Lecture 11: Monetary & Fiscal Policy

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Lecture 11 Monetary Fiscal Policy

• Influencing the state of the economy

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Purpose of the lecture

• Briefly review the main macroeconomic models
• Bring together the main macroeconomic models to
  show the effect of selected macroeconomic
  policies
• Briefly discuss the trade-off between employment
  and inflation

3
The purpose of policy

• Maintain long-term growth
• Stabilise the economy
• Moderating the business cycle
• Maintain employment levels where possible
• Control inflation

4
Policy options for recessions

• Do nothing
• Lower costs and wages will result in an eventual
  increase in output.
• Stimulate aggregate demand with monetary policy
• Stimulate aggregate demand with fiscal policy

5
Do nothing (market correction)
AS2
A
P1
B
P2
P3
C
AD2
0
Y1
Y2
6
The limits of self-correction

• Hardship for some households
• Adds to long-term unemployment
• Adds to consumer producer pessimism
• Political unrest

7
Monetary Policy and Aggregate Demand
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The process of monetary policyExpansionary
Contractionary

• Central bank buys securities
• Onight cash rate increases
• Interest rates increase
• Increase in consumption investment
• Increase in aggregate demand

• Central bank selld securities
• Onight cash rate decreases
• Interest rates decrease
• Decrease in consumption investment
• Decrease in aggregate demand

9
The result of expansionary monetary policy
P2
B
A
P1
AD2
0
Y1
Y2
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When to use expansionary policy

• Growth rate is low and
• Consumer and investor sentiment is pessimistic
  but
• Inflation should also be low
• Stimulation increases prices

11
Fiscal Policy Aggregate Demand
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Fiscal Policy

• Fiscal policy refers to the governments choices
  regarding the overall level of government
  purchases or taxes.
• Fiscal policy influences saving, investment, and
  growth in the long run.
• In the short run, fiscal policy primarily affects
  the aggregate demand.

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Fiscal Policy

• The Federal governments control of the economy
  is both direct and indirect.
• Its expenditures have a direct effect on
  aggregate demand.
• Taxes and tax policy have an indirect effect on
  consumer spending.

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The Multiplier Effect of Government Purchases

• Government purchases are said to have a
  multiplier effect on aggregate demand.
• Each dollar spent by the government can raise the
  aggregate demand for goods and services by more
  than a dollar.
• The total impact on the quantity of goods and
  services demanded can be much larger than the
  initial change in government spending.

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The Multiplier Effect of Government Purchases
2. but the multiplier effect can amplify the
shift in aggregate demand.
AD3
1. An increase in government purchases of 5
billion initially increases aggregate demand by
5 billion
AD2
AD1
0
Quantity of Output
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A Formula for the Government Purchases Multiplier

• The formula for the multiplier is
• Multiplier 1/(1 - MPC)
• An important number in this formula is the
  marginal propensity to consume (MPC).
• It is the fraction of extra income that a
  household consumes rather than saves.
• eg if households spend 80 cents out an extra 1
  they earn, then the MPC is 0.8

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An Example of the multiplier effect

• MPC 0.9
• Multiplier 1/(1-0.9) 1/0.1 10
• Government spends 200,000
• Extra activity 10 x 200,000 2,000,000
• NB same mathematical principle as the money
  multiplier
• Size of increase is determined by how much is
  kept back

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Changes in Taxes

• When the government cuts taxes, it increases
  households take-home pay.
• Households save some of this additional income.
• Households also spend some of it on consumer
  goods.
• Increased household spending shifts the
  aggregate-demand curve to the right.

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Changes in Taxes

• The size of the resulting shift in aggregate
  demand is also affected by the multiplier and
  crowding-out effects.
• The size of the shift in the aggregate demand is
  also determined by the households perceptions
  about the permanency of the tax change.

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Automatic Stabilisers

• Automatic stabilisers are changes in fiscal
  policy that stimulate aggregate demand when the
  economy goes into a recession without
  policymakers having to take any deliberate
  action.

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Examples of automatic stabilisation

• Taxes automatically decline in a recession
• Helps maintain disposable income
• Government welfare payments
• Increase in total in recessions

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The Crowding Out Effect
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The Crowding-Out Effect

• Fiscal policy may not affect the economy as
  strongly as predicted by the multiplier.
• An increase in government purchases causes the
  interest rate to rise.
• A higher interest rate reduces investment
  spending.

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The Crowding out effect of fiscal stimulation
2. but higher interest rates lead to a decrease
in investment and a decrease in aggregate demand.
1. An increase in government purchases initially
increases aggregate demand
AD2
AD3
AD1
0
Quantity of Output
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The Employment/Inflation Trade-off

• Society faces a short-run trade-off between
  unemployment and inflation.
• If policymakers expand aggregate demand, they can
  lower unemployment, but only at the cost of
  higher inflation.
• If we reduce aggregate demand, they can lower
  inflation, but at the cost of temporarily higher
  unemployment.

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The Phillips Curve

• The Phillips curve illustrates the short-run
  relationship between inflation and unemployment.
• It shows the short-run combinations of
  unemployment and inflation that arise as shifts
  in the aggregate demand curve move the economy
  along the short-run aggregate supply curve.

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Aggregate Demand, Aggregate Supply, and the
Phillips Curve

• The greater the aggregate demand for goods and
  services, the greater is the economys output,
  and the higher is the overall price level.
• A higher level of output results in a lower level
  of unemployment.

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Phillips Curve
Inflation Rate (percent per year)
B
6
A
2
Phillips curve
0
4
7
Unemployment Rate (percent)
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Policy Impact

• Monetary and fiscal policy can shift the
  aggregate demand curve, thus moving the economy
  along the Phillips curve.
• The Phillips curve illustrates the trade-off
  between inflation and unemployment faced by
  policymakers.

