UK Recessionary Economy: The impact of increased money supply and government expenditure, analyzed under IS-LM-BP framework and Phillips Curve MONEY & BANKING
Abstract The purpose of this paper is to evaluate the effect of an expansionary monetary and fiscal policy. Specifically, the UK economy was used as an example, given a recessionary stage of the business cycle, flexible exchange rate system and high level of international capital mobility. The impact of the increased money supply and increased government spending was studied through the prism of IS-LM-BP framework, or generally known as the Mundell- Fleming model, and through the Phillips curve. The analysis was conducted both in the short and long run. The final conclusion made by the end of the paper is that in the short run under both models the monetary policy can take the UK economy out of the slump in the recovery phase of the business cycle. In the long run, according to the Phillips curve both policies have showed as ineffective. 1
Table of Contents 1. Introduction... 3 2. Literature Review... 4 2. 1. Brief Overlook of UK Economy Conditions... 4 2.2. IS-LM Model... 5 2.3. Mundell-Fleming Model... 7 3. Analysis and Policy Implications... 8 3.1. Expansionary Monetary policy... 8 3.2. Expansionary Fiscal Policy... 9 3.3. Phillips Curve: Analysis of Expansionary Monetary and Fiscal Policy... 10 3.3.1. Phillips Curve: Expansionary Monetary Policy... 12 3.3.2. Phillips Curve: Expansionary Fiscal Policy... 13 4. Conclusion... 15 5. References... 16 2
1. Introduction One of the most significant discussion topic that has prevailed years ago and it is still a vibrant topic in the international financial world is the choice of the most adequate and lucrative economic policy. The reason behind it is because of its key role in the economic stability and growth of each country. One of the most crucial goals of every government worldwide is price stability, high employment, economic growth, stability in the financial market, stability in the interest rate and exchange rate. A lot of models have been developed in order to assess the relation and dependence between these macroeconomic variables (Plasmans, 2001). The models used in this paper are the basic IS-LM model, the Mundell-Fleming model and the Phillips curve. The UK small open economy is used as a case study, given a recessionary stage in the business cycle, high level of international capital mobility and flexible exchange rate system. 3
2. Literature Review 2. 1. Brief Overlook of UK Economy Conditions Nelson (2009) argues that comprehending UK macroeconomic behaviour and the reasons behind it is a global issue. Moreover, he states UK economy exemplify an eminent laboratory for testing macroeconomic hypothesis. According to Wheeler (1995) UK economy is often regarded as a small, open economy used for econometric and macroeconomic behaviour testing purposes. The analysis in this paper is conducted within a two-country context, the UK economy and the rest of the world (Benigno and De Paoli, 2010). The analysis conducted in this paper is based on pre-set economic conditions, including recessionary economy, high rate of inflation and unemployment both in the short and long run, high degree of international capital mobility and flexible exchange rate system. Since the analysis is performed in recessionary economy, it is all logical to assume that output growth has contracted sharply. For instance, during the global financial crisis the GDP growth rate in England was 0.2% in 2008:3Q, and from then on negative until 2009:4Q (Woo and Zhang, 2011). The substantial increase in international capital mobility in the new global economy is considered as well in the analysis, and as Hsing (2008) highlights, the driving force behind it is the amalgamation of financial markets worldwide. As Hein and Truger (2009) point out, UK has Anglo-Saxon liberal capitalism and it is a member of the European Union (p.54). After its short membership period in the European Monetary System, UK renounce from the euro area in 1992 and went back to its pound sterling. The Bank of England is the regulatory and supervising body regarding inflation targeting in UK, since its independence and responsibility for monetary policy was established in 1979 (Osborn and Sensier, 2009). The Bank of England, will find this challenging, 4
trying to stimulate growth in one hand and keep inflation at low and stable level (Lipinska et al, 2011). 