Lecture 9 monetary and fiscal policy

Macroeconomics lecture Monetary and Fiscal Policy Chapter 34 Lecture Objectives Theory of liquidity preference Monetary policy Fiscal policy Multiplier effect Crowding-out effect • • Synergy of the monetary and fiscal policy Case study Aggregate Demand M Value Price Level P1 P2 Aggregate demand Y1 Y2 Quantity of Output The Money Market and Aggregate Demand (a) The Money Market Interest Rate (b) Commodity & service Market Price Money supply Level …increases the An increase in the price demand for money… level… P2 r2 Money demand at price level P2, MD2 Aggregate demand P1 r1 Money demand at price level P1, MD1 Quantity fixed by the CB Quantity of Y2 Quantity of Output Money …which increases the equilibrium rate… Y1 …which in turn reduces the quantity of goods and services demanded The Theory of Liquidity Preference ◦The interest rate adjusts to balance the supply and demand for money Equilibrium in the Money Market Interest Rate Money supply r1 Equilibrium interest rate r2 Money demand M d Quantity fixed by the CB M d Quantity of Money Monetary Policy Central bank Change Money Supply Or Target Interest rate through: ◦Open-market operations ◦Changing the reserve requirements ◦Changing the discount rate  change in AD (consumption and investment)  change in GDP Regulated Money Supply (a) The Money Market Interest Rate Money supply, MS1 (b) The Aggregate-Demand Curve MS2 …which increases the Price Level quantity of goods and services demanded at a When the CB given price level increases the money supply… P r1 r2 AD2 Aggregate demand, AD1 Quantity …the equilibrium interest rate falls… of Money Y1 Y2 Quantity of Output How Monetary Policy Influences Aggregate Demand ◦Three reason for the downward slope of the aggregate-demand curve: ◦The wealth effect ◦The interest-rate effect ◦The exchange-rate effect ◦The most important reason: interest-rate effect Strengths of Monetary Policy ◦Powerful to pursue contractionary policies ◦Swift and flexible action ◦Political acceptability Weaknesses of Monetary Policy ◦Difficult to predict time-lag between action and outcome ◦Weak when trying to stimulate economic activity The Fiscal Policy Income tax Soc Security Business tax Health Sales Tax Education Excise duty Defence Non-tax rev Other Public serv’s Public debt $ $ interest Other Revenue Outlays BUDGET Fiscal policy - Measures ◦Government spendings, led to effects: ◦The multiplier effect ◦The crowding-out effect ◦Taxation Multiplier Effect Price …but the multiplier effect can amplify the shift in aggregate Level demand $20 billion AD3 An increase in government purchases of $20 billion initially increases aggregate demand by $20 billion… AD2 Aggregate demand, AD1 Quantity of Output Multiplier Effect ◦The formula for the multiplier is: Multiplier = 1/(1 - MPC) ◦MPC: marginal propensity to consume - fraction of extra income that a household consumes rather than saves The Crowding-Out Effect ◦Crowding-out effect: reduction in demand that results when a fiscal expansion raises the interest rate The Crowding-Out Effect (a) The Money Market (b) The Shift in Aggregate Demand …which in turn partly Interest Rate offsets the initial increase in Price aggregate demand Level Money supply …the increase in spending increases money r2 demand… $20 billion AD2 r1 MD2 AD3 Aggregate demand, AD1 Money demand, MD1 Quantity fixed by the Fed …which increases the equilibrium interest rate… Quantity of Quantity of Output Money When an increase in government purchases increases aggregate demand… Changes in Taxes The extent of effects on aggregate demand subject to: Multiplier effect Crowding-out effect Households’ perceptions Strengths of Fiscal Policy ◦Open to public oversight  transparency ◦More effective in a recession in stimulating AD than monetary policy ◦Easy to target specific groups in the community with assistance Weaknesses of Fiscal Policy ◦Uncertainty of its outcomes ◦Timing/ Implementation lags ◦Political sensitivity ◦“Crowding-out” effect of budget deficit CASE STUDY VN stabilisation policy in 2019? Background: at closure of 2018 • • • Real GDP: 659 billion (base year: 2011) Estimated growth rate: 7.1% Annual inflation rate: 5.25% GOV issued circular 01 to stabilise the economy Which measures does circular 01 entail? VN stabilisation policy in 2019 ◦Background: at closure of 2018  Real GDP: 659 billion (base year: 2011)  Estimated growth rate: 7.02%  Annual inflation rate: 5.25% GOV issued circular 01  To increse the investment and GDP more?  Or to reduce the inflation rate? Which measures should circular 01 entail? Hints: combined monetary and fiscal policy: Discout rate? Minimal capital requirement at banks? State invested infrastructure projects? Salary scheme at public sector? • • • • Lecture Review ◦Theory of liquidity preference ◦Monetary policy ◦Fiscal policy ◦Synergy of monetary and fiscal policy ◦Case study .. .Monetary and Fiscal Policy Chapter 34 Lecture Objectives Theory of liquidity preference Monetary policy Fiscal policy Multiplier effect Crowding-out effect • • Synergy of the monetary and fiscal. .. Salary scheme at public sector? • • • • Lecture Review ◦Theory of liquidity preference ? ?Monetary policy ? ?Fiscal policy ◦Synergy of monetary and fiscal policy ◦Case study ... of Monetary Policy ◦Powerful to pursue contractionary policies ◦Swift and flexible action ◦Political acceptability Weaknesses of Monetary Policy ◦Difficult to predict time-lag between action and