Monetary and Fiscal Policy Notes

Page 1: Monetary and Fiscal Policy

Page 2: Introduction

  • The IS curve represents equilibrium in the goods market.
  • The LM curve represents equilibrium in the money market.
  • The intersection of IS and LM curves determines output and interest rates in the short run, according to a given price level.
  • Expansionary Monetary Policy:
    • Moves the LM curve to the right.
    • Raises income and lowers interest rates.
  • Contractionary Monetary Policy:
    • Moves the LM curve to the left.
    • Lowers income and raises interest rates.
  • Expansionary Fiscal Policy:
    • Moves the IS curve to the right.
    • Raises both income and interest rates.
  • Contractionary Fiscal Policy:
    • Moves the IS curve to the left.
    • Lowers both income and interest rates.

Page 3: Interest Rate

  • Representation of IS-LM equilibrium:
    • Interest Rate: i_0
    • Equilibrium point: E
    • LM curve intersects IS curve at point E
    • X-axis represents Income, Output (Y), Y-axis represents Interest Rate (i)

Page 4: Monetary Policy

  • Central banks conduct monetary policy, mainly through open market operations.
  • Open Market Operation:
    • The central bank buys/sells bonds in exchange for money.
    • Buying bonds increases the stock of money; selling bonds reduces it.
  • Purchasing bonds reduces bond quantity in the market, increasing their price, lowering their yield.
  • At a lower interest rate, public holds less wealth in bonds and more in money.

Page 5: Open Market Purchase Example

  • Open Market Purchase Impact:
    • Initial equilibrium at point E corresponds to real money supply M/P.
    • An open market purchase increases nominal and real quantities of money.
    • LM shifts to LM'.
    • New equilibrium at point E’ with lower interest rate and higher income level.
    • Reason: Lower interest rates increase investment spending.

Page 6: Graphical Representation of Purchase Effect

  • Increase in real money stock: M/P
  • LM curve shifts from LM to LM'.
  • New income: Y' , decreased interest rate: i

Page 7: Sensitivity of Money Demand to Interest Rates

  • If money demand is sensitive to interest rate (flat LM curve), change in money stock affects interest rate minimally.
  • If not sensitive (steep LM curve), a change in money supply significantly affects interest rates and investment demand.

Page 8: Adjustment Process of Monetary Expansion

  • At point E, increase in money supply causes excess money supply.
  • Public attempts to buy assets, raising their prices and lowering yields.
  • Rapid market adjustment leads to point E1, where money market clears, and public holds larger real money stock at reduced interest rates.
  • At point E1, excess demand for goods occurs; output expands as inventories decrease.

Page 9: Effects of Increased Real Money Stock

  • Representation of increase in real money stock and its effects on interest rates and income.

Page 10: Impact of Increasing Money Stock

  • Increase in money stock leads to:
    • Initially declining interest rates.
    • Higher aggregate demand due to lower interest rates.

Page 11: The Transmission Mechanism

  • Two key steps in the transmission mechanism:
    1. Increase in real balances causes portfolio disequilibrium.
    2. This disequilibrium drives asset buying, changing asset prices and yields.
  • Changes in money supply shift interest rates, affecting aggregate demand.

Page 12: Linkages between Money Stock and Output

  • Two crucial links:
    1. Change in real balances must lead to change in interest rates.
    2. Change in interest rates must affect aggregate demand.
  • If imbalances do not lead to changes in interest rates, or if spending doesn't respond, the connection between money and output breaks down.

Page 13: The Process of Adjustment

  1. Change in real money supply.
  2. Portfolio adjustments affecting asset prices/interest rates.
  3. Spending adjusts to new interest rates.
  4. Adjustments lead to changes in output and aggregate demand.

Page 14: The Liquidity Trap

  • A liquidity trap occurs when the public holds unlimited amounts of money at a certain interest rate.
  • In this case, the LM curve is horizontal, and monetary policy fails to affect interest rates or income.
  • The concept emerged from Keynes' theories regarding low interest rates.

Page 15: Representation of the Liquidity Trap

  • Demand for money is perfectly elastic at given interest rates.

Page 16: Historical Context of the Liquidity Trap

  • The liquidity trap is primarily an explanatory concept, although it has current relevance under certain conditions (e.g., zero interest rates).

Page 17: The Japanese Case

  • With interest rates at zero, conventional monetary policy cannot stimulate the economy.
  • Japan experienced a liquidity trap in the late 1990s through early 2000s as rates fell to zero.

Page 18: Zero Interest Rate Behavior

  • A nominal interest rate comprises a real interest rate and expected inflation.
  • Economies fall into zero interest rate bounds when experiencing significant deflation.
  • Policymakers can avoid liquidity traps by maintaining positive inflation.

Page 19: Japanese Interest Rates Over Time

  • Graph showing Japanese interest rates from 1995 to 2004.

Page 20: The Classical Case

  • Vertical LM curve implies the demand for money is unresponsive to interest rates.
  • The LM curve representation: \frac{M}{P} = kY - hi
  • If h=0, LM curve is vertical, indicating unique income level at money market equilibrium.

Page 21: Money and Output

  • In the classical case, nominal GDP only influenced by the money supply.
  • Quantity theory of money: Nominal income depends solely on money quantity.

Page 22: Vertical LM Implications

  • A significant monetary change maximally affects income.
  • IS curve shifts do not impact income with a vertical LM curve; hence monetary policy is more effective than fiscal.

Page 23: Fiscal Policy and Crowding Out

  • IS curve slopes downwards; decreased interest rates boost investment.
  • Fiscal policy shifts IS curve; fiscal expansion raises equilibrium income and interest rates.

Page 24: Fiscal Expansion Example

  • Increase in government spending shifts IS schedule rightward by \alpha G.
  • Equilibrium income rises, but excess demand for money raises interest rates, dampening investment.

Page 25: Graphical Impact of Increased G

  • Graph showing effects of increased government spending on income and interest rates.

Page 26: Complete Adjustment Process

  • Full adjustment requires equilibrium in both goods and money markets at point E’.

Page 27: Crowding Out Overview

  • Increased government spending raises income and interest rates.
  • A rise in interest rates dims the expansionary effects of spending.

Page 28: Degree of Crowding Out

  • Crowding out decreases as LM becomes flatter.
  • Fiscal expansion leads to higher income and saving, allowing for larger budget deficits.
  • With unemployment, fiscal expansion can occur without raising interest rates.

Page 29: Liquidity Trap Effects on Fiscal Policy

  • In a liquidity trap, fiscal policy maximally impacts income with a complete multiplier effect.
  • No change in interest rates occurs, allowing for uninterrupted investment.

Page 30: Monetary Policy in Liquidity Trap

  • Monetary policy ineffective below employment potential in the liquidity trap.

Page 31: Fiscal Policy in Liquidity Trap

  • Graphical representation of the effects of fiscal policy within a liquidity trap.

Page 32: Classical Case and Its Implications

  • Vertical LM indicates fiscal spending has no impact on income, only interest rates increase.
  • This leads to full crowding out with offsetting reductions in private spending.

Page 33: Full Crowding Out Representation

  • Graphical depiction showcasing full crowding out effects on interest rates and income.

Page 34: Evaluating Crowding Out Importance

  • Full crowding out less likely in economies with unemployed resources.
  • Fiscal expansion can occur without significant crowding out with accommodated monetary policy.

Page 35: Monetary Policy Accommodation

  • Monetary policy accommodates fiscal expansion by increasing the money supply to stabilize interest rates.
  • Both IS and LM schedules shift right.

Page 36: Policy Mix for Recession Recovery

  • Graphical portrayal of the relationship between fiscal and monetary policy during recession, emphasizing their interconnected effects on output and investment demand.