The Impact of an Increase In The Money Supply and Government Spending In The UK Economy 1/11/2016
Abstract The international economic medium has evolved in the direction of financial integration. In the consequence, when conducting monetary and fiscal policy, it is essential for policy makers to consider the practical implications of the trade and finance within an international context. The two major theories that dominate macroeconomics are the Keynesian and Monetarist theories. Both theories have fundamentally different views about the equilibrium of the economy in the long-run regarding the fiscal and monetary policy. In this paper, the Mundell-Fleming provides a framework for evaluating the effects and consequences of the choice of economic policy on a small open economy with a high degree of capital mobility under a flexible exchange rate. For a small economy operating under a floating exchange rate, the increase in government spending changes the balance of trade but does not necessary lead to an improvement in the level of output and employment. On the other hand, an increase in money supply under flexible exchange rate system causes an adjustment of price level and therefore alters the level of employment and output if wage rates are rigid. In conclusion, there are situations in which monetary and fiscal policy can be coordinated to achieve a specific economic outcome and other cases in which monetary policy is implemented in order to neutralize or mitigate the effects of the fiscal policy. Keywords: Mundell-Fleming model; UK economy; Monetary policy; Fiscal policy; Philips curve. 1
Table of Contents 1. Introduction... 3 2. The Keynesian-Monetarist controversy... 3 3. International Financial Crisis: Europe 1992 and UK economy... 4 4. The IS-LM model... 6 4.1 The effects of a monetary expansion... 7 4.2 A rise in government spending... 8 5. Mundell Fleming model... 8 5.1 Flexible Exchange Rates, Mobile Capital, Increase in Money Supply... 9 5.2 Flexible Exchange Rates, Mobile Capital, Increase in Government Spending... 11 6. The Short-Run Phillips Curve... 12 7. The Long-Run Phillips Curve... 13 8. Conclusion... 15 Reference:... 16 2
1. Introduction The international economic medium has evolved in the direction of a financial integration. The trend, manifested in increased mobility of capital and freer movement of goods, has been dynamized by the diminishing of exchange and trade controls in Europe. In the consequence, when conducting monetary and fiscal policy, it is essential for policy makers to consider the practical implications of the trade and finance within an international context. The first section of the paper reviews the performance of fixed exchange rates in Europe since 1972 and the recession in the UK economy. Furthermore, the IS-LM-BP framework combined with a Phillips curve has been used in order to analyze the impact on the UK economy of an increase in money supply and government spending. The IS-LM-BP model has been developed into the Mundell Fleming model assuming a small open and recessionary economy that operates under a flexible exchange rate system and with a very high degree of international capital mobility. As a second focus, the inflation and unemployment rate have been investigated both in the short and long run. After analyzing the main economic theories the final section of the paper provides interpretation of the results generated. 2. The Keynesian-Monetarist controversy The two major theories that dominate macroeconomics are the Keynesian and Monetarist theories. Both theories have fundamentally different views about the equilibrium of the economy in the long-run. Monetarists state that changes in the money supply are the only one important source of shifts in the aggregate demand curve (Wood, 2014). Keynesian economics, on the other hand, emphasize that fiscal policy and net export are equally important factors of movements in the aggregate demand. However, monetarists 3
suggest that an increase in government spending will result in an increase in the interest rate and a fall in the private spending (C, I and NX decrease) (Birol and Gencer, 2014). Keynesians argue that only partial crowding out occurs in the short-run and the decrease in private spending does not completely offset the increase in government spending. Keynesians also state that a liquidity trap may occur in a recession due to the increased private savings. This happens when the interest rates are too low or zero and fail to stimulate spending (Birol and Gencer, 2014). Therefore, monetary policy becomes ineffective because an increase in money supply fail to lead to a raise in spending since interest rates cannot decrease any further (Wood, 2014). A liquidity trap occurred in the UK economy when the base interest rates were decreased to 0.5% in 2009 (Bank of England, 2015). Despite the implementation of the monetary policy, the economy remained in recession. In 2010, the quantitative easing resulted only in a weak recovery until the fall in the growth rate of 2011 and 2012 (Sutton, 2013). In the circumstances, Monetarists claim that the increase in government spending moves resources from the private to the public sector without an increase in the economic activity (Wood, 2014). The experience of the Japanese economy in the 1990s is an evidence for the failure of government spending to solve the liquidity trap (Palley, 2013). These differing theories regarding the strengths and weaknesses of the monetary and fiscal policy will provide the basis of this paper. 3. International Financial Crisis: Europe 1992 and UK economy Most European currencies were linked to a currency basket before the establishment of European Monetary System (EMS) and the European Exchange Rate Mechanism (ERM) in 1979 (Geamanu, 2015). During the 1980s, many European countries including the UK were facing economic downturns which were deepened by the tight monetary policy and increased interest rates. Monetary tightening and credit squeeze which includes high domestic 4
