APPLICATIONS: ECONOMIC
POLICY IN THE SHORT-PERIOD
academic year 2015/16
Introduction to Economics
Augusto Ninni
ECONOMIC POLICY IN THE SHORT-PERIOD

What are the objectives of economic policy?

How can the Government and Central Bank affect
the equilibrium of the economic system in the shortperiod?

How does economic policy operate? What are its
effects?
ECONOMIC POLICY IN THE SHORT-PERIOD

Objectives and instruments of economic policy in
the short period

Effects of fiscal policy

Effects of monetary policy

Liquidity trap
THE OBJECTIVES OF ECONOMIC POLICY
In the short-period economic policy is implemented in order
to affect the level of GDP (Y).
Main objective: ↑ Y in case of recession.
Let’s assume that we observe a decrease in autonomous
consumption (e.g., ↓ C0) -> Previous analysis shows that
this cause ↓ Y.
Economic policy is implemented to avoid ↓ Y.
In these cases the interventions are called “expansionary
policies”.
THE OBJECTIVES OF ECONOMIC POLICY
In some cases, however, the objective of economic policy
is just the opposite: ↓ Y (to slow down growth).
Explanation: under certain circumstances too rapid
growth may generate inflation.
In these cases the interventions are called “restrictive
policies”
The Instruments of economic policy
Economic policy can impact on the short-period
equilibrium in different ways:
•
Government -> through Public expenditure (G) and
taxes (T) -> Fiscal policy
•
Central Bank -> through Money supply (MS/P) or
analogous instruments -> Monetary policy
The effects of fiscal policy
1)
Increase of taxes ( ↑T)
To study the effects of ↑ T we use the IS-LM model:

T appears in the IS -> IS shift leftwards

T des not appear in the LM -> LM doesn’t move
We start from equilibrium E: ↑T -> IS shifts leftward
i
LM
E
iE
iE’
IS
E’
IS’
Y E’
YE
Effects: E -> E’ ; YE -> YE’ -> Y and iE-> iE’ -> i
Y
The effects of fiscal policy
Explanation ↓Y :
•
Increase of taxes ( ↑ T) ->
•
Decrease of disposable income (↓ YD) ->
•
Decrease of consumption (↓ C) ->
•
Decrease of aggregate demand (↓ Z) ->
•
Decrease of production (↓ Y)
•
+ effects of multiplier
The effects of fiscal policy
Explanation ↓ i :
•
Decrease of production (↓ Y) ->
•
Decrease of money demand (↓ MD) ->
•
(Given MS) Reduction of interest rate (↓ i)
The effects of fiscal policy
Effects on the other components of aggregate demand
a) Consumption -> C = C (Y-T)
+
↑ T impacts on consumption through the income
↑ T -> ↓ YD -> ↓ C -> Y… -> ↓ YD -> ↓ C
(multiplier)
The increase of taxes reduces consumption.
The effects of fiscal policy
b) Investment -> I = I(Y,i)
+↑ T has two counteracting effects:

↑ T -> ↓ Y -> ↓ sales -> ↓ I

↑ T -> ↓ i -> ↓ financial cost -> ↑ I
Total effect is ambiguous (I can increase or decrease)
The prevailing effect depends on the shape of the IS and
LM curves
The effects of fiscal policy
2) Increase of public expenditure (↑ G)
IS-LM:

G appears in the IS -> IS shifts rightward

G does not appear in the LM -> LM doesn’t shift
We start from equilibrium E: ↑ G -> IS shifts rightward
i
LM
E’
iE’
iE
E
IS’
IS
YE
Y E’
Effects: E -> E’; YE -> YE’ -> Y and iE -> iE’ -> i
Y
The effects of fiscal policy
Explanation of ↑ Y :
•
Increase of public expenditure (↑ G) ->
•
Increase of aggregate demand (↑ Z) ->
•
Increase of production (↑ Y) ->
•
+ effects of multiplier
Explanation of ↑ i -> ↑ MD but money supply is constant.
Effects on other components of aggregate demand -> C
and ambiguous effect on I -> analogous to the preceding
case.
The effects of fiscal policy
We examined:
•
T -> Y -> Restrictive fiscal policy
Note: analogous effects obtain for G
•
G -> Y -> Expansionary fiscal policy
Note: analogous effects obtain for T
The effects of fiscal policy
It is important to consider that fiscal policy impacts on the
public budget: Public deficit = G – T
It follows that:
Expansionary
Restrictive
fiscal policy (↑ G or ↓ T) -> ↑ Public deficit;
fiscal policy (↓ G or ↑ T) -> ↓ Public deficit;
In practice restrictive fiscal policy is often implemented to
balance the public budget.
The effects of monetary policy
Increase of money supply (↑ MS/P)
IS-LM:

MS/P doesn’t appear in the IS -> IS doesn’t move;

