BOX 19.4 ENVIRONMENTALLY SUSTAINABLE MACROECONOMIC EQUILIBRIUM
19.4 TAKING INFLATION INTO ACCOUNT
1The Group of Seven countries are Canada, France, Germany, Italy, Japan, the UK and the USA.
5. A change in national income will cause a movement along the LMcurve. A change in anything else that affects interest rates (i.e. a change in the demand or supply of money other than as a result of a change in national income) will shift the LMcurve.
6. Simultaneous equilibrium in both goods and money markets (i.e. the equilibrium national income and the equilibrium rate of interest) is where IS=LM.
7. A change in injections or withdrawals will shift the IS curve. A rise in injections will shift it to the right. This will cause a rise in both national income and the rate of interest. The rise in income will be bigger and the rise in the rate of interest smaller, the steeper the IS curve and the flatter the LMcurve.
8. A rise in money supply will shift the LMcurve downwards. This will cause a fall in interest rates and a rise in national income. The rise in national income will be larger, the flatter theIScurve and the steeper the liquidity preference curve (L) and hence the bigger the downward shift in the LMcurve for any given increase in the money supply.
9. An ADcurve can be derived from an ISLMdiagram. A higher price level will shift the LMcurve upwards. This will lead to a lower level of national income. The higher price level and lower national income gives a new point on the ADcurve.
The aggregate demand/inflation curve
As with the normal ADcurve, the ADIcurve is downward sloping. In other words, a higher rate of inflation leads to a lower level of (real) aggregate demand. But why?
The reason is simple. It consists of a two-stage process.
1. If the rate of inflation (π) goes above the target level, the central bank will raise the real rate of interest (i). In other words it will raise the nominal rate morethan the rise in inflation. Thus if inflation goes up from a targeted 2 per cent to 3 per cent, the nominal interest rate must rise by more than 1 percentage point in order to achieve a rise in the real interest rate.
2. The higher real rate of interest will then reduce (real) aggregate demand (AD), through both the interest rate mechanism and the exchange rate mechanism (see pages 536–42).
To summarise:
π ↑ →i ↑ →AD ↓
Similarly, a fall in the rate of inflation will cause the cen- tral bank to lower the real rate of interest. This will then lead to an increase in aggregate demand.
The slope of the ADI curve. The slope of the ADI curve depends on the strength of the two stages. The curve will be relatively flat
• the more real interest rates respond to a change in inflation. Interest rate changes will be larger, the faster the central bank wants to get inflation back to its target level and the less concerned it is about cutting back on aggregate demand and hence output and employment;
• the more responsive investment, consumption and exports (i.e. the components of aggregate demand) are to a change in interest rates.
A movement along the ADI curve. This will be caused by a change in the rate of inflation. If inflation rises, there will
be a movement up the curve as the central bank raises the real rate of interest and this causes real income to fall.
When inflation begins to fall in response to the higher rate of interest, there will be a movement back down the curve again.
The position of the ADI curve. A given ADIcurve represents a given monetary policy. The particular ADIcurve in Figure 19.16 intersects with the inflation target line at a real income of Y1. This means that if inflation is on target, real national income will be Y1. The central bank will need to consider whether this is consistent with long-term equilib- rium in the economy: in other words, whether Y1 is the potentiallevel of national output, i.e. the level of income with a zero output gap (see Box 14.3 on page 398). If it is, then the monetary policy it has chosen is appropriate.
A shift in the ADI curve. Any factor that causes aggregate demand to change, other than the central bank responding to inflation being off target, will cause the ADI curve to shift. A rightward shift represents an increase in aggregate demand. A leftward shift represents a decrease.
Examples of a rightward shift include cuts in tax rates, an increase in government expenditure and a rise in con- sumer or business confidence. The ADIcurve will also shift to the right if the government or central bank sets a higher target rate of inflation. The reason is that this will lead to lower interest rates at every level of inflation.
