16 Macroeconomic equilibrium

New classical

• increase in AD

• decrease in AD

• if increase in AD, with SRAS and and LRAS, inflationary gap

  • level of output greater than level of output

  • only possible in short run, SRAS shifts back, above previous

    

• If decrease in AD, deflationary gap

  • price of FOP’s fell, firms COP fall, sras shifts outwards

Keynesian perspective - inflationary/defaltionary

• AS can be perfectly elastic - due to spare capacity

• Deflationary gap whereby level of AD not sufficient to buy up potential output, that could be produced at full employment

Three categories of public gov spending

• capital - spending that adds to capital stock of economy

• current - tend to be ongoing, eg wages

• transfer - benefits paid to people

How do government get income

• tax and indirect taxes

• social security payments

• corporate taxes

• tariffs

• gov owned businesses

What is fiscal policy

defined as set of government’s policies relating to its expenditure and taxation rates

expansionary vs deflationary fiscal - AD

• expansionary - increase ad

• deflationary - decrease AD

Aims of fiscal policy

• maintain low and stable rate of inflation

• low unemployment rate

• stable economic environment for growth

• reduce fluctuations is business cycle

• promote equitable income distribution

• external balance between export revenue and import expenditure

What is expansionary fiscal policy? and effect

• if want to encourage increase C, lower income tax

• encourage investment, lower corporate taxes, more profit, increase investment

• increase g spending

• inflationary pressure, APL increase

• trade off between lower unemployment and increase prices

How have fiscal policy helped before

• in great depression, helped with deep recession

• G expenditure can be used to target specific sectors of the economy

Constraints of fiscal policy

1. Time lags

   • Changing tax rates takes time

   • even after implemented, takes time for AD to change - people have to recognise and react

2. Political pressure

   • often influenced by political factors, rather than economic

3. Sustainable debt

   • may have to run budget deficits

     • accumulate into unsustainable debt

4. effect of net exports

   • expansionary, may lead to increase in IR

     • lead to increase in exchange rate (exports less attractive, imports more)

   • fall in (x-m)

5. Crowding out

   • if G spending increases, through increased borrowing, monopolise funds

   • firms don’t have access to funds, and this investment drops

   • less shift in AD

   • Increase in D for borrowing, IR increases thus contractionary monetary effects

6. Inability to achieve specific targets

   • large changes, effect may areas of economy

   • difficult to predict outcome

What is gov debt

It is the accumulation of all the budget deficits over the years and represents the total amount of money that the government owes to its creditors, both domestic and foreign.

How is gov debt expressed

normally expressed as a percentage of GDP

• shows the percentage of annual national output that the government owes, both domestically and abroad

What does deficit spending by gov drive

Drives economic growth

Debt servicing costs

amount of money needed to make payments on the principal and interest on a loan in a given time period

Relationship between gov debt and servicing costs

As gov debt increases, so do servicing costs

Bad effects of gov debt.

1. Lead to crowding out of private investments

2. Interest payments increase as a % of G budget expenditure, damaging effect on other areas of spending, benefits and services from gov must be cut

3. require higher rates of taxation to fund expenditure

4. decrease ability of gov to respond to emergencies, gov has to borrow. If debt too big, fewer fiscal options available

What effect does G spending have to fix deflationary gap

Financial increase in AD be greater than amount of spending

What happens to injections in economy

multiplied by economy, people receive a share of the income and spend part of what they receive

What happens to the income

• goes back to gov as form of tax

• some saved

• spent on foreign goods and services

• spent on domestic goods/services

  • goes to income for others, happens in rounds

MPC

Marginal propensity to consume, income spent on domestic goods and services

What happens when all the money has been respent

• final addition, gives value of the contribution that the injection had on national income

  • MPW is the value of MPS + MRT (Marginal rate of taxation) + MPI (MP import)

What can be used for value of multiplier

• MPC or MPW (Marginal propensity to withdraw)

Formulas

Any change in withdrawls =

change multiplier

What must gov estimate to fill deflationary gap

• estimate gap between equilibrium output and full employment

• value of multiplier

What is monetary policy

official policies governing supply of money and level of interest rates in an economy

• expansionary - increase AD

• deflationary - decrease AD

What do commercial banks set

interest rates

What is the central bank

government bank

ultimate control of money supply in an economy

What is the central bank responsible for

• mostly responsible for maintaining low and stable rate of inflation in economy

Goals of monetary policy

• maintain low and stable rate of inflation

• low unemployment rate

• stable economic environment for growth

• reduce fluctuations is business cycle

• promote equitable income distribution

• external balance between export revenue and import expenditure

What is expansionary monetary policy

• increase AD

  • banks might lower base rate of interest

    • reduces cost of borrowing, increase C and I

  • Increase supply of money

    • lower its price, lower rate of interest, since IR is the price of money

      • increase I and C

Effect on economy of expansionary monetary policy

• inflationary pressure

• increase in real output, increase in national income, economic growth, decrease unemployment

Strength of monetary policy

1. Relatively quick

2. No political intervention

   • generally adjusted by central bank, no political processes to be approved

3. Absence of “crowding out“

4. Ability to make small changes

   • more precise than fiscal

Limitations of monetary

1. time lags

   • Can take months, by then economic factors may have changed, no longer applicable

2. Ineffectiveness when IR are low

   • cannot continuously lower interest rates. When approach zero no more cuts available

3. low consumer and business confidence

How do commercial banks create money

• credit creation

  • occurs when lend money to consumers, more than they get, they lend out

    • money multiplier

Money multiplier related to min. reserve requirement

& calcularion

• percentage of deposits than commercial banks are legally required to hold in reserve, to meet cash requirement of depositor

Tools available for G to control money supply

1. minimum reserve requirement

   • larger them MRR, smaller the multiplier

   • if gov wants to reduce money supply, increase MRR

     • reduce ability of banks to create credit, reduce money supply

     • increase IR, thus lower AD

   • If gov wants to increase MS, reduce MRR

     • ability of banks to create credit, increase money supply

       • lower interest rate and increase AD

2. open market operations

   • involve buying and selling gov, securities by central bank

     • gov security is a bond. offers interest on nominal value of bond. very low risk

3. changes in central bank min, lending rate

   • when they raise it: increases the cost of borrowing. reducing c and I

   • lower: encourage investment and C so increase AD

4. Quantitive easing

   • CB injects new money into economy by purchasing assets, mostly securities, from commercial banks and other financial institutions with newly created electronic cash

     • expansionary effects:

     • increase reserve of commercial banks as they sell securities. Increase liquidity, encourage to lend more to firms and households

     • IR reduces, reduces debt: increase confidence

     • Lower IR, exchange rates drop, exports less expensive. imports more expensive. Increase (X-M)

What is gov security

gov security is a bond. offers interest on nominal value of bond. very low risk

Min. lending rate

the rate of interest which the central bank charges on loans and advances to commercial banks.

What is interest rate

Opportunity costs of holsing/spending money

Nominal rate of interest

Rate of interest available in money market not allowing for inflation

real rate of interest

adjusted for inflationI

If nominal IR increase

Give up large return on their savings and investment, so hold/demand less money

If nominal IR decreases

opportunity cost of spending/holding money will be less, hold/demand more money

Graph money supply

Real rate of interest equal to

and example

= nominal rate of interest - inflation rate