interest rates in order to avoid devaluation usually leads to a decline in domestic demand for consumption and investment purposes (Geamanu, 2015). The outcome for the UK was that the demand curve shifted to D3 since the relative expected return of the pound decreased dramatically. Graph 1: Foreign exchange market 1992: British pounds Consequently, many investors started to question the sustainability of the fixed exchange rate regime and there were speculative attacks causing selloff of pounds as a result of the excess supply of pound assets at the E par. As a result, the UK had to leave the ERM, depreciate the pound by 10% against the mark and let its currency float (Sutton, 2013). Therefore, when the market is pursuing currency depreciation defending fixed exchange rate parity can be very costly in terms of output. The UK economy experienced deep recession from 1979 to 1983, when the inflation decreased from 13.4% to 4.6%, while the unemployment increased from 4.7% to 11.1% (Bank of England, 2015). Hassani et al. (2013) stated that the severity of the recession is attributed to adverse external and supply-side shocks. On the other hand, the monetary disinflation was initiated 5
by the Thatcher government which had a credibility problem (Sutton, 2013). If the monetary authority lacks credibility, painless disinflation cannot occur and inflationary expectations will not fall enough to avoid employment and output costs. Many of the economic events in the UK since 1979 can be analyzed in terms of the attempts of the government to exchange unemployment for inflation. This raises the issue for policy-makers whether it is worth exchanging a temporary fall/rise in the rate of unemployment for a permanent rise/fall in the inflation rate (Sutton, 2013). The question will be further discussed in the following sections. 4. The IS-LM model The IS-LM model analyses changes in the income as the price level being fixed and shows why the aggregate demand curve shifts. The equilibrium in the goods market Ys = Yd is determined by the IS (investment and spending) curve for combinations of interest rate and income. The LM (liquidity and money) curve determines the equilibrium in the money market Md = Ms for the same combinations (Findlay, 1999). Graph 2: The IS-LM model 6
The intersection point of the IS and LM curve is the simultaneous equilibrium in the money and goods markets. At this point, a proper stabilization policy has to be implemented if the level of income is bellow full employment (Findlay, 1999). There are two common types of stabilization policy: monetary policy and fiscal policy. Monetary policy is the action of a central bank or other regulatory committee that determines the growth of money supply, which in turn influence interest rates (Gali and Monacelli, 2005). Fiscal policy involves the government spending and adjusting tax rates in order to affect aggregate demand, the distribution of income, and savings and investment in the economy (Gali and Monacelli, 2005). The next section of the paper will examine how the monetary and fiscal expansion policy can be illustrated within the IS-LM model. 4.1 The effects of a monetary expansion The financial markets response to economic changes is quick, while the IS curve responds more slowly. Therefore, an increase in the money supply causes a shift of the LM curve down and to the right. A short-run equilibrium exists at the IS-LM intersection. The increase in the money supply decreases the real interest rates which in turn increase consumption, investment and aggregate output in the short-run. Graph 3: IS-LM model: Monetary expansion 7
4.2 A rise in government spending Expansionary fiscal policy involves tax reduction or government spending to affect the levels of aggregate output. As shown in the graph 4 below, the increased government spending shifts IS curve up and to the right (tax reduction has the same effect on the IS curve). In the circumstances, the output increases from Y1 to Y2 and in contrast to monetary policy, the interest rate rises from i1 to i2. Graph 4: IS-LM model: Increase in government spending The main difference between both policies is that monetary expansionary policy lowers interest rates, whereas fiscal policy increases them. Both of them cause an increase in aggregate output. 5. Mundell Fleming model The aforementioned IS-LM model has been used with all other factors being constant. However, there are forces in the open macroeconomics that interfere with the operation of the IS-Lm model. Cenesiz and Pierdzioch (2009) have stated that an increase in the international capital mobility and the choice of foreign exchange policy highly affect the effectiveness of the economic policies mentioned above. The Mundell-Fleming model also known 8
