UBEA 1013: ECONOMICS 1 CHAPTER 11: FISCAL & MONETARY POLICY 11.1 The Multiplier Effect 11.2 The Fiscal Policy 11.3 The Monetary Policy 11.4 Fiscal versus Monetary 11.5 Crowding-out Effect

UBEA 1013: ECONOMICS The Multiplier Effect Multiplier is the ratio of the change in the equilibrium level of output to a change in some autonomous variable. An autonomous variable is a variable that is assumed not to depend on the state of the economy that is, it does not change when the economy changes. Autonomous variable (I, G, T) Effect to Aggregate Expenditure / Output / Income Multiplier (direct or indirect impact)

UBEA 1013: ECONOMICS 3 Y = C + I + G Y = (a + bY) + I + G Y (1 – b) = a + I + G Y = (a + I + G) [1/(1 – b)] ………… Equation 11.1 Since, b = MPC Y = (a + I + G) [1/(1 – MPC)]or Y = (a + I + G) [1/MPS] Multiplier: Planned Investment: Planned Investment: [1/(1 – MPC)] or [1/MPS] Government Spending: Government Spending: [1/(1 – MPC)] or [1/MPS] Autonomous Consumption: Autonomous Consumption: [1/(1 – MPC)] or [1/MPS] Tax multiplier???

UBEA 1013: ECONOMICS 4 Y = C + I + G Y = [a + b(Y-T)] + I + G Y = [a + bY – bT] + I + G Y (1 – b) = a – bT + I + G Y = (a – bT + I + G) [1/(1 – b)] ………… Equation 11.2 Since, b = MPC Y = (a – bT + I + G) [1/(1 – MPC)]or Y = (a – bT + I + G) [1/MPS] Multiplier: Tax multiplier = – b / (1 – b) = – MPC / (1 – MPC)or = – MPC / (1 – MPC)or = – MPC / MPS = – MPC / MPS

UBEA 1013: ECONOMICS The Fiscal Policy Keynesian school of thought. Fiscal tools: Spending & taxes (Government budget) Two categories of fiscal policy: i. Expansionary fiscal policy:  Increase G and/or cut down T  To stimulate economy  Could cause inflation  May lead to budget deficit (need debt to finance the deficit – burden the next generation)

UBEA 1013: ECONOMICS 6 Two categories of fiscal policy: ii. Contractionary fiscal policy:  Decrease G and/or increase down T  To slow down economy or reduce demand-pulled inflation  Could cause unemployment  Usually lead to surplus budget Government spending / Taxes Effect to Aggregate Expenditure / Output / Income Multiplier (G: direct / T: indirect impact)

UBEA 1013: ECONOMICS 7 Government Spending (G): In an economy with a MPC of 0.75, a $50 billion increase in government spending (G) magnifies the aggregate expenditure four times higher through the multiplier effect. It is illustrated numerically and graphically as follow: ∆Y = ∆G X [multiplier] = ∆G X [1/(1 – MPC)] = 50 X [1/(1 – 0.75)] = 50 X [4] ∆Y = $200 billion

UBEA 1013: ECONOMICS 8 Taxes (T): In an economy with a MPC of 0.75, a $50 billion of tax cuts magnifies the aggregate expenditure three times higher through the multiplier effect. ∆Y = ∆T X [multiplier] = ∆T X [MPC/(1 – MPC)] = 50 X [0.75/(1 – 0.75)] = 50 X [3] ∆Y = $150 billion Compare to government spending effect: Increase $50 billion in G causes increase of $200 billion in Y

UBEA 1013: ECONOMICS 9 Balance Budget: Increase in G = Decrease in T Decrease in G = Increase in T ∆ = $50 billion +∆G = – ∆T ∆Y = + G effect –T effect = + $200 billion – $150 billion = + $50 billion (= ∆) Why????

UBEA 1013: ECONOMICS 10 T multiplier + G multiplier = [– (MPC) / (MPS)] + [1 / (MPS)] = (1 – MPC) / (MPS) = MPS / MPS = 1 If both G & T increase by (∆G = ∆T): ∆Y = (∆T)[– (MPC/MPS)] + (∆G)[1/MPS] = (∆G)[– (MPC/MPS)] + (∆G)[1/MPS] = (∆G)[1/MPS][1 – MPC] = (∆G)[1/MPS][MPS] ∆Y = ∆G = ∆T If both G & T increase by $50 billion (∆G = ∆T), MPC = 0.75: ∆Y = (∆T)[– (MPC/MPS)] + (∆G)[1/MPS] ∆Y = (50)[– (0.75/0.25)] + (50)[1/0.25] = (50)[– (3)] + (50)[4] = – = 50 ∆Y = ∆G = ∆T = $50 billion

UBEA 1013: ECONOMICS The Monetary Policy Monetarist of thought. Monetary tools: Money supply (M) & Interest rate (r) (Central Bank) Two categories of monetary policy: i. Easy/Expansionary monetary policy:  Increase M – interest rate will drop  Effect investment  Effect local currency and net export

UBEA 1013: ECONOMICS 12 ii. Tight/Contractionary monetary policy:  Decrease M – interest rate will rise  Effect investment  Effect local currency and net export The central bank can affect the equilibrium interest rate by changing the supply of money using one of its three monetary tools: i) Reserve ratio ii) Discount rate iii) Open market operation (buy or sell government securities from banks and public)

UBEA 1013: ECONOMICS 13 r0r0 r1r1 r0r0 r1r1 An increase in the supply of money lowers the rate of interest. As investment has a negative relationship with interest rate (refer Chapter 10), lower interest rates, will increase investment (from I 0 to I 1 ).

UBEA 1013: ECONOMICS 14 C + I 1 (r 1 ) + G C + I 0 (r 0 ) + G Y0Y0 Y1Y1 M S up, Interest rate down, Investment up, AE up (AE curve shift up), Y up. At the initial equilibrium level of national income, Y 0, planned aggregate expenditures are now more than national output. Firms begin to experience an unexpected reduced in their stocks. This signals them to increase output, generating higher income. Higher income results in higher spending (multiplier process).

UBEA 1013: ECONOMICS 15 International Sector (Export & Import): Increase in MInterest rate fall Investor earning lower IR Seek better investment abroad Sell local currency Buy foreign currency Exchange rate fall (depreciate) Local (foreign) product cheaper (more expensive) Net export increase

UBEA 1013: ECONOMICS 16 Initial at Y 0 G increase, Y increase Y increase, M d increase M d increase, r increase, Investment fall Planned AE shift down Y 1 fall back to Y* Crowding out Effect End