Week 11 Monetary and fiscal policy

Goods market equilibrium The goods market is in equilibrium when 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. See Section 24-2 in the main text.

The IS schedule AD1 AD0 IS At a relatively high interest rate r0, consumption and investment are relatively low – so AD is also low. AD 45o line AD1 At a lower interest rate r1 consumption, investment and AD are higher. r1 Y1 Equilibrium is at Y1. Equilibrium is at Y0. Y0 Income r IS The IS schedule shows all the combinations of real income and interest rate at which the goods market is in equilibrium. See Section 24-2 and Figure 24-2 in the main text. Income

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 24-2 in the main text.

The LM schedule r r LM r1 r0 r0 LL1 LL0 L0 Y0 Y1 The LM schedule traces out the combinations of real income and interest rate in which the money market is in equilibrium. At Y1, money demand is at LL1,and equilibrium is at r1. r1 Y1 LL1 LL0 r0 Y0 At income Y0, money demand is at LL0 and equilibrium in the money market requires an interest rate of r0. r0 L0 Real money balances Income See Section 24-2 in the main text and Figure 24-3.

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 investment autonomous consumption government spending The position of the LM schedule depends upon money supply (the price level) See Section 24-2 in the main text. Notice that although we have so far assumed the price level to be fixed, this will be relaxed in Chapter 25.

Equilibrium in goods and money markets IS Bringing together the IS schedule (showing goods market equilibrium) LM 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. See Section 24-2 and Figure 24-4 in the main text. Income

Fiscal policy in the IS-LM model Y0, r0 represents the initial equilibrium. r IS1 A bond-financed increase in government spending shifts the IS schedule to IS1. LM Equilibrium is now at r1, Y1. r1 Y1  r0  Some private spending (Y1Y’) has been crowded out by the increase in the rate of interest. Y’  IS0 See Section 24-3 in the main text. Y0 Income

Fiscal policy in the IS-LM model (2) Y0, r0 represents the initial equilibrium. r IS1 A bond-financed increase in government spending shifts the IS schedule to IS1. LM Loosening monetary policy in order to keep the rate of interest at r0 allows output to expand to Y’. Y’  LM’ Equilibrium is now at r1, Y1. r1 Y1  r0  IS0 See Section 24-3 in the main text. Y0 Income

Monetary policy in the IS-LM model Y0, r0 represents the initial equilibrium. r LM0 LM1 An increase in money supply shifts the LM schedule to the right. r0  Y1 r1 Equilibrium is now at r1, Y1.  IS0 See Section 24-4 in the main text. Y0 Income

The policy mix Demand management is the use of monetary and fiscal policy to stabilize the level of income around a high average level. Y* Income level Y* can be attained by: r IS1 LM1 r1 OR with ‘easy’ fiscal policy (IS1) with ‘tight’ monetary policy (LM1).  r0 LM0 IS0 ‘Tight’ fiscal policy (IS0) with ‘easy’ monetary policy (LM0)  See Section 24-6 and Figure 24-6 in the main text. This affects the private: public balance of spending in the economy. Income

But... The IS-LM model seems to offer government a range of options for influencing equilibrium income. But… there are other issues to be considered the price level and inflation the supply-side of the economy the exchange rate

Aggregate supply, prices and adjustment to shocks

The classical model of macroeconomics The CLASSICAL model of macroeconomics is the polar opposite of the extreme Keynesian model. It analyses the economy when wages and prices are fully flexible. In this model, the economy is always at its potential level. See the introduction to Chapter 25 in the main text.

The classical model of macroeconomics (2) Excess demand or supply are rapidly eliminated by wage or price changes so that potential output is quickly restored Monetary and fiscal policy affect prices but have no impact on output In the short-run before wages and prices have adjusted, the Keynesian position is relevant whilst the classical model is relevant to the long-run See the introduction to Chapter 25 in the main text.

The macroeconomic demand schedule The macroeconomic demand schedule (MDS) shows the combinations of inflation and output for which aggregate demand equals output. Higher inflation is associated with lower aggregate demand and lower output. Output Inflation MDS See Section 25-1 and Figure 25-1 in the main text.

Aggregate supply and potential output Potential output depends upon: the level of technology the quantities of labour demanded and supplied in the long-run, when the labour market is fully adjusted When wages and prices are fully flexible, output is always at the potential level In the short-run we can treat potential output as given See Section 25-2 in the main text.

The classical aggregate supply schedule The classical model has an aggregate supply curve which is vertical at potential output This means that equilibrium output can be reached at different levels of inflation In the classical model, people do not suffer from money illusion Consequently, only changes in real variables influence other real variables See Section 25-2 and Figure 25-2 in the main text.

