monetary and fiscal policy in a closed economy

Bringing together the real and financial sectorsHaving seen equilibrium in the goods and money markets separately, it is now time to explore the links between them and to look at simul

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.

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.

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.

Permanent income

Thus wealth and interest rates may influence consumption.

Income varies over an individual's lifetime.

Actual income

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.

Analysis of fixed investment in the UK

by type of asset 1965-1998

0 20

Trans Other mc/eq Dwellings Other build Intangible

Source: Economic Trends Annual Supplement, Monthly Digest of Statistics

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.

The investment demand schedule

… shows how much investment firms wish to

undertake at each interest rate.

Investment demand

II

At relatively high interest rates, less investment

projects are viable.

At r 0 , I 0 projects are viable.

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

I 0

A fall in interest rates shifts the consumption function to CC 1 , and

leads to higher investment at I 1 .

CC 1

I 1

Aggregate demand rises

to AD 1 , and the new equilibrium is at Y 1 .

Y 1

Fiscal policy and crowding out

Initially, equilibrium moves to Y 1 .

AD 2

Y 2

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.

at which the goods market

is in equilibrium.

AD 1

At a lower interest rate r 1 Consumption, investment and AD are higher.

r 1

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.

The LM schedule

Income

Real money balances

At income Y 0 , money demand is at LL 0 and equilibrium

in the money market requires an interest rate of r 0 .

The LM schedule traces out the combinations of real income

and interest rate in which the money market is in equilibrium.

Shifting IS and LM schedules

 The position of the IS schedule

Equilibrium in goods and money markets

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.

Fiscal policy in the IS-LM model

IS 1

A bond-financed increase in government spending shifts the IS schedule to IS 1 .

r 1

Y 1

Equilibrium is now at

r 1 , Y 1 Some private spending has been crowded out

by the increase in the rate of interest.

Monetary policy in the IS-LM model

LM 1 An increase in money supply shifts the LM

schedule to the right.

Y 1

r 1

Equilibrium is now

at r 1 , Y 1 .

The composition of aggregate demand

Income

r

Demand management is the use of monetary and fiscal policy

to stabilize the level of income around a high average level.

IS 1

LM 1

policy (IS 1 ) with ‘tight’ monetary policy (LM 1 ).

This affects the private:

public balance of spending

in the economy.

 The IS-LM model seems to offer

government a range of options for

influencing equilibrium income.

– there are other issues to be considered

 the price level and inflation

 the supply-side of the economy

 the exchange rate