MACROECONOMICS LECTURE 2

FISCAL POLICY There are a variety of ways in which policy makers can influence the economy Fiscal policy is the government’s decisions about spending and taxes; it is where the government uses changes in government spending or taxes to influence the economy

Income expenditure model MODEL SUMMARY Income expenditure model Y National Income C Consumer spending I Investment G Government spending X Spending on Exports M Spending on Imports AE Aggregate Expenditure

MODEL SUMMARY Agg. Expenditure AE = C + I + G + (X-M) Injections I + G + X Withdrawals S + T + M Net Exports (X – M) Disposable Income YD=(1-t)Y Tax revenue T = tY Budget Deficit (G – tY)

EQUILIBRIUM NATIONAL INCOME AE Y 45 330 440 Expenditure=Income AE=330+0.25Y

Fiscal Policy?

FISCAL POLICY To raise the level of economic activity: - raise government spending. The rise in aggregate expenditure raises output

Expansionary Fiscal Policy: Income goes up

withdrawals injections

FISCAL POLICY To raise the level of economic activity: - lower income tax. Less taxes increases disposable income in the economy

FISCAL POLICY The slope of AE increases

Expansionary Fiscal Policy: Income goes up

withdrawals injections

Conversely: To lower economic activity (Y) - lower government spending - raise taxes Graphically this looks like this…

GOVERNMENT SPENDING The Government Budget deficit = (Gov spending on good and services) - (indirect tax revenue + direct tax rev) Therefore = Expenditure – Revenue = G – tY

FISCAL POLICY When considering fiscal policy we need to be aware of: The Multiplier Effect

The MULTIPLIER Effect Y = k x G

MULTIPLIER – You have a go! Knowledge of the multiplier is very useful for policy makers. For example, suppose the Government wishes to raise national income by US$18 billion. If the multiplier is 3, by how much should government spending be increased? Y = k x G 18 3 ??

MULTIPLIER – You have a go! Knowledge of the multiplier if very useful for policy makers. For example, suppose the Government wishes to raise national income by US$18 billion. If the multiplier is 3, by how much should government spending be increased? Y = k x G 18 3 ?? G = US$6 bn D

NEXT TOPIC As well as using fiscal policy to influence the economy, governments can also use Monetary Policy In England, the Bank of England is responsible for Monetary Policy To understand what is meant by Monetary Policy we must first understand what is meant by “Money”

MONEY Historically many items have served as money e.g. dogs teeth (admiralty islands), sea shells (Africa), gold (19th Century), cigarettes (prisoner of war camps) notes and coins (legal tender) To serve as “money” an item must fulfill as number of functions…

FUNCTIONS OF MONEY Medium of Exchange Money provides medium for exchange of goods and services; is more efficient than barter, which wastes resources.

BARTER ECONOMY A barter economy is inefficient: people spend a lot of time and effort finding people who want to swap As an example of a barter economy, consider the following account of life without money, during the 1800s, from the World Development Report (1989)…

FUNCTIONS OF MONEY Store of value Money can be used to make purchases in the future Unit of Account A unit in which prices are quoted and accounts are kept. Standard of Deferred Payment A unit of account over time: enables borrowing and lending.

FUNCTIONS OF MONEY Money is any generally accepted means of payment for delivery of goods or the settlement of debt Notes and coins are “legal tender” so legally they must be accepted as means of payment for goods and services. But how about a current account?

MONEY

MONEY

MONEY SUPPLY MONEY SUPPLY value of total stock of money, the medium of exchange, in circulation. M0= notes and coins in circulation outside the BOJ + bank’s cash reserves at the BOJ (narrow money)

MONEY SUPPLY M2 = notes and coins held by the public + dollar retail deposits at JA banks and building societies M4 = M2 + all other private sector interest bearing deposits (including time deposits) of banks and building societies, and certificates of deposits. (broad money)

MONEY SUPPLY M0 M2 M4

MONEY SUPPLY Deposits form the largest part of M2 and M4. Banks and building societies create money by lending out their excess reserves.

WAYS OF HOLDING WEALTH MONEY BONDS CASH DEMAND DEPOSITS TIME DEPOSITS BONDS, BILLS GILT EDGED SECURITIES PERPETUITIES SHARES (EQUITIES) MONEY BONDS

WAYS OF HOLDING WEALTH

Opportunity cost of holding money?

DEMAND FOR MONEY Why do people hold money? We identify a number of motives for holding their wealth as money (rather than any other form of financial instrument)

DEMAND FOR MONEY Transactions Motive Money is held to finance known transactions Precautionary Motive People hold money to meet unforeseen contingencies

DEMAND FOR MONEY Asset Motive People hold money as a low risk component of a mixed portfolio Precautionary Motive People hold money to exploit a profitable opportunity to invest in bonds which may arise.

DEMAND FOR MONEY How does the “demand for money” change when there is a: Change in the interest rate? Change in income? Change in price?

DEMAND FOR MONEY People hold money up to the point at which the marginal benefit of holding money just equals its marginal cost in interest forgone.

DEMAND FOR MONEY

Increase in interest rate reduces money holdings

Increase in income raises money holdings

DEMAND FOR MONEY Let us distinguish between: Nominal Money Demand is in terms of so many pounds Real Money Demand is in terms of so many units of goods and services that the money can buy

DEMAND FOR MONEY We can take these findings and construct another curve, the so called “money demand” schedule or the “liquidity preference” curve. As the interest rate rates, money demand falls… As income rises, money demand increases…

MONEY DEMAND CURVE

MONEY DEMAND CURVE

MONEY SUPPLY CURVE

MONEY MARKET EQUILIBRIUM

MONEY MARKET EQUILIBRIUM Money market equilibrium occurs when the quantity of real money balances demanded equals the quantity supplied.

MONETARY POLICY Monetary policy is used when the Bank of Jamaica deliberately alters the supply of money or the interest rate in order to influence the level of aggregate demand in the economy and therefore output, employment and prices.

MONETARY POLICY

MONETARY POLICY

MONETARY POLICY

MONETARY POLICY

MONETARY POLICY

PRACTICAL PROBLEMS TIME LAGS POLITICAL PRESSURE EVASION OF CONTROLS UNCERTAINTY ABOUT MONEY DEMAND EXCHANGE RATE REGIME

MIXING POLICIES It is possible to mix policies. A given level of AD can be achieved either by: i) Loose Fiscal Policy (high G, low t) and a Tight Monetary Policy (high r). This gives a large public sector and a relatively small private sector

MIXING POLICIES (ii) Tight Fiscal Policy (low G, high t) and a Loose Monetary Policy (low r). This would give a small public sector and a relatively large private sector. (iii) Demand Management is the use of monetary policy and fiscal policy to stabilize output near the level of potential output

There is another type of policy… (iv) SUPPLY SIDE POLICIES Supply side economics is the pursuit of policies aimed not at increasing aggregate demand but aggregate supply. Supply side policies include: