Macroeconomics 2 Assignment 2 Policy Implication Report Therefore, fiscal policy is recommended to both countries despite of unavoidable practical problems in implementation

Theoretically, the expansionary fiscal policy isconsidered effective with steep IS - flat LM, while the expansionary monetary policy exertsstronger impact on flat IS - steep LM.. b Slope

Macroeconomics 2

Assignment 2 Policy Implication Report Lecturer: Woocheol Lee

Course name: Macroeconomics 2

Course code: ECON1266

Team member

Word Count:

Part A: Abstract

The COVID-19 pandemic has spread around the world and caused the worst economiccrisis since 1930s depression First, the report will review the relationship between policyeffectiveness and slopes of IS - LM curves Theoretically, the expansionary fiscal policy isconsidered effective with steep IS - flat LM, while the expansionary monetary policy exertsstronger impact on flat IS - steep LM Once theory reviewed, relevant macroeconomic data ofThailand and the UK during October 2019 – June 2020 will be collected and analysed, bothdetermining steep IS - flat LM during the pandemic Therefore, fiscal policy is recommended

to both countries despite of unavoidable practical problems in implementation

Part B: Theoretical review

a) Determinants of slope of IS – LM curves

The first determinant of the slope of IS curve is interest elasticity of investment,

demonstrating how sensitive investment is to fluctuations in the interest rate (r) The more

sensitive the investment, the flatter the IS curve is Another determinant is marginal

propensity to consume (MPC) - the proportion of additional income being spent on

consumption Higher MPC implies a larger expenditure multiplier, meaning a rise ininvestment due to falling r will result in a higher income increase, hence IS curve becomesflatter

Determinants of the slope of LM curve are the income sensitivity (k) and interest sensitivity (h) of money demand (Md) Md depends on income, as higher income requires

larger amount of money for spending The more sensitive Md is to income change, thesteeper LM curve Additionally, Md depends on r because the higher r, the more people want

to invest their money, thus the lower demand for cash Hence, the more sensitive Md is to rchange, the flatter LM curve (Revier 2000)

b) Slope of IS-LM curve & Policy Effectiveness

 Monetary policy

Figure 1: The impact of slope of the LM curve on monetary policy’s effectiveness

An expansionary monetary policy, for instance, increases money supply (Ms) anddecreases r Both LM and LM shift rightward by the same distance LM is steeper than1 2 1

LM2, implying Md at LM is less responsive to r change, so r at LM must decline more to1 1balance the increase in Ms with Md Lower borrowing cost encourages more investment(I >I1 2), hence the shift of LM generate more output than LM Therefore,1 2 the steeper LM is, the more effective monetary policy.

Figure 2: The impact of slope of the IS curve on monetary policy’s effectiveness

IS1 is flat, indicating investment demand at IS is sensitive to the fall in r under the1expansionary policy Investment increases greatly in response to the decreasing borrowingcost, leading to a significant rise in Y Meanwhile, IS is steep, meaning investment at IS is2 2not so sensitive, hence the increase in Y is insignificant Therefore, flatter IS makes monetary policy more effective.

 Fiscal policy

Figure 3: The impact of slope of the LM curve on fiscal policy’s effectiveness

Expansionary fiscal policy, for example, shifts the IS curve rightward given increasinggovernment spending and tax-cut As Y grows, Md increases, leading to higher r LM is2steeper than LM , implying the Md at LM is more responsive to income change, hence the1 2rising Y causes Md and r at LM to increase more than at LM The higher borrowing cost2 1reduces private investment at LM more greatly, so net rise in Y at LM is smaller than at2 2

LM1, due to larger crowding-out effect Therefore, fiscal policy is more effective given

flatter LM.

Figure 4: The impact of slope of the IS curve on fiscal policy’s effectiveness

As mentioned before, fiscal expansion increases Y and r IS is flatter than IS , so1 2investment demand at IS is more responsive to r change than at IS At IS , an increase in r1 2 1leads to a greater fall in private investment than at IS Hence, net rise in Y at IS is smaller2 1than at IS , due to larger crowding-out effect Therefore, 2 fiscal policy is more effective when

IS is steep.

Part C: Slope of IS - LM curve in the United Kingdom and Thailand

a) The United Kingdom

Categories Oct-19 Nov-19 Dec-19 J an-20 Feb-20 Mar-20 Apr-20 May-20 J un-20

(million USD) (current)

Gross fixed capital

457,455.13 442,989.86 329,723.71 128,649.76 126,839.53 98,171.38

The United Kingdom

719,270.63 711,057.13 590,325.59 1.01 -2.08 -21.46

Figure 5: Macroeconomic data of The United Kingdom during Oct 2019 – Jun 2020 Source: BoE 2020, CEIC Data n.d

Figure 6: Velocity of Money (M2) during the Covid-19 of the world

Source: Fred 2020

 Slope of the IS curve

Besides long-lasting method and supply chain disruption caused by Covid-19, the Britisheconomy also severely suffered no-deal Brexit scenario, which altogether depressed firms’confidence, indicated by the lowest BCI ever of -87 in the UK (Joanna 2020) Therefore,despite constant ‘r’ at 0.75% in Q1/2020, this negative outlook inevitably caused investmentfall sharply by 23.4% in Q1-Q2 2020, implying the left shift of IS during the pandemic.

