Presentation on theme: "1. Bringing together the Real and Financial Sectors"— Presentation transcript:
0 Macroeconomics (ECON 1211) Lecturer: Mr S Macroeconomics (ECON 1211) Lecturer: Mr S. Puran Topic: Monetary and Fiscal policy in a Closed Economy
1 1. 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 themand to look at simultaneous equilibrium in both.
2 2. Consumption Revisited Income is a key determinant of consumptionbut other factors shift the consumption function (mainly autonomous consumption)household wealthavailability of creditcost of creditThese create a link between the financial and real sectorsbecause interest rates can be seen to influence consumption.See Section 25-1 in the main text.
3 3. The Keynesian Consumption Function Based on the Psychological Law of ConsumptionWhen there is an increase in the level of income, the MPC does not change in the same proportion as the change in income.It change by lessThere is a level of autonomous consumption which remainsAPC ( C/ Y)and MPC (< 1)See Section 25-1 in the main text.
4 4. The Permanent Income Hypothesis A modern theory of consumption developed by Milton Friedmanargues that people like to smooth planned consumption even if income fluctuatesConsumption depends upon permanent not transitory income.See Section 25-1 in the main text.
5 4. The Permanent Income Hypothesis An individual has a current level of income and therefore has a brief idea of the consumption level he/she can sustain over his/her lifetimeAn increase in income: permanent or transitoryTransitory: no major effect on consumptionIf the increase can be sustained then the individual will accept that permanent income has increaseSee Section 25-1 in the main text.
6 4. The Permanent Income Hypothesis An increase in permanent income will change consumption level as the former can sustain the latterThus, consumption depends on what individual expect to earn over a considerable period of timeIndividuals save during period of high income and dissave during period of low incomeA Phd student should have a higher level of consumption than an undergraduate studentSee Section 25-1 in the main text.
7 4. The Permanent Income Hypothesis Example, past four years income: £12,000; £12,000; £10,000; £10,000Then permanent income should be £11,000Permanent income and life – cycle hypotheses loosen relationship C and Y so that an exogenous change in investment may not have a constant multiplier effectTemporary change in income: little effect in spendingSee Section 25-1 in the main text.
8 5. The Life - Cycle Hypothesis A theory of consumption developed by Ando and Modigliani.Income varies over anindividual's lifetime.ActualincomeSavings occur duringmiddle ageIndividuals try to smooththeir consumption, basedon expected lifetimeincome.PermanentincomeIncome, consumptionand dissaving in youthand old age.See Section 25-1 in the main text.DeathAgeThus wealth and interest rates may influence consumption.
9 5. The Life – Cycle Hypothesis What are the goals of individuals:1) They prefer a high standard of living to a low standard of living,2) Most individuals prefer to have a constant standard of living throughout timePut together these two goals suggest that we assume that individuals try to maintain the highest, smooth consumption pathSee the "Economics in action" box in the main text.
10 6. 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.See the "Economics in action" box in the main text.
11 7. Investment Demand Investment spending includes: fixed capital Transport equipmentMachinery & other equipmentDwellingsOther buildingsIntangiblesworking capitalstocks (inventories)work in progressand is undertaken by private and public sectorsSee Section 25-2 in the main text."Intangibles" includes investment in computer software etc.
12 8. The Demand for Fixed Investment Investment entails present sacrifice for future gainsfirms incur costs in the short runbut reap gains in the long runExpected returns must outweigh the opportunity cost if a project is to be undertakenso at relatively high interest rates, less investment projects are viable.See Section 25-2 in the main text.
13 9. The Investment Demand Schedule … shows how much investment firms wish toundertake at each interest rate.IIAt relatively high interestrates, less investmentprojects are viable.Interest ratebut if the interest raterises to r1, desiredinvestment falls to I1.r1I1At r0, I0 projects are viable.r0I0See Section 25-3 in the main text, and Figure 25-3.Investment demand
14 9. Interest Rates and Aggregate Demand The position of the AD schedule is now seen to depend upon interest rates through the effects onconsumptioninvestment
15 10. Inventory InvestmentFirms desire stocks of raw materials, partly finished goods awaiting saleFirms may be betting on price changesMany production process take timeStocks help smooth costly adjustments in output. If output demand rises suddenly, plant capacity cannot be changed overnightSee Section 25-2 in the main text.