as the IS-LM-BP model displays the relationship between the economy`s nominal exchange rate, interest rate, and the output in the short-run (Garcia and Gonzalez, 2014). This model also identifies that an economy cannot at the same time maintain an independent monetary policy, capital mobility, a fixed exchange rate, and mobile capital (the impossible trinity) (Aizenman et al., 2013). Below are the equations on which the Mundell Fleming model is based: The IS curve: Y = C + I + G + NX Where Y is GDP, C is consumption, I is investment, G is government spending and is NX net exports. The LM curve: M P = L (i, Y) Where M is money supply, P is average price, L is liquidity, i is the interest rate. The BP (Balance of Payments) Curve: BP = CA + KA Where CA is the current account and KA is the capital account. Table 1. In the circumstances, the next section of the paper will take into consideration the influence of the degree of international capital mobility and the choice of foreign exchange policy on the IS-LM model in an open economy. After developing the model, an important question can be addressed regarding which policy is more effective: fiscal expansionary policy or monetary expansionary policy. 5.1 Flexible Exchange Rates, Mobile Capital, Increase in Money Supply The increase in the Money supply causes a shift of the LM curve down and to the right, and therefore the economy goes from point A to point B. The lower 9
interest rates lead to an increase in money demand and in income level. There is an incipient deficit in the Balance of Payments at point B due to the insufficiency of the level of capital inflows to offset the deficit in the Current Account. The incipient deficit in the BP is associated with the exchange rate being depreciated (there is an excess supply of the currency on the foreign exchange market). As e increases (exchange rate depreciates), Net Exports increase because of the decreased relative price of domestic goods on international markets. There are two effects that occur at the same time because of increased Net Exports (NX): Total Expenditures increase therefore the IS curve shifts to the right from IS0 to IS1 and the Current Account improves, therefore, the BP curve shifts to the right from BP0 to BP1 (these shifts are marked as 2a and 2b, respectively, in the diagram below). In the case of flexible exchange rate and perfect capital mobility, the BP curve does not shift (it is a horizontal line) because capital inflows and outflows are infinite and therefore they exceed the effect that the change in NX has on the CA. At point C is the new equilibrium, where the aggregate output in the economy has increased from Y0 to Y1. It can be concluded that the monetary policy is effective in shifting the level of domestic output under flexible exchange rates with mobile capital. Graph 5: Mundell Fleming model: Increase in Money supply 10
5.2 Flexible Exchange Rates, Mobile Capital, Increase in Government Spending The increase in Government spending is associated with an increase in Total Expenditures. On the graph below it can be noticed that the IS curve moves to the right and the equilibrium moves from point A to point B.There is an incipient surplus in the Balance of Payments at point B because the level of capital inflows is more than enough to offset the deficit in the Current Account. As a consequence, the exchange rate is appreciating (the demand for the currency on forex increases). Since the exchange rate appreciates (e decreases), this leads to fall in Net Exports due to the increased relative price of domestic goods on international markets. Two effects result from the decrease in the NX: The decrease in the Total Expenditures shifts the IS curve to the left from IS1 to IS2 and the CA deteriorates, therefore, the BP curve shifts to the left from BP0 to BP1. The two shifts are marked as 2a and 2b respectively. In the case of flexible exchange rate and perfect capital mobility the BP curve does not shift because capital inflows and outflows are infinite and therefore they exceed the effect that the change in NX has on the CA. At point C is established the new equilibrium, where the aggregate output in the economy has increased from Y0 to Y1. The fiscal policy is more effective in shifting the level of domestic output under flexible exchange rates with mobile capital than with perfect capital mobility. As mentioned above this expansionary fiscal policy increases expenditure and shifts the IS curve to the right. However, the outcome is that the income increases if the central bank holds the interest rate constant. Therefore, the investment, the exchange rate, and NX are not affected because of the constant interest rate. Since the disposable income of households increases, private consumption increases. Higher income leads to higher money demand and, consequently, the central bank must allow the money supply to increase if the interest rates are constant. If money supply or interest rates are constant, income remains fixed and therefore taxes and 11