2.2. IS-LM Model Hicks in 1937 build the ISLM model based on the fundamental argument in Keynes General Theory (Bordo and Schwartz, 2004). The model focuses on the goods market and money market simultaneously, by showing them on a single diagrammatical schedule. It basically ascertains aggregate output (Y) and interest rate (i) using the IS and LM curves (Ritter et al, 2004). The fundamental assumption the model relies on, is wage rigidity and fixed price level in a closed economy, implying it cannot be applied for inflation analysis, since the real interest rate is the same as the nominal one (Romer, 2000). The goods and service market is depicted through the IS curve, which shows the relationship between investment (I) and savings (S). Given that investment and interest rate have inverse relationship whilst savings has positive relationship with aggregate output, Y and i have a negative correlation. Thus, if the interest rates are low, the investments are high due to their inverse relation, the output must be high to trigger the required savings in order to match the demand for investment, so the goods market to be in equilibrium. The contrary scenario holds in case of high interest rates. Thus, IS is a downward slopping curve, as shown is Figure 1, which connects all the equilibriums at which the quantity of goods supplied is equivalent to the quantity of goods demanded. It shows all the combinations of r and Y when the goods market is in equilibrium (Bordo and Schwartz, 2004). The money market is depicted by the LM curve, which represents the equilibrium between the quantity of money demanded, or liquidity demand (L) and money supply (M). The demand for money is influenced by both income (transactional demand) and interest rate (speculative demand). Speculative demand considers only two types of financial assets, money and 5
bonds, where only bonds are interest bearing assets. Transactional demand has a positive relation with income, while speculative demand has a negative relationship with i. Thus, if interest rates are falling the demand for money will increase, since people will be willing to hold money over bonds, to dodge capital losses. Therefore, money demand has negative relationship with i and positive with Y. The supply for money is assumed to be fixed in the short run, since it is basically determined by the central bank. Accordingly, the LM curve is upward slopping, as shown in Figure 1, depicting all the combinations of Y and i that clear the financial market (Romer, 2000). Figure 1: Equilibrium in ISLM Model The point of intersection (E) between the two curves is the equilibrium, where aggregate output matches aggregate demand (IS) and money demand matches money supply (LM). Only at E, both goods and money market are in simultaneous equilibrium. The market forces always tend to move the economy towards E (Ritter et al, 2004). 6
2.3. Mundell-Fleming Model Mundell and Fleming extended the initial ISLM model, convenient for analysis of autarky economy, into an IS-LM-BP model intended to analyse a small open economy. The Mundell-Fleming model takes into consideration a third curve, namely the Balance of payments or BP curve. This curve relies on the high degree of international capital mobility assumption, and given a flexible exchange rate system the BP curve is a flat horizontal line in the Y and i space, as it could be seen in Figure 2. The capital mobility assumption in reality allows the actors in the economy to transfer their capital in the country of their choice, which theoretically has the highest yields. On the other hand, the demand and supply forces in the open market will reinforce the existence of a single interest rate (i*) worldwide (Dixon and Gerrard, 2000). Figure 2: Equilibrium in Mundell-Fleming Model 7
3. Analysis and Policy Implications 3.1. Expansionary Monetary policy In order to increase the money supply the Bank of England will apply expansionary monetary policy. There are three available tools that can be used for manipulation purposes of the money supply and the interest rate. Namely, the open market operation affecting the monetary base and reserves, discount lending influencing the monetary base and changes in the reserve requirements which impacts the money multiplier (Mishkin, 2007). The outcome of an expansionary monetary policy by increasing the money supply will shift the LM curve to the right, establishing new equilibrium E ", with a lower interest rate i " and higher output Y ". Since the domestic interest rate will be lower than the foreign one, people will invest more internationally, causing a capital outflow from UK economy. This will result in depreciation of the Pound Sterling, because investors will be interested in the foreign currencies. Ultimately, UK s goods will be cheaper abroad, but foreign goods imported in the UK economy will be more expensive (Plasmans, 2001). Logically, the demand for export (X) of UK goods will increase while the demand for import will decrease (I), all leading to higher net exports (NX). Given that changes in NX is one of the autonomous factors that affects the IS curve, there will be a rightward shift of the IS curve establishing a new equilibrium E %. The ultimate result of an expansionary monetary policy by increase in the money supply will be a higher level of national output Y at the same level of interest rate i (Mishkin, 2010). The balance of payments also will be affected the increased current account. The increased export will affect UK trade balance, resulting in trade surplus. However, analysing the current account balance of UK it could be inferred that generally, it was oscillating around zero and from 1998 onwards it was in constant deficit (Coutts and Rowthorn, 2013). More precisely, UK s 8
