Recap Questions
1. What are the components of MS?
Recap Questions
1. What are the components of MS?
2. What are the components of MB?
3. What are the components of the money multiplier?
Recap Questions
1. What are the three ways the central bank can influence
money supply?
2. Explain each of them.
Recap Questions
1. A well functioning government bond market is essential for:
a) OMOs
b) Effective use of the discount rate
c) Ability to change the Reserve Ratio
2. A competitive commercial banking sector is essential for:
a) OMOs
b) Effective use of the discount rate
c) Ability to change the Reserve Ratio
Lecture 6
Analysing policy effects in the medium
run: the AD/AS model
Analysing policy effects in the
medium run
We have previously looked at policy effects in the short-run.
What do we mean by the short-run?
Today we will be looking at policy effects in the medium run.
Expansionary Policy Under Fixed
Exchange Rates
What is meant by a fixed exchange rate?
Why would a country adopt a fixed exchange rate regime?
Expansionary Policy Under Fixed
Exchange Rates
Let’s begin with the short-run:
Discuss with the people beside you what effect an expansionary fiscal
policy would have under a fixed exchange rate. Use graphs and
equations in your answer.
C0 + C1 * (Y - T)
Y = C + I + G + (X - M)
LM
i
a
b
iD > iF
c
€
IS
y
FIXED INTEREST RATES
Expansionary Fiscal Policy Under
Fixed Exchange Rates
Government expenditure increases, national income increase, consumption
increases…
1.
2.
3.
4.
5.
6.
7.
IS Curve shifts to the right,
MD increases
Interest rate (i) increases (Why?)
MS increases (why?),
LM shifts to the right,
Interest rate decreases,
Overall, Y increases.
Expansionary Fiscal Policy Under
Fixed Exchange Rates
i
𝐿𝑀!
𝐿𝑀"
B
𝑖!
A
C
𝐼𝑆!
Y
𝐼𝑆"
Y
Expansionary Fiscal Policy Under
Fixed Exchange Rates
As you can see, as the economy enters the
medium run, prices are rising as a result of this
policy.
For the sake of the new classical model, let’s
assume that this expansionary policy was
unanticipated.
This causes a deviation between actual prices and
the prices expected by workers and firms before
the implementation of the policy.
Real wages are now lower, what do we think the
consequence of this will be?
Expansionary Fiscal Policy Under
Fixed Exchange Rates
New Keynesian
Firms are better off than they thought as their
labour costs fall in real terms;
Workers are worse off as their real wages turn
out to be lower.
The size of the price rise depends on the slope
of the AS curve.
New Classical
Firms are better off than they thought as their
labour costs fall in real terms;
Workers are worse off as their real wages turn
out to be lower.
Workers are stuck for a while with lower real
wages as they are locked into wage contracts.
This effect happens very quickly, as individual
workers are free to negotiate higher wages at
any point.
Eventually they will be able to negotiate
higher money wages.
As a result, in the New Classical theory, the AS
curve might not move out to the right at all.
This causes firms’ labour costs to rise again
and the AS curve moves back in eventually.
Expansionary Fiscal Policy Under
Fixed Exchange Rates
What happens to trade in the medium-run?
As prices rise, how will the domestic real exchange rate change?
𝜋"
𝜀 = 𝐸𝑅! ×
𝜋#
How will this change affect trade in the medium run?
Expansionary Fiscal Policy Under
Fixed Exchange Rates
What happens to trade in the medium-run?
As prices rise, how will the domestic real exchange rate change?
𝜋"
𝜀 = 𝐸𝑅! ×
𝜋#
𝜋" will increase, causing the real exchange rate to rise.
X - M
This will cause the real exchange rate to rise, thus making the economy less
competitive.
Expansionary Fiscal Policy Under
Fixed Exchange Rates
So, expansionary fiscal policy under a fixed exchange rate increases G
but reduces net exports.
