BOX 18.5 CALCULATING THE MONEY MULTIPLIER ECONOMICS EXPLORING
19.2 THE MONETARY EFFECTS OF CHANGES IN THE GOODS MARKET
Section summary
1. The quantity equation MV=PYcan be used to analyse the possible relationship between money and prices.
Whether and how much increases in money supply (M) affect the price level (P) depends on whether the velocity of circulation (V) and the level of real national income (Y) are independent of money supply (M).
2. The interest rate transmission mechanism works as follows: (a) a rise in money supply causes money supply to exceed money demand; interest rates fall;
(b) this causes investment to rise; (c) this causes a multiplied rise in national income; but (d) as national income rises, so the transactions demand for money rises, thus preventing quite such a large fall in interest rates.
3. The effect will be weak if the demand-for-money curve (L) is elastic and the investment demand curve is inelastic. The effects may also be unreliable because of an unstable and possibly inelastic investment demand.
4. The exchange rate transmission mechanism works as follows: (a) a rise in money supply causes interest rates to fall; (b) the rise in money supply plus the fall in interest rates causes an increased supply of domestic currency to come on to the foreign exchange market;
this causes the exchange rate to fall; (c) this causes increased exports and reduced imports, and hence a multiplied rise in national income.
5. According to the theory of portfolio balance, if people have an increase in money in their portfolios, they will attempt to restore portfolio balance by purchasing assets, including goods. Thus an increase in money supply is transmitted directly into an increase in aggregate demand.
6. The demand for money is more stable in the long run than in the short run. This leads to a greater long-run stability in V(unless it changes as a result of other factors, such as institutional arrangements for the handling of money).
saving (i.e. saving minus borrowing) will rise as the higher interest rate acts as both an incentive for households to save and a disincentive for them to borrow. This causes an upward shift in the Wcurve. The result is that national income will not rise as far as Y2. In the extreme case, there would be no rise in national income at all.
If, however, the central bank responded to the increase in investment by expanding the money supply to M’s, there would be no change in the rate of interest and hence no dampening effect on either investment or consumption.
Assume that the government cuts its expenditure and thereby runs a public-sector surplus.
(a) What will this do initially to equilibrium national income?
(b) What will it do to the demand for money and initially to interest rates?
(c) Under what circumstances will it lead to (i) a decrease in money supply;
(ii) no change in money supply?
(d) What effect will (i) and (ii) have on the rate of interest compared with its original level?
Crowding out
Another example of the monetary constraints on expan- sion in the goods market is the phenomenon known as financial crowding out. This is where an increase in public- sector spending reduces private-sector spending (see Box 16.2 on page 461).
To illustrate the effects, assume that previously the government has had a balanced budget, but that now it chooses to expand the level of government expenditure without raising additional taxes. As a result, it runs a bud-
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get deficit (G>T). But this deficit will have to be financed by borrowing. The resulting public-sector net cash require- ment will lead to an increase in the money supply if it is financed by borrowing from the central bank through the issue of bonds (gilts), or by the sale of Treasury bills to the banking sector. Alternatively, if it is financed by selling bills or bonds outside the banking sector, there will be no increase in the money supply.
The effect can once more be shown in Figure 19.8. The rise in government expenditure will cause injections to rise to J2 and, other things being equal, national income will rise to Y2. But, as with the case of increased investment, this increase in national income will lead to a rise in the demand for money. In Figure 19.8(b), the demand-for- money curve shifts from Lto L′. If the PSNCR is financed in such a way as to allow money supply to expand to M′s, there will be no change in the interest rate and no crowding- out effect. If, however, the money supply is not allowed to expand, interest rates will rise to r2. This in turn will reduce investment: crowding out will occur. Injections will fall back again below J2. In the extreme case, injections could even fall back to J1and thus national income return to Y1. Here crowding out is total.
The extent of crowding out
Just how much crowding out will occur when there is an expansionary fiscal policy, but when money supply is not allowed to expand, depends on two things.
The responsiveness (elasticity) of the demand for money to a change in interest rates. If the demand is relatively elastic (as in Figure 19.9(a)), the increase in demand, represented by a horizontalshift in the liquidity preference curve from Lto L′, will lead to only a small rise in interest rates. If, however, the demand is relatively inelastic (as in Figure 19.9(b)), the same horizontal shift will lead to a bigger rise in interest rates.
As we saw in section 19.1, Keynesians generally see the liquidity preference curve as being more elastic than do Figure 19.8 The monetary effects of a rise in injections
Financial crowding out Where an increase in government borrowing diverts money away from the private sector.
