Promoting active learning

1
Fiscal and Monetary Policy
2
Fiscal and Monetary Policy

• The Nature of Fiscal Policy

3
THE NATURE OF FISCAL POLICY

• The purpose of fiscal policy
• correcting a fundamental disequilibrium
• fine tuning
• Government finances
• budget deficits and surpluses
• financing a deficit
• the PSNCR

4
UK public-sector deficits/surpluses 19792001
5
UK public-sector deficits/surpluses 19792001
6
UK public-sector deficits/surpluses 19792001
7
UK public-sector deficits/surpluses 19792001
8
UK general government expenditure as of GDP
Annual growth rate ()
9
UK general government expenditure as of GDP
Annual growth rate ()
10
UK general government expenditure by function ()
H General public services 4.4 I Housing,
etc 3.6 J Recreation, etc 1.7 K
Environment 0.9
H General public services 5.1 I Housing,
etc 1.5 J Recreation, etc 1.0 K
Environment 0.7
1999
1991
11
UK general government expenditure by function ()
H General public services 4.4 I Housing,
etc 3.6 J Recreation, etc 1.7 K
Environment 0.9
H General public services 5.1 I Housing,
etc 1.5 J Recreation, etc 1.0 K
Environment 0.7
1999
1991
12
General government deficits/surpluses and debt as
of GDP
13
General government deficits/surpluses and debt as
of GDP
14
THE NATURE OF FISCAL POLICY

• The purpose of fiscal policy
• correcting a fundamental disequilibrium
• fine tuning
• Government finances
• budget deficits and surpluses
• financing a deficit
• the PSNCR
• the national debt and public-sector debt

15
Getting budget deficits down?
16
Getting budget deficits down?
France
17
Getting budget deficits down?
Germany
France
18
Getting budget deficits down?
Italy
Germany
France
19
Getting budget deficits down?
Italy
Spain
Germany
France
20
Getting budget deficits down?
Belgium
Italy
Spain
Germany
France
21
Getting budget deficits down?
Belgium
Italy
Spain
Germany
France
Netherlands
22
National Debt (as of GDP)
National Debt
23
National Debt (as of GDP)
National Debt
UK
24
National Debt (as of GDP)
National Debt
USA
UK
25
National Debt (as of GDP)
National Debt
Euro area
USA
UK
26
THE NATURE OF FISCAL POLICY

• Public-sector deficits or surpluses and the
  governments fiscal stance
• fiscal stance and the state of the economy
• the structural balance
• Automatic fiscal stabilisers
• tax stabilisers
• benefits stabilisers

27
National income and the size of the public-sector
deficit or surplus
G, T
SURPLUS
DEFICIT
O
Y
28
THE NATURE OF FISCAL POLICY

• Public-sector deficits or surpluses and the
  governments fiscal stance
• fiscal stance and the state of the economy
• the structural balance
• Automatic fiscal stabilisers
• tax stabilisers
• benefits stabilisers
• Discretionary fiscal policy

29
THE NATURE OF FISCAL POLICY

• Public-sector deficits or surpluses and the
  governments fiscal stance
• fiscal stance and the state of the economy
• the structural balance
• Automatic fiscal stabilisers
• tax stabilisers
• benefits stabilisers
• Discretionary fiscal policy
• changing government expenditure

30
THE NATURE OF FISCAL POLICY

• Public-sector deficits or surpluses and the
  governments fiscal stance
• fiscal stance and the state of the economy
• the structural balance
• Automatic fiscal stabilisers
• tax stabilisers
• benefits stabilisers
• Discretionary fiscal policy
• changing government expenditure
• changing taxes

31
A cut in taxes (a) lump-sum taxes
W, J
W1
O
Y
32
A cut in taxes (a) lump-sum taxes
W, J
W1
W2
O
Y
33
A cut in taxes (a) lump-sum taxes
W, J
W1
W2
DT x mpcd
O
Y
34
A cut in taxes (b) cut in tax rates
W, J
W1
O
Y
35
A cut in taxes (b) cut in tax rates
W, J
W1
W2
O
Y
36
A cut in taxes (b) cut in tax rates
W, J
W1
W2
DT x mpcd
O
Y
37
Fiscal and Monetary Policy

