1. 1 Fiscal and monetary policy in a closed economy Lecture 5

2. consumption determinants Current income Permanent income Cumulated savings in the past (wealth effect) Changes in the supply of the consumer credit expectations 2

3. Wealth effect Money and the interest rate have an impact on the wealth Changes in wealth affect the consumption and the aggregate demand 2 cases: 1) increase in wealth caused by changes in real money supply 2) increase in wealth caused by changes in interest rate. Lower interest rate → higher prices of share and bonds Why? Market prices of shares and bonds = present value of payments to be received in the future We have to pay a higher price today to receive any given future payment the lower is the interest rate the present value ↑if the interest rate↓ 3

4. 4 The consumption function The permanent income theory (M. Friedman): consumption proportional to permanent income, not to current income. If household income has fallen temporarily, consumption is not cut so much Life cycle consumption: consumption is related to income over a longer period than a year, in this case the period of entire lifetime of individual. Future income affects current consumption. People who expect a higher income will borrow now, people who expect lower income in future (retirement) save to draw savings when they earn little.

5. 5 Demand for investment Investment spending „I” is spending on new production of machinery, business structures and inventories „I”: depends on:  Interest rate  Current cost of new machinery and equipment  Future profits  Expected life of machinery and equipment  The firm has to compare the value of future income receipts with the current cost

6. The role of interest rate To finance investment the firm borrows money Investment should yield enough extra profits to pay back the loan + interest The future benefits must be sufficiently large relative to current costs Therefore high interest rates discourage investment planned by firms, on the contrary at low interest rate investment will be large If the firm does not borrow money to invest, the interest rate will still matter, WHY? 6

7. The investment schedule The investment demand schedule shows the amount of investment at each rate of interest, (the price of capital goods, expected profits, available technology and wages are constant). Higher interest rate diminishes the number of investment projects – movement along investment demand curve 7

8. Investment demand and the interest rate Investment project Rate of return % Funds required Interest rate Amount of investment A10150 0004%550 000 (A+B+C+D) B15100 0008%300 000 (A+B+C) C850 00010%250 000 (A+B) D7250 00015%100 000 (B) 8

9. 9 Money, interest rates and aggregate demand Central Bank affects the demand for investment by changing the supply of money (monetary policy) Monetary expansion, by lowering interest rates, raises investment spending, income and output Ms ↑→r↓→I and C↑→Y↑ the aggregate demand curve shifts upward, new equilibrium level output But effect of the policy is less than would be expected if feedbacks were ignored Ms ↑→r↓→Y↑→r↑→Y↓ feedback diminishes impact of expansionary monetary policy

10. The effects of increased money quantity on output (expansionary monetary policy) 12345 Central bank increases money stock Excess supply of money Interest rates fall to clear money market Lower interest rates raise investment and aggregate demand Firms raise output, employment and income, New equilibrium level output 10

11. Dampening Effects The increase of income being result of monetary expansion, raises money demand, money demand curve shifts to the right The increase in money demand raises the interest rates back up somewhat Investment will not increase as much as table (previous slide) implies The income expansion smaller Dampening effects dampen the income expansion BUT Still an increase in money stock increases aggregate expenditure and output 11

12. Fiscal policy and crowding out The inclusion of interest rate into the basic macro model modifies effects of fiscal policy (impact of tax cut or higher budget spending) Rise in income increase the demand for money – the money demand curve shifts right. The interest rate raises, reducing investment, aggregate demand, and output, offsetting the effects of expansionary fiscal policy BUT The expansionary effect of fiscal policy is not reversed Fiscal policy with a constant money stock less expansionary than it would be if the money stock adjusted to keep interest rates constant 12

13. Fiscal expansion and crowding out 1234 Higher government spending or lower taxes raise output and income Higher income raises demand for money Higher money demand and unchanged money supply lead to higher interest rates Higher interest rates crowd out investment and dampen the expansion 13

14. 14 Model IS - LM Explains the equilibrium on both markets: a money market and a goods market IS curve – all combinations of income and interest rates that make aggregate demand equal to income Y(I = S) LM curve – identifies all combinations of income and the interest rate for which the demand for money „L” equals the money supply „M”).

