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

25.1 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.

25.2 Consumption revisited n Income is a key determinant of consumption n but other factors shift the consumption function – household wealth – availability of credit – cost of credit n These create a link between the financial and real sectors – because interest rates can be seen to influence consumption.

25.3 The permanent income hypothesis n A modern theory of consumption developed by Milton Friedman – argues that people like to smooth planned consumption even if income fluctuates n Consumption depends upon permanent not transitory income.

25.4 Savings occur during middle age and dissaving in youth and old age. The life-cycle hypothesis A theory of consumption developed by Ando and Modigliani. Age 0 Income, consumption Death Individuals try to smooth their consumption, based on expected lifetime income. Permanent income Thus wealth and interest rates may influence consumption. Income varies over an individual's lifetime. Actual income

25.5 Ricardian equivalence n 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. n 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.

25.6 Investment demand n Investment spending includes: – fixed capital n Transport equipment n Machinery & other equipment n Dwellings n Other buildings n Intangibles – working capital n stocks (inventories) n work in progress n and is undertaken by private and public sectors

25.7 Analysis of fixed investment in the UK by type of asset Source: Economic Trends Annual Supplement, Monthly Digest of Statistics

25.8 The demand for fixed investment n Investment entails present sacrifice for future gains – firms incur costs in the short run – but reap gains in the long run n Expected returns must outweigh the opportunity cost if a project is to be undertaken n so at relatively high interest rates, less investment projects are viable.

25.9 The investment demand schedule … shows how much investment firms wish to undertake at each interest rate. Investment demand Interest rate II At relatively high interest rates, less investment projects are viable. At r 0, I 0 projects are viable. r0r0 I0I0 but if the interest rate rises to r 1, desired investment falls to I 1. r1r1 I1I1

25.10 Interest rates and aggregate demand n The position of the AD schedule is now seen to depend upon interest rates through the effects on – consumption – investment

25.11 Monetary policy when aggregate demand depends upon the interest rate Income Aggregate demand 45 o line AD 0 Y0Y0 CC 0 Suppose the economy starts with consumption at CC 0, investment at I 0 and equilibrium at Y 0. I0I0 A fall in interest rates shifts the consumption function to CC 1, and leads to higher investment at I 1. CC 1 I1I1 Aggregate demand rises to AD 1, and the new equilibrium is at Y 1. AD 1 Y1Y1

25.12 Fiscal policy and crowding out Income Aggregate demand 45 o line AD 0 Y0Y0 Suppose an increase in government spending shifts the AD curve to AD 1. AD 1 Initially, equilibrium moves to Y 1. Y1Y1 But higher income raises money demand, so interest rates rise and consumption and investment fall, shifting AD back to AD 2 and equilibrium income to Y 2. AD 2 Y2Y2

25.13 Goods market equilibrium n The goods market is in equilibrium when the aggregate demand and actual income are equal n The IS schedule shows the different combinations of income and interest rates at which the goods market is in equilibrium.

25.14 The IS schedule Income AD 45 o line Income r AD 0 r0r0 At a relatively high interest rate r 0, consumption and investment are relatively low – so AD is also low. Y0Y0 Y0Y0 Equilibrium is at Y 0. Y1Y1 Y1Y1 Equilibrium is at Y 1. IS The IS schedule shows all the combinations of real income and interest rate at which the goods market is in equilibrium. AD 1 At a lower interest rate r 1 Consumption, investment and AD are higher. r1r1

25.15 Money market equilibrium n The money market is in equilibrium when the demand for real money balances is equal to the supply. n The LM schedule shows the different combinations of income and interest rates at which the money market is in equilibrium.

25.16 The LM schedule r r Income Real money balances L0L0 LL 0 r0r0 r0r0 Y0Y0 At income Y 0, money demand is at LL 0 and equilibrium in the money market requires an interest rate of r 0. r1r1 Y1Y1 r1r1 LL 1 At Y 1, money demand is at LL 1, and equilibrium is at r 1. LM The LM schedule traces out the combinations of real income and interest rate in which the money market is in equilibrium.

25.17 Shifting IS and LM schedules n The position of the IS schedule depends upon: – anything (other than interest rates) that shifts aggregate demand: e.g. n autonomous investment n autonomous consumption n government spending n The position of the LM schedule depends upon – money supply – (the price level)

25.18 Equilibrium in goods and money markets Income r 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.

25.19 Fiscal policy in the IS-LM model Income r IS 0 LM Y0Y0 r0r0 Y 0, r 0 represents the initial equilibrium. IS 1 A bond-financed increase in government spending shifts the IS schedule to IS 1. r1r1 Y1Y1 Equilibrium is now at r 1, Y 1. Some private spending has been crowded out by the increase in the rate of interest.

25.20 Monetary policy in the IS-LM model Income r IS 0 LM 0 Y0Y0 r0r0 Y 0, r 0 represents the initial equilibrium. LM 1 An increase in money supply shifts the LM schedule to the right. Y1Y1 r1r1 Equilibrium is now at r 1, Y 1.

25.21 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* can be attained by: LM 0 IS 0 r2r2 ‘Tight’ fiscal policy (IS 0 ) with ‘easy’ monetary policy (LM 0 ) IS 1 LM 1 r1r1 OR with ‘easy’ fiscal policy (IS 1 ) with ‘tight’ monetary policy (LM 1 ). This affects the private: public balance of spending in the economy.

25.22 But... n The IS-LM model seems to offer government a range of options for influencing equilibrium income. n But… – there are other issues to be considered n the price level and inflation n the supply-side of the economy n the exchange rate