• The Effectiveness of Fiscal Policy

38
EFFECTIVENESS OF FISCAL POLICY

• Effectiveness of automatic stabilisers
• adverse supply-side effects
• the problem of fiscal drag
• Discretionary policy problems of forecasting the
  magnitude of the effect
• effects on other injections and withdrawals
• crowding out

39
The monetary effects of fiscal policy
W, J
W
J1
O
Y1
Y
(a) The goods market
40
The monetary effects of fiscal policy
Rate of interest
W, J
MS
r1
W
L1
J1
O
Y1
O
Y
Money
(a) The goods market
(b) The money market
41
The monetary effects of fiscal policy
Rate of interest
W, J
MS
An expansionary fiscal policy
r1
W
J2
L1
J1
O
Y2
Y1
O
Y
Money
(a) The goods market
(b) The money market
42
The monetary effects of fiscal policy
Rate of interest
W, J
MS
An expansionary fiscal policy
Effect on the demand for money
r2
r1
W
J2
L2
L1
J1
O
Y2
Y1
O
Y
Money
(a) The goods market
(b) The money market
43
The monetary effects of fiscal policy
Rate of interest
W, J
MS
MS2
An expansionary fiscal policy
r2
r1
W
J2
L2
L1
J1
O
Y2
Y1
O
Y
Money
(a) The goods market
(b) The money market
44
EFFECTIVENESS OF FISCAL POLICY

• Effectiveness of automatic stabilisers
• adverse supply-side effects
• the problem of fiscal drag
• Discretionary policy problems of forecasting the
  magnitude of the effect
• effects on other injections and withdrawals
• crowding out
• size of the multiplier and accelerator effects

45
EFFECTIVENESS OF FISCAL POLICY

• Discretionary fiscal policy problems of timing
  and time lags
• various time lags
• policy may be destabilising

46
Fiscal policy stabilising or destabilising?
3
4
Real national income
3
2
4
2
1
1
O
Time
47
Fiscal policy stabilising or destabilising?
Path (a) no intervention
3
4
Real national income
3
2
4
2
1
1
O
Time
48
Fiscal policy stabilising or destabilising?
Path (a) no intervention
Path (b) policy stabilises
3
4
Real national income
3
2
4
2
1
1
O
Time
49
EFFECTIVENESS OF FISCAL POLICY

• Discretionary fiscal policy problems of timing
  and time lags
• various time lags
• policy may be destabilising
• Side-effects of discretionary fiscal policy

50
EFFECTIVENESS OF FISCAL POLICY

• Discretionary fiscal policy problems of timing
  and time lags
• various time lags
• policy may be destabilising
• Side-effects of discretionary fiscal policy
• Changing government expenditure versus changing
  taxes

51
Fiscal and Monetary Policy

• Varieties of Monetary Policy

52
VARIETIES OF MONETARY POLICY

• The policy setting
• historical approaches to monetary policy
• current approach to monetary policy
• Control of money supply over medium and long term
• control of banks liquidity ratio
• restricting size of PSNCR
• Short-term monetary control the alternatives

53
The demand for and supply of money
Rate of interest
O
Money
54
The demand for and supply of money
MS
Rate of interest
r1
L
O
Q1
Money
55
VARIETIES OF MONETARY POLICY

• Techniques to control money supply
• preliminary decisions
• statutory or prudent ratios?
• what to control monetary base or broad money?
• open-market operations
• funding
• variable minimum reserve ratios

56
Effect of raising the minimum reserve ratio from
10 to 20
Initial position 10 reserve ratio
57
Effect of raising the minimum reserve ratio from
10 to 20
Initial position 10 reserve ratio
New position 20 reserve ratio
58
VARIETIES OF MONETARY POLICY

• Techniques to control money supply
• preliminary decisions
• statutory or prudent ratios?
• what to control monetary base or broad money?
• open-market operations
• funding
• variable minimum reserve ratios
• Techniques to control interest rates

