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

1. 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. 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. 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. 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.

5. 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.

6. 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.

7. 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.

8. 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.

9. 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.

10. 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.

11. 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.

12. 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.

13. 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

14. 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

15. 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.

16. 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.

17. 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

18. 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

19. 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.

20. 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

21. 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.

22. 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.

23. 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.

24. 19. Equilibrium in Goods and Money MarketsIS
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

25. 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.

26. 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.

27. 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

28. 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