Macro Wk10: Monetary Policy and Fiscal Policy

The Coronavirus Recession: A Difficult Policy Problem

Lecture 9 developed the aggregate supply-aggregate demand model, illustrating how output and the average price level are jointly determined.
The coronavirus recession in Australia and its associated policy challenges can be analyzed using this model.
The onset of coronavirus led to business shutdowns and reduced social activities.
This also reduced business profits, incomes, and aggregate demand, impacting business and consumer confidence, which further reduced investment and consumption spending.
Result: Lower output and prices.

The effects of COVID-19 on the economy

Shutdown, Income and Confidence Effects
Diagram visually represents the shift in aggregate demand (AD) and short-run aggregate supply (SRAS) due to COVID-19, leading to a new equilibrium with lower output and prices.

Policy Options: Monetary and Fiscal

Government intervention is needed to address a coronavirus-type recession (Point C).
Monetary policy: Manipulating the money supply or interest rates to affect aggregate demand.
Fiscal policy: Manipulating government spending and taxes to affect aggregate demand.
The goal is to shift the AD curve to the right, increasing output and possibly the price level.

Policy Shift of the AD Curve

A diagram illustrating the desired shift of the AD curve to the right, representing the effect of monetary or fiscal policy interventions.

What is Monetary Policy?

Monetary policy involves manipulating the money supply or interest rates to affect aggregate demand.
It is typically conducted by a country’s central bank (e.g., the Reserve Bank of Australia - RBA).
During a recession (output falls, unemployment rises), the central bank injects money and reduces interest rates.
During inflation, the central bank withdraws money and increases interest rates.

Australian Central Banking

The RBA operates independently of the executive government.
Its functions include:
- Conducting monetary policy
- Maintaining financial stability (Emergency lending to banks)
- Operating the non-cash payments system
RBA uses an inflation targeting approach to monetary policy:
- The primary target is inflation between 2 and 3%.
- The timeframe is the medium term, allowing temporary deviations for other goals.
- If inflation is too high, the RBA increases the interest rate, slowing down borrowing and spending, leading to lower inflation and output.
- If inflation is too low, the RBA lowers the interest rate, encouraging higher borrowing and spending, leading to higher inflation and output.

Monetary Policy: The Money Market

The money market is where agents who demand money meet those who supply or lend money.
This market determines the nominal interest rate (r).
The Liquidity Preference Model is used to describe this market and explain interest rate determination.
This model simplifies the Australian Cash Market where the Cash Rate is determined.
Explaining the interest rate requires describing the supply and demand for money.

Money Supply

Money supply is the quantity of money available in the economy.
- Currency (C_p): notes and coins in the hands of the non-bank public.
- Current deposits (D): balances in bank accounts accessible on demand via cards or cheques.
- Money supply Ms = Cp + D
- Various measures of money supply exist: M0, M1, M2, M3 up to Broad Money, each expanding the types of deposits included.

Money Demand

Money is one form in which wealth can be held; others include bonds, stocks, and houses.
The benefit of holding money is its liquidity: ease of exchange.
The opportunity cost of liquidity is forgone interest.
As the interest rate rises, demand for money falls, and vice versa.

Liquidity Preference Model

The market where agents who demand money meet agents who supply money.
This market determines the nominal interest rate (r).
The liquidity preference model explains how this happens.

Liquidity Preference Model

A simple theory of the interest rate (r).
r adjusts to balance the supply and demand for money.
Money supply is assumed fixed by the central bank and does not depend on the interest rate.
Money demand reflects how much wealth people want to hold in liquid form.
A household’s “money demand” reflects its preference for liquidity.
Variables influencing money demand: Y, r, and P.

How r Is Determined

MS (Money Supply) curve is vertical: Changes in r do not affect MS, which is fixed by the central bank.
MD (Money Demand) curve is downward sloping: A fall in r increases the quantity of money demanded.
Equilibrium interest rate is determined where MS intersects MD.

Monetary Policy and Aggregate Demand

To achieve macroeconomic goals, the RBA uses monetary policy to shift the AD curve.
The RBA’s policy instrument is MS (Money Supply).
The RBA often targets the interest rate, specifically the cash rate, which banks charge each other on short-term loans.
To change the interest rate and shift the AD curve, the RBA conducts open market operations to change MS.

The Effects of Reducing the Money Supply

The RBA can raise r by reducing the money supply.
An increase in r reduces the quantity of goods and services demanded.
Diagram illustrates the shift of MS to the left, leading to a higher interest rate and a leftward shift of the AD curve.

Effects of Increasing the Money Supply

RBA can reduce r by increasing the money supply.
A fall in r increases the quantity of goods and services demanded.
Diagram illustrates the shift of MS to the right, leading to a lower interest rate and a rightward shift of the AD curve.

RBA Cash Rate

Graph of the Cash Rate Target from 1990 to 2025, sourced from RBA.

The Transmission Mechanism

Changing money supply and interest rates leads to changes in AD, which affects prices (inflation) and output (and jobs).
This effect is transmitted through various mechanisms:
1. r \downarrow \rightarrow I \uparrow, provided firms are confident about the future.
2. r \downarrow \rightarrow C \uparrow, provided households are confident about the future.
3. r \downarrow \rightarrow ER \downarrow \rightarrow X \uparrow and M \downarrow, provided net exports are elastic.
Reverse outcomes if r is raised.

Fiscal Policy (FP)

FP is the use of government spending and revenue instruments to influence aggregate demand, output, employment, and economic growth.
1. On the spending side, the main instrument is G, expenditure on final goods and services by the government (e.g., infrastructure projects).
- A second instrument is transfer payments, but these work indirectly by encouraging households and firms to spend more on C and I. Transfer payments are ignored for simplicity.
1. On the revenue side, the main instrument is taxation rates on income (personal or company income) or on expenditure (GST).
- These also operate indirectly by encouraging households and firms to spend less or more on C and I. GST is also ignored for simplicity.

Stimulatory FP and AD

Suppose the economy is in recession or growing too slowly. The government can respond by increasing G or lowering tax rates.
- G \uparrow. Suppose the government funds the building of a second Sydney airport by the private sector. This directly affects the production of goods and services, with effects spread out over time.
- G \uparrow \rightarrow AD \uparrow \rightarrow Y \uparrow \rightarrow economic growth\uparrow
- Tax rates (t) \downarrow. Suppose the government lowers personal income tax rates (t). This directly increases the disposable income of households but only affects AD if this leads to more consumption expenditure on goods and services.
- Personal tax rate\downarrow \rightarrow Y_{\text{disposable}} \uparrow \rightarrow C \uparrow \rightarrow AD \uparrow \rightarrow Y \uparrow \rightarrow growth\uparrow
- Similarly, decreases in company tax rates will encourage higher I and AD.

Shifting the AD right . . .

Diagram showing the AD curve shifting to the right, leading to a new equilibrium with higher output and prices.

Contractionary FP and AD

Suppose the economy is booming or growing too fast. The government can respond by decreasing G or increasing tax rates.
- G \downarrow. The government can reduce the amount of infrastructure it is prepared to finance. This will directly decrease and hence slow down the production of goods and services compared to previous levels.
- G \downarrow \rightarrow AD \downarrow \rightarrow Y \downarrow \rightarrow growth\downarrow
- Tax rates\uparrow. Suppose the government increases company tax rates. This makes investment less profitable, so I will typically fall.
- Company tax rate\uparrow \rightarrow \text{expected profits} \downarrow \rightarrow I \downarrow \rightarrow AD \downarrow \rightarrow Y \downarrow \rightarrow growth\downarrow
- Or the government could increase personal income tax rates to encourage lower C and AD.

Government Budget

The government budget is the difference between government revenue and government spending.
In our simplified model, these are written as T and G, respectively.
The government budget can be in 3 possible states:
- Budget surplus BS = T – G with T > G
- Budget deficit BD = G – T with G > T
- Budget balance BS = 0 with T = G
There is always much discussion about budgetary policy. When is it appropriate to run budget deficits or budget surpluses? This question combines both economic and political factors.

The Overall Impact of Fiscal Policy

The overall impact that fiscal policy has on output and employment is the outcome of two main effects:
- A multiplier effect where the impact on output from a certain amount of government spending has a bigger effect than the size of the government spending.
- A crowding-out effect where the extra government spending leads to a reduction in other components of aggregate demand.

The Multiplier Effect

Each $1 increase in G can generate more than a $1 increase in aggregate demand.
Also true for the other components of GDP.
- Example: Suppose a recession overseas reduces demand for Australian net exports by $10b. Initially, aggregate demand falls by $10b.
- The fall in Y causes C to fall, which further reduces aggregate demand and income.

The Multiplier Effect

A $20b increase in G initially shifts AD to the right by $20b.
The increase in Y causes C to rise, which shifts AD further to the right.
Diagram illustrating the successive shifts of the AD curve due to the multiplier effect.

The Multiplier Effect

How big is the multiplier effect? It depends on how much consumers respond to increases in income.
Marginal propensity to consume (MPC): the fraction of extra income that households consume rather than save.
Multiplier = \frac{1}{1 – MPC}
Example: if MPC = 0.8, the multiplier is \frac{1}{1 – 0.8} = 5

The Multiplier Effect

The size of the multiplier depends on MPC.
- E.g., if MPC = 0.5, multiplier = 2
- if MPC = 0.75, multiplier = 4
- if MPC = 0.9, multiplier = 10
\Delta Y = \frac{1}{1 – MPC} \Delta G
A bigger MPC means changes in Y cause bigger changes in C, which in turn cause more changes in Y.

The Multiplier Effect

Example: if government expenditure increases by $20b,
Y increases by (assuming MPC = 0.8) where \Delta Y and \Delta G are changes in Y and G
\Delta Y = \frac{1}{1 – MPC} \Delta G
\Delta Y = \frac{1}{1 – 0.8} 20 = 100

The Crowding-Out Effect

Fiscal policy has another effect on AD that works in the opposite direction.
A fiscal expansion raises r, which reduces investment, which then reduces the net increase in aggregate demand.
So, the size of the AD shift may be smaller than the initial fiscal expansion.
This is called the crowding-out effect.

How the Crowding-Out Effect Works

A $20b increase in G initially shifts AD right by $20b
But higher Y increases MD and r, which reduces AD.
Diagram illustrates the initial shift of the AD curve to the right, followed by a shift back to the left due to the crowding-out effect.

Summary

Fiscal Policy is the use of government spending and revenue instruments to influence the level of aggregate demand, and thus output, employment, and economic growth.
When the economy is in recession Governments should increase spending (G) and cut taxes (T) moving the Government Budget into deficit.
When the economy is booming Governments should reduce spending (G) and raise taxes (T) moving the Government Budget into surplus.
The overall effect of fiscal policy depends on the relative sizes of the multiplier and crowding out effects.