deficit current account for 2015:Q2 was 3.6% of GDP (Office for National Statistics, 2015). Figure 3: Expansionary Monetary Policy 3.2. Expansionary Fiscal Policy The other alternative to rescue the UK economy from the recession is to apply expansionary fiscal policy to stimulate the aggregate output s growth. Two tools are available for that purpose, manipulation with the government spending and taxes. The primary effect of increased government expenditure is augmented real GDP figures which will have a multiplicative effect in the economy, stimulating the economic output. Expansionary fiscal policy can occur as a result of decreased tax rates as well, leaving more disposable income for the households and businesses, which in turn leads to an increase in real GDP, thereby increased economic output (Mishkin and Eakins, 2012). The initial outcome of an expansionary fiscal policy will be higher interest rate i " and higher national output Y ", caused by a rightward shift of the IS curve and the creation of new equilibrium E ". Since the interest rates in UK have increased, it is more appealing for investors to invest in UK compared with the rest of the world s economies. Theoretically, capital inflows are expected to 9
occur which will increase the value of the national currency, therefor appreciate the Pound Sterling. However, the increased value of the British Pound relative to other currencies will consecutively lead to a decrease in exports (X) and increase in the quantity of imported goods (I). Foreign goods will become cheaper in UK and UK s goods will become more expensive abroad due to the stronger currency. Thus, net exports (NX) will decrease and since it is an important autonomous factor that impacts the IS curve, there will be a leftward shift of the IS curve (Mishkin, 2010). As it could be seen from Figure 4, there will be no change in the output or interest rate ultimately. Eventually, applying expansionary fiscal policy will not have the wanted effect of rescuing the UK economy from the recession, since the national output will be at the initial level. This policy will only cause appreciation of the national currency (Silber, 1970). Figure 4: Expansionary Fiscal Policy 3.3. Phillips Curve: Analysis of Expansionary Monetary and Fiscal Policy As it has been mentioned above, the IS-LM model assumes fixed price levels and wage rigidity, thus it cannot be used for inflation analysis. The analysis done above are just an abstraction of the reality, because it excludes 10
the possibility of changes in price levels and unemployment as well. In order to analyse the economy as a whole without any abstractions from reality, and the effect of possible monetary or fiscal expansion the Phillips curve is more suitable. Basically, it plots the inflation rate and unemployment rate on a scatter diagram, showing their negative relationship. Phillips considered that there is a trade-off between these two variables. A lower inflation rate goes with a higher unemployment rate, and vice versa; a lower unemployment rate will inevitably bring high inflation. Therefore, the short run Phillips curve is downward slopping, as shown in Figure 5 (Gali, 2000). However, the oil crisis that took place in the 1970s disintegrated the previously seemed stable pattern. The result was a vertically flat Phillips curve in the long run at the natural level of unemployment, demonstrating that changes in inflation rate will not cause changes in the unemployment rate. The analysis in this paper is conducted considering a recessionary economy thus, the unemployment rate is above the natural unemployment rate (Mishkin, 2013). Figure 5: Short and Long Run Phillips Curve 11
3.3.1. Phillips Curve: Expansionary Monetary Policy Considering the expansionary monetary policy by increased money supply, analysed in the Aggregate Supply (AS) and Aggregate Demand (AD) schedule with Phillips curve the following set of events will occur. Initially, the increased money supply will shift the AD curve rightwards, resulting in higher price level and higher output level as well. The changes in the AD-AS model can be replicated from the Phillips curve perspective, and as it could be noted in Figure 6, the outcome will be reduced unemployment and higher inflation rate in the short run (Croushore, 2007). Figure 6: Phillips Curve: Expansionary Monetary Policy in the Short Run On the other hand, the outcome differs in the long run. As mention above, the long run Phillips curve is assumed to be vertical flat line at the natural level of unemployment. Thus, the increased money supply will only increase inflation. As it is depicted in Figure 7, considering the long run Phillips curve, the unemployment will remain at the same level, and the inflation will raise (Croushore, 2007). 12
Figure7: Phillips Curve: Expansionary Monetary Policy in the Long Run 3.3.2. Phillips Curve: Expansionary Fiscal Policy The initial outcome of expansionary fiscal policy is the same as the monetary expansion. AD shifts rightwards, the new equilibrium is at higher inflation and higher output level. The outcomes on the short run Phillips curve are identical as in the monetary expansion, decreased unemployment rate and increased price level. Nevertheless, as explained via the IS-LM-BP model, increased government spending triggers a decline in the level of NX, leading to leftward shift of AD at its initial position. There is a movement along the short run Phillips curve leading to the original inflation and unemployment level. The ultimate result is that in the short run, applying this policy does not impact nor inflation neither unemployment (Ritter et al, 2004). 13
Figure 8: Phillips Curve: Expansionary Fiscal Policy in the Short Run Though, having into consideration the flat vertical nature of the AS and Phillips curve in the long run, the outcomes differ in the long run. The rightwards shift in AD increases the price level, while output remaining unchanged. The Phillips curve will experience higher inflation rate, with the same unemployment rate. As explained before, the NX will impact the long run AD curve and long run Phillips curve by bringing both curves at their initial position. The final outcome is reduced overall price level and unchanged level of unemployment (Mishkin, 2013). Figure 9: Phillips Curve: Expansionary Fiscal Policy in the Long Run 14
4. Conclusion The implications of this study is that the monetary expansion through increased money supply is the alternative that should be chosen, given that the results from both models, Mundell-Fleming and Phillips curve indicated an increased level of economic output. Additionally, the short run Phillips curve depicted a decreased level of unemployment as well. Thus, following the results of both models, in the short run the increased money supply by the Bank of England will offer an escape from the recession and will lead to recovery of the UK economy. In the long run, the Phillips curve shows the inability and ineffectiveness of both monetary and fiscal expansion to increase the national output and take the economy on the right way. The failure of the models used in this paper to give the proper forecast in the long run does not mean they are biased or should not be applied. Simply, as Bordo and Schwartz (2004) point out, there are no longer the common language for debates among monetary theorists, there are classroom devices to guide the society towards deeper and more accurate understanding of the different impacts that diverse policies have (p.235). 15
5. References Benigno, G. and De Paoli, B. (2010) On the International Dimension of Fiscal Policy. Journal of Money, Credit and Banking. 42 (8), 1523-42. Bordo, M. D. and Schwartz, A. J. (2004) IS-LM and Monetarism. History of Political Economy. 36 (4), 217-39. Coutts, K. and Rowthorn, R. (2013) The UK balance of payments: structure and prospects. Oxford Review of Economic Policy. 29 (2), 307-25. Croushore, D. (2007) Money & Banking: A Policy-Oriented Approach. USA. Houghton Mifflin Company. Dixon, H., and Gerrard, B. (2000) Old, new and post Keynesian perspectives on the IS-LM framework: A contrast and evaluation. In Young et al. (eds) IS-LM and modern macroeconomics. New York, Springer Science and Business Media. p.7-28. Hein, E. and Truger, A. (2009) The Crisis: How to Fight (or Not to Fight) a Slowdown. Challenge. 52 (3), 52-75. Hsing, H. M. (2008) International Capital Mobility in the Short Run and the Long Run: A Daily Data Study for Japan, Singapore and Taiwan. Asian Economic Journal. 22 (1), 67-82. Lipinska, Anna et al. (2011) International Spillover Effects and Monetary Policy Activism. Journal of Money, Credit and Banking. 43 (8), 1735-48. Mishkin, F. S. (2013) The Economics of Money, Banking and Financial Markets. 10 th edition. UK. Pearson Education. Mishkin, F. S. and Eakins, S. G. (2012) Financial Markets and Institutions. 7 th edition. England. Pearson Education Limited. Mishkin, F. S. (2010) The Economics of Money, Banking and Financial Markets. 9 th edition. USA. Pearson Education. 16
Mishkin, F. S. (2007) The Economics of Money, Banking and Financial Markets. 9 th edition. USA. Pearson Education. Nelson, E. (2009) An overhaul of doctrine: The underpinning of UK inflation targeting. The Economic Journal. 119 (6), F333-F368. Office for National Statistics (2015) Balance of Payments, Quarter 2 (April to June) 2015. Statistical Bulletin. 1-44. Osborn, D. R. and Sensier, M. (2009) UK Inflation: Persistence, Seasonality and Monetary Policy. Scottish Journal of Political Economy. 56 (1), 24-44. Plasmans, J. (2001) The effects of Fiscal and Monetary Policy in and Open Economy: A Case of EU, the USA and Japan. Journal of Applied Economics. 16 (4), 50-68. Ritter, Lawrence S. et al. (2004) Principles of Money, Banking and Financial Markets. 11 th edition. USA. Pearson Education. Romer, D. (2000) Keynesian Macroeconomics without the LM curve. Journal of Economic Perspectives. 14 (2), 149-69. Silber, W. L. (1970) Fiscal Policy in IS-LM Analysis: A Correction. Journal of Money, Credit and Banking. 2 (4), 461-72. Wheeler, M. (1995) Money, income, and exchange rate regimes: Evidence from the U.K. Atlantic Economic Journal. 23 (2), 85-96. Woo, W. T. and Zhang, W. (2011) Combating the Global Financial Crisis with Aggressive Expansionary Monetary Policy: Same Medicine, Different Outcomes in China, the UK and USA. The World Economy. 34 (5), 667-86. 17