1. Week 11 Monetary and fiscal policy

2. 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.

3. 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

4. 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.

5. 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.

6. 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.

7. Equilibrium in goods and money marketsIS
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

8. 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

9. 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

10. 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

11. 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

12. 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

13. Aggregate supply, prices and adjustment to shocks

14. 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.

15. 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.

16. 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.

17. 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.

18. 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.

19. 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

20. 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..

21. Equilibrium inflationAS
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

22. 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

23. 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

24. 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.

25. Inflation, expectations and credibility

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

27. 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.

28. 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.

29. 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.

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

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

32. 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

33. 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

34. 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

35. 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

36. 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.