The curve will also shift if the central bank changes its monetary policy, such that it no longer wants Y1to be the equilibrium level of national income. For example, if Y1
in Figure 19.16 were below the potential level, and there was therefore demand-deficient unemployment, the cen- tral bank would want to reduce real interest rates in order to achieve a higher level of aggregate demand at the target rate of inflation. This will shift the ADIcurve to the right.
In other words, each level of inflation along this new ADI curve would correspond to a lower real rate of interest (i) and hence a higher level of aggregate demand.
But what determines the level of Y? This is determined by the interaction of aggregate demand and aggregate supply.
To show this we introduce a third line: the ASIcurve.
The aggregate supply/inflation curve
The ASIcurve, like the normal AScurve, is upward sloping.
In the short run it will be relatively flat. In the long run it will be relatively steep, if not vertical at the potential level of national income. The curve illustrated in Figure 19.17 is the short-run ASIcurve. But why is it shaped this way?
Why will a higher rate of inflation lead to higher real national income?
Assume that the economy is currently generating a real national income of Y1and that inflation is on target (πtarget).
Equilibrium is at point a. Assume also that Y1represents the long-run potential level of output.
Figure 19.16 ADplotted against inflation
Now assume that consumer confidence rises, and that, as a result, the ADIcurve shifts to ADI2. Firms will respond to the higher aggregate demand partly by raising prices more than the current (i.e. target) rate of inflation and partly by increasing output: there is a movement along the ASIcurve. Equilibrium moves to point b, where ADI=ASI.
But why will firms raise output as well as prices? The rea- son is that wage rises lag behind price rises. This is because of the time it takes to negotiate new wage rates and the fact that people were probably anticipating that inflation would stay at its target level. The higher prices now charged by firms will generate bigger profit margins for them, and thus they will be willing to supply more.
Over time, however, if the higher demand persists, wage rises would get higher. This would be the result of firms trying to obtain more labour to meet the higher demand and of unions seeking wage increases to compensate for the higher rate of inflation. Thus, assuming no increase in productivity, the ASIcurve would shift upwards and con- tinue doing so until real national income returned to the potential level Y1. The long-run ASIcurve would be vertical through point a.
Response to changes in aggregate demand and supply
A rise in aggregate demand
Assume, in Figure 19.17, that there has been a rise in real aggregate demand and that the ADI curve has shifted to ADI2. Assume also that Y1is the potential level of national output. If inflation remained at its target level, the eco- nomy would move to point c, with national income increas- ing to Y3. But as firms respond partly by increasing prices more rapidly, equilibrium is reached at point b. In other words, there has been a movement up along the ASIcurve from point a to point band back up along the new ADI curve from point cto point b. This movement along curve
ADI2is the result of the higher interest rates imposed by the central bank in response to inflation rising to π2.
But equilibrium at point bis above the target rate. This is unsustainable, even in the short run. One of two things must happen. The first option is for the central bank (or government) to accept a higher target rate of inflation:
i.e. π2. But if it does this, real income can only remain above its potential level in the short run. Soon, higher prices will feed through into higher wages and back into higher prices, and so on. The ASIcurve will shift upwards.
The second option – the only effective option in the long run – is for the central bank to reduce aggregate demand back to ADI1. This will mean changing monetary policy, such that a higher real rate of interest is chosen for each rate of inflation. This tighter monetary policy shifts the ADIcurve to the left.
In other words, if the central bank is adhering strictly to an inflation target, any rise in real aggregate demand can have only a temporary effect, since the higher inflation that results will force the central bank to bring aggregate demand back down again.
The one exception to this would be if the higher aggre- gate demand encouraged firms to invest more. When the effects of this on aggregate supply began to be felt in terms of higher output, the short-term ASIcurve itself would shift to the right, leading to a new equilibrium to the right of point a. In such a case, there would have been a long-term increase in output, even though the central bank was stick- ing to an inflation target.
Using a graph similar to Figure 19.17, trace through the effect of a reduction in aggregate demand.