Therefore, the medium run increase in Y will not be as significant as
the initial, short-run increase.
Which economies would be least affected by this increase in the real
exchange rate?
Expansionary Fiscal Policy Under
Fixed Exchange Rates
Which economies would be least affected by this increase in the real
exchange rate?
More self-sufficient economies that rely less on international trade will
be less affected.
Expansionary Fiscal Policy Under
Fixed Exchange Rates
Recall,
Expected prices and wages —> employment
𝑊 = 𝑃! 𝐹(𝑈, 𝑧)
Where:
W = Wages,
𝑃! = Price expectations
U = Unemployment
z = Institutional factors
How will wages be affected by this (unanticipated) expansionary fiscal
policy?
Expansionary Fiscal Policy Under Fixed Exchange
Rates
How will wages be affected by this
(unanticipated) expansionary fiscal policy?
• People will want to see their money wages
increase to compensate for the increase in
prices as a result of the expansionary policy
(𝑃$ to 𝑃% )
• But they don’t just take into account existing
prices when negotiating wages. We know they
also look to the future. This will likely change
their expectation of future price increases.
• This increases the real cost of labour for
firms and the AS curve moves back as a result
Expansionary Fiscal Policy Under Fixed Exchange
Rates
So, expansionary policy caused:
• Actual prices to rise
• Then caused price expectations to rise
• The economy moves to higher prices at P3
• Income falls back to its original level
The AS curve has moved back, and prices
have risen to P3. And the positive impact of
the expansionary fiscal policy has
disappeared. As the economy moves into the
long run, Y equals 𝑌# but at a higher actual
price level than before.
Apart from the higher price level, what else
has changed?
Expansionary Fiscal Policy Under Fixed Exchange
Rates
The composition of Y has changed.
As government spending has increased, the
contribution of (X – M) has fallen (and it falls
further as the economy moves from P2 to P3).
You shouldn’t be surprised to see that the
effect of the expansionary fiscal policy fades
away over time. Remember the multiplier
effect. Because the mpc is less than one, the
effect peters out over time.
The worrying thing that wasn’t considered in
the short run model is the distorting impact of
the policy on price expectations in the medium
run.
Expansionary Monetary Policy Under
Fixed Exchange Rates
In our short-run model, we saw that expansionary monetary policy is
not effective under fixed exchange rates.
It will:
• Shift the LM curve out to the right,
• This drives the domestic interest rate down,
• This puts pressure on the value of the domestic currency to fall.
• The Central Bank has to reduce money supply to ensure the
exchange rate remains unchanged.
• This shifts the LM curve back to the left.
Expansionary Monetary Policy Under
Fixed Exchange Rates
But what if the central bank could influence interest rates, without this
change influencing the exchange rate.
It can. Recall,
𝑀𝐵 = 𝐷𝐶 + 𝐹𝑅
Where,
DC = Domestic Credit
FR = Foreign Reserves
How might the central bank reduce interest rates without this change
causing the domestic currency to depreciate?
Expansionary Monetary Policy Under
Fixed Exchange Rates
𝑀𝐵 = 𝐷𝐶 + 𝐹𝑅
Expansionary Monetary Policy Under
Fixed Exchange Rates
The Central Bank will have to reduce FRs to alleviate the pressure on
the currency. But it could increase purchases of DC to compensate.
The Central Bank cannot buy up large amounts of DC either, so if the
pressure on the currency is very large, these purchases won’t offset the
fall in FRs as the Central Bank strives to keep the value of the currency
fixed. This policy of using DC to offset changes in FRs is called
sterilisation. For the reasons described here, the policy can only be a
short run one.
Expansionary Monetary Policy Under
Fixed Exchange Rates
This sterilisation policy might just be effective enough to increase
prices in the medium run. If it did, then this increase in prices would
have the same impact on wage negotiations and on future price
expectations as we saw above. At the end of the medium run, the
economy would be left with higher prices and the same output level as
before.
