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Lecture Notes 4 - Monetary and Fiscal Policy in a Closed and Open Economy Luca Andriani
Macroeconomics for Business (MOMN033H5)
Birkbeck, University of London
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Macroeconomics for Business
Lecture 4
Monetary and Fiscal Policy in a Closed and Open
Economy
Luca Andriani
1. Monetary and Fiscal Policy in a Closed Economy: Notes on the
IS-LM Model
To understand the dynamics of the intervention of the authorities in the market we can try to understand the mechanism and the dynamics regulating both the goods and the money markets in a closed economy. This means that in this case we assume that there is no international trade so no exports and no imports. In this sense we can use the so called IS-LM model which provides an interesting explanation about the mechanisms and the reactions of the good and money markets when monetary or fiscal policy take place. Simply speaking by fiscal policy we refer to government expenditures and taxes. So when we use the expression expansionary fiscal policy we refer to an increase of government expenditures and/or to a decrease in taxes. When we use the expression contractionary fiscal policy we refer to a decrease in government expenditures and/or to an increase in taxes. By monetary policy we mainly refer to the action taken place by the Central Bank (CB). So for simplicity when we use the expression expansionary monetary policy we refer to an increase in money supply from the CB. This can be done by injecting money in the market by buying bonds. The IS-LM models refer to the aggregate demand Keynesian models (Williamson 2008). The IS and LM schedules capture the behaviours in the good markets and in the money markets respectively. Before explaining what we mean by monetary and fiscal policy within the IS-LM structure, let’s go step by step in identifying all the elements of the framework. Firstly we might start with the description of the dynamics occurring in the good market through the IS curve. Secondly we can describe the dynamics of the money market through the LM curve. Thirdly we can put the two markets together and investigate the effect of a fiscal and monetary policy.
1 The IS Curve and the Good Market
The good market clearing requires that output (how much the market produces – i. GDP) is equal to consumption (households), investments (firms) and government’s expenditures as in equation (1). The missing elements of X (exports) and M (imports) are due to the fact that the market is closed.
Y=C+I+G (1)
Y = output C = consumption I = investments G = government’s expenditures
We assume that consumption is a positive function of income (Y) and a negative function of interest rate (r) as in the equation (2). This means that as income increases, consumers will consume more (part of the additional income will be addressed to additional consumption – remember the marginal propensity to consume in lecture 2?). Consumption is also a negative function of interest rate. In a very simplistic mind set we might think that as the interest rate increases, additional consumption becomes more expensive in terms of opportunity costs. In other words, even though for simplicity we do not involve a variable money here, we can think that if interest rate increases, consumers might prefer to keep their money in the bank account and enjoy the benefit of a higher interest rate rather than immediately consumes that money.
C=C(Y , r) (2)
Equation (3) states that Investment is a negative function of interest rate. For investment we mean investment in capital good (machineries, laptop, equipment, building and so on). An increase in the interest rate implies an increase in the interest rate on the loan for investment (or a higher opportunity cost as we argued before for consumption). This implies that as interest rate increases investment decreases.
I=I(r) (3)
Notice that in our setting it does not matter whether the interest rate r is nominal or real since we assume zero inflation
What if in the market there is an excess of supply in the sense that the market produces more than what it is demanded? This is the case depicted in figure 2. In graphical terms this means to pick a point on the curve randomly and move towards right (point A). In order to go back to a point along the curve (for ex. point B), we reduce the interest rate. This might create a incentive to consumer to consume more and to invest more in capital goods up to the point where equation (4) holds again.
Figure 2 IS curve, Excess of supply in the good market
There are factors causing the shift of the IS curve as in figure 3 that do not depend on the movement of the interest rate. These are the following (Figure 2)
Increase in government’s expenditures Decrease of the present value of taxes Anticipated increase in future income Decrease in the current capital stock of capital Increase in future total factor of productivity
Figure 3 IS shift
If government expenditures increase then the demand for goods consumed by the government increases and, hence, Y. This shifts the IS to the right.
If the present value of taxes decrease then the demand for current consumption goods by consumers increases and, hence, Y. This shifts the IS to the right
If current capital stock decreases then future marginal product of capital increases and, hence, the current demand for investment goods increases and, hence, Y. This shifts the IS to the right.
