ISLaMic Economics:
Monetary and Fiscal Policy
Headlines
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Obama Plans Major Shifts in Spending
To Pay for Health Care, Obama Looks to
Taxes on Affluent
Reports Show More Signs of Downturn
Preparing for a Flood of Energy Efficiency
Spending
Home Sales and Prices Continue to
Plummet
Now Is No Time to Cut Research
Bernanke Again Rejects Bank Takeovers
California Drought Drives Up Joblessness
What is ISLM economics?
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Discussed real sector of economy:
production and income
Discussed monetary sector
How do the consumers, savers, lenders,
borrowers, and monetary authorities interact
to determine level of national income and
rate of interest?
Rough model. “Economics is a two-digit
science”
Macroequilibrium in Real Sector
Equilibrium in Monetary Sector
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Levels of income (Y) and interest (r) at
which demand for money = supply of money
Reality Check
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Do you think Ben Bernanke and Geithner
know what the hell is going on?
I will try to explain the model that they more
or less follow.
What Determines S and I?
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What happens to savings as income (Y) increases?
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What happens to savings as interest rates (r)
increase?
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Would you save more in a hedge fund at 20% or in
government bonds at 2%?
What happens to investment as income increases?
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Who saves more, the poor or the rich?
Will firms invest more when people are buying lots of
stuff or nothing?
What happens to investment as interest rates
increase?
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Would you be more likely to start your own business with
interest rates at 1% or 20%? (Both rates exist today)
What Determines S and I?
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S=S(r,Y)
I=I(r,Y)
Equilibrium in real sector occurs when
S(r,Y)=I(r,Y)
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One equation, two unknowns
Multiple solutions
Depicted by IS curve
Assumption is that economy is always
moving towards equilibrium
Equilibrium?
Chapter 7: Efficiency and Exchange
Slide 11
IS Curve
r
Why downward sloping?
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Low interest = more profitable investment
opportunities => more investment => more
income
Higher income = more savings
Higher interest = more savings?
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Do poor people carry credit card debt at 20%?
When savings are high, interest rates must
be low for sectors to balance.
Why do people demand money
instead of real assets?
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Avoids inconvenience of barter
Transactions demand for money
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More income = more transactions = more
transactions demand for money
Liquidity preference: we prefer liquid assets
to frozen ones. Cash is most liquid
What is the cost to holding cash?
What is the cost of holding non-liquid
assets?
How is Demand for Money Related
to Income and Interest?
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What happens to your demand for cash
money as interest rates increase?
As income increases?
DM=L(r,Y)
Equilibrium occurs when DM=SM
What determines SM?
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Discoveries of silver and gold?
Ben Bernanke?
Equilibrium occurs when L(r,Y)=M
LM Curve
Why does LM slope upwards?
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More income = greater demand for money.
Less money available to lend. Higher r
required for equilibrium
Moving Towards Equilibrium in LM
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M>L
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More money available than people want
Use excess to buy non-liquid interest bearing
assets, e.g. Bonds
Demand for bonds increases, price increases,
interest rate on bond goes down.
Increase in supply of money drives interest rate
down
Lower r = lower opportunity cost of holding
money, higher demand for money
Lower r = greater Y = higher demand for money
Combining IS and LM
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Two simultaneous equations with two
unknowns
One unique combination of r and Y for
which I=S, L=M
Equilibrium in real and monetary sector
We do not assume that economy is in
equilibrium, but rather that it is moving
towards it.
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Perhaps better to assume that economy is never
in equilibrium, but that monetary and fiscal policy
are likely to push it in specific directions under
certain circumstances
Combining IS and LM
How do we use this?
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Comparative statics: How do r and Y
respond to exogenous changes?
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Changes include monetary and fiscal policy as
well as liquidity preferences, propensity to save,
efficiency of capital investment, etc.
How does the economy move towards
equilibrium when policy pushes it away?
Doesn't look at dynamic path
Was current crisis an exogenous change?
In the US? Internationally?
Non-Policy Changes: IS
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Propensity to Save
What has happened to US propensity to save?
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In last 50 years? In last 50 weeks?
S>I for all I, injection into economy (I) < leakage
(S) for all Y and r on old equilibrium
Income decreases until I=S again, new
equilibrium
Higher savings rate, but lower income.
Less expenditure deters investment. IS curve
shifts to left
Paradox of thrift
How can policy counter this?
Non-Policy changes: LM
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Increase in liquidity preference
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L>M
Higher r required to induce lending
Each level of Y associated with higher r on new
LM
Shift upward
Same thing occurs from decrease in M
(monetary policy)
How can policy counter this?
r
Monetary Policy: 3 tools Fed can use:
Reserve requirements (within bounds set by
congress)
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Allows private banks to create more or less money
Interest rates (discount window)
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Rate at which Fed loans money to banks
Open market operations: buying and selling
government securities (bonds)
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Changes money supply.
Goal typically is to increase or decrease overnight interest
rates for banks loaning to one another (Fed funds rate)
Current Monetary Policy
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Discount window from 5.75% August 2007
to ~0% today; Fed funds rate shows similar
plunge
NYT Headlines from last year:
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A Rate of Zero Percent From the Fed? Some
Analysts Say It Could Be Coming
Monetary Policy
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Increase in M shifts LM curve downwards
(to right)
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Decrease in M shifts LM curve upwards (to
left)
Why would we want to decrease M?
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Higher income, lower interest
Real M=nominal M/P
Any other reasons?