59
VARIETIES OF MONETARY POLICY

• Techniques to control money supply
• preliminary decisions
• statutory or prudent ratios?
• what to control monetary base or broad money?
• open-market operations
• funding
• variable minimum reserve ratios
• Techniques to control interest rates
• statutory base rates

60
VARIETIES OF MONETARY POLICY

• Techniques to control money supply
• preliminary decisions
• statutory or prudent ratios?
• what to control monetary base or broad money?
• open-market operations
• funding
• variable minimum reserve ratios
• Techniques to control interest rates
• statutory base rates
• operations in discount and repo markets

61
Bank of England operations in the bill andgilt
repo markets to raise interest rates
Rate of discount
O
Bills
(a) Bank of England sells more bills
62
Bank of England operations in the bill andgilt
repo markets to raise interest rates
S1 by B. of E.
D by banks
Rate of discount
r1
O
Bills
(a) Bank of England sells more bills
63
Bank of England operations in the bill andgilt
repo markets to raise interest rates
Rate of discount / gilt repo rate
O
Bills and gilts
(b) Bank of England buys fewer bills / gilts
64
Bank of England operations in the bill andgilt
repo markets to raise interest rates
D1 by B. of E.
Rate of discount / gilt repo rate
r1
S by banks
O
Bills and gilts
(b) Bank of England buys fewer bills / gilts
65
VARIETIES OF MONETARY POLICY

• Techniques to control money supply
• preliminary decisions
• statutory or prudent ratios?
• what to control monetary base or broad money?
• open-market operations
• funding
• variable minimum reserve ratios
• Techniques to control interest rates
• statutory base rates
• operations in discount and repo markets
• Credit rationing

66
Fiscal and Monetary Policy

• Problems of Monetary Policy

67
PROBLEMS OF MONETARY POLICY

• Medium and long-term control over the money
  supply reducing PSNCR
• automatic fiscal stabilisers
• the desire to cut taxes
• difficulty in cutting government expenditure

68
PROBLEMS OF MONETARY POLICY

• Practical difficulties in short-run control of
  the money supply
• problems with monetary base control
• with statutory cash ratios
• without statutory cash ratios
• problems with controlling broad liquidity
• with statutory reserve ratios
• without statutory reserve ratios
• the effect on interest rates

69
The effect on interest rates of a change in
demand for money money supply kept at fixed
level by the authorities
Rate of interest
O
Money
70
PROBLEMS OF MONETARY POLICY

• Problems with credit rationing
• Goodhart's law
• bank resistance
• stifles competition
• distortionary effects on economy
• Problems with controlling interest rates
• inelastic demand for loans

71
An inelastic demand for loans
Rate of interest
r1
Demand for loans
O
Q1
Q2
Loans
72
An inelastic demand for loans
Rate of interest
r1
Demand for loans
O
Q1
Q2
Loans
73
PROBLEMS OF MONETARY POLICY

• Problems with credit rationing
• Goodhart's law
• bank resistance
• stifles competition
• distortionary effects on economy
• Problems with controlling interest rates
• inelastic demand for loans
• unstable demand for money

74
PROBLEMS OF MONETARY POLICY

• Problems with credit rationing
• Goodhart's law
• bank resistance
• stifles competition
• distortionary effects on economy
• Problems with controlling interest rates
• inelastic demand for loans
• unstable demand for money
• possible conflict between domestic goals and
  exchange-rate goals

75
PROBLEMS OF MONETARY POLICY

• Using monetary policy
• problems of using it to manage aggregate demand
• using it to keep to a target
• inflation
• exchange rate
• money supply

76
Fiscal and Monetary Policy

• ISLM Analysis of Fiscal and Monetary Policy

77
Equilibrium in both the goods and money markets
LM
Rate of interest
IS
O
National income
78
ISLM ANALYSIS OF FISCAL AND MONETARY POLICY

• Fiscal policy and ISLM analysis
• shifting the IS curve
• effect on interest rates and national income

79
ISLM analysis of fiscal and monetary policy
LM
Rate of interest
r1
IS
O
Y1
National income
80
ISLM analysis of fiscal and monetary policy
LM
Expansionary fiscal policy
Rate of interest
r1
IS1
O
Y1
National income
81
ISLM ANALYSIS OF FISCAL AND MONETARY POLICY