If total factors of productivity are expected to increase in the future then also future marginal product of capital is expected to increase in the future. This drives the demand for investment goods to increase and, hence, Y. This shifts the IS to the right.
1 LM Curve and the Money Market
Money market clearing means that money demanded by households is equal to money supplied by the government as in equation (5)
M = L (5)
M = money supply L = money demand
The more income households have the more transactions they make and, hence, the higher is their demand for money.
Figure 5 Excess of demand and of supply
In case of an excess of supply of money, interest rate should decrease to stimulate the demand of money until the point in which supply and demand for mony are equal as in the equation (7) In case of excess of demand for money, interest rate should increase in order to disincentive the demand for money until the point in which money demand and supply are equal as in equation (7).
Notice that one of the main reasons for which the LM curve shifts is an increase or decrease in money supply. If money supply increases then the LM shifts to the right (as in figure 6). The reverse is valid: in case of decrease in money supply the LM shifts to the left.
Figure 6: LM curve shifts to the right
1 Equilibrium in the money and good market
The intersection point of the two curves IS and LM is the equilibrium in both the goods and
the money markets. This point is shown in figure 7 and it is indicated by the pair ( Y
¿ , r ¿ ). What happens if we are out of equilibrium?
Figure 7 Equilibrium in the IS-LM
What happens if we are out of equilibrium? We can reasonably assume that while it takes time for the output to adjust, interest rate can adjust immediately. Then, if we were out of equilibrium (figure 8), let’s say in point A, the interest rate would immediately jump to put the economy at B. Then the economy would move down along the IS curve to point C
Figure 8 Economy out of equilibrium
1 IS-LM and the Expansionary Fiscal Policy
1 IS-LM and the Expansionary Monetary Policy
Under an expansionary monetary policy the central bank (CB) injects money in the economy (increase in the money supply) by buying bonds. The price of the bonds increases and the risk of the bonds decreases. Hence the interest rate decreases. An increase in the money supply shifts the LM to the right (from LM1 to LM2) as in figure 11
Figure 11: Expansionary monetary policy
If money supply M increases then money demand has to increase as well in order to keep
M = L. In fact a decrease in interest rate stimulates the money demand by increasing consumption and investment in the good market. At the new point of equilibrium (intersection between LM2 and IS) the overall result is that: Y (increases) r (decreases) C (increases) and I (increases)
Notice that the monetary policy becomes more effective if: - L is not too sensitive to a change in r (so LM stepper as in figure 12) - Investments are very sensitive to a change in r (IS flatter as in figure 12)
Figure 12: Expansionary monetary policy with LM stepper and IS flatter
1 The Case of a Liquidity Trap. When the Monetary Policy is not Effective
The case of a liquidity trap is a case in which an expansionary monetary policy risks being ineffective. This was the case of Japan at the beginning of the century. This means that even though the CB injects money in the market, hence, increases money supply this will not have a positive economic effect. The reason is that under a liquidity trap the interest rate is already very close to zero (almost zero). The liquidity trap story tells us that when interest rate is zero or very near to zero, the demand for money becomes very elastic. In other words, the leftmost part of the LM curve becomes flat. If the IS curve intersects the LM curve in the flat part then changes in money supply will not have any effect on interest rate or output.
2 The IS curve
The IS curve represents the combination between r and Y that makes the leakage (S+M) equal to injections (I+G+X) as in equation (2). Of course for S we mean aggregate savings and for M we mean imports. Given the following identity in an open economy
Y=C+G+I+X−M (1)
If Y−C=S
⇒S+M=G+I+X (2)
For simplicity
S=Sa+sY (3)
Equation (3) means that S depends on autonomous savings and savings that are function of
income ( sY ) where s is the marginal propensity to save (similar to the marginal propensity to consume in the previous chapter)
Similarly with import where
M=Ma+mY (4)
As in the IS-LM model investment is a an inverse function of interest rate such that
I=I(r) (5)
∂I ∂r
< 0
The IS present the same shape and slope as in the IS-LM model and it is a combination of Y and r that satisfies equation (2) In the case of the Mundell-Fleming model we can argue that the IS is downward sloping because higher level of income generates more leakage (S + M) which implies higher I in order to maintain (2). Hence, higher I implies lower r. Notice that IS schedule shifts to the right (figure 1) if:
I↑G↑X↑
S↓M↓
e↓ (Exchange rate depreciation will lead to less import and more export)
Figure 1 Shift of the IS schedule
Notice that if I↑G↑X↑ then injection increases. Therefore, keeping r fixed, Y needs to increase in order to satisfy equation (2).
