Introduction to Economics. MACROECONOMICS Chapter 4 Stabilization Policy

Transcription

1 Introduction to Economics MACROECONOMICS Chapter 4 Stabilization Policy

2 contents Stabilization Policy Fiscal Policy Monetary Policy Monetary Policy Tools of Central Banks Fiscal Policy or Monetary Policy? Is Fine Tuning Desirable?

3 4.1 Stabilization Policy Stabilization Policy instability of the economy - the causes of instability of the economy can be found mostly on demand side too little aggregate demand recession and unemployment too much aggregate demand inflation - stabilization policies basically try to manage the level of aggregate demand although the root of the problem lies in supply side, managing aggregate supply which is determined by the availability of resources or productivity by short-term measures is extremely difficult

4 4.1 Stabilization Policy government tries to stabilize the economy by maintaining aggregate demand at an appropriate level such government intervention is carried out by fiscal policy or monetary policy fiscal policy - government tries to adjust aggregate demand using fiscal means such as government expenditure or tax revenues monetary policy - government tries to adjust aggregate demand by changing money supply or interest rate

5 4.2 Fiscal Policy fiscal policy - policies which try to affect aggregate demand by changing government expenditure or tax revenues - there are three types of fiscal policies to boost aggregate demand (1) increasing government expenditure (2) tax cut (3) simultaneous increase in tax revenue and government expenditure the choice of the type of fiscal policy depends on the preference about the size of government

6 4.2 Fiscal Policy Effects of an Increase in Government Expenditure - an increase in government expenditure an increase in aggregate demand an increase in (equilibrium) national income - aggregate demand curve shifts from AD 0 to AD 1 as a result of an increase in government expenditure national income increases from Y 0 to Y 1 and price level rises from P 0 to P 1 - note that an increase in government expenditure results in an increase in national income through an increase in aggregate demand - but this is not the end of the story since we have to consider the effect of a change in interest rate on investment

7 4.2 Fiscal Policy Impact of Fiscal Policy on National Income

8 4.2 Fiscal Policy Multiplier Effect in general, an increase in government expenditure by G results in an increase in national income by a greater amount multiplier effect because the effect of a fiscal policy does not stop at a direct increase in national income due to an increase in government expenditure such an increase in national income gives rise to an increase in consumption, and this would result in an additional increase in national income chain effect : an increase in national income an increase in consumption an additional increase in national income an additional increase in consumption

9 4.2 Fiscal Policy Crowding-out Effect we have seen that as a result of an increase in government expenditure, national income increases to Y 1 but we have to consider that a change in interest rate will occur and this will lead to a change in investment interest rate is determined by the interaction of supply and demand for money an increase in national income combined with a rise in price level (to P 1 ) an increase in the demand for money a rise in interest rate a fall in the level of investment this is called crowding-out effect

10 4.2 Fiscal Policy Crowding-out Effect - a fall in the level of investment offsets the expansionary effects of the increase in government expenditure - government expenditure in effect crowds out investment of the private sector - in the figure we saw before, aggregate demand curve shifts rightward to AD 1 at first, but the crowding-out effect makes it shift leftward to AD 2 - this change makes (equilibrium) national income decrease from Y 1 to Y 2 - in spite of crowding-out effect, an increase in government expenditure results in an increase in national income in most cases

11 4.3 Monetary Policy monetary policy tries to affect the level of investment by adjusting money supply or interest rate the fact that money supply curve is drawn as a vertical line reflects the assumption that the central bank can adjust the supply of money at will if money supply is increased, money supply curve will shift rightward from MS 0 to MS 1, and as a result interest rate falls form r 0 to r 1

12 4.3 Monetary Policy Money Market and Interest Rate an increase in money supply makes money supply curve shift to the right and interest rate falls as a result interest rate (r) stock of money (M)

13 4.3 Monetary Policy What Is the Stock of Money? the stock of money refers to the amount of money circulated in the economy money reminds us coins and currencies, but demand deposits can also be called money because it plays the exactly same roles as cash in our pockets even savings deposits can be withdrawn as cash if we pay some minor cost therefore various kinds of deposits and financial assets are considered money when we measure the stock of money depending on which deposits and financial assets are included, we can get various kinds of measures of money such as M1, M2, Lf

14 4.3 Monetary Policy Transmission Mechanism of Monetary Policy a fall in interest rate an increase in investment an increase in aggregate demand a rightward shift of aggregate demand curve aggregate demand curve moves from AD 0 to AD 1, and national income increases from Y 0 to Y 1 as a result (prices level also rises from P 0 to P 1 ) this process is called the transmission mechanism of monetary policy

15 4.3 Monetary Policy Effects of Monetary Policy

16 4.3 Monetary Policy Transmission Mechanism of Monetary Policy an increase in money supply a fall in interest rate an increase in investment (multiplier effect) an increase in aggregate demand an increase in national income <first step> <second step> <third step> a decrease in money supply an rise in interest rate a decrease in investment (multiplier effect) a decrease in aggregate demand a decrease in national income

17 4.3 Monetary Policy Effectiveness of Monetary Policy for monetary policy to be effective in boosting the economy, the following conditions should be met (1) interest rate should respond sensitively to changes in money supply (if a liquidity trap exists, monetary policy becomes ineffective) (2) investment expenditure should respond sensitively to changes in interest rate - Keynes argued that, in the presence of severe depression, the economy tended to fall into a liquidity trap - and he also argued that investments were determined by animal spirit of businessmen - in conclusion, fiscal policy is more effective than monetary policy

