Macroeconomics (ECON 1211) Lecturer: Mr S Macroeconomics (ECON 1211) Lecturer: Mr S. Puran Topic: Monetary and Fiscal policy in a Closed Economy

1. 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.

2. Consumption Revisited Income is a key determinant of consumption but other factors shift the consumption function (mainly autonomous consumption) 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. See Section 25-1 in the main text.

3. The Keynesian Consumption Function Based on the Psychological Law of Consumption When there is an increase in the level of income, the MPC does not change in the same proportion as the change in income. It change by less There is a level of autonomous consumption which remains APC ( C/ Y)and MPC (< 1) See Section 25-1 in the main text.

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. See Section 25-1 in the main text.

4. The Permanent Income Hypothesis An individual has a current level of income and therefore has a brief idea of the consumption level he/she can sustain over his/her lifetime An increase in income: permanent or transitory Transitory: no major effect on consumption If the increase can be sustained then the individual will accept that permanent income has increase See Section 25-1 in the main text.

4. The Permanent Income Hypothesis An increase in permanent income will change consumption level as the former can sustain the latter Thus, consumption depends on what individual expect to earn over a considerable period of time Individuals save during period of high income and dissave during period of low income A Phd student should have a higher level of consumption than an undergraduate student See Section 25-1 in the main text.

4. The Permanent Income Hypothesis Example, past four years income: £12,000; £12,000; £10,000; £10,000 Then permanent income should be £11,000 Permanent income and life – cycle hypotheses loosen relationship C and Y so that an exogenous change in investment may not have a constant multiplier effect Temporary change in income: little effect in spending See Section 25-1 in the main text.

5. The Life - Cycle Hypothesis A theory of consumption developed by Ando and Modigliani. Income varies over an individual's lifetime. Actual income Savings occur during middle age Individuals try to smooth their consumption, based on expected lifetime income. Permanent income Income, consumption and dissaving in youth and old age. See Section 25-1 in the main text. Death Age Thus wealth and interest rates may influence consumption.

5. The Life – Cycle Hypothesis What are the goals of individuals: 1) They prefer a high standard of living to a low standard of living, 2) Most individuals prefer to have a constant standard of living throughout time Put together these two goals suggest that we assume that individuals try to maintain the highest, smooth consumption path See the "Economics in action" box in the main text.

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. See the "Economics in action" box in the main text.

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 See Section 25-2 in the main text. "Intangibles" includes investment in computer software etc.

8. 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. See Section 25-2 in the main text.

9. The Investment Demand Schedule … shows how much investment firms wish to undertake at each interest rate. II At relatively high interest rates, less investment projects are viable. Interest rate but if the interest rate rises to r1, desired investment falls to I1. r1 I1 At r0, I0 projects are viable. r0 I0 See Section 25-3 in the main text, and Figure 25-3. Investment demand

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

10. Inventory Investment Firms desire stocks of raw materials, partly finished goods awaiting sale Firms may be betting on price changes Many production process take time Stocks help smooth costly adjustments in output. If output demand rises suddenly, plant capacity cannot be changed overnight See Section 25-2 in the main text.

11. The Accelerator Theory of Investment Investment responds to changing demand condition. If D increases, there will be an excess demand for goods. Firms have two choices: either to raise prices or to meet demand by raising supply Keynesian: in order to meet higher production, firms will increase their output capacity by investing in plant and investment I = Kt – Kt-1 = Yt – Yt-1 I = Kt – Kt-1 = v (Yt – Yt-1) where v = K/Y See Section 25-2 in the main text.

12. Monetary Policy when aggregate demand depends upon the interest rate CC 0 Suppose the economy starts with consumption at CC0, investment at I0 and equilibrium at Y0. I0 45o line Aggregate demand rises to AD1, and the new equilibrium is at Y1. AD1 Y1 Aggregate demand AD0 A fall in interest rates shifts the consumption function to CC1, and leads to higher investment at I1. CC1 I1 See Section 25-3 in the main text. Income

13. Fiscal policy and Crowding out Suppose an increase in government spending shifts the AD curve to AD1. AD1 45o line Initially, equilibrium moves to Y1. Y1 Aggregate demand and consumption and investment fall, shifting AD back to AD2 and equilibrium income to Y2. AD2 Y2 AD0 But higher income raises money demand, so interest rates rise See Section 25-4 in the main text. Y0 Income

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. See Section 25-5 in the main text.

15. The IS schedule AD1 AD0 Y0 r r0 r1 IS Y1 At a relatively high interest rate r0, consumption and investment are relatively low – so AD is also low. 45o line AD1 At a lower interest rate r1 Consumption, investment and AD are higher. r1 AD Y1 Equilibrium is at Y1. Y0 Equilibrium is at Y0. Income r IS The IS schedule shows all the combinations of real income and interest rate at which the goods market is in equilibrium. See Section 25-5 in the main text and Figure 25-6. Income

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. See Section 25-5 in the main text.

17. The LM Schedule r r LM r1 Y1 LL1 LL0 r0 Y0 L0 The LM schedule traces out the combinations of real income and interest rate in which the money market is in equilibrium. r1 Y1 LL1 At Y1, money demand is at LL1,and equilibrium is at r1. LL0 r0 Y0 At income Y0, money demand is at LL0 and equilibrium in the money market requires an interest rate of r0. L0 Real money balances Income See Section 25-5 in the main text and Figure 25-7.

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) See Section 25-5 in the main text. Notice that although we have so far assumed the price level to be fixed, this will be relaxed in Chapter 26.

19. Equilibrium in Goods and Money Markets IS Bringing together the IS schedule (showing goods market equilibrium) LM and the LM schedule (showing money market equilibrium). Y* r* We can identify the unique combination of real income and interest rate (r*, Y*) which ensures overall equilibrium. See Section 25-5 in the main text. Income

20. Fiscal Policy in the IS-LM Model Y0, r0 represents the initial equilibrium. Income r IS0 LM Y0 r0 IS1 A bond-financed increase in government spending shifts the IS schedule to IS1. r1 Y1 Equilibrium is now at r1, Y1. See Section 25-5 in the main text. Some private spending has been crowded out by the increase in the rate of interest.

21. Monetary Policy in the IS-LM model Y0, r0 represents the initial equilibrium. Income r IS0 LM0 Y0 r0 LM1 An increase in money supply shifts the LM schedule to the right. Y1 r1 Equilibrium is now at r1, Y1. See Section 25-5 in the main text.

22. 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. Y* Income level Y* can be attained by: r IS1 LM1 r1 OR with ‘easy’ fiscal policy (IS1) with ‘tight’ monetary policy (LM1). LM0 IS0 r2 ‘Tight’ fiscal policy (IS0) with ‘easy’ monetary policy (LM0) See Section 25-6 in the main text. This affects the private: public balance of spending in the economy. Income

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