Monetary and Fiscal Policy Notes

Chapter 11: Monetary and Fiscal Policy

Introduction

In 2008, the American economy experienced a significant downturn. Both monetary and fiscal policies were implemented to mitigate the recession. The Federal Reserve lowered the federal funds rate, and the government enacted tax cuts and new spending programs.

This chapter uses the IS-LM model to illustrate how monetary and fiscal policies function as macroeconomic tools to maintain economic growth and manage recessions and booms. Fiscal policy initially impacts the goods market, while monetary policy primarily affects asset markets. Both policies influence output and interest rates due to the interconnectedness of these markets.

The IS-LM Framework

The IS curve represents equilibrium in the goods market, and the LM curve represents equilibrium in the money market. Their intersection determines short-run output and interest rates for a given price level.

  • Expansionary monetary policy shifts the LM curve to the right, increasing income and decreasing interest rates.

  • Contractionary monetary policy shifts the LM curve to the left, decreasing income and increasing interest rates.

  • Expansionary fiscal policy shifts the IS curve to the right, increasing both income and interest rates.

  • Contractionary fiscal policy shifts the IS curve to the left, decreasing both income and interest rates.

Monetary Policy

Monetary policy is typically enacted by central banks through open market operations.

Open Market Operations

Open market operations involve the Federal Reserve buying or selling bonds to influence the money supply. Buying bonds increases the money supply, while selling bonds reduces it.

When the Fed purchases bonds, it increases the price of bonds and lowers their yield, leading to a lower interest rate. This encourages the public to hold more money and less bonds.

Graphical Representation

An open market purchase shifts the LM curve to the right, resulting in a new equilibrium with a lower interest rate and a higher income level. The effectiveness of monetary policy depends on the slope of the LM curve. A steeper LM curve indicates that changes in the money supply will significantly affect the interest rate and investment demand, whereas a flatter LM curve suggests a smaller impact.

Adjustment Process

Following a monetary expansion, an excess supply of money leads the public to buy other assets, increasing asset prices and decreasing yields. This adjustment quickly moves the economy to a point where the money market clears. The decrease in interest rates increases aggregate demand, causing inventories to deplete and output to expand. The interest rate rises during this adjustment as the increased output raises the demand for money.

Transmission Mechanism

The transmission mechanism is the process through which monetary policy affects aggregate demand. It involves:

  1. Portfolio disequilibrium: Changes in real money balances create an imbalance, prompting people to adjust their asset holdings.

  2. Changes in asset prices/interest rates: Portfolio adjustments lead to changes in asset prices and yields.

  3. Spending adjustments: Changes in interest rates affect investment, consumption and aggregate demand.

  4. Output adjustments: Changes in spending lead to changes in output.

Liquidity Trap

A liquidity trap occurs when the public is willing to hold any amount of money at a given interest rate, rendering monetary policy ineffective because the LM curve becomes horizontal. In this scenario, open market operations do not affect interest rates or income. The zero lower bound is a critical practical concern where interest rates cannot go any lower, making conventional monetary policy useless.

The Zero Interest Rate Lower Bound

Nominal interest rates comprise the real interest rate and expected inflation. Deflation can lead to a zero interest rate bound, which policymakers can counteract by increasing the money supply to maintain positive inflation.

Banks' Reluctance to Lend

In certain situations, such as the early 1990s, banks may be unwilling to lend despite lower interest rates due to prior bad loans, which impairs the transmission mechanism of monetary policy.

Federal Reserve's Dual Mandate

The Federal Reserve's objective is to achieve both maximum employment and stable prices. To achieve its dual mandate the Federal Reserve uses interest rates to influence financial conditions and, ultimately, the course of the U.S. economy.

Setting Interest Rates vs. Money Supply

The Federal Reserve can set either the money supply or interest rates. Pegging the interest rate involves adjusting the money supply to keep the LM curve intersecting the IS curve at the desired interest rate target.

Unorthodox Monetary Policy

During the 2007-2009 Great Recession, the Federal Reserve implemented quantitative easing, purchasing long-term bonds and other assets to lower long-term interest rates when nominal interest rates hit the zero lower bound. Additionally, the Fed implemented credit easing, targeting loans directly at struggling sectors.

The Classical Case

The classical case assumes the LM curve is vertical because money demand is entirely unresponsive to interest rates. M = (P \times Y)

In this scenario, nominal GDP depends solely on the quantity of money, and monetary policy has a maximal effect on income, while fiscal policy has no effect.

Fiscal Policy and Crowding Out

Fiscal policy involves changes in government spending and taxation, which shift the IS curve and affect equilibrium in the goods market.

The equation for the IS curve is as follows:

Y = \alpha(A - bi)

where \alpha = \frac{1}{1-c(1-t)}

Increase in Government Spending

An increase in government spending raises aggregate demand, shifting the IS curve to the right and increasing both equilibrium income and interest rates.

Crowding Out

Crowding out occurs when expansionary fiscal policy increases interest rates, reducing private spending, particularly investment. The extent of crowding out depends on the slopes of the IS and LM curves. Income increases more and interest rates increase less with a flatter LM schedule. The opposite is true with a steeper LM curve. Income increases less and interest rates increase less with a flatter IS curve, and increases more with a steeper IS Curve.

Liquidity Trap (Fiscal Policy)

In a liquidity trap, government spending has its full multiplier effect on income without increasing interest rates, as the LM curve is horizontal.

The Classical Case and Crowding Out

With a vertical LM curve, an increase in government spending has no effect on income and only increases the interest rate, leading to full crowding out of private investment.

Is Crowding Out Important?

In an economy with unemployed resources, there will not be full crowding out because the LM schedule is not vertical. Also, monetary authorities can accommodate fiscal expansion by increasing the money supply, preventing interest rates from rising.

The Composition of Output and the Policy Mix

Both monetary and fiscal policy can affect income, but they differ in their impact on aggregate demand components. Monetary policy stimulates interest-responsive spending, mainly investment, while fiscal policy depends on government purchases and tax changes.

Investment Subsidy

An investment subsidy, such as an investment tax credit, can raise investment spending even with increased interest rates. This shifts the IS schedule by the amount of the multiplier times the increase in autonomous investment brought about by the subsidy.

The Policy Mix

The policy mix involves combining monetary and fiscal policies to achieve full employment and address other policy problems. Decisions on whether to use fiscal or monetary policies often reflect political preferences.

The Policy Mix in Action

This section reviews historical U.S. monetary-fiscal policy mixes, including the 1980s recession and recovery, the 1990-1991 recession, the 2001 recession and recovery, and the Great Recession of 2007-2009. It also examines policy decisions in Germany following reunification.

The 1980s Recession and Recovery

This period featured tight monetary policy to combat inflation and expansionary fiscal policy through tax cuts and defense spending increases. The real interest rate increased sharply, and investment responded to both increased rates and recession.

The Recession of 1990-1991

Fiscal policy was immobilized due to a large budget deficit and disagreement between the Bush administration and Congress. The Federal Reserve aggressively cut interest rates to combat the recession, which proved sufficient to ward off a double-dip recession.

The Longest Peacetime Expansion - The 1990s

Low inflation and unemployment rates lead to a long peacetime expansion that was credited to technological growth and prudent management by the Federal Reserve.

The Recession of 2001 and Subsequent Recovery

A mild recession led to lowered interest rates and a significant tax cut that helped increase GDP growth to combat the mild recession.

Fiscal Policy in the Face of Crisis

The Obama administration and Congress enacted a large fiscal stimulus package during the Great Recession, with tax collections falling and federal spending increasing significantly.

The German Policy Mix, 1990-1992

German reunification led to increased government spending without significant tax increases. The Bundesbank maintained tight money policies, resulting in high interest rates and concerns about inflation.