Advanced Macroeconomics Lecture: Stabilization policy Date:

Investment The value of that part of the economy’s output for any time period that takes the form of new structure, new producres’ durable equipment and change in inventories Inventories Stocks of goods held by business in production -Materials awaiting for use -Goods in process -Finished products awaiting sale to the distributors or final users

Investment The decision to invest depends on prospective profitability which is determined by three elements -The expected income flow from the capital good -Purchase price of that good -The market rate of interest

Investment function Investment demand function I=e-dR Where, I=Investment R=Rate of interest e=Autonomous Investment d=Slope (Rate of change in investment due to the percentage change in interest rate)

Investment function Investment Function Interest rate R Investment I ∆I ∆R

Net export Net export= Export – Import Net export is negatively related with the rate of interest If interest rate is higher in the domestic economy then say in BD, its attractive to put funds in taka, there will be appreciation of currency→ Higher exchange rate → export goods more expensive Imports become cheaper Fall in net export Hence net export depend negatively on the interest rate

Interest rate Nominal interest Rate Real interest rate Real interest rate=Nominal interest rate- Expected rate of inflation Nominal interest rate is 10 percent and expected rate of inflation rate is 6 percent then real interest rate is 4 percent Implication large in the financial market???

Key macro relationships Macro variables The endogenous Variables Income Y Consumption, C Investment, I Net export, X Interest rate, R The exogenous variables Government purchases, G and Money supply, M (Decided by CB, Government)

Key macro relationships Five relationships Y=C+I+G+X (Income identity) C=a+ (1-t)Y(Consumption Function) I=e-dR(Investment function) X=Export-Import(Net export function) M=(kY-hR)P (Money demand function where k and h are constant)

Key macro variables Dependent VariablesIndependent Variables ConsumptionTax, Income InvestmentInterest rate ExportInterest rate Money SupplyInterest rate, Income

IS Curve Shows all the combinations of R and Y at which ex ante investment is equal to ex ante savings I stands for investment and S for savings Downward sloping curve as higher interest rate reduces investment and net export, hence reduces GDP through multiplier effect R GDP Y IS curve

Effects G↑ → R Y IS Curve

LM Curve Shows different combinations of Y and R at which the ex ante demand for money holding, L is equal to the ax ante supply of money for a given level of the money balances M L stands for liquidity preference and M, for money supply Slopes upward as increase in interest rate reduces money demand, As money supply is fixed, to offset the demand fall, income must increase to push up the money demand for equilibrium in the money market Hence if interest rate increases income increases

LM Curve LM curve R Y

Effects Nominal Money, M Real money M/P M/P= kY-hR If money supply increases in the economy then LM curve shits to the right R Y LM curve →

Equilibrium in both money and product market Y and R that satisfies the equilibrium condition both in the money market and product market R Y LM IS

Monetary Policy IS curve shows all the combinations of Y and R that satisfy the spending balance LM curve shows all the combinations of Y and R that satisfy money market equilibrium Monetary expansion M↑, More money in the economy, money supply exceeds money demand, R ↓, demand for money increases Lower interest rate stimulates investment and net export

Monetary Policy Monetary Expansion R1R1 R2R2 Y1Y1 Y2Y2 LM IS

Fiscal policy Government decides to increase defense spending G↑, increases GDP through multiplier, demand for money is pushed up More money is needed for transaction purpose No change in money supply, to offset the excess money demand, R↑ Increase in R reduces investment demand and net export Thus offset some of the stimulus to GDP by government spending The offsetting negative effect is termed as crowding out

Fiscal Policy Fiscal Expansion R1R1 R2R2 Y1Y1 Y2Y2 LM IS

Case Study (US) Expansionary policy in 1982 Booming in 1987 Inflationary pressure in the economy Tighten monetary policy Short term interest rate rose from 6 to 10% end of 1989 High interest rate on business and consumer loans Businesses and purchases decline

Case Study (US) As a result in the drop of demand, economy slowed down Inflationary pressure eased Fed lowered interest rate Slow economic growth continued as monetary policy works with a lag Slow growth culminated recession started in July, 1990 Could avoided recession but oil price hike with Iraque’s invasions in Kuwait and loss of consumers confidence

Relative effectiveness of Fiscal policy and monetary policy Depend on the sensitivity of investment demand and net export to interest rate The sensitivity of money demand to interest rate

Effectiveness of fiscal policy Expansionary fiscal policy would have a relatively weaker effect on AD if Interest rate is considerably high Large negative effect on investment and net export Fall in investment and net export will offset the positive effect of fiscal expansion

Effectiveness of fiscal policy There would be two circumstances: If the sensitivity of investment demand and net export to the interest is very large then i↑, there will be sharp decrease in investment and net export

Effectiveness of fiscal policy If the sensitivity of money demand is very small to the change in interest rate Then the increase in money demand that arises as a result of the increased government expenditure Would cause a big rise in interest rate If the economy has higher interest sensitivity to investment and net export and low interest sensitivity to money demand even a large multiplier will not result in strong effects of fiscal policy

Effectiveness of fiscal policy Expansionary fiscal policy would have stronger effect on AD if investment demand and net export is less sensitive to the change in interest rate Explanation is just reverse of the previous two circumstances

Effectiveness of Monetary policy An expansionary monetary policy have weaker effect on AD if the drop in interest rate that occurs due to the increase in money, small influence on investment demand or net export

Effectiveness of monetary policy Effectiveness depend on two circumstances The sensitivity of investment and net export to interest rate is very small then investment is not stimulated by the decline in interest rate The sensitivity of money demand to interest rate is very large then the increase in money supply doesn't cause much of a drop in interest rate

Effectiveness of monetary policy Expansionary monetary policy would have large impact if interest rate fall by a large amount and stimulate investment and net export, explanation is just opposite of the previous explanation

The IS-LM interpretation IS curve is relatively flat if investment demand and net export are highly sensitive to interest rate Small changes in interest rate is associated with big change in demand If IS curves is relatively steep implies investment and net export are relatively insensitive to interest rate

The IS-LM interpretation The LM curve is relatively flat if money demand is much sensitive to interest rate Small change in interest rate is sufficient to reduce money demand when it increases with a change in income LM curve is relatively steep if money demand is very much insensitive to interest rate

The IS-LM interpretation Relative effectiveness of monetary policy IS(Flat) LM Fed: Strong IS(Steep) LM Fed: Weak R YY R

The IS-LM interpretation Relative effectiveness of monetary policy LM(Flat) IS LM(Steep) IS Fed: Weak Fed: Strong R Y Y R

The IS-LM interpretation Effectiveness of fiscal policy LM Fiscal: Strong IS (Steep) LM IS (Flat) Fiscal: Weak R Y Y R

The IS-LM interpretation Effectiveness of fiscal policy LM(Flat) IS LM(Steep) IS Fiscal: Strong Fiscal : Weak R YY R