A rise in aggregate supply
Assume now that aggregate supply rises. This could be a temporary ‘supply shock’, such as a cut in oil prices or a good harvest, or it could be a permanent increase caused, say, by technical progress. Let us take each in turn.
A temporary supply shock. In Figure 19.18, initial equilib- rium is at point a, with curves ADI1and ASI1intersecting at the target rate of inflation. The rise in aggregate supply causes the ASIcurve temporarily to shift from ASI1to ASI2. Inflation thus falls below the target rate. As a result, the central bank reduces the real rate of interest (i). The effect is to increase aggregate demand. This is shown by a move- ment along curve ADI1from point ato point d. Inflation has fallen to π3and real national income has risen to Y4. Since this is only a temporary increase in aggregate supply, the central bank will not change its monetary policy. The ADIcurve, therefore, will not shift.
As the supply shock subsides, aggregate supply will fall again. The ASIcurve will shift back from ASI2to ASI1, caus- ing inflation to rise again. The result is a move back up the ADI1curve from point dto point a.
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Figure 19.17 ADand ASplotted against inflation
KI 31 p320
1. Trace through the effect of an adverse supply shock, such as a rise in oil prices.
2. What determines the amount that national income fluctuates when there is a temporary shift in the ASI curve?
A permanent increase in aggregate supply. Now assume that ASI2represents a permanent shift. As before, the reduction
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in inflation causes the central bank to reduce interest rates.
If there is no change in monetary policy, there would be simply be, once more, a movement from point ato point d with inflation now at π3.
Once the central bank realises that the rise in aggregate supply is permanent, it will want to move to equilibrium at point e. To do this it will have to changeits monetary policy and adopt a lower real interest rate at each rate of inflation.
This will shift the ADIcurve to ADI2. If it does this, equilib- rium will be restored at the target rate of inflation. Y5will be the new sustainable level of real national income.
In other words, the central bank, by maintaining an inflation target, will allow aggregate demand to expand sufficiently to accommodate the full rise in aggregate supply.
In the next chapter we explore policies to control aggregate demand. In the final section of that chapter (section 20.5), we look at whether it is best for a central bank to target inflation or whether it should adopt an alternative target.
We also look at the more general issue of whether govern- ments ought to set targets and stick to them, or whether they should allow themselves more discretion in managing the economy.
Figure 19.18 The effects of an increase in aggregate supply
Section summary
1. Today, most countries have low rates of inflation compared with the past. Part of the reason for this is the deliberate targeting of low inflation by governments and central banks.
2. The effects of adhering to an inflation target can be illustrated in a modified version of the aggregate demand and supply diagram. Inflation, rather than the price level, is plotted on the vertical axis. The aggregate demand curve in this diagram (labelled ADI) is downward sloping. This is because higher inflation encourages the central bank to raise interest rates and this leads to a fall in real national income.
3. The aggregate supply (ASI) curve in the short run is upward sloping. This is because wage rises lag behind price rises and thus firms are encouraged to supply more in response to a rise in demand knowing that their profits will increase.
4. If aggregate demand rises, the ADI curve will shift to the right. Inflation will rise above its target level. This is shown by a movement up the ASI curve and back up the new ADI curve to the new intersection point (as in Figure 19.17). The movement up the new ADI curve is in response to the higher interest rate now set by the
central bank as it attempts to bring inflation back down to its target level.
5. Since the new equilibrium is above the target rate of inflation, the central bank must change to a tighter monetary policy and raise the real rate of interest. This shifts the ADI curve back to the left, and equilibrium is restored back at its original level. The rise in aggregate demand (unless accompanied by a rightward shift in aggregate supply) has had only a temporary effect on real national income.
6. A rise in aggregate supply (unless merely a temporary supply shock) will have a permanent effect on real national income. A rightward shift in aggregate supply will lead to an initial equilibrium at a rate of inflation below target and some rise in real national income as the rate of interest is reduced (as in Figure 19.18). The equilibrium is now below the target rate of inflation.