Definition
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monetarists. Thus, unlike monetarists and new classical economists, they argue that a rise in money demand nor- mally leads to only a relatively modest rise in interest rates.
The responsiveness (elasticity) of investment to a change in inter- est rates. Keynesians argue that investment is relatively unresponsive to changes in interest rates. Businesspeople are much more likely to be affected by the state of the market for their product than by interest rates. Thus in Figure 19.10(a), there is only a small fall in investment.
Monetarists and new classical economists argue that invest- ment is relatively responsiveto changes in interest rates.
Thus in Figure 19.10(b), there is a bigger fall in investment.
In the Keynesian case, therefore, the rise in demand for money arising from an expansionary fiscal policy will have only a small effect on interest rates and an even smaller effect on investment. Little or no crowding out takes place. In fact, the expansion of demand might cause an increase in investment through the accelerator effect (see pages 496–7).
Monetarists argue that interest rates will rise signific- antly and that there will be a severe effect on investment.
Crowding out is substantial. For this reason, they argue that, if money supply is to be kept under control to prevent inflation rising, it is vital for governments to reduce the size of their budget deficit. They argue that, in the long run, crowding out is total, given the long-run stability of the velocity of circulation.
Is money supply exogenous or endogenous?
Money supply is exogenous(independently determined) if it can be fixed by the authorities and if it does not vary with aggregate demand and interest rates. The money supply
‘curve’ would be vertical, as in Figure 19.9(b). It would shift only if the government or central bank choseto alter the money supply.
Money supply is endogenous (determined within the model) if it is determined by aggregate demand and hence the demand for money: banks expanding or contracting credit in response to customer demand. In such a case, the
BOX 19.3 CROWDING OUT IN AN OPEN ECONOMY Taking exchange rate effects into account
EXPLORING ECONOMICS
• The higher exchange rate will reduce the level of exports (an injection) and increase the level of imports (a withdrawal). This will add to the degree of crowding out.
Thus in an open economy with floating exchange rates, an expansionary fiscal policy will be crowded out not only by higher interest rates, but also by a higher exchange rate.
We have argued that the short-term inflow of finance following a rise in the rate of interest will drive up the exchange rate. Are there any effects of expansionary fiscal policy on the demand for imports (and hence on the current account) that will go some way to offsetting this?
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Will fiscal policy be crowded out in an open economy with floating exchange rates? Assume that the government increases its expenditure but does not allow the money supply to expand: a case of pure fiscal policy. What will happen?
• The increased government expenditure will increase the demand for money (see Figure 19.8(b)).
• This will drive up interest rates – the amount depending on the elasticity of the liquidity preference curve.
• This will lead to an inflow of finance from abroad, which in turn will lead to an appreciation of the exchange rate.
Figure 19.9 Different views on the demand for money
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Section summary
1. Changes in injections or withdrawals will have monetary implications. If there is a rise in investment with no change in the money supply, the increased demand for money will drive up interest rates and reduce both investment and consumption. The resulting rise in income will be smaller.
2. Similarly, if there is a fiscal expansion and nochange in the money supply, the increased demand for money will again drive up the interest rate. This will to some extent crowd out private expenditure and thus reduce the effectiveness of the fiscal policy.
3. The extent of crowding out will depend on the shape of the liquidity preference curve and the investment demand curve. The less elastic the demand for money,
and the more elastic the investment demand, the more crowding out will take place, and the less effective will fiscal policy be.
4. If there is a rise in aggregate demand, money supply may rise in response to this. The more elastic the supply of money curve, the less crowding out will take place.
5. Money supply is not totally exogenous. This makes it hard for the authorities to control it precisely.
Generally, therefore, central banks try to control interest ratesand attempt to alter liquidity to back this up. Sometimes, however, they may take more deliberate steps to inject extra liquidity into the financial system.
Figure 19.10 Different views on the demand for investment
money supply curve would be upward sloping or even hori- zontal. The more that money supply expands in response to an increase in aggregate demand, the more gently upward sloping the money supply curve would be.
The more elastic the money supply curve, the less will money act as a constraint on expansion in the goods market, and the less will a rise in government expenditure crowd out private expenditure. In other words, the less will interest rates rise in response to a rise in the demand for money.
The extreme monetarist position is that money supply is wholly exogenous. The extreme Keynesian position is that money supply is wholly endogenous. Money simply passively expands to meet the demand for money.
In reality, money supply is partly exogenous and partly endogenous. The authorities are able to influence money supply, but banks and other financial institutions have considerable scope for creating credit in response to demand. If control of the money supply is adopted as the basis for policy, the authorities must reduce the endogen- ous element to a minimum.