MS
LM
IS
Expansionary Policy Under Flexible
Exchange Rates
Here, the Central Bank is not restricted to keeping the value of the
domestic currency at a particular level and can use expansionary
monetary policy to increase Y in the short run. But first we look at
expansionary fiscal policy.
Expansionary Fiscal Policy Under
Flexible Exchange Rates
In your groups, determine the short-run effects of an expansionary
fiscal policy under a flexible exchange rate regime. Do so using graphs
and equations.
G
Y
C
i0 > if
€
i
IS’
IS
y
Fiscal Policy under Flexible Exchange
Rates
i
LM
5.
6.
7.
8.
9.
B
𝑖!
A
IS
IS
Y
1.
2.
3.
4.
Y
G increases or T decreases.
IS curve shifts to the right.
The economy moves from point A to point B.
Domestic interest rates are greater than foreign
interest rates.
Demand for domestic assets increase.
Domestic currency appreciates.
Exports fall, imports increase.
LM curve moves back to the left.
The economy returns to point A.
Fiscal Policy under Flexible Exchange
Rates
i
LM
At the very least, the effect of the expansionary fiscal
policy will be severely weakened under flexible
exchange rates in the short run.
B
𝑖!
A
IS
IS
Y
Y
But suppose the net effect is an increase in Y. What
will the effect on the AD and AS curves be?
Remember, in the medium-run prices can change.
Fiscal Policy under Flexible Exchange
Rates
P
𝐴𝑆"
𝐴𝑆!
The impact will be an increase in prices, and this will
affect price expectations going forward.
𝑃"
𝑃!
C
The positive impact will fade away, and the economy
will be stuck at its original Y but with higher prices
due to higher price expectations.
B
A
𝐴𝐷"
𝐴𝐷!
Y
Y
Expansionary Monetary Policy under
Flexible Exchange Rates
In your groups, determine the short-run effects of an expansionary
monetary policy under a flexible exchange rate regime. Do so using
graphs and equations.
Monetary Policy under Flexible
Exchange Rates
i
𝐿𝑀!
𝐿𝑀"
𝑖!
A
C
B
𝐼𝑆"
𝐼𝑆!
Y
Y
1.
2.
3.
4.
5.
Money Supply is increased.
LM curve shifts to the right.
The economy moves from point A to point B.
Low interest rates stimulate domestic investment.
Domestic interest rates are lower than foreign
interest rates, causing the currency to depreciate.
6. This increases net exports.
7. The IS curve shifts to the right due to points 4, 5
and 6.
Expansionary Monetary Policy under
Flexible Exchange Rates
In your groups, determine the medium-run effects of an expansionary
monetary policy under a flexible exchange rate regime. Do so using
graphs and equations.
Monetary Policy under Flexible
Exchange Rates
P
𝑃"
𝑃!
𝐴𝑆"
𝐴𝑆!
C
B
A
𝐴𝐷"
𝐴𝐷!
Y
Y
1.
2.
3.
4.
The AD curve has moved out to the right.
Prices rise; thus, the real wage will be lower.
Workers will therefore demand higher wages.
The AS curve moves back, and by the end of the
medium run, the policy effect is reversed.
5. All that remains are higher prices.
Learning Outcomes
You should now be able to explain, using graphs and
equations, the short and medium run effects of fiscal and
monetary policy under fixed and flexible exchange rates.
Questions
Using graphs and equations, explain the short-run and
medium-run effects of expansionary fiscal policy under
fixed exchange rates
Questions
Using graphs and equations, explain the short-run and
medium-run effects of expansionary monetary policy under
fixed exchange rates
Questions
Using graphs and equations, explain the short-run and
medium-run effects of expansionary fiscal policy under
flexible exchange rates
Questions
Using graphs and equations, explain the short-run and
medium-run effects of expansionary monetary policy under
flexible exchange rates