Liquidity trap
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When demand is inadequate, firms have excess
capacity, increasing money supply (reducing r)
has no impact on investments.
'Pushing on a string'
Fiscal Policy
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Taxation
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Government expenditure
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Reduces demand, contracts economy, drives
down interest rates
Stimulates investment, expands economy
Drives up interest rates if competing with private
sector
Crowding out
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When economy is at full capacity, government
expenditure simply displaces private sector
expenditure
This was dominant belief until last year
3 Ways for Government to Spend
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Tax and spend
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Borrow and spend
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Spending more than counteracts equal tax
Surplus = taxes > expenditures
Greater short term impact than tax and spend
Deficit = expenditures > taxes
Borrowing now = taxes in future
Print money and spend
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Does not increase interest rates
Threat of inflation
We could increase reserve requirements,
give government more control
NYT description
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“The Federal Reserve, through its power to
raise and lower interest rates, exercises
more influence over economic growth and
the level of employment than any other
government entity. That unusual role dates
from the 1970s, when the executive branch
and Congress pulled back from the use of
fiscal tools — vast New Deal spending and
targeted tax cuts — as a means of
regulating prosperity.”
Is this true? Real World Fiscal
Policy: the Federal deficit
Who Controls the Fed?
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The governors appointed by the president,
approved by Congress
Chair appointed for 14 years
Regional bank presidents “selected by
leaders of their communities, particularly
bankers.” (NYT)
What is the goal of the Fed?
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Officially to target unemployment and
inflation
“Their main thrust has been to limit inflation,
even at the risk of a recession — although
they have cut rates when the nation seemed
in danger of one, as the Bernanke Fed has
recently done.”
The Task Ahead: First on To-Do List: Tame
Inflation by DAVID LEONHARDT
Inflation, Disinflation, Deflation
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Is inflation a problem?
Good for debtors, bad for creditors
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Facilitates price adjustments
Predicted vs. unpredicted
Moderate inflation vs. hyperinflation
Disinflation
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2% inflation x 7 trillion debt (at fixed interest) = 140
billion “inflation tax”
Also tax on those who hold money (reduce L).
Predicted vs. unpredicted
Deflation
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More feared than inflation
Creates incentive not to spend money
Deflation
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NYT Headline (Nov. 1)
Fear of Deflation Lurks as Global Demand
Drops
NYT 2005, calling Bernanke a safe choice:
“The lessons of the Depression sometimes
seem to hover behind much of his thinking.
Shortly after becoming a Fed governor in
2002, for example, Mr. Bernanke argued
forcefully for tough action to head off a
possible epidemic of deflation, or downward
spiraling prices.”
Fighting Deflation
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Bernanke’s remedies
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Buying treasury securities with longer maturities
Buy up privae debt, e.g. corporate bonds
“In effect, the Federal Reserve would be printing
more money and injecting it into the economy —
a strategy of “quantitative easing,” in Fed
jargon.”
Fighting Inflation
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Increase supply
Reduce demand (typical approach)
Fiscal policy
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Monetary policy
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Increase taxes
Decrease spending
Can be targeted
Raise interest rates: bad for debtors, good for
creditors, bad for farming, construction
Decrease money supply
Blunt instrument
Either one can increase unemployment, reduce
wages
Unemployment and Inflation
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NAIRU and Phelps
Bargaining power of labor vs. capital
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Black death
Wage push or Profit push inflation?
Impact on wages
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Does this work in global economy?
Unemployment and National
Income
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Positive feedback loops (vicious circles)
Fiscal policies and stability
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Welfare payments
Unemployment insurance
What Does Fed Target?
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Bernanke
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“he is trying to establish himself as an inflation
fighter”
“speaking out on a wide array of topics about the
economy as well as about the central bank's
need to become more open and to peg policy to
publicly stated inflation targets.”
“As both an academic and former Fed governor,
he focused on the importance of the Fed's antiinflation credibility.”
Why does Fed Target Inflation?
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Who are the Fed's constituents?
Not elected
Where do Fed reserve governors come from?
Why do stock markets dislike inflation?
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Inflation increases uncertainty
Fear of higher interest rates
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“In settling on Mr. Bernanke, President Bush
... chose a candidate who would satisfy
others -- investors on Wall Street,
lawmakers in Congress -- more than himself
or his Republican base.”
''They needed somebody that everybody,
including the financial markets, would react
positively to.''
“But Mr. Bernanke had what many outsiders
wanted: a world-class reputation among
economists; credibility on Wall Street”
Impact of Policies on Scale,
Distribution and Allocation
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What should our goals be?
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Sustainable Scale
Just Distribution
Efficient allocation
Stability
How do we reduce consumption without
increasing unemployment, while making poor
better off?
What is appropriate balance between market
goods and public goods?
Monetary Policy
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Only affects market goods directly
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Difficult to simultaneously address scale and
distribution
Poor at dealing with public goods, including
ecosystem services
Changing reserve requirements
Blunt instrument
Fiscal Policy
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Taxes
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Can be targeted: 'tax bads, not goods'; 'tax what
we take, not what we make'
Reduces overall consumption
Stabilize economy
Can have important impact on scale
Fiscal Policy
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Subsidies
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Research and development
Activities that provide positive externalities:
'subsidize goods, not bads'
Fiscal Policy
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Government expenditures
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Can be targeted: welfare for corporations or for
the poor?
Public goods or private goods? What offers
highest marginal benefits?
Investments in human made vs. natural K
Crowding out in a full world