If exchange rate depreciates then export will increase and Y↑ is required for equation (2) to hold.
2 The LM curve
The LM curve looks like that one in the LM model (see previous chapter). The LM schedule shows the different combinations of Y and r for which the money market is in equilibrium (money demand = money supply). From the IS-LM we know that money demand depends positively on the level of income and negatively on interest rate. The LM curve is upward sloping because higher income requires higher transaction balance (higher money demand). To keep the equality in the money market then higher interest rate is required (to offset higher income). As in the IS-LM case an increase in money supply will shift the LM to the right.
2 The BP curve
Notice that if the domestic currency depreciates 1 then imports decrease, hence, CA increases and the only way to ensure BP equilibrium is to increase Y.
Figure 2: BP Curve and Shift of the BP curve
The point of intersection of the three curves (IS, LM and BP) is the point of equilibrium (figure 3)
Figure 3 Equilibrium
1 This occurs if the Marshall-Lerner condition holds. The Marshall-Lerner condition says that a devaluation will improve the CA if the sum of the foreign elasticity of demand for exports and the domestic elasticity of demand for imports is greater than 1.
2 Monetary Policy
Besides the two endogenous variables (Y and r) there is a third element to take into account in our analysis: the exchange rate regime (floating and fixed). Floating exchange rate: the nominal exchange rate adjusts in order to keep the zero BP condition Fixed exchange rate: the e is given. Hence the central bank has to conduct official foreign exchange intervention to maintain the exchange rate fixed. There are two types of monetary policies: expansionary monetary policy (Central Bank buys bonds from the public) and contractionary monetary policy (Central Bank sells bonds)
Expansionary monetary policy CB buys bonds. This raises the price of bonds increases as well as the money supply. Hence
r↓⇒I↑⇒Y↑
From the BP point of view an increase in output reduces the CA and more capital outflow (due to lower interest rate) ⇒ BP deficit
Contractionary monetary policy The Central Bank sells bonds. This lowers the price of bonds as well as the money supply.
Hence r↑⇒I↓⇒Y↓
Expansionary monetary policy under fixed exchange rate (see figure 5)
As we have seen under the floating exchange rate, an expansionary monetary policy will increase money supply which implies a shift to the right of the LM as in the previous case.
This will cause the interest rate r to fall ⇒I↑⇒Y↑⇒CA↓ and more capital outflow
due to lower interest rate. This causes the BP to be in deficit. As in the previous case, an increase in imports M means that the domestic consumers are supplying more domestic currencies (remember the demand and supply of the exchange rate lecture 3?) which means that the domestic currency depreciates. However, under fixed exchange rate the CB cannot allow the currency to depreciate. Hence, the CB has to sell foreign currency for domestic currency to appreciate the domestic currency (and counterbalance the depreciation effect) and keep the exchange rate fixed. Notice that the CB buying domestic currency is the equivalent of withdrawing money from the market, hence, applying a contractionary monetary policy (reduce the supply of money!). This means that
the LM shift back at the original point ( LM 1 →LM 0 ).
Figure 5 expansionary monetary policy under fixed exchange rate
2 Fiscal Policy
An expansionary fiscal policy (increase in government’s expenditures) is financed by selling
bonds. This reduces the price of bonds and increases the interest rate. This r↑ is only partially offset by an increase of income (due to more government expenditures).
What about BP? The answer is that we cannot provide any precise estimation and outcome about the BP.
We are going to consider expansionary fiscal policy under floating and fixed exchange rate in the presence of perfect capital mobility as in Melvin (2004). In this case the BP schedule will be horizontal and completely flat.
Expansionary fiscal policy under floating exchange rate (figure 6)
Lecture Notes 4 - Monetary and Fiscal Policy in a Closed and Open Economy Luca Andriani
Module: Macroeconomics for Business (MOMN033H5)
University: Birkbeck, University of London
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