1. MACROECONOMICS
LECTURE 2

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

3. 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

4. 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)

5. EQUILIBRIUM NATIONAL INCOMEAE Y 45
330
440
Expenditure=Income
AE= Y

7. Fiscal Policy?

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

9. Expansionary Fiscal Policy:
Income goes up

10. withdrawals
injections

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

12. FISCAL POLICY
The slope of AE increases

13. Expansionary Fiscal Policy:
Income goes up

14. withdrawals
injections

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

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

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

18. The MULTIPLIER Effect
Y = k x G

19. 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 ??

20. 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 ??
G = US$6 bn D

21. 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”

22. 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…

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

24. 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)…

25. 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.

26. 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?

27. MONEY

28. MONEY

30. 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)

31. 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)

32. MONEY SUPPLY M0 M2 M4

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

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

35. WAYS OF HOLDING
WEALTH

36. Opportunity cost of holding money?

37. 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)

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

39. 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.

40. 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?

41. 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.

42. DEMAND FOR MONEY

43. Increase in interest rate reduces money holdings

44. Increase in income raises money holdings

45. 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

46. 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…

47. MONEY DEMAND CURVE

48. MONEY DEMAND CURVE

49. MONEY SUPPLY CURVE

50. MONEY MARKET EQUILIBRIUM

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

52. 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.

53. MONETARY POLICY

54. MONETARY POLICY

55. MONETARY POLICY

56. MONETARY POLICY

57. MONETARY POLICY

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

60. 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

61. 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

62. 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: