MACROECONOMIC

ENVIRONMENT
7. Fiscal And
Monetary Policy

Monetarists
In 1970s monetarists emerged under Friedman.
Their belief was that inflation is caused by too much money
chasing too few goods.
They blamed Keynesian policy of too much money to be created
(monetary expansion) as responsible for the stagflation of the
1970s.
They believe in monetary control and in theory of free markets
(like classicists).
Economy is self regulating. Governments should not intervene
except to reduce imperfections.
Rejected Keynesian fiscal policy because it leads to crowding
out of the private sector.

Keynesian And Monetarist Views On The

Demand For Money
Keynesians believe that money and other financial
assets are close substitutes and therefore, a rise in
interest rates will lead to a more than proportionate fall in
the demand for money as people transfer their savings
out of money and into other financial assets. i.e demand
for money is interest elastic (flat money demand
curve). Consequently they believe that LM curve is also
flat.
Monetarists believe that demand for money is interest
inelastic (steep money demand curve). Consequently
they believe that LM curve of an economy is steep.

The Liquidity Trap

Two extreme cases arise when discussing the effects of
monetary policy on the economy. First is the liquidity
trap.
Liquidity trap = a situation in which the public is
prepared, at a given interest rate, to hold whatever
amount of money is supplied.
Implies the LM curve is horizontal. Changes in the
quantity of money do not shift it.
Monetary policy has no impact on either the
interest rate or the level of income, i.e. monetary
policy is powerless.
Possibility of a liquidity trap at low interest rates :
Keynes.

The Classical Case

The opposite of the horizontal LM curve (implies that monetary
policy cannot affect the level of income) is the vertical LM curve.
If LM is vertical = demand for money is entirely unresponsive
to the interest rate.
The equation for the LM curve is
(1)
M
kY of
hiincome
If h is zero, then there is a unique level
P
corresponding to a given real money supply - VERTICAL
LM CURVE.
The vertical LM curve is called the classical case (at Yf).
Rewrite equation (1), with h = 0:
(2)
M only
k ( Pon Ythe
) quantity of
Implies that nominal GDP depends
money - quantity theory of money.

The Classical Case

When the LM curve is vertical

1. A given change in the quantity of money has a maximal effect
on the level of income.
2. Shifts in the IS curve do not affect the level of income.

When the LM curve is vertical, monetary policy has

a maximal effect on the level of income, and fiscal
policy has no effect on income.

Vertical LM curve implies the comparative effectiveness of

monetary policy over fiscal policy.
Only money matters for the determination of output.
Requires that the demand for money be irresponsive to i important issue in determining the effectiveness of alternative
policies.

Keynesian And Monetarist Views On The

Demand For Investment
Keynesians believe that demand for investment is interest
inelastic (steep IS curve). They believe that increase in
G will cause a slight increase in roi, but I will decrease
only slightly and thus AD (and Y) will increase
substantially. Alongwith a steep IS curve, a flat LM curve
(because money demand is elastic) makes monetary
policy ineffective in influencing national income. Crowding
out is small & fiscal policy is very effective in influencing Y.
According to monetarists, investment is interest elastic
(flat IS curve). Along with this, a steep LM curve (because
money demand is inelastic) leads to maximum crowding
out of private investment on account of higher G and
hence a very small increase in Y i.e. according to
monetarists, fiscal policy is ineffective in influencing
national income. Monetary policy is very effective in
influencing Y.

Japan Liquidity Trap

In late 1980s stock and real estate markets collapsed leading to a long
period of deflation and slow growth and recession.
The year on year consumer price inflation rate was negative from 1998 to
2005.
BOJ in Feb.1999, in a bid to stimulate the economy, reduced the roi to as
low as possible. The overnight call money roi has been virtually zero
since then till 2005.
With zero roi, demand for money is unlimited since everyone will hold
cash and nobody has an incentive to hold financial instruments.
Conventional monetary policy (dealing with OMO & short term roi)
becomes ineffective.
With nominal roi being zero, real roi is positive, discouraging investment.
During deflation, consumers postpone consumption, companies lay off
workers vicious circle.
Fiscal expansion alongwith unconventional monetary policy revived the
Japanese economy somewhat till recession hit it again in 2008-09.