15. 15 IS curve (1), G and Y given; lower interest rate increases investment and consumption demand The slope of IS curve The slope of IS curve depends on the sensitivity of I and C to the change in the interest rate

16. 16 The shift of IS curve(2), interest rate given, increase of G, I or/and C increases aggregate demand Y=C+I+G, shift of IS curve= change in Y at given interest rate (b)The IS curve shifts left if governments expenditure ↓, a) IS shifts right if I goes up (positive expectations ), c) IS shifts right if C goes up The shift of IS curve

17. 17 LM curve (1), supply of money constant, increase of income increases demand for money.the increase of interest rate needed to achieve equality od the demand and supply of money The slope of LM curve The slope of LM curve depends on the sensitivity of the interest rate on income changes ( how strong are transactions and precautionary motives to hold money). The more flat LM curve: the change of Y → relative small change of interest rate (b), the more steep LM curve the same change of Y → relative large change of interest rate (c)

18. 18 LM curve (2) The shift of LM curve →Y constant, the impact of money supply and money demand on the interest rate (a) The supply of money M ↓, LM shifts left, interest rate ↑. b) the supply of money ↑, LM shifts right → interest rate↓, c) money demand ↑, LM shifts left, interest rate↑

19. 19 goods market and money market in equilibrium At A the goods market in equilibrium, no equilibrium on money market, at Y1 interest rate R1 to high to clear money market, demand for money to low, excess of supply of money. This makes R go down At C the goods market in equilibrium, no euilibrium on money market, at Y2 interest rate to low to clear money market, the demand for money to high. The interest rate goes up to restore equilibrium At E the equilibrium on both markets

20. Components of the IS-LM model Two equations of the model: Y = C(Y-T) + I(r) + GIS M/P = L(r, Y)LM At equilibrium point actual expenditure equals planned expenditure and the demand for real money balances equals the money supply IS-LM model used to analyze the short run effects of policy changes 20

21. 21 Fiscal policy in the IS-LM model (1), shift of IS curve Easy (expansionary) fiscal policy and no change in money supply (tight monetary policy) The increase of government expenditure money stock constant → move from A to B, IS curve shifts to the right. The interest rate and Y higher. Crowding out of private investment present

22. 22 Monetary and fiscal policy in the IS-LM model (2), shift of LM and IS curves Easy fiscal policy and easy monetary policy : government spending financed by the increase of money stock - shift of LM and IS (A→C), the interest rate may be the same (depends on the impact of fiscal and monetary policy). No crowding out effect if the interest rate does not change

23. 23 Monetary and fiscal policy in the IS-LM model(3) Easy monetary policy and tight fiscal policy: shift of the LM curve, equilibrium point moves from A to D. At D different structure of GDP: lower public investment and higher private investment than at B but the income level the same

24. The policy mix Both monetary and fiscal expansion increase the output and employment, BUT Have different effects on the composition of aggregate demand A monetary expansion (easy monetary policy) → lowers interest rates → rise in investment A fiscal expansion (easy fiscal policy)→increases interest rate → decrease in investment Both policies tight → GNP raises more slowly → recession Both policies expansionary → increase in demand – move out of recession or going into a boom Policy mix: different combinations of tight or expansionary monetary policy and tight or expansionary fiscal policy 24

25. Policy mixes Tighter moneyEasier money Tighter fiscal policyRecession/slowdownCrowding in: share of private investment in GNP rises ( A →D) Easier fiscal policy (expansionary fiscal policy) Crowding out: share of private investment in GNP falls (A →B) Boom/recovery (A →C), interest rate may be the same 25

26. Keynesian economics Analysis of aggregate demand- contribution of J. M. Keynes (1883-1946) and Keynesians (L. Klein, P. Samuelson, J. Tobin, J. Robinson)Keynesian analysis proceeds on the assumption that the prices level is given and unemployment exists Critics of Keynesian type economic policy: Policy works with a lag Should the monetary and fiscal policy be adjusted continuously? Is fine tuning effective? The need to include aggregate supply changes 26