MS/P appears in the LM -> LM shifts downward.
We start from eq. E: ↑ MS/P -> LM shifts downward
i
LM
E
iE
iE’
YE
E’
LM’
IS
Y E’
Effects: E -> E’; iE -> iE’ -> i and YE -> YE’ -> Y
Y
The effects of monetary policy
Explanation ↓ i :
• Increase of money supply ( ↑ MS/P ) ->
• Decrease of interest rate (↓ i)
Explanation ↑ Y :
• Decrease of interest rate (↓ i) ->
• Increase of investments (↑ I) ->
• Increase of aggregate demand (↑ Z) ->
• Increase of production (↑ Y) ->
• + Effects of multiplier
The effects of monetary policy
Effects on the other components of aggregate demand.
a) Consumption -> C = C (Y-T)
+
↑ MS/P -> ↑ Y -> ↑ YD -> ↑ C
The increase of money supply increases consumption
The effects of monetary policy
b) Investments -> I = I(Y,i)
+↑ MS/P has two effect that go in the same direction:
•
•
↑ MS/P -> ↓ i -> > ↑ I
↑ MS/P -> ↑ Y -> ↑ sales -> ↑ I
The increase of money supply increases investments.
The effects of monetary policy
We examined: ↑ MS/P -> ↑ Y -> Expansionary monetary
policy
The opposite effect on Y obtain for ↓ MS/P -> Restrictive
monetary policy
The latter kind of policy produces opposite effects also on
i, C and I
THE POLICY MIX
So far we examined the effects of fiscal policy and
monetary policy in isolation.
What happens if the fiscal policy and monetary policy are
used jointly?
When is this the case?
Is it possible to pursue different objectives of economic
policy at the same time?
POLICY MIX: DEFINITION
Policy mix: Joint implementation of different
policies (mainly fiscal and monetary policies) in
order to pursue different economic objectives with
greater efficacy.
POLICY MIX: DEFINITION
In terms of instruments the policy mix jointly exploits the
tools of fiscal and monetary policies (e.g., G and MS)
(IMPORTANT: not G and T).
In terms of objectives the mix:
•
Allows one to pursue one single objective with greater
efficacy;
•
Allows one to pursue more than one objective at the
same time.
EXAMPLE: REDUCTION OF PUBLIC DEFICIT
WITHOUT RECESSION
Public deficit = Difference between public expenditure and
taxes (G-T)
If an economy has a deficit taxes are not sufficient to cover
public expenditure (G>T)
In this case part of the public expenditure is financed
through debts (e.g. Bond, Bot, Btp, ecc.).
Public deficit -> Bonds emission -> Public debt.
EXAMPLE: REDUCTION OF PUBLIC DEFICIT
WITHOUT RECESSION
If public deficit remains for long time, public debt grows over
time.
If the public debt grows too much, there is the risk that it
cannot be paid back (Mexico, Argentina… Italy) -> financial
instability
For this reason the the economies with high public deficit
should try to reduce it.
To reduce public deficit -> ↓ (G-T) -> ↓ G or ↑ T
(restrictive fiscal policy)
EXAMPLE: REDUCTION OF PUBLIC DEFICIT
WITHOUT RECESSION
Problem: restrictive fiscal policy -> ↓ Y
Through the policy mix one can: reduce public deficit -> ↓
(G-T) without ↓ YE
Two joint objectives -> two instruments -> policy mix
Let’s examine the effects of the mix.
We start from point E: ↓ Deficit -> ↓ G or ↑ T -> IS shifts
leftward
Restrictive fiscal policy in isolation -> ↓ Y
i
LM
E
E’
IS
IS’
Y E’
YE
Y
To avoid this we use the other available tool: ↑ MS/P (expansionary
monetary policy)-> LM shifts rightward
Total effect: E -> E’’ -> Y does not change.
LM
i
LM’
E’
E
IS
E’’
IS’
Y E’
YE
Y
A mix of restrictive fiscal policy (↑T or ↓ G) and expansionary
monetary policy (↑ MS/P) allows one to reduce the public
deficit without causing a recession.
LM
i
LM’
E’
E
IS
E’’
IS’
Y E’
YE
Y
EXAMPLE US

A good example of policy mix is the one
implemented by Clinton and Greenspan

Premise: during the 80s large increase in US public
deficit

End 1992 (Clinton is elected) a large plan to reduce
public deficit is launched

Problem: Negative effects on GDP (↓Y)
NB: A recession had occurred 1990-91

To avoid recession expansionary monetary policy
EXAMPLE EU

This is pretty much what has happened during the EU
debt crisis

Southern EU countries have large public debts (which
undermine their trustfulness in financial market)

This situation calls for restrictive fiscal policy

In a period of recession such policies can create
further damage

To limit the recessive effect of restrictive fiscal policy
the ECB is adopting expansionary monetary policies
(in open markets)
Liquidity trap
We showed that the LM curve is increasing in i.
Particular case: part of the curve is horizontal.
i
LM
Horizontal part
Y
What is the effect of an expansionary monetary policy in
this case?
MS/P -> LM shifts rightward
The equilibrium does not change
i
IS
LM
LM’
E
YE
Y
Liquidity trap
In this case an expansionary monetary policy has no effect
on the equilibrium and Y does not change (policy is
ineffective).
This case is usually called liquidity trap.
When does this happen?
In general the shape of the LM depends on MD and
therefore individual choices concerning the allocation of
financial wealth.
Liquidity trap
A recent example of liquidity trap is the Japanese economy.
The Japanese economy went through a long crisis (total
growth 1998-2002 = -0,1% , negative growth in 1998,
2001 e 2002).
The Central Bank implemented an expansionary monetary
policy.
After a short period of modest impacts a liquidity trap
emerged and the policy stopped to produce effects.