Remarkably, even when ‘r’ cut to 0.1% showed its effectiveness in Q3/2020 (BoE 2020)and ideally supported by easing lockdown (Osborne 2020), ‘I’ still could not recovery asexpected with still 8% lower than pre-Covid Hence, IS slope is steeper during pandemicsince firms still concerned about further restriction and political issues, were reluctant toborrow, thus less sensitive to ‘r’

Figure 7: Slope of the IS curve in the United Kingdom before and during the pandemic

 Slope of the LM curve

The pandemic created the panic among UK’s households Indeed, people tendentiallypreferred greater liquidity during uncertain times due to high default rate of other assets(Wright 2012) Evidently, consumers hold 10% more banknotes in March but their spendingfell by nearly 30% in April (BoE 2020) even before their income decreased in Aprillockdown policy In other words, ‘hoarding’ phenomenon occurred in Q1/2020 when peoplekept hoarding money rather than spending or investing, which led to rising money demand

despite unchanged ‘Y’, inferring the left shift of LM curve.

Noticeably, in Q2/2020, although income increased from strong tax cut, Job Retentionand $40Bn Covid-package, consumption still under-performed in Q3/2020 with 12% lowerthan pre-Covid time Explanatorily, the looming future of further lockdown encouragesconsumers to save more at 28% saving ratio (Reuters 2020), limiting money demand for

transaction Consequently, ‘r’ unchanged with the less sensitive of money demand to

income, indicating flatter LM due to Covid-19.

Figure 8: Slope of the LM curve in the United Kingdom before and during the pandemic

Furthermore, during pandemic, cash provides liquidity for urgent health care and acts as asafe haven for storing value with around 0% inflation deriving from demand shock in the UK(BoE 2020) Therefore, even money supply (M2) increased by 8% from monetary policy,75% of UK residents still chose cash for value-storing place (BoE 2020) Henceforward,

rising money supply has a little effect on ‘r’ of other financial assets, inferring the elastic

interest sensitivity for real money and a flatter LM.

Figure 9: Slope of the Md, which infers LM curve, in the UK before and during the pandemic

(million USD) (current)

Gross fixed capital

139,540.72

60,880.23 68,705.35

70,426.30 31,306.18 28405.052 27,472.73

Figure 10: Macroeconomic data of Thailand during Oct 2019 – Jun 2020

Source: Tradingeconomics n.d, CEIC Data n.d

 Slope of the IS curve

As an intertrade-based economy, Covid-19 also shocked business sentiment in Thailand.Therefore, even prior to ‘r’ cut in February, ‘I’ shrank by 12% in first half of 2020 resultedfrom firms’ pessimistic outlook, indicated by the lowest BCI ever at 32.6 in April (TheNation Thailand 2020) Thus, IS curve shifts left due to falling ‘I’ regardless to ‘r’ impact inearly outbreaks

Notably, when imposed ‘r’ worked in Q3/2020, ‘I’ rebounded quite well with only 4%lower than pre-Covid period Despite concern of further coronavirus wave and uncertainpolitics, this good recovery was still recorded, coming from the easing lockdown method inJuly, which raised BCI to nearly pre-Covid level Therefore, Thai firms are quite ready for

further ‘r’ change, inferring a quite steeper IS curve over Covid crisis but relatively flatter

than the UK’s case

Figure 11: Slope of the IS curve in Thailand before and during the pandemic

 Slope of the LM curve

Likewise, Thai residents were also panic as a concern of projected 8 million unemployedpeople during pandemic (Apisitniran 2020) Henceforth, almost all Thais felt financiallyuncertain during the pandemic, which motivated them to hold more cash even before imposedlockdown policy (WARC 2020) In other words, even their income was unchanged before

restriction, high money demand for hoarding leads to the left shift of LM curve during

pandemic

Moreover, although their income raised from $64Bn stimulus package, consumers stillspent 4% less than pre-Covid level when 72% of young Thais spent less (WARC 2020) Infact, instead of spending, Thais household used additional income for paying private debt,raised from struggling affordability during no-income lockdown period Evidently, theirprivate debt raised dramatically, contributing to nearly 83% of Thais GDP in Q2/2020

(Reuters 2020) So, Thai money demand for transactions is extremely insensitive to

interest rate when their priority is paying debt rather than spending, hence making LM curve flatter.