• Fiscal policy and ISLM analysis
• shifting the IS curve
• effect on interest rates and national income
• Monetary policy and ISLM analysis
• shifting the LM curve
• effect on interest rates and national income

82
ISLM analysis of fiscal and monetary policy
LM1
Expansionary monetary policy
Rate of interest
r1
IS
O
Y1
National income
83
ISLM ANALYSIS OF FISCAL AND MONETARY POLICY

• Fiscal policy and ISLM analysis
• shifting the IS curve
• effect on interest rates and national income
• Monetary policy and ISLM analysis
• shifting the LM curve
• effect on interest rates and national income
• Fiscal and monetary policy together

84
ISLM analysis of fiscal and monetary policy
LM1
Expansionary fiscal and monetary policy
Rate of interest
r1
IS1
O
Y1
National income
85
ISLM ANALYSIS OF FISCAL AND MONETARY POLICY

• Analysis under Keynesian assumptions
• effectiveness of fiscal policy

86
Keynesian analysis of fiscal and monetary policy
LM
Expansionary fiscal policy
Rate of interest
IS1
O
Y1
National income
87
ISLM ANALYSIS OF FISCAL AND MONETARY POLICY

• Analysis under Keynesian assumptions
• effectiveness of fiscal policy
• ineffectiveness of monetary policy

88
Keynesian analysis of fiscal and monetary policy
Expansionary monetary policy
LM1
Rate of interest
IS
O
Y1
National income
89
ISLM ANALYSIS OF FISCAL AND MONETARY POLICY

• Analysis under Keynesian assumptions
• effectiveness of fiscal policy
• ineffectiveness of monetary policy
• Analysis under monetarist assumptions

90
ISLM ANALYSIS OF FISCAL AND MONETARY POLICY

• Analysis under Keynesian assumptions
• effectiveness of fiscal policy
• ineffectiveness of monetary policy
• Analysis under monetarist assumptions
• ineffectiveness of fiscal policy

91
Monetarist analysis of fiscal and monetary policy
LM
Expansionary fiscal policy
Rate of interest
IS1
O
Y1
National income
92
ISLM ANALYSIS OF FISCAL AND MONETARY POLICY

• Analysis under Keynesian assumptions
• effectiveness of fiscal policy
• ineffectiveness of monetary policy
• Analysis under monetarist assumptions
• ineffectiveness of fiscal policy
• effectiveness of monetary policy

93
Monetarist analysis of fiscal and monetary policy
LM1
Expansionary monetary policy
Rate of interest
IS
O
Y1
National income
94
Fiscal and Monetary Policy

• Fiscal and Monetary Policy in the UK

95
UK growth, unemployment and inflation 1920-2002

Growth
96
UK growth, unemployment and inflation 1920-2002

Growth
97
UK growth, unemployment and inflation 1920-2002


Growth Unemployment
98
UK growth, unemployment and inflation 1920-2002


Growth Unemployment Inflation
99
UK Macroeconomic performance 1921 99
100
UK Macroeconomic performance 1921 99
101
UK Macroeconomic performance 1921 99
102
FISCAL AND MONETARY POLICY IN THE UK

• Attitudes towards demand management
• Keynesian demand management in the 1950s and
  1960s
• stopgo policies
• monetarist criticisms
• Demise of fine tuning in the 1970s
• the causes of stagflation
• demand management policies in the 1970s
• the rise of monetarism

103
Selected monetary indicators 19692001
104
FISCAL AND MONETARY POLICY IN THE UK

• Monetarism in the early 1980s
• medium-term financial strategy
• the recession of the early 1980s
• assessment of the monetarist experiment
• return to discretion in mid 1980s
• Targeting the exchange rate
• its advantages and disadvantages
• shadowing the German mark
• membership of the ERM (19902)
• exit from the ERM