BMI, JAPAN, Q4, 2011;

XGS=exports of goods & services

Unconventional Monetary Policy (QE) Of

Central Banks
Purchase assets with long term maturities such
as long term government bonds.
Intervene directly in credit markets by
purchasing private assets or providing loans
collateralized by private sector assets.
Guide long term roi by committing to keep policy
rates low for an extended period till inflation
becomes non negative (i.e influencing market
expectations to revive investor confidence).

QE In USA And In Japan

In late November 2008, the Fed started buying $600 billion in Mortgagebacked securities (MBS). By March 2009, it held $1.75 trillion of bank
debt, MBS, and Treasury notes, and the total reached a peak of $2.1
trillion in June 2010.
In November 2010, the Fed announced a second round of quantitative
easing, or QE2, buying $600 billion of Treasury securities by the end of
the second quarter of 2011.
QE3, was announced by the Federal Reserve in September 2012. The
third round includes a plan to purchase US$40 billion of mortgagebacked securities (MBS) per month and also to continue extremely low
rates policy until at least mid-2015. Sept 18, 2013 : Fed to continue with
QE. QE withdrawn gradually by Oct. 2014.
Reasons economy not growing enough and high unemployment rate.
In October 2011 the Bank of Japan expanded its asset purchase
program by 5 trillion ($66bn) to a total of 55 trillion.

United States Economic Data

2010

2011

2012

2013

Population (million)
310
312
GDP per capita (USD)
48,310
49,725
GDP (USD bn)
14,964
Growth (GDP, annual variation in %)
2.5
Consumption (annual variation in %)
1.9
Investment (annual variation in %)
1.5
Exports (G&S, annual variation in %)
11.9
Imports (G&S, annual variation in %)
12.7
Industrial Production (annual variation in %) 5.7
Unemployment Rate
9.6
8.9
Fiscal Balance (% of GDP)
-8.6
Public Debt (% of GDP)
93.9
Money (annual variation in %)
2.5
Inflation Rate (CPI, annual variation in %)
1.6
Policy Interest Rate (%)
0.25
0.25
Current Account (% of GDP)
-3.0

2014

2015

314
317
319
321
51,409 52,939 54,597 55,868
15,518 16,163
16,768 17,419
1.6
2.3
2.2
2.4
2.3
1.8
2.4
2.5
6.4
8.3
4.7
5.3
6.9
3.3
3.1
3.2
5.5
2.3
1.1
4.0
3.3
3.8
2.9
4.2
8.1
7.4
6.2
5.3
-8.4
-6.7
-4.1
-2.8
98.3
102
104
104
7.3
8.6
6.7
6.2
3.1
2.1
1.5
1.6
0.25
0.25 0.25
0.50
-3.0
-2.9
-2.4 -2.4

17,947
2.4
3.1
4.0

1.1
4.9
0.3
-2.4
106
5.9
0.1
-2.7

United States Economic Outlook

October 27, 2015

The outlook for the U.S. economy is stable but not as promising compared
to a few months ago. The economy will likely continue to move along at a
steady but unimpressive rate going forward. Economists maintained their
forecast for 2015 GDP from last month at 2.5%. For 2016, they see GDP
growth at 2.6%.

October 25, 2016

The U.S. economy seems to be back on track for robust growth in Q3, as
monthly indicators strengthened in September following Augusts overall
cooldown. Ahead of Novembers presidential elections, polls suggest that
Hillary Clintons lead over Donald Trump has widened. A Clinton presidency
would broadly involve a continuation of current economic policy while a
victory of Trump would increase policy uncertainty and lead the U.S. into
unchartered waters.

QE In Japan, 2012-13
Abenomics is the name given to measures introduced by
Japanese prime minister Shinzo Abe after his December 2012 reelection to the post he last held in 2007. His aim was to revive the
sluggish economy with "three arrows": a massive fiscal stimulus,
more aggressive monetary easing from the Bank of Japan, and
structural reforms to boost Japan's competitiveness.
By the end of February 2013 the measures had resulted in a
dramatic weakening of the yen and a 22 per cent rise in the Topix
stock market index since his election win. Japan's central bank
had also yielded to pressure to set an inflation target of 2 per cent.
Japanese prime minister is one step closer to slaying the
Deflationary Dragon that has been terrorising the land for last 15
years.

The Three Arrows Of Abenomics: QE In Japan, 2012-13

The three arrows of Abenomics:

1.- Quantitative Easing : the BOJ (Bank of Japan) leaves the interest rates near 0%
and makes the money flow to commercial banks to create excess liquidity with the
objective of promoting lending. With this objective, the BOJ is buying government
bonds and Asset Backed Securities. The objective over the next years is to double
the amount of money in circulation and as a consequence reach a 2% inflation target.
Another consequence is that the yen has been depreciating fast against other
currencies since the Abenomics measures started to be implemented.

2.- Fiscal policies to stimulate demand: investment in public works and renovation
of infrastructure which is older than 50 years (built shortly after the Second World
War) and fiscal deductions to companies that invest in R&D, that hire more
employees, that pay higher salaries, that buy new equipment, etc. These measures
aim to achieve an increase of investments, create jobs and increase salaries.

3.- Deregulations and creation of sustainable growth: there is a group of experts

(mainly CEOs of large, medium and small companies) that will propose measures to
the government over the next few years. This arrow includes plans to join the TransPacific Partnership (TPP), a new free-trade agreement between countries in the AsiaPacific region that would help Japanese companies export more.

Effect Of Abenomics
In July 2013, consumer price inflation rose to 0.7 per cent, the
highest in nearly five years. In 2014, it was 2.8%.
Growth, too, has risen briskly for three straight quarters, up
by an annualised 3.8 per cent in the three months to June
2013, putting Japan among the best-performing mature
economies in the world.
The GDP in Japan contracted 0.40 percent in the third
quarter of 2014 over the previous quarter. GDP Growth Rate
in Japan averaged 0.49 Percent from 1980 until 2014,
reaching an all time high of 3.20 Percent in the second
quarter of 1990 and a record low of -4 Percent in the first
quarter of 2009.

Japanese Economy, 2014

Japans prime minister Shinzo Abe has called a parliamentary elections,
as he seeks a new mandate to delay a second increase in consumption
taxes.
Parliament was dissolved on November 21st, 2014 less than two years
into four-year term. New elections returned Abe to power. The sales tax
raise (to 10%) would be postponed to April 2017 from October 2015.
The decision comes after preliminary data on third-quarter gross
domestic product released in November 2014 showed that the tax
increase (from 5 to 8%) which took effect in April, 2014, depressed
consumer spending more than expected and pushed Japan into a
recession.

Japan Economic Data

2010

2011

2012

Population (million)
128
128
GDP per capita (USD)
43,021
46,440
GDP (USD bn)
5,509
5,939
Growth (GDP, annual variation in %)
4.7
Consumption (annual variation in %)
2.8
Investment (annual variation in %)
-0.2
Exports (G&S, annual variation in %)
25.0
Imports (G&S, annual variation in %)
11.1
Ind. Production (annual variation in %) 15.6
Unemployment Rate
5.1
4.6
Fiscal Balance (% of GDP)
-9.5
Public Debt (% of GDP)
190
203
Money (annual variation in %)
2.3
Inflation Rate (CPI, annual variation in %) -0.7
Policy Interest Rate (%)
0.10
Exchange Rate (vs USD)
81.17
Current Account (% of GDP)
4.0

2013

2014

128
46,792
5,971
-0.5
0.3
1.5
-0.4
5.9
-2.6
4.3
-9.5
210
3.2
-0.3
0.10
76.96
2.2

127
38,270
4,873
1.7
2.3
3.2
-0.2
5.3
0.2
4.0
-9.0
212
2.6
0.0
0.10
86.75
1.0

2015
127
36,425
4,628
1.6
2.1
3.2
1.1
3.0
-0.6
3.6
-9.1
211
4.2
0.4
0.10
105.3
0.8

127
32,484
4,117
-0.1
-1.3
2.4
8.4
7.4
2.1
3.4
-8.3
209
3.6
2.7
0.10
119.7
0.5

0.5
-1.2
0.1
2.7
0.2
-0.9
-6.7
3.1
0.8
0.10
120.3
3.3

Japan Economic Outlook

October 27, 2015

Poor dynamics in Asia and rising global economic uncertainties are taking their
toll on the economy. Moreover, slow progress in the implementation of muchneeded pro-growth reforms is constraining Japans long-term economic outlook.
That said, the possibility of further fiscal stimulus to rekindle growth along with
positive spillovers from the Trans Pacific Partnership could prop up the economy
in the medium term. Economists see GDP expanding 0.7% in 2015, and foresee
it rising to 1.2% in 2016.