savings remain unchanged. Consequently, since the goods market is in equilibrium, the change in government spending is equal to the import surplus. On the other hand, under a flexible exchange rate regime, the balance of payments equilibrium implies that capital inflows are equal to the import surplus (the money and goods market are in equilibrium between change in the public debt and capital imports rate, and between budget deficit and the import surplus respectively)( Schmitt-Grohe and Uribe,2002). It can be concluded that the fiscal policy lacks the power of a domestic stabilizer when the money supply is held constant and the exchange rate is flexible. Graph 6: Mundell Fleming model: Increase in Government spending 6. The Short-Run Phillips Curve The Phillips Curve shows the trade-off between the inflation and unemployment rate in an economy (Rusticelli, 2015). Since the 1970s, however, there was little sign of the inverse relationship between them (Galí, 2000). In reference with that, according to Sutton (2013) UK is capable of expanding its economy without experiencing inflation through effective supply-side reforms. The increased labour immigration and improvement in 12
the flexibility in the labour market have mitigated the pressure at times of growth in the labour market. Another significant factor that has played a role in reducing inflationary expectations and impairs the link between future and current inflation is the independence of the Bank of England (Sutton, 2013). Graph 7: Aggregate Supply and Aggregate Demand On the first graph, it can be seen that the AD shifts with no AS shifts. There is a positive relationship between P and Y. On the second graph AS shifts with no AD shifts and there is a negative relationship between P and Y. A leftward shift of the AS curve indicates that the economy experience both an increase in the unemployment rate (decreased output) and inflation. The third graph shows that both AD and AS are shifting and no systematic relationship exists between P and Y. 7. The Long-Run Phillips Curve If the AS curve is vertical in the long-run, so is the Phillips Curve. In the long-run it corresponds to the natural rate of unemployment that is consistent with the concept of a fixed long-run output at potential output. Changes in AD, including an increase in government spending, lead to an increase of prices 13
but do not change employment. The vertical Phillips Curve implies that when the unemployment rate is driven below the natural rate, there is an increase in wages and thus pushing up costs. As a consequence, the level of output falls and pushes the unemployment back to the natural rate (at full employment) (Rusticelli, 2015). Graph 8: The Natural Rate of Unemployment If the AS curve is vertical in the long-run, so is the Phillips Curve. In the long-run it corresponds to the natural rate of unemployment that is consistent with the concept of a fixed long-run output at potential output. Changes in AD, including an increase in government spending lead to an increase of prices but do not change employment. The vertical Phillips Curve implies that when the unemployment rate is driven below the natural rate, there is an increase in wages and thus pushing up costs. As a consequence, the level of output falls and pushes the unemployment back to the natural rate (at full employment) (Rusticelli, 2015). In the case of this paper, if the government uses expansionary monetary or fiscal policy while attempting a fall in the unemployment rate below the natural rate, the resulting rise in aggregate demand will lead to firms increasing their prices faster that workers had anticipated. The higher revenues encourage firms to employ more workers at the current wage rates 14
or even greater. In the short-run the workers are stimulated by the increased ages and are willing to supply more labor (unemployment rate decreases) (Erceg et al., 2000). In the long-run as worker start to anticipate higher rates of price inflation, they supply less labor and demand higher wages to offset the inflation rate (Galí, 2000). Therefore, the real wage is reestablished at its previous level while the unemployment rate is restored to the natural rate. On the other hand, the wage and price inflation remains at the new, higher rates. 8. Conclusion In this paper, the Mundell-Fleming provides a framework for evaluating the effects and consequences of the choice of economic policy on a small open economy with a high degree of capital mobility under a flexible exchange rate. The paper also summarizes the short-run effects of the monetary and fiscal policies on the trade balance, the exchange rate, and income. An important insight of the paper is that under flexible exchange rate the monetary policy is effective in shifting the level of domestic output. It can also be concluded that the increase in government spending is more effective in causing a shift in the level of output with mobile capital rather than with perfect capital mobility. For a small economy operating under a floating exchange rate, the increase in government spending changes the balance of trade but does not necessary lead to an improvement in the level of output and employment. Moreover, when the money supply is held constant and the exchange rate is floating the fiscal policy lack the competence of a domestic stabilizer. On the other hand, an increase in money supply under flexible exchange rate system causes an adjustment of price level and therefore alters the level of employment and output if wage rates are rigid. In conclusion, there are situations in which monetary and fiscal policy can be coordinated to achieve a specific economic outcome and other cases in which monetary policy is implemented in order to neutralize or mitigate the effects of the fiscal policy. 15
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