16 11. The Accelerator Theory of Investment Investment responds to changing demand condition.If D increases, there will be an excess demand for goods.Firms have two choices: either to raise prices or to meet demand by raising supplyKeynesian: in order to meet higher production, firms will increase their output capacity by investing in plant and investmentI = Kt – Kt-1 = Yt – Yt-1I = Kt – Kt-1 = v (Yt – Yt-1) where v = K/YSee Section 25-2 in the main text.
17 12. Monetary Policy when aggregate demand depends upon the interest rate CC 0Suppose the economystarts with consumptionat CC0, investment at I0and equilibrium at Y0.I045o lineAggregate demand risesto AD1, and the newequilibrium is at Y1.AD1Y1Aggregate demandAD0A fall in interest ratesshifts the consumptionfunction to CC1, andleads to higherinvestment at I1.CC1I1See Section 25-3 in the main text.Income
18 13. Fiscal policy and Crowding out Suppose an increase ingovernment spendingshifts the AD curve to AD1.AD145o lineInitially, equilibriummoves to Y1.Y1Aggregate demandand consumption andinvestment fall, shifting ADback to AD2 and equilibriumincome to Y2.AD2Y2AD0But higher income raisesmoney demand, sointerest rates riseSee Section 25-4 in the main text.Y0Income
19 14. Goods Market Equilibrium The goods market is in equilibrium when the aggregate demand and actual income are equalThe IS schedule shows the different combinations of income and interest rates at which the goods market is in equilibrium.See Section 25-5 in the main text.
20 15. The IS schedule AD1 AD0 Y0 r r0 r1 IS Y1 At a relatively high interestrate r0, consumption andinvestment are relativelylow – so AD is also low.45o lineAD1At a lower interest rate r1Consumption, investmentand AD are higher.r1ADY1Equilibrium is at Y1.Y0Equilibrium is at Y0.IncomerISThe IS schedule shows allthe combinations of realincome and interest rateat which the goods marketis in equilibrium.See Section 25-5 in the main text and Figure 25-6.Income
21 16. 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.See Section 25-5 in the main text.
22 17. The LM Schedule r r LM r1 Y1 LL1 LL0 r0 Y0 L0 The LM schedule traces out the combinations of real incomeand interest rate in which the money market is in equilibrium.r1Y1LL1At Y1, money demand is at LL1,and equilibrium is at r1.LL0r0Y0At income Y0, money demand is at LL0 and equilibriumin the money market requires an interest rate of r0.L0Real moneybalancesIncomeSee Section 25-5 in the main text and Figure 25-7.
23 18. Shifting IS and LM Schedules The position of the IS schedule depends upon:anything (other than interest rates) that shifts aggregate demand: e.g.autonomous investmentautonomous consumptiongovernment spendingThe position of the LM schedule depends uponmoney supply(the price level)See Section 25-5 in the main text.Notice that although we have so far assumed the price level to be fixed, this will be relaxed in Chapter 26.
24 19. Equilibrium in Goods and Money Markets ISBringing together theIS schedule (showinggoods market equilibrium)LMand the LM schedule(showing money marketequilibrium).Y*r*We can identify theunique combination ofreal income and interestrate (r*, Y*) which ensuresoverall equilibrium.See Section 25-5 in the main text.Income
25 20. Fiscal Policy in the IS-LM Model Y0, r0 represents theinitial equilibrium.IncomerIS0LMY0r0IS1A bond-financedincrease in governmentspending shifts the ISschedule to IS1.r1Y1Equilibrium is now atr1, Y1.See Section 25-5 in the main text.Some private spendinghas been crowded outby the increase in therate of interest.
26 21. Monetary Policy in the IS-LM model Y0, r0 represents theinitial equilibrium.IncomerIS0LM0Y0r0LM1An increase in moneysupply shifts the LMschedule to the right.Y1r1Equilibrium is nowat r1, Y1.See Section 25-5 in the main text.
27 22. The Composition of Aggregate Demand Demand management is the use of monetary and fiscal policyto stabilize the level of income around a high average level.Y*Income level Y* canbe attained by:rIS1LM1r1OR with ‘easy’ fiscalpolicy (IS1) with ‘tight’monetary policy (LM1).LM0IS0r2‘Tight’ fiscal policy (IS0)with ‘easy’ monetarypolicy (LM0)See Section 25-6 in the main text.This affects the private:public balance of spendingin the economy.Income
28 But...The IS-LM model seems to offer government a range of options for influencing equilibrium income.But…there are other issues to be consideredthe price level and inflationthe supply-side of the economythe exchange rate