Lecture Business economics - Lecture 26: The Influence of Monetary and Fiscal

In this chapter you will learn the theory of liquidity preference as a short-run theory of the interest rate, analyze how monetary policy affects interest rates and aggregate demand, analyze how fiscal policy affects interest rates and aggregate demand, discuss the debate over whether policymakers should try to stabilize the economy.

Review of the previous lecture

• In the long run, the aggregate supply curve is vertical.

• The short-run, the aggregate supply curve is upward sloping

• The are three theories explaining the upward slope of short-run aggregate supply: the misperceptions theory, the sticky-wage theory, and the sticky-price theory

Review of the previous lecture

• Keynes proposed the theory of liquidity preference to explain determinants

of the interest rate

• According to this theory, the interest rate adjusts to balance the supply and demand for money

• An increase in the price level raises money demand and increases the

interest rate

• A higher interest rate reduces investment and, thereby, the quantity of

goods and services demanded

• The downward-sloping aggregate-demand curve expresses this negative relationship between the price-level and the quantity demanded

Review of the previous lecture

• Policymakers can influence aggregate demand with monetary policy.

• An increase in the money supply will ultimately lead to the

aggregate-demand curve shifting to the right

• A decrease in the money supply will ultimately lead to the

aggregate-demand curve shifting to the left

• Policymakers can influence aggregate demand with fiscal policy

• An increase in government purchases or a cut in taxes shifts the demand curve to the right

aggregate-• A decrease in government purchases or an increase in taxes shifts the

aggregate-demand curve to the left

Review of the previous lecture

• When the government alters spending or taxes, the resulting shift in

aggregate demand can be larger or smaller than the fiscal change

• The multiplier effect tends to amplify the effects of fiscal policy on aggregate demand

• The crowding-out effect tends to dampen the effects of fiscal policy on

aggregate demand

The Influence of Monetary and Fiscal

Policy on Aggregate Demand

Instructor: Prof.Dr.Qaisar Abbas

Course code: ECO 400

Lecture 26

Changes in Taxes

• When the government cuts personal income taxes, it increases households’ take-home pay

– Households save some of this additional income

– Households also spend some of it on consumer goods

– Increased household spending shifts the aggregate-demand curve to the right

• The size of the shift in aggregate demand resulting from a tax change is affected by the multiplier and crowding-out effects

• It is also determined by the households’ perceptions about the permanency

of the tax change

Using Policy To Stabilize The Economy

• Economic stabilization has been an explicit goal of U.S policy since the Employment Act of 1946

The Case for Active Stabilization Policy

• The Employment Act has two implications:

– The government should avoid being the cause of economic fluctuations

– The government should respond to changes in the private economy in order to stabilize aggregate demand

• Some economists argue that monetary and fiscal policy destabilizes the economy

• Monetary and fiscal policy affect the economy with a substantial lag.

• They suggest the economy should be left to deal with the short-run

fluctuations on its own

Automatic Stabilizers

• Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers

having to take any deliberate action

• Automatic stabilizers include the tax system and some forms of government spending

Poverty - I

Instructor: Prof.Dr.Qaisar Abbas

Course code: ECO 400

Introduction

•Poverty has many dimension The poor have not only low incomes but also lack access to basic needs such as education, health, clean drinking water and proper sanitation

•The lack of access to basic needs undermines the capabilities of poor, limits their opportunities to secure employment and therefore, results in their social exclusion and exposes them to exogenous shocks

•The vicious cycle of poverty is accentuated when the governance structures exclude the most vulnerable from the decision making process

Growth – Poverty Nexus

•The fight against poverty represents the greatest challenge of our times

Considerable progress has been made in different parts of the world in

Growth – Poverty Nexus

•Recent trends in global, regional and national poverty clearly suggest one thing and that is, that stronger economic growth over a prolonged period is essential for poverty reduction Economic growth reduces poverty because average incomes of the poor tend to rise proportionately with average income

of the population This result is robust overtime and across countries and

regions

•Empirical evidence suggest that a one percent increase in annual rate of economic growth is associated with a decrease of about 0.9 percent in the percentage of population living below the poverty line

How Growth Affects Poverty?

•At the macro level, economic growth implies greater availability of public resources to improve the quantity and quality of education, health and other services

•At the micro level, economic growth creates employment opportunities, increases the income of the people and therefore, reduces poverty

•Many developing countries have succeeded in boosting growth for a short period But only those that have achieved higher economic growth over a long period have seen a lasting reduction in poverty – East Asia and China are classic examples

How Growth Affects Poverty?