The central bank must therefore change to a looser monetary policy and reduce the real rate of interest.
This will shift the ADI curve to the right, causing a further rise in real national income that now fully reflects the rise in aggregate supply.
Online resources
Additional case studies in MyEconLab
19.1 Crowding out. This case looks at a different version of crowding out from that analysed in section 19.2.
Maths Case 19.1 Using ISand LMequations to find the equilibrium national income and interest rate.Using the algebra in a worked example.
Websites relevant to Chapters 18 and 19
Numbers and sections refer to websites listed in the Web Appendix and hotlinked from this book’s website at www.pearsoned.co.uk/sloman.
• For news articles relevant to this and the previous chapter, see the Economics News Articles link from the book’s website.
• For general news on money and banking, see websites in section A, and particularly A1–5, 7–9, 20–22, 25, 26, 31, 36.
See also links to economic and financial news in A42.
• For monetary and financial data (including data for money supply and interest rates), see section F and particularly F2.
Note that you can link to central banks worldwide from site F17. See also the links in B1 or 2.
• For monetary targeting in the UK, see F1 and E30. For monetary targeting in the eurozone, see F6 and 5.
• For links to sites on money and monetary policy, see the Financial Economics sections in I4, 7, 11, 17.
• For student resources relevant to Chapters 18 and 19, see sites C1–7, 9, 10, 12, 13, 19. See also ‘2ndfloor – economic policy’ in site D1. See also site D11 (The virtual bank of Biz/ed).
END OF CHAPTER QUESTIONS
1. Using one or more diagrams like Figures 19.2, 19.7, 19.8, 19.9 and 19.10, illustrate the following:
(a) The effect of a contraction in the money supply on national income. Refer to both the interest rate and exchange rate transmission mechanisms and show how the shapes of the curves affect the outcome.
(b) The effect of a fall in investment on national income. Again show how the shapes of the curves affect the outcome. Specify your assumptions about the effects on the supply of money.
2. Controlling the money supply is sometimes advocated as an appropriate policy for controlling inflation. What implications do different assumptions about the relationships between M and V, and M and Y, in the equation MV=PY have for the effectiveness of this policy?
3. Why may an expansion of the money supply have a relatively small effect on national income? Why may any effect be hard to predict?
4. Why does the exchange rate transmission mechanism strengthen the interest rate transmission mechanism?
5. Explain how the holding of a range of assets in people’s portfolios may help to create a more direct link between changes in money supply and changes in aggregate demand.
6. Explain how financial crowding out can reduce the effectiveness of fiscal policy. What determines the magnitude of crowding out?
*7. What determines the shape of the IS and LM curves?
*8. Under what circumstances will (a) a rise in investment and (b) a rise in money supply cause a large rise in national income?
*9. Using ISLM analysis, explain what would cause the aggregate demand curve to be steep.
10. What would cause (a) a steep ADI curve; (b) a gently sloping ADI curve? Compare the short-run and long- run effects of (i) a temporary adverse supply shock and (ii) a permanent supply reduction under each of (a) and (b).
11. Under what circumstances would a rightward shift in the ADI curve lead to a permanent increase in real national income?
20 Ch apt er
Fiscal and Monetary Policy
20.1 Fiscal policy 562
Government finances: some terminology 562 The government’s ‘fiscal stance’ 563
Automatic fiscal stabilisers 565
The effectiveness of automatic stabilisers 565
Discretionary fiscal policy 565
The effectiveness of discretionary fiscal policy 567
Problems of magnitude 568
Problems of timing 569
Fiscal rules 571
20.2 Monetary policy 574
The policy setting 574
Control of the money supply over the medium
and long term 574
The operation of monetary policy in the short term 576 Techniques to control the money supply 576 Techniques to control interest rates 584
Using monetary policy 587
*20.3 ISLManalysis of fiscal and
monetary policy 589
The Keynesian position 590
The monetarist position 590