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The employment growth trade-off
(b) The Phillips Curve
(a) AD/AS Model
3. Unemployment decreases but inflation
increases.
Inflation rate
Price level (deflator)
2. Demand increases to output of 6b
AS1
1. Output 5 b Unemployment 8 percent

106


102

AD2
AD1
0
3
8
5
6
0
Output (b)
Unemployment rate ()
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The Phillips Effect in Australia1960s-1990s
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The Phillips Curve in the 1960s
Include figure 18.8 here
Generally low inflation rate and low unemployment
rate
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The Phillips Curve in the 1970s and early 1980s
Include figure 18.11 here
Generally high inflation and medium to high
unemployment rate
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The Phillips Curve in the late 1980s and
early1990s
Insert Figure 18.12
Generally low inflation rate and medium to high
unemployment rate
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Policy trends

• Growth a priority in the 1960s
• Wage control in the mid-1980s reduced supply-side
  wage pressures on inflation.
• Restrictive monetary policy in the late 1980s
• Inflation fell but unemployment rose.
• Current RBA policy is generally keeping
  inflationary expectations low.
• Medium unemployment rate

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MACROECONOMIC POLICY DEBATES
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Should Policymakers try to stabilise the
economy?YES Vs NO

• The economy is inherently unstable.
• Monetary and fiscal policy can influence
  aggregate demand and offset this.
• No reason for society to suffer through the booms
  and busts of the business cycle.
• Stabilising aggregate demand will boost
  production and employment.

• There are time lags between decision response
  for both monetary fiscal policy
• This means intervention will be largely
  ineffective in the short run and may be harmful
  by exacerbating downturns or upswings

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Monetary PolicyRules vs
Discretion

• The problems of discretionary policy are not
  proven
• Need flexibility for changing circumstances
• Leave it to the experts
• What rules are valid anyway?

• Discretionary policy can easily be mismanaged
• Policy is manipulated in the political business
  cycle
• Policy makers dont follow through on
  announcements
• Economic actors are sceptical about announcements
  
• Need moderate and steady growth of the money
  supply to limit the problems

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The central bank should aim for zero
inflationYES Vs NO

• Zero inflation is probably unattainable and
  output and unemployment costs from policy are too
  high.
• Instead aim for a low inflation.
• Policymakers can reduce many of the costs of
  inflation without actually reducing inflation.

• No benefits but many costs to inflation
• eg shoeleather, menu, etc
• Reducing inflation is a policy with temporary
  costs and permanent benefits.
• Once the disinflationary recession is over, the
  benefits of zero inflation would persist.

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The Government should balance the budgetYES
Vs NO

• The problem of deficits is often exaggerated.
• Current govt spending may produce benefits well
  into the future.
• Need flexibility in spending for emergencies etc
• Govt debt can increase because population growth
  and technological progress increase the nations
  ability to pay the interest on the debt.

• Deficits are a burden on future generations
• Need more taxes or less spending
• Deficits reduce savings therefore investment in
  capital therefore lower growth

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Tax laws should be reformed to encourage
savingYES

• A nations productive capability is determined
  largely by how much it saves and invests for the
  future.
• A nations saving rate is a key determinant of
  its long-run economic prosperity.
• When the saving rate is higher, more resources
  are available for investment in new plant and
  equipment.

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Tax laws should be reformed to encourage
savingYES

• We heavily tax the income from capital and reduce
  benefits for those who have accumulated wealth.
• This reduces saving, capital accumulation, lower
  labour productivity and economic growth.

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Tax laws should be reformed to encourage
savingYES

• An alternative to income tax policies advocated
  by many economists is a consumption tax.
• With a consumption tax, a household pays taxes
  based on what it spends not on what it earns.
• Income that is saved is exempt from taxation
  until the saving is later withdrawn and spent on
  consumption goods.

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Tax laws should be reformed to encourage savingNo

• Such changes in tax laws would primarily benefit
  the wealthy.
• High-income households save a higher fraction of
  their income than low-income households.
• Any tax change that favours people who save will
  also tend to favour people with high incomes.

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Tax laws should be reformed to encourage savingNo

• Reducing the tax burden on the wealthy would lead
  to a less egalitarian society.
• Raising public saving by eliminating the
  governments budget deficit would provide a more
  direct and equitable way to increase national
  saving.

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Conclusion

• The study of economics does not always make it
  easy to choose among alternative policies.
• Few if any policies come with benefits but no
  costs.
• The study of economics should make you a better
  participant in our national debates.

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Self-Test (Hakes Parry) Chapter 17

• Match all Terms Definitions
• Answer questions 2 3 of the Practice Problems
• Answer Short Answer questions 6, 8 10
• Do all True/False Questions
• Answer Multiple Choice Questions 6, 8, 9, 10, 15,
  18
• Check answers in guide and revise accordingly

48
Self-Test (Hakes Parry) Chapter 18

• Answer question 3 of the Practice Problems
• Answer Short Answer question 7
• Answer Multiple Choice Questions 1, 2, 4, 5 8
• Check answers in guide and revise accordingly

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Self-Test (Hakes Parry) Chapter 19

• Match all Terms Definitions
• Answer question 1 of the Practice Problems
• Answer Short Answer questions 1, 3, 5 8
• Do all True/False Questions
• Answer Multiple Choice Questions 1, 2, 3, 5, 7, 8
  11
• Make notes on the Advanced Critical Thinking
  questions 1 2
• Check answers in guide and revise accordingly

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Reading

• This week Text and Study Guide Chapters 17 19
  and the main points from 18
• Revision