As we shall see in the next chapter, the authorities in many countries recognise the difficulties in controlling the money supply directly. They therefore influence the supply of money indirectly by controlling interest rates and hence the demand for money.
Sometimes, however, in extreme circumstances, the authorities may attempt to control money supply directly.
Thus in 2008/9, central banks in several countries, includ- ing the USA, the eurozone, the UK and Japan, injected large amounts of liquidity into the financial system in an attempt to stimulate bank lending in the face of the credit crunch. Money supply had been falling as banks, finding that many of their assets were less liquid than they thought or finding that some of their customers were defaulting on loans, created less credit. The idea of the central banks making considerably more liquid funds available to banks was that the banks could use this additional liquidity as the basis for additional credit. Just how much credit would be created, however, and thus how much broad money would expand, was nevertheless very uncertain.
The goods and money markets
In this chapter, we have shown that there are two key mar- kets in the economy at macroeconomic level, and that these two markets interact. The first is the goods market;
the second is the money market. Each of these two markets has been analysed by using a model.
In the case of the goods market, the model is the Keynesian injections/withdrawals model. Any change in injections or withdrawals will cause national income to change. For example, a rise in government expenditure shifts the Jline upwards and causes a rise in equilibrium national income. In other words, an increase in the demand for goods and services causes a (multiplied) rise in the output of goods and services (assuming that there are sufficient idle resources).
In the case of the money market, the model is the one showing the demand for money (L) and the supply of money (M) and their effect on the rate of interest. A change in the supply or demand for money will cause the equilib- rium rate of interest to change. Monetary policy operates directly in this market, either by affecting the supply of money or by operating on interest rates.
What we have shown in this chapter is that the two markets interact: that changes in one market cause changes in the other. Take the case of an increase in investment: it has a direct effect in the goods markets, but also an indirect effect in money markets. We illustrated this in Figure 19.8.
The goods market effect was shown in Figure 19.8(a). The rise in injections led to a multiplied rise in income to Y2. The money market effect was shown in Figure 19.8(b). The rise in income led to a rise in the transactions demand for money and a resulting rise in interest rates to r2. This in turn had an effect back in the goods market, with a higher interest rate dampening investment and consumption somewhat and reducing the final rise in income.
The effect of a rise in money supply in the two markets was shown in Figures 19.1, 19.2 and 19.7 (on pages 537 and 540). The rise in money supply reduces interest rates.
This then, via an increase in investment (or a reduction in the exchange rate and a resulting increase in exports and a reduction in imports), leads to a multiplied rise in income in the goods market. This in turn has an effect back in the money market, with a higher income leading to a higher demand for money, thus limiting the fall in interest rates.
The trouble with our analysis so far is that we have needed at least two diagrams. What we are going to look at in this section is a model which combinesthese two mar- kets, which means that we will need only one diagram. The model is known as the ISLM model.
The model allows us to examine the effects of changes originating in one of the two markets on both national income andinterest rates: it shows what the equilibrium will be in both the goods and the money markets simul- taneously. The model, as its name suggests, consists of two curves: an IScurve and an LMcurve. The IScurve is based on equilibrium in the goods market; the LMcurve is based on equilibrium in the money market.
Let us examine these two curves in turn.
The IS curve Deriving the IS curve
To explain how the IS curve is derived, let us examine Figure 19.11, which as you can see is in two parts. The top part shows the familiar Keynesian injections and with- drawals diagram, only in this case, for simplicity, we are assuming that saving is the only withdrawal from the cir- cular flow of income, and investment the only injection.
Thus in equilibrium I=S (i.e. J=W). The bottom part of Figure 19.11 shows the IScurve. This shows all the various combinations of interest rates (r) and national income (Y) at which I=S.
Let us assume that initially interest rates are at r1. Both investment and saving are affected by interest rates, and thus, other things being equal, an interest rate of r1will give particular investment and saving schedules. Let us say that, in the top part of Figure 19.11, these are shown by the curves I1and S1. Equilibrium national income will be where I=S, i.e. at Y1. Thus in the lower part of Figure 19.11, an interest rate of r1will give a level of national income of Y1. Thus point a is one point on the IScurve. At an interest rate of r1 the goods market will be in equilibrium at an income of Y1.
Now what will happen if the rate of interest changes?
Let us assume that it falls to r2. This will cause a rise in investment and a fall in saving. A rise in investment is shown in the top part of Figure 19.11 by a shift in the investment line to I2. Likewise a fall in saving is shown by a shift in the saving curve to S2. This will lead to a multiplied rise in income to Y2 (where I2 =S2). This corresponds to point bin the lower diagram, which therefore gives a sec- ond point on the IScurve.