The classical aggregate supply schedule (2) This schedule shows the output firms wish to supply at each inflation rate. AS Inflation When wages and prices are flexible, output is always at its potential level (Y*) Potential output is the economy’s long-run equilibrium output. Y* See Section 25-2 and Figure 25-2 in the main text.. Output

The classical aggregate supply schedule (3) Better technology will shift AS to the right and hence increase potential output Increased employment will also shift AS to the right and increase potential output As will the use of more capital In the short-run, we can treat potential output as given See Section 25-2 and Figure 25-2 in the main text..

Equilibrium inflation AS So overall equilibrium is shown where MDS = AS at the potential output level Y* and inflation level *. MDS *  A Inflation At A, the goods, money and labour markets are all in equilibrium Y* See Section 25-3 in the main text. Output

Equilibrium inflation: a supply shock A beneficial supply shock raises potential output by shifting AS0 to AS1and lowers inflation to 2* at D.  D 2* Y1* AS0 This will lead to an increased amount of money being demanded: to achieve, money market equilibrium at this interest rate, the bank must supply more money. MDS1 C  If the central bank pursues its target of 0* when the economy is at potential output, it must respond by reducing its target real interest rate. 0*  A Inflation MDS0 See Section 25-3 and 26-3 in the main text, and Figure 25-3. Y0* Output

Equilibrium inflation: a demand shock Beginning at A, an increase in aggregate demand brought by an increase in investment say, would shift MDS0 to MDS1 moving us to a new equilibrium B. At B, potential output is the same but  is higher at 1* MDS1 B 1*  AS0 0*  A Inflation Since potential output is the same at B, the bank must tighten its monetary policy in order to hit its target of 0* . Since the bank follows a Taylor rule, it will increase the target real interest rate and thereby reverse the increase in MDS. MDS0 See Section 25-3 in the main text, and Figure 25-3. Y0* Output

Supply-side economics The pursuit of policies aimed not at increasing aggregate demand, but at increasing aggregate supply. A way of influencing potential output, seen as critical in the classical view of the economy. See Section 25-3 in the main text. Further discussion follows in Chapter 27 in the context of unemployment and the labour market.

Inflation, expectations and credibility

Inflation is ... Inflation is a rise in the price level See the Introduction to Chapter 26 in the main text.

The quantity theory (1) The quantity theory of money says: ‘Changes in the nominal money supply lead to equivalent changes in the price level (and money wages) but do not have effects on output and employment.’ See Section 26-1 of the main text.

The quantity theory (2) We can state it algebraically as: MV = PY where V = velocity of circulation Y = potential level of real GDP P = the price level M = nominal money supply Given constant velocity, if prices adjust to maintain real income at the potential level an increase in nominal money supply leads to an equivalent increase in prices See Box 26-1 in the main text.

Money, prices and inflation (1) Milton Friedman famously claimed ‘Inflation is always and everywhere a monetary phenomenon.’ i.e. it results when money supply grows more rapidly than real output. See Section 26-1 in the main text.

Inflation and interest rates REAL INTEREST RATE Nominal interest rate minus inflation rate See Section 26-2 in the main text.

The Phillips curve Inflation rate (%) Phillips curve U* See Section 26.4 Unemployment rate (%) U*

The long-run Phillips curve (1) The vertical long-run Phillips curve implies that sooner or later, the economy will return to U* whatever the inflation rate the position of the short-run Phillips curve depends on expected inflation

The long-run Phillips curve (2) the long-run and short-run curves intersect when actual and expected inflation are equalised the long run Phillips curve shows that in the long-run there is no trade-off between unemployment and inflation

The Long-run Phillips curve and an increase in aggregate demand (1) Suppose the economy begins at E, with unemployment at the natural rate U*, and inflation at 1 E 1 Inflation An increase in government spending funded by an expansion in money supply takes the economy to A, with lower unemployment (U1) but inflation at 2. A 2 U1 See Section 26.4 U* PC1 … but what happens next? Unemployment

The Long-run Phillips curve and an increase in aggregate demand (2) If the nominal money supply continues to expand at the same rate thereafter, the economy will eventually move to B on PC2. LRPC Inflation At B, inflation expectations coincide with actual inflation and nominal wages have been renegotiated so that the real wage and hence, employment are the same as before the monetary expansion A 2 B 1 E See Section 26.4 PC2 U1 U* PC1 ie there is no trade- off between unemployment and inflation in the long-run Unemployment

Defeating inflation In the long run, inflation will be low if the rate of money growth is low. The transition from high to low inflation may be painful if expectations are slow to adjust. Policy credibility may speed the adjustment process See Section 26-6 in the main text.