the links between fiscal and monetary policy

breakout presenta-on:

The Links between Fiscal and Monetary Policy

Dirk Ehnts Berlin School of Economics and Law

IS/LM: a false dichotomy?

LM curve

IS curve

A

interest ra

te

income


LM curve

IS curve

A

Moving the IS curve inde-‐pendently of the LM curve = fiscal policy

B

interest ra

te

income


LM curve

IS curve

A

C

Moving the IS curve inde-‐pendently of the LM curve = fiscal policy Moving the LM curve inde-‐pendently of the