Macroeconomics (ECON 1211)
Lecturer: Mr S. Puran
Topic: Monetary and Fiscal policy in a
Closed Economy
1.
Bringing together the Real and Financial
Sectors
Having seen equilibrium in the goods
and money markets separately,
it is now time to explore the links
between them
and to look at simultaneous
equilibrium in both.
25.1
2. Consumption Revisited


Income is a key determinant of consumption
but other factors shift the consumption
function (mainly autonomous consumption)
–
–
–

household wealth
availability of credit
cost of credit
These create a link between the financial and
real sectors
–
because interest rates can be seen to influence
consumption.
25.2
3. The Keynesian Consumption
Function





Based on the Psychological Law of
Consumption
When there is an increase in the level of
income, the MPC does not change in the
same proportion as the change in income.
It change by less
There is a level of autonomous
consumption which remains
APC ( C/ Y)and MPC (< 1)
25.3
4.

The Permanent Income
Hypothesis
A modern theory of consumption
developed by Milton Friedman
–

argues that people like to smooth
planned consumption even if income
fluctuates
Consumption depends upon
permanent not transitory income.
25.4
4.




The Permanent Income
Hypothesis
An individual has a current level of income
and therefore has a brief idea of the
consumption level he/she can sustain
over his/her lifetime
An increase in income: permanent or
transitory
Transitory: no major effect on
consumption
If the increase can be sustained then the
individual will accept that permanent
income has increase
25.5
4.




The Permanent Income
Hypothesis
An increase in permanent income will change
consumption level as the former can sustain
the latter
Thus, consumption depends on what individual
expect to earn over a considerable period of
time
Individuals save during period of high income
and dissave during period of low income
A Phd student should have a higher level of
consumption than an undergraduate student
25.6
4.




The Permanent Income
Hypothesis
Example, past four years income: £12,000;
£12,000; £10,000; £10,000
Then permanent income should be
£11,000
Permanent income and life – cycle
hypotheses loosen relationship C and Y
so that an exogenous change in
investment may not have a constant
multiplier effect
Temporary change in income: little effect
in spending
25.7
5. The Life - Cycle Hypothesis
A theory of consumption developed by Ando and Modigliani.
Actual
income
Permanent
income
0
Income varies over an
individual's lifetime.
Individuals try to smooth
their consumption, based
on expected lifetime
income.
Savings occur during
middle age
Death and dissaving in youth
Age
and old age.
Thus wealth and interest rates may influence consumption.
25.8
5. The Life – Cycle Hypothesis
What are the goals of individuals:
1) They prefer a high standard of
living to a low standard of living,
2) Most individuals prefer to have a
constant standard of living
throughout time
 Put together these two goals suggest
that we assume that individuals try to
maintain the highest, smooth
consumption path

25.9
6. Ricardian Equivalence

Individuals will react to a shock such
as a tax change in different ways,
depending on whether changes are
seen to be temporary or permanent.

If the government cut taxes today,
but individuals realise this will have
to be balanced by higher taxes in the
future, then present consumption
may not adjust.
25.10
7. Investment Demand

Investment spending includes:
–
–

fixed capital

Transport equipment

Machinery & other equipment

Dwellings

Other buildings

Intangibles
working capital

stocks (inventories)

work in progress
and is undertaken by private and public sectors
25.11
8. The Demand for Fixed
Investment

Investment entails present sacrifice
for future gains
–
–
firms incur costs in the short run
but reap gains in the long run
Expected returns must outweigh the
opportunity cost if a project is to be
undertaken
 so at relatively high interest rates,
less investment projects are viable.

25.12
9. The Investment Demand
Schedule
… shows how much investment firms wish to
undertake at each interest rate.
At relatively high interest
rates, less investment
projects are viable.
At r0, I0 projects are viable.
r1
r0
I1
I0
II but if the interest rate
rises to r1, desired
investment falls to I1.
Investment demand
25.13
9. Interest Rates and Aggregate
Demand

The position of the AD schedule is
now seen to depend upon interest
rates through the effects on
–
consumption
–
investment
25.14
10. Inventory Investment




Firms desire stocks of raw materials,
partly finished goods awaiting sale
Firms may be betting on price changes
Many production process take time
Stocks help smooth costly adjustments in
output. If output demand rises suddenly,
plant capacity cannot be changed
overnight
25.15
11. The Accelerator Theory of
Investment