18 4.4 Monetary Policy Tools of Central Banks central banks employ various measures to manage the level of money supply (1) discount rate policy discount rate refers to the interest rate applied to central banks loans to commercial banks by lowering or raising the discount rate, central banks can adjust money supply discount rate lowered commercial banks can get more loans and use them for lending to firms money supply increases the central bank prints more money

19 4.4 Monetary Policy Tools of Central Banks (2) reserve requirement ratio policy - reserve requirement refers to the obligatory holding of reserves in preparation for withdrawals of deposits - the ratio of reserve requirement is usually determined by law - reserve requirement ratio raised commercial banks feel the necessity to reduce lending deposits reduced money supply reduced - recently reserve requirement ratio policy is not used that much

20 4.4 Monetary Policy Tools of Central Banks (3) open market operation - open market operation refers to central banks buying and selling of bonds in the open market to control money supply - most frequently used measure of controlling money supply in many countries - central bank buys bonds in the open market money supply increases - in general, there is an inverse relationship between the price of bond and interest rate - central bank buys bonds in the open market a rise in the prices of bonds a fall in interest rate

21 (4) direct control 4.4 Monetary Policy Tools of Central Banks - central banks can exert direct influences on commercial banks to maintain money supply at a desirable level ex) a loan ceiling for each bank, temporary restraint of new loans - in Korea, direct controls were frequently used up until 1997

22 4.5 Fiscal Policy or Monetary Policy? Different views about the transmission mechanism of monetary policy Keynesian view transmission mechanism of monetary policy too long and uncertain - ineffectiveness of monetary policy due to the existence of a liquidity trap - investments determined by animal spirit of businessmen effects of fiscal policy more direct and certain - an increase in government expenditure directly leads to an increase in aggregate demand

23 4.5 Fiscal Policy or Monetary Policy? Rebuttal of Monetarists arguments of monetarists Chicago school economists in the 1960s and 70s are called monetarists M. Friedman monetarists do not believe in the concept of the transmission mechanism of monetary policy since money is used as a medium of exchange, a change in money supply directly affects the state of national economy independently of interest rate but the effectiveness of fiscal policy doubtful because of crowding-out effect besides, a decrease in investment due to fiscal expansion is detrimental to economic growth

24 4.5 Fiscal Policy or Monetary Policy? Different Views about Policy Lags policy lag policy lag refers to the span of time between the inception of a certain policy and materialization of its effects - the existence of policy lags is a serious impediment to the effectiveness of stabilization policies - fiscal policy it takes much time to prepare a policy and put it into effect, but it can boost aggregate demand in a short period of time - monetary policy central banks can start a certain monetary policy in a short period of time, but it takes much time for its effects to materialize

25 4.6 Is Fine Tuning Desirable? aggregates demand management policy - Keynesian economists argue that we can lead the national economy in the direction we want by appropriate combinations of fiscal and monetary policies - that is, they believe that the national economy can be stabilized by the appropriate management of aggregate demand

26 4.6 Is Fine Tuning Desirable? fine-tuning - efforts to lead the national economy in the direction we want by adjusting the direction and degree of fiscal and monetary policies - problem of trade-off between inflation and unemployment

27 4.6 Is Fine Tuning Desirable? Phillips Curve and Fine Tuning Philips curve Phillips curve shows the relationship between unemployment rate and inflation rate it has a negative slope which means that there is a negative correlation between the two high unemployment rate inflation rate tends to be low low unemployment rate inflation rate tends to be high Keynesian economists in early periods believed that we can figure out the relationship between unemployment rate and inflation rate from the Phillips curve and utilize this knowledge in preparing stabilization policies

28 4.6 Is Fine Tuning Desirable? Phillips Curve of the U.S. Economy (1960~1969)

29 4.6 Is Fine Tuning Desirable? Controversy over Fine Tuning Monetarists arguments monetarists are doubtful about the feasibility of fine tuning they point out that government intervention could make the situation worse - they believe that stabilization policy will be helpless in reducing unemployment

30 4.6 Is Fine Tuning Desirable? Controversy over Fine Tuning classification of stabilization policy (1) active policy vs. passive policy (2) discretionary policy vs. rule rule based policy sets up certain rules of responding to changes in economic conditions beforehand and stick to these rules as economic conditions change a good example of a rule based policy is a k% rule the type of stabilization policy that Keynesian economists prefer is active and discretionary while that monetarists prefer is passive and rule based

31 4.6 Is Fine Tuning Desirable? Rational Expectations Hypothesis Chicago school in the 1970s raised the flag of rational expectations hypothesis - R. Lucas - rational expectation refers to the method of forecasting future events by making the best use of dada currently available rational expectations school argue that stabilization policy cannot have any impact on unemployment proposition of policy ineffectiveness

32 4.6 Is Fine Tuning Desirable? Proposition of Policy Ineffectiveness suppose the central bank increases money supply to boost the economy - if all people forecast future event by way of rational expectation, they will predict that prices will rise as a result of the increase in money supply - they will demand wage raises to offset expected inflation real wages remain unchanged firms maintain the current level of employment no change in unemployment rational expectations school are extremely antagonistic to stabilization policy

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