Figure 12: Slope of the LM curve in Thailand before and during the pandemic

Additionally, cash holding raised from 30% to 40% in Thai portfolio during Covid-19 due

to uncertainty and preferred liquidity Conversely, with high default rate, Thais tendentiallyescaped other financial assets, leading to a decrease in bond price (Phoonphongphiphat 2020)and the worst-performance Asian stock market (Preiss 2020) Therefore, with the 10% highermoney supply (M3) in monetary policy, Thais residents still hoarded cash or, ideally, gold(evidently gold price hit all-time high recently (Yuvejwattana 2020)), rather than investing in

low-demand financial assets, hence less impacting interest rate Hence, the money demand

curve is elastic during pandemic, so, the flatter LM curve

Figure 13: Slope of the Md, which infers LM curve, in Thailand before and during the

pandemic

Part D: Policy recommendations and Expected Outcomes

As proven theory, given steep IS flat LM curves in the two nations, fiscal policyimplementation is more effective Indeed, the impact of monetary policy is significantlyhampered by low business confidence and credit crunch amid the pandemic (BoE 2020).Besides, monetary policy is considered unable to eliminate effective demand shortfalls due todispersed economic losses across sectors (Woodford 2020)

Figure 14: Comparison of effectiveness of expansionary monetary and fiscal policy given

steep IS – flat LM curve in the United Kingdom

(a) Expansionary monetary policy (b) Expansionary fiscal policy

Figure 15: Comparison of effectiveness of expansionary monetary and fiscal policy given

steep IS – flat LM curve in Thailand

a) The United Kingdom

The direct cost of fiscal policy since March is estimated at £184bn, including £66bn ofgrants and loans for businesses (Fitch Ratings 2020) With lower tax and more jobs created

by public projects, households have greater purchasing power which fuels higher demand andconsumption Firms earn greater after-tax profit, encouraged to invest Consequently, givenflat LM curve, IS curve shifts rightward, making output increase greatly despite minor change in r Crowding-out effect is limited as people tendentially save more during

recession, meaning more loanable fund available (Economics Online n.d.) Expansionarymonetary policy also helps maintain low interest rates.

Even fiscal policy has difficulties in recovering aggregate demand to pre-pandemic leveldue to smaller multiplier given low consumer and business confidence (Woolford 2020).Although being supported by tax-relief and transfer payments, consumers and firmstendentially save and focus on deleveraging, preparing for future tax changes raised bybudget deficit and no-deal Brexit outcome (Reuters 2020; Fraser 2020) Policy lag could alsodampen the impact of fiscal policy

Altogether, fiscal policy is recommended for the UK, especially when its fiscal policyannounced targeted at providing sectoral-level intervention (Dalton & Pope 2020)

b) Thailand

Thai fiscal policy included a fiscal package of THB 1.5 trillion (IMF 2020) Tax reductionand tax deadline extension were imposed, decreasing Thai government revenue (KPMG2020), despite 4% higher in government expenditure to $105.6bn (Techakitteranun 2020).The policy aimed to encourage consumption and investment, thus stimulating aggregate

demand According to part B, a steep IS flat LM framework will lead to a great leap in real

income with minor change in r Crowding-out effect would be limited , similarly to the

UK

Noticeably, fiscal policy would be less effective in Thailand than in the UK Indeed, Thai

IS curve is flatter given higher business confidence, which rebounded since May (Figure 10).Besides, as a developing country, Thailand’s economic potential is weaker than the UK, thusthe over-usage of fiscal policy could be a burden on government budget As of September

2020, Thailand is facing an all-time high government debt at 42,3% of GDP (CEIC Datan.d.) Lack of transparency in public spending is another hindrance (Promchertchoo 2020)

Nonetheless, Thai IS curve is still remarkably steeper than pre-pandemic Moreover, Thaigovernment debt is not yet alarming compared to the world's government debt which hovers

at around 100% (Villers 2020)

Overall, based on theory and the situation of Thai economy, fiscal policy is suggested.

Despite some challenges and the hampered effect compared to the UK, the benefits of fiscalpolicy outweigh its difficulties and it is believed to boost Thailand's economy

Part E: Conclusion

In conclusion, theoretically, steep IS and flat LM is ideal for applying fiscal policy whilemonetary policy is suitable given flat IS steep LM curves In the UK and Thailand,macroeconomic data proved that Covid-19 shifts both curves to the lefts and simultaneouslymade IS steeper but LM flatter, whereas Thai model has flatter IS and LM Therefore,expansionary fiscal policy is recommended for both nations to stimulate investment andconsumption, thus aggregate demand Moreover, low interest elasticity of investment alsodiscourages the crowding-out effect, enhancing its effectiveness However, the optimalimpact can be hindered as consumers and firms probably save more and prepare for future taxchanges, not mention to the policy lag