Investment responds to changing demand
condition.
If D increases, there will be an excess demand for
goods.
Firms have two choices: either to raise prices or
to meet demand by raising supply
Keynesian: in order to meet higher production,
firms will increase their output capacity by
investing in plant and investment
I = Kt – Kt-1 = Yt – Yt-1
I = Kt – Kt-1 = v (Yt – Yt-1) where v = K/Y
25.16
12. Monetary Policy
Aggregate demand
when aggregate demand depends upon the interest rate
I1
I0
Y0
Suppose the economy
starts with consumption
45o line
AD1 at CC0, investment at I0
and equilibrium at Y0.
AD0
CC1 A fall in interest rates
shifts the consumption
CC 0 function to CC , and
1
leads to higher
investment at I1.
Aggregate demand rises
Y1 Income
to AD1, and the new
equilibrium is at Y1.
25.17
Aggregate demand
13. Fiscal policy and Crowding
out
45o line
Suppose an increase in
government spending
shifts the AD curve to AD1.
AD1
Initially, equilibrium
AD2 moves to Y .
1
AD0 But higher income raises
money demand, so
interest rates rise
Y0 Y2 Y1 Income
and consumption and
investment fall, shifting AD
back to AD2 and equilibrium
income to Y2.
25.18
14. Goods Market Equilibrium

The goods market is in equilibrium
when the aggregate demand and
actual income are equal

The IS schedule shows the different
combinations of income and interest
rates at which the goods market is in
equilibrium.
25.19
15. The IS schedule
45o line
AD1
AD0
r
r0
Y0
Y1
Income
r1
IS
Y0
Y1
Income
At a relatively high interest
rate r0, consumption and
investment are relatively
low – so AD is also low.
Equilibrium is at Y0.
At a lower interest rate r1
Consumption, investment
and AD are higher.
Equilibrium is at Y1.
The IS schedule shows all
the combinations of real
income and interest rate
at which the goods market
is in equilibrium.
25.20
16. Money Market Equilibrium

The money market is in equilibrium
when the demand for real money
balances is equal to the supply.

The LM schedule shows the different
combinations of income and interest
rates at which the money market is in
equilibrium.
25.21
17. The LM Schedule
r
r
LM
r1
r1
r0
LL1
r0
LL0
L0
Real money
balances
Y0
Y1
Income
At income Y0, money demand is at LL0 and equilibrium
in the money market requires an interest rate of r0.
At Y1, money demand is at LL1,and equilibrium is at r1.
The LM schedule traces out the combinations of real income
and interest rate in which the money market is in equilibrium.
25.22
18. Shifting IS and LM
Schedules

The position of the IS schedule
depends upon:
–
anything (other than interest rates) that
shifts aggregate demand: e.g.
 autonomous
investment
 autonomous consumption
 government spending

The position of the LM schedule
depends upon
–
–
money supply
(the price level)
25.23
19. Equilibrium in Goods and Money
Markets
Bringing together the
LM IS schedule (showing
goods market equilibrium)
r
and the LM schedule
(showing money market
equilibrium).
r*
IS
Y*
Income
We can identify the
unique combination of
real income and interest
rate (r*, Y*) which ensures
overall equilibrium.
25.24
20. Fiscal Policy in the IS-LM
Model
Y0, r0 represents the
initial equilibrium.
r
LM
r1
r0
Y0 Y1
A bond-financed
increase in government
spending shifts the IS
schedule to IS1.
IS1 Equilibrium is now at
IS0 r1, Y1.
Some private spending
has been crowded out
Income
by the increase in the
rate of interest.
25.25
21. Monetary Policy in the IS-LM
model
Y0, r0 represents the
initial equilibrium.
r
LM0
r0
r1
IS0
Y0 Y1
An increase in money
LM1 supply shifts the LM
schedule to the right.
Equilibrium is now
at r1, Y1.
Income
25.26
22. The Composition of Aggregate
Demand
Demand management is the use of monetary and fiscal policy
to stabilize the level of income around a high average level.
r
LM1
Income level Y* can
be attained by:
‘Tight’ fiscal policy (IS0)
LM0 with ‘easy’ monetary
policy (LM0)
r1
r2
IS1
IS0
Y*
Income
OR with ‘easy’ fiscal
policy (IS1) with ‘tight’
monetary policy (LM1).
This affects the private:
public balance of spending
in the economy.
25.27
But...
The IS-LM model seems to offer
government a range of options for
influencing equilibrium income.
 But…

–
there are other issues to be considered
 the
price level and inflation
 the supply-side of the economy
 the exchange rate
25.28