•Growth, however, does not come automatically It requires policies that will promote growth Macroeconomic stability (low budget and current account deficits, low inflation, stable exchange rate) is therefore, key to a sustained high economic growth In the case of Pakistan, a 6-8% economic growth is essential for poverty alleviation

•Individual country experiences, however, present a somewhat different

picture Despite higher economic growth in Thailand, the reduction in poverty has been modest Malaysia has been able to achieve both a high rate of

growth and impressive reduction in poverty Bangladesh on the other hand, has dramatically reduced poverty in spite of a low economic growth

Growth Vs Quality of Economic Growth

•For poverty reduction, it is the quality of growth which is more important than growth

•Quality of growth implies ‘inclusive growth’ Growth coming from sectors

which employ more unskilled/low skill workforce For example, contribution to growth coming from agriculture, particularly livestock and dairy sector, SMEs, Housing and Construction, Information Technology would be more poverty reducing growth or ‘pro-poor’ growth or ‘inclusive’ growth

•Growth is necessary but not sufficient to reduce poverty Strategy of

promoting growth must be accompanied by improvement in opportunities for the poor, that is, it must be accompanied by higher investment on people

technical training, vocational training and improvement in delivery of social services)

Defining Poverty

•Poverty is generally defined as lack of command over resources to satisfy basic needs, mainly food, shelter and clothing This approach is basically an income approach as it measures the degree of lowness of income or

consumption in the society

•This is an uni-dimensional approach to poverty, which views poverty as income or consumption deprivation

•Poverty is not uni-dimensional, rather it is multi-dimensional phenomenon

Poverty should be viewed as the deprivation of basic capabilities such as health, lack of education, vulnerabilities, powerlessness and social

Three Types of Poverty

a Relative Poverty

b Subjective Poverty

c Absolute Poverty

a Relative Poverty: A relative poverty line is set at around 50% of the

average per capita income of the country This measure is typically used

in developed country

Drawback: Poverty line is not constant; moves upward with the rise in per

capita income; therefore, it is not appropriate to measure poverty in

developing countries

b Subjective Poverty: The subjective poverty line refers to that level of

income at which people feels that their income is just equal to the

minimum income required to meet end need

Drawback: This is a subjective estimates People with same level of welfare

may give different answers for their minimum income requirement and may be treated differently with respect to poor and non-poor

Three Types of Poverty

c Absolute Poverty: The absolute poverty line is defined as a minimum

socially acceptable level of income or consumption used to distinguish the poor from non-poor The individuals below the poverty line are poor

Consistency requires that poverty line remains constant in real term across regions and overtime

What is Poverty Line?

•A poverty line represents a specific minimum level of income or consumption needed to satisfy the basic physical needs of food, clothing, shelter, education and health in order to ensure continued survival

•The extent of absolute poverty is therefore defined as the number of people who are unable to command sufficient resources to satisfy the needs

•The poverty line is set at a level that remains constant in real term so that we can measure our progress on an absolute level over time

changed

Poverty Indices

Headcount Ratio: It is defined as the proportion of people living below the

poverty line This measure is easy to calculate However, it takes no account

of the depth of poverty The Headcount ratio is nevertheless the most widely used poverty estimate

Poverty Gap: Poverty gap measures the depth of poverty It also measures

the total income necessary to raise everyone who is below the poverty line up

to that line A lower value would indicate that most of the poor are bunched around the poverty line

Method of Estimating Poverty Line

Calorie Intake Method:

• The calorie approach to set the poverty line is based on minimum

food requirements, expressed in terms of calorie intake per day

• Income vs consumption as welfare indicator

• Consumption is preferred for the following reasons

It is smoother than income

Income is subject to seasonal variability while consumption is less variable

Consumption is considered more direct indicator of achievement and fulfillment of basic needs

Respondents in developing countries are reluctant to reveal income

Consumption is more easily observable and measurable

•

Method of Estimating Poverty Line

• Consumption aggregate is comprehensive It consists of

Fuel and Utilities

• Adjustment of Consumption Aggregate

While expenditures (food and non-food) are recorded at the household level, Poverty needs to be measured at the individual level

Adjust consumption expenditure by the size and composition of household

Adult equivalence scale (with weight 0.8 to individuals younger than 18 years old and 1.0 for all other individuals)

• Poverty line be updated between the two Surveys by price indices The most widely used method is to adjust poverty line with CPI-

based inflation This method allows for changes in prices but the consumption basket associated with poverty line remains

unchanged Thus poverty line remains constant over time

Why Poverty Estimates Can Differ?

Poverty estimates are highly sensitive to a variety of factors The very basis of drawing the poverty line may differ across researchers

 Calorie intake approach vs basic needs approach

 Within calorie intake basis some my use 2250 calories; 2550 calories;

or 2350 calories per adult equivalence

 CPI vs SPI vs WPI vs prices (or unit values) as derived from the survey

to adjust poverty line

• At the macro level, economic growth implies greater availability of public resources to improve the quantity and quality of education, health and other services

• At the micro level, economic growth creates employment opportunities,

increases the income of the people and therefore, reduces poverty

• Poverty is generally defined as lack of command over resources to satisfy basic needs, mainly food, shelter and clothing This approach is basically an income approach as it measures the degree of lowness of income or

consumption in the society

• A relative poverty line is set at around 50% of the average per capita

income of the country

• The subjective poverty line refers to that level of income at which people feels that their income is just equal to the minimum income required to meet end need

• The absolute poverty line is defined as a minimum socially acceptable level

of income or consumption used to distinguish the poor from non-poor