October 25, 2016

The economy appears to have withstood the strengthening of the yen relatively
well in Q3. Private consumption benefited from the sharp decline in the
unemployment rate, which is at around a two-decade low. However, further gains
in household spending will be limited by weak salary growth as an important part
of the new employment gains are part-time jobs. Industrial activities gained steam
in recent months. Rumors are mounting that the prime minister could call a snap
general election in January as he is seeking to expand his party leadership, which
ends in 2018, in order to continue implementing his Abenomics policies.

Negative Interest Rates, 2016

The European Central Bank in 2014 reduced its key interest rate to below
zero. The rate of interest on their deposit facility is now -0.4% while the rate on
their main refinancing operations is zero (Jul 28, 2016).

The idea was to discourage banks from stashing their money in the central
bank by charging them a modest rate for doing so. Since the banks would lose
money rather than earn interest on their deposits, they would be prompted
instead to make more loans at lower rates to businesses and consumers.

Denmark, Switzerland and Sweden adopted similar policies in the following

months; the Bank of Japan joined them in January 2016.

The E.C.B. expects growth of 1.6 % this year, same as last year. Lower rates
dont address the real economic problems of many countries: weak consumer
demand and weak business investment. Companies are less likely to borrow
for new investments when demand for their goods and services is not
increasing,even if the cost of borrowing is cheaper than ever.

Negative Interest Rates, 2016

There are limits to the benefits of such unconventional monetary

policies. It would be far better if governments used fiscal policy to
increase demand by investing in roads, bridges, railroads, ports and
other infrastructure. Government spending would create jobs and
stimulate economic activity, and would not cost much. For eg. Bond
investors are willing to lend money to the German government for
30 years at a rate of just 0.38 percent; in France, the rate is only
0.878 percent.

Persistent negative rates could force banks to raise fees on

checking and savings accounts to recoup the rising cost of
depositing reserves at the central bank. This, in turn, would
encourage individuals and businesses to take some of their money
out of banks and stash it in safes, or under mattresses. And that
would not be good for the stability of banks.

Degree Of Crowding Out

The Classical argument explains full crowding out based
on the proposition that the LM curve is vertical at full
employment level of output.

Consider an economy with given prices, in which the

economy operates below full employment. Under such
conditions, when fiscal expansion increases demand,
firms can increase their output by hiring more workers.
But if the economy is at full employment level, crowding
out becomes a much more realistic possibility because
firms cannot increase their output through additional
hiring. In this situation an increase in demand will lead to
an increase in price level rather than an increase in
output.

Crowding Out
In an economy with unemployed resources full crowding
out will not occur because the LM curve is not vertical. A
fiscal expansion will raise interest rates, but income will
also rise depending on the slope of the LM curve.
Crowding out, if it occurs, is thus a matter of degree.
There is evidence of significant crowding out of private
credit by govt borrowing in developing countries.

Exercise
Given C=0.8(1-t)Y; t=0.25; I=900-50i; G=800;
L=0.25Y-62.5i; M/ P=500.
a)

What is the equation that describes the IS curve?

b)

What is the equation that describes the LM curve?

c)

What are the equilibrium levels of income and the interest

rate?

d)

What is the value of G multiplier?

e)

By how much does an increase in government spending

of G increase the level of income in this model, which
includes the money market?

f)

By how much does a change in government spending of

G affect the equilibrium interest rate?

g)

Explain the difference between your answers to parts (d)

and (e).

Exercise
Show that a given change in the money
stock has a larger effect on output the less
interest-sensitive is the demand for money.
How does the response of the interest rate
to a change in the money stock depend on
the interest sensitivity of money demand
(i.e.h)?

Deriving the AD Schedule

Derive the equation for the AD curve using the equations
for the IS-LM curves: IS : Y G ( A bi )
1
M
LM : i kY
h
P

Substituting LM equation into the IS equation:

b
M

Y G A kY
h
P

h G
b G
M

A
h kb G
h kb G P

(3)

By equating IS and LM, the eqn that we get in terms of i is

i = kG A - 1
M
h+kbG
h+kbG P