105
FISCAL AND MONETARY POLICY IN THE UK

• Return to domestic-orientated policies
• targeting inflation 19937
• Policies of the Labour government 1997?
• fiscal policy
• the 'Golden Rule'
• Comparison with EU Stability and Growth Pact
• monetary policy
• Bank of England inflation target
• ECB targets
• effectiveness of recent monetary and fiscal
  policies

106
Fiscal and Monetary Policy

• Rules versus Discretion

107
RULES VERSUS DISCRETION

• Case against discretion
• time lags
• over-correction
• government may ignore long-term consequences
• Case for rules
• help to reduce inflationary expectations
• create a stable environment for investment and
  economic growth

108
RULES VERSUS DISCRETION

• Case against rules
• can cause severe fluctuations in interest rates
  and can cause greater instability
• which rule to choose?
• rules may conflict
• rules may become unsuitable
• Case for discretion
• fine tuning can be improved by better forecasting
  and quicker-action

109
RULES VERSUS DISCRETION

• Inflation targeting
• use of inflation targets around the world

110
Who sets explicit targets and monitoring ranges
for the exchange rate, money and inflation
Source The Use of Explicit Targets for Monetary
Policy Practical Experiences of 91 economies in
the 1990s, (Bank of England, August 1999)
111
Who sets explicit targets and monitoring ranges
for the exchange rate, money and inflation
Source The Use of Explicit Targets for Monetary
Policy Practical Experiences of 91 economies in
the 1990s, (Bank of England, August 1999)
112
Who sets explicit targets and monitoring ranges
for the exchange rate, money and inflation
Source The Use of Explicit Targets for Monetary
Policy Practical Experiences of 91 economies in
the 1990s, (Bank of England, August 1999)
113
Who sets explicit targets and monitoring ranges
for the exchange rate, money and inflation
Source The Use of Explicit Targets for Monetary
Policy Practical Experiences of 91 economies in
the 1990s, (Bank of England, August 1999)
114
Source Bank of England
115
RULES VERSUS DISCRETION

• Inflation targeting
• use of inflation targets around the world
• weaknesses of money supply targets

116
RULES VERSUS DISCRETION

• Inflation targeting
• use of inflation targets around the world
• weaknesses of money supply targets
• weaknesses of exchange rate targets

117
RULES VERSUS DISCRETION

• Inflation targeting
• use of inflation targets around the world
• weaknesses of money supply targets
• weaknesses of exchange rate targets
• relative strength of inflation targets

118
RULES VERSUS DISCRETION

• Inflation targeting
• use of inflation targets around the world
• weaknesses of money supply targets
• weaknesses of exchange rate targets
• relative strength of inflation targets
• Issues with inflation targets

119
RULES VERSUS DISCRETION

• Inflation targeting
• use of inflation targets around the world
• weaknesses of money supply targets
• weaknesses of exchange rate targets
• relative strength of inflation targets
• Issues with inflation targets
• choice of the target
• what level?
• central point or ceiling?

120
RULES VERSUS DISCRETION

• Issues with inflation targets (cont.)
• who sets the target?
• changing the target
• multiple targets
• a Taylor rule for setting interest rates

121
ADI curves based on different Taylor rules
Curve ADI1 based on Taylor rule
giving relatively high weight to stable inflation
O
National income
122
ADI curves based on different Taylor rules
Curve ADI1 based on Taylor rule
giving relatively high weight to stable
inflation Curve ADI2 based on Taylor rule giving
relatively high weight to stable real national
income
b
a
ADI1
O
Y0
Y1
National income
123
RULES VERSUS DISCRETION

• Issues with inflation targets (cont.)
• who sets the target?
• changing the target
• multiple targets
• a Taylor rule for setting interest rates
• targeting inflation and the money supply

124
RULES VERSUS DISCRETION

• Issues with inflation targets (cont.)
• who sets the target?
• changing the target
• multiple targets
• a Taylor rule for setting interest rates
• targeting inflation and the money supply
• basing interest rates on forecasts of inflation

125
RULES VERSUS DISCRETION

• Issues with inflation targets (cont.)
• who sets the target?
• changing the target
• multiple targets
• a Taylor rule for setting interest rates
• targeting inflation and the money supply
• basing interest rates on forecasts of inflation
• the problem of deflation