Stabilizers and Multipliers
Chapter 21,22, 24, 28, 29
Consumption and Investment
Expenditure are Sensitive to the
Business Cycle
• Multiplier Effect: When household income
increases, household consumption will also
increase.
• Financial Accelerator Effect: Download When
business cycle conditions improve, business
cash flow also improves. Businesses,
especially those without access to financial
markets, rely on cash flow for financing.
Expenditure is a Feedback Loop
• Consumption and Investment Expenditure
are determined by household and corporate
income.
• Income is determined by the value added of
output in the economy.
• Output (at a given wage level) will be
determined by demand for expenditure.
Multiplier Effect
Production
Consumption
Income
Savings
Multiplier Effect 2
Production
Consumption
Income
Savings
Multiplier Effect 3
Production
Consumption
Income
Savings
Multiplier Effect in the Open
Economy
• Multiplier feedback is moderated by international
trade.
• Some of the extra expenditure generated by extra
income/cash flow will be spent on imports and
thus not generate extra demand for domestic
goods.
• Multiplier effect smaller in economies that spend a
high fraction of their income on imported goods.
Multiplier Effect: Open Economy
Production
Consumption
Income
Imports
Savings
Investment & Business Cycles
• Corporate & residential investment tends to
be one of the most pro-cyclical economic
variables though rising real rates during
boom may tend to ameliorate these effects.
• Reasons:
– Investment may be a driver of business cycles
due to animal spirits or advances in technology.
– Financial Accelerator Effect
Stabilizers
Monetary Policy
Channel of Monetary Policy
• When the central bank increases the monetary base, the
money supply will increase.
• Banks have excess liquidity which they use to make
more loans.
• The supply of liquidity will exceed demand and banks
must compete to attract borrowers who will hold this
liquidity only at a lower interest rate.
Dynamics of Monetary Transmission
• Money supply expansion reduces interest
rates
• Lower interest rates implies an increase in
borrowing and affects demand for interest
sensitive goods.
• Lower interest rates increase demand for US$
in forex market depreciating the exchange rate.
• Aggregate demand shifts out. Given fixed
input prices this increase in demand stimulates
output.
Monetary Transmission Mechanism
ECB Web Site
Expansionary Monetary Policy
P
ΔI ΔC, ΔNX
AD
AD′
Y
An Expansionary Cycle Driven by
monetary policy
2. Monetary
Policy Cuts
Interest Rate
YP
P
3
1. Economy at
LT YP.
SRAS
3. Investment
rises. The
AD curve
shifts out.
2
P*
1
AD′
AD
Output Gap
Y
4. Tight labor
markets.
SRAS
returns to
long run
equilibrium
Interest Rate Management
• In most economies around the world, the
central bank does not simply act to maintain
a fixed money supply.
• Rather, they adjust money supply to
maintain and manage interest rate changes
in response to business cycle conditions.
Monetary Policy
• In the US (and Euroland and Japan and
most OECD economies), the central bank
sets monetary policy by picking a short-run
interest rate they would like to prevail.
• In HK, the central bank sets monetary
policy by picking a fixed exchange rate.
U.S. Central bank cuts interest rates
during recessions
Demand Driven Recession
w/ Counter-cyclical monetary policy
YP
P
2
P*
SRAS
2. Monetary
Policy Cuts
Interest Rate
1
AD′
Y*
Recessionary Gap
1. Economy in
a recession.
Fed detects
deflationary
pressure
AD
Y
3. Investment
increases
spending to
shift the AD
curve back
to long run
equilibrium
Demand Driven Expansion
w/ Counter-cyclical monetary policy
YP
P
2. Monetary
Policy
Raises
Interest Rate
SRAS
1
P*
2
AD
AD′
Inflationary Gap
1. Economy in
expansion.
Fed detects
inflationary
pressure
Y
3. Investment
decreases
spending to
shift the AD
curve back
to long run
equilibrium
Taylor Rule
•
Economist named John Taylor argues that US
target interest rate is well represented by a
function of
1. current inflation
2. Inflation GAP: current inflation vs. target
inflation
3. Output Gap: % deviation of GDP from long run
path
•
Function: Inflation Target π* = .02
TGT
t
i
 .025   t 
1
 ( t   )  1 2  Output Gapt
*
2
The Taylor Rule Download
What should be the current Fed Funds
rate? Will they be increasing it soon?
• Step 1. Find Inflation Rate
• Step 2. Find Output Gap
• Step 3. Calculate Taylor Rule implied rate
and compare with current rate.
Answer
P_2008_2
P_2007_2
Inflation
Y
YP
Output Gap
Inflation Gap
Taylor Rule
Fed Funds Rate
121.91
120.00
0.016
11740.3
11904.0
-0.014
-0.004
0.032
0.02
US Recessions are becoming shorter
as stabilization policies were adopted.
Average Length of Contraction
25
Months
20
15
10
5
0
1854-1919
1919-1945
1945-2001
Fiscal Policy
Sources of Revenue HK 2004/2005
Land Premium &
Sales
20%
Profit Tax
24%
Investment Income
10%
Betting, Fees,
Duties
25%
Salaries Tax &
Property, Other
21%
HK Government Outlays by
Category 2005/06
Support
12%
Community Affairs Economic
3%
6%
Social Welfare
14%
Education
22%
Security
10%
Infrastructure
10%
Environment and
Food
4%
Housing
6%
Health
13%
Fiscal Policy
• The government directly controls its own
expenditure and can thereby directly affect
aggregate demand.
• The government controls the tax levels and
therefore they can indirectly impact the
spending of households that pay taxes.
– Expansionary policy: Increase spending, cut
taxes.
– Contractionary policy: Decrease spending, raise
taxes
Stabilization policy
• In an economy subject to shocks to aggregate
demand (animal spirit shocks, external shocks,
asset market shocks), the economy will have a
self-correcting mechanism.
• However, if this self-correction mechanism
takes a long time to work, then government may
use policy to speed adjustment.
– Use expansionary policy to close a recessionary gap
– Use contractionary policy to close an inflationary
gap
Demand Driven Recession
Counter-cyclical fiscal policy
YP
P
3
P*
1
2
Y*
Recessionary Gap
SRAS
w/
1. Economy in LT
equilibrium
2. Demand shifts
in
3. Government
increases
AD spending to shift
the AD curve
back
AD′
Y
Demand Driven Expansion
Counter-cyclical fiscal policy
YP
P
SRAS
1. Economy in LT
equilibrium
2. Demand shifts
out
2
P*
3. Government
cuts spending to
shift the AD
AD′ curve back
1
3
Y*
w/
AD
Inflationary Gap
Y
Lags and Fiscal Policy
• Administrative lags for fiscal policy may likely be large.
• Except in absolute dictatorships, government will have
mechanisms for building a consensus for expenditures.
Adjusting this consensus will be time consuming.
• If lags are too long, stabilizing government spending or
transfer payments may have a destabilizing effect,
shifting out demand after the economy has already
recovered.
Automatic Stabilizers
• Taxes are usually collected as a fraction of
incomes of households. Even if the
government keeps the tax rate unchanged.
– When the economy goes into a boom, taxes are
automatically raised mitigating the effects of
the boom.
– When the economy goes into a recession, taxes
are automatically cut, ameliorating the
recession.
Budget Deficit
• Governments in most economies issue debt to
make up for shortfalls in revenues in relation to
spending.
Budget Deficit = Expenditures – Taxes
• Tax collection is cyclical so the budget deficit
tends to be counter-cyclical.
• Maintaining a balanced budget over the cycle
means raising taxes in a recession an cutting taxes
in a boom which makes the business cycle more
extreme.
Procyclical Budget Surplus in HK
.12
.08
.04
.00
-.04
-.08
1990 1992 1994 1996 1998 2000 2002 2004 2006
Budget Surplus (as a % of GDP)
Detrended GDP
Turkey
Thailand
Singapore
Poland
Peru
Mongolia
Israel
India
Cote d'Ivoire
Chile
Botswana
Belarus
Albania
180
160
140
120
100
80
60
40
20
0
%
Most Economies Have Positive
Government Debt.
Debt/GDP
Why would a persistent deficit be a
problem?
Two Reasons
1. High government borrowing may push up
interest rates and crowd out investment
2. High government borrowing means that
the interest obligations of the government
will rise.
-1.00%
-2.00%
-3.00%
-4.00%
-5.00%
-6.00%
-7.00%
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
Budget Surplus in USA
(as a % of GDP)
0.00%
Government Interest Payments per
US Resident
$1,000.00
$900.00
$800.00
$600.00
$500.00
$400.00
$300.00
$200.00
$100.00
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
$0.00
1975
1996 US$
$700.00
Hong Kong Has Traditionally had negative Debt.
Government Wealth
800000
700000
600000
500000
400000
300000
200000
100000
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
0
Question: Problem with Central Bank
Stabilization
• Situation: Economy is in long-run
equilibrium, but central bank overestimates
potential output.
• Draw outcome if central bank believes that
the potential output is higher than it is.
Learning Outcomes
Students should be able to:
• Explain the effect of business cycles on different
components of expenditure
• Use the Taylor rule to calculate a forecast of U.S. interest
rates.
• Explain the uses of counter-cyclical monetary and fiscal
policy in stabilization.
• Explain the effect of budget deficits on real interest rates
on capital markets.
• Explain the negative effects of long-term budget deficits.