Monetary and fiscal policy in a closed economy

1. Monetary and fiscal policy in a closed economy

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4. 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.

5. Consumption revisited • Income is a key determinant of consumption • but other factors shift the consumption function • 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.

6. 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.

7. Income varies over an individual's lifetime. Actual income Individuals try to smooth their consumption, based on expected lifetime income. Permanent income 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. Income, consumption 0 Death Age Thus wealth and interest rates may influence consumption.

8. 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.

9. 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

10. Analysis of fixed investment in the UK by type of asset 1965-1998 Source: Economic Trends Annual Supplement, Monthly Digest of Statistics

11. 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.

12. At relatively high interest rates, less investment projects are viable. r1 At r0, I0 projects are viable. r0 but if the interest rate rises to r1, desired investment falls to I1. II I0 I1 The investment demand schedule … shows how much investment firms wish to undertake at each interest rate. Interest rate Investment demand

13. 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

14. Suppose the economy starts with consumption at CC0, investment at I0 and equilibrium at Y0. AD1 A fall in interest rates shifts the consumption function to CC1, and leads to higher investment at I1. CC1 I1 CC 0 I0 Aggregate demand rises to AD1, and the new equilibrium is at Y1. Y0 Y1 Monetary policywhen aggregate demand depends upon the interest rate 45o line Aggregate demand AD0 Income

15. Suppose an increase in government spending shifts the AD curve to AD1. AD1 Initially, equilibrium moves to Y1. AD2 and consumption and investment fall, shifting AD back to AD2 and equilibrium income to Y2. Y2 Y1 Fiscal policy and crowding out 45o line Aggregate demand AD0 But higher income raises money demand, so interest rates rise Y0 Income

16. 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.

17. At a relatively high interest rate r0, consumption and investment are relatively low – so AD is also low. AD1 AD0 Equilibrium is at Y0. At a lower interest rate r1 Consumption, investment and AD are higher. Y1 Y0 Equilibrium is at Y1. r0 The IS schedule shows all the combinations of real income and interest rate at which the goods market is in equilibrium. r1 IS Y0 Y1 The IS schedule 45o line AD Income r Income

18. 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.

19. LM r1 r1 r0 r0 LL1 LL0 Y1 Y0 At income Y0, money demand is at LL0 and equilibrium in the money market requires an interest rate of r0. At Y1, money demand is at LL1,and equilibrium is at r1. The LM schedule traces out the combinations of real income and interest rate in which the money market is in equilibrium. The LM schedule r r Real money balances L0 Income

20. 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)

21. Bringing together the IS schedule (showing goods market equilibrium) LM and the LM schedule (showing money market equilibrium). r* IS We can identify the unique combination of real income and interest rate (r*, Y*) which ensures overall equilibrium. Y* Equilibrium in goods and money markets r Income

22. r LM A bond-financed increase in government spending shifts the IS schedule to IS1. r1 r0 IS1 Equilibrium is now at r1,Y1. IS0 Y0 Y1 Income Fiscal policy in the IS-LM model Y0, r0 represents the initial equilibrium. Some private spending has been crowded out by the increase in the rate of interest.

23. r LM0 An increase in money supply shifts the LM schedule to the right. LM1 r0 r1 Equilibrium is now at r1, Y1. IS0 Y0 Y1 Income Monetary policy in the IS-LM model Y0, r0 represents the initial equilibrium.

24. Income level Y* can be attained by: LM1 ‘Tight’ fiscal policy (IS0) with ‘easy’ monetary policy (LM0) LM0 r1 OR with ‘easy’ fiscal policy (IS1) with ‘tight’ monetary policy (LM1). r2 IS1 IS0 Y* 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. r This affects the private: public balance of spending in the economy. Income

25. 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

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