowers their yield. This increases the nominal quantity of money and, at the price level, the real quantity of money. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Monetary Policy Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Monetary Policy From Figure 9.3, the purchase of bonds shifts the LM curve will shift the right to LM'. Because money and assets adjust rapidly: The economy quickly moves to E1 on the new LM' curve This is consistent with money market equilibrium. However, at E1 there is goods market disequilibrium because the economy is off the IS curve. At E1 there is excess demand for goods. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Monetary Policy Because of the excess demand for goods: Inventories will fall Output must expand to Y' This increase in output will take time. Interest rates must also rise during this second process. Increase in output raises the demand for money. With constant money supply, interest rates must increase. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Monetary Policy The final equilibrium is at E' with A lower interest rate and a higher level of Y. Equilibrium Y increases because: Open market purchases reduce the interest rate, which increases investment spending. Note that the interest rate overshoots by: Quickly falling to equilibrate the money market Slowly rising as increased incomes increase the demand for real-money balances. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Monetary Policy The steeper the LM curve the larger the change in Y for a given increase in real money stock. Therefore, open market purchases are more effective in increasing Y if: Money demand is not very sensitive to the interest rate, and/or Money demand is not very sensitive to income. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Steps of the Transmission Mechanism change in real money supply portfolio adjustments lead to changes in asset prices and interest rates spending adjusts to changes in interest rates output adjusts to the change in AD Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Monetary Policy Three extreme cases provide useful illustrations of the possible limits to the effectiveness of monetary policy: - The liquidity trap - Failure to open the credit channel - The classical case. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Monetary Policy The liquidity trap is a situation whereby the public are willing to hold, at a given interest rate, whatever amount of money is supplied (h is infinite). This implies that the LM curve is horizontal. Changes to the money supply do not shift the LM curve. Monetary policy is powerless because it has no effect on interest rates or Y. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Monetary Policy Failure to open the credit channel. As interest rates fall banks may become reluctant to increase their lending. In this situation investment will not increase. If lending does not increase the transmission mechanism between the open market purchase by the RBA and aggregate demand is out of action. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Monetary Policy The classical case is a situation whereby the demand for money is unresponsive to the interest rate (h = 0). The LM curve is vertical. Shifts in the LM curve (a change in monetary policy) have a maximal effect on income. While shifts in the IS curve (changes in fiscal policy) do not affect income. This implies that the interest sensitivity of the demand for money has an important impact on policy effectiveness. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Chapter Organisation 9.1 Monetary Policy 9.2 Fiscal Policy and Crowding Out 9.3 The Composition of Output and the Policy Mix 9.4 The Policy Mix in Action Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

9.2 Fiscal Policy and Crowding Out The government may affect the IS curve through three avenues. The autonomous component through government expenditure: Purchases (G) Transfers (TR). The multiplier through income taxes (t). Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

An Increase in Government Spending Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Fiscal Policy and Crowding Out From Figure 9.4: Initially, the government increases spending. The IS curve shifts right by the autonomous increase times the multiplier G. However, at E" the money market is in disequilibrium as the increased income has increased money demand. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Fiscal Policy and Crowding Out The excess demand for money causes interest rates to rise. Firms’ planned investment spending declines at higher interest rates and AD falls off. The economy moves to E' where the goods market is back in equilibrium. Note that the economy does not move to E" because interest rates rise along the LM curve. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Fiscal Policy and Crowding Out Increased government spending increases both Y and interest rates. The increased interest rates reduce investment demand. Crowding out (CO) occurs when expansionary fiscal policy causes interest rates to rise, thereby reducing private spending, particularly investment. That is, public spending crowds out private spending. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Fiscal Policy and Crowding Out The factors that determine the extent of crowding out are: Flatter LM (less crowding out) Steeper IS (less crowding out) A larger multiplier shifts IS more, giving larger increases in Y and the interest rate. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Fiscal Policy and Crowding Out If the LM curve is horizontal (the economy is in a liquidity trap) then an increase in G has its full multiplier effect on the level of Y. There is no change in interest rates associated with the increase in G. Therefore, there is no crowding out of private investment spending. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Fiscal Policy and Crowding Out If the LM curve is vertical, (the classical case) an increase in G only raises the interest rate and has no effect on the level of Y. In this case, the increase in interest rates crowds out an amount of private spending equal to the increase in G. Thus there is full crowding out and fiscal policy is powerless. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Fiscal Policy and Crowding Out Is crowding out important? Crowding out may be a problem if fiscal policy expansion occurs when the economy is at/or very close to full employment. In this case, an increase in aggregate demand will increase the price level and result in a reduction in the real money supply. The decrease in the money supply shifts the LM curve to the left, raising interest rates, and full crowding out occurs. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Fiscal Policy and Crowding Out If there are unemployed resources in the economy, fiscal expansion will raise interest rates but output will also increase. The increase in income will expand savings, making it possible to fund a larger budget deficit without placing undue pressure on interest rates and private investment. In this case, partial crowding out may occur. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Fiscal Policy and Crowding Out Monetary accommodation may be used to stabilise interest rates. Monetising the budget deficit leads to further increases in output but not necessarily interest rates. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Chapter Organisation 9.1 Monetary Policy 9.2 Fiscal Policy and Crowding Out 9.3 The Composition of Output and the Policy Mix 9.4 The Policy Mix in Action Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Composition of Output and the Policy Mix Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Composition of Output and the Policy Mix Table 9.2 indicates that different policy options have different impacts on interest rates. Different policy options have different effects on the components of aggregate demand. Monetary policy impacts on interest-sensitive components such as investment. Fiscal policy effects depend on what goods and services the government buys or what taxes and transfers it changes. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Composition of Output and the Policy Mix Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Composition of Output and the Policy Mix Figure 9.8 shows the problem of reaching full-employment output, Y*, for an economy at E. Should fiscal policy be used so that point E1 is attained? Or should monetary policy be used so that point E2 is attained? This is the problem of political economy. Governments choose the policy mix in accordance with their objectives and their beliefs about the desirable size of the government sector. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Chapter Organisation 9.1 Monetary Policy 9.2 Fiscal Policy and Crowding Out 9.3 The Composition of Output and the Policy Mix 9.4 The Policy Mix in Action Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

9.4 The Policy Mix in Action The early 1980s recession and rapid recovery In mid-1981, Australia was experiencing strong growth in GDP (3.5% p.a.) and low unemployment (5.8%). The budget deficit was small and the full-employment budget was in surplus (1.2% of GDP). However, inflation was high (9.2%). Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Policy Mix in Action The RBA responded to the high prices by adopting a tight monetary stance (interest rates were 16%). As well, global economic activity slowed. As a result: Investment collapsed Exports fell Unemployment rose to over 9% The Australian economy went into recession. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Policy Mix in Action The 1990s recession and sluggish recovery The policy mix of the 1980s featured expansionary fiscal and tight monetary policy. In 1989, GDP growth and consumption growth was high. Unemployment was low at 6%. However, inflation remained a problem. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Policy Mix in Action The RBA responded by tightening interest rates, which saw nominal interest rates jump from 11% to 17% from 1988 to 1989. Growth slowed throughout 1989. Inflation declined slightly. Unemployment began to rise. Investment collapsed. The recession began in 1990. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Policy Mix in Action The RBA allowed interest rates to fall slowly as fears of an oil supply shock heightened with the invasion of Kuwait by Iraq. In 1991, the RBA began to cut interest rates aggressively. However, during this period, inflation fell fast, meaning real wages increased. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Policy Mix in Action This increased unemployment, which remained over 9% until mid-1994. The combination of the loosening of monetary policy and full-employment budget deficits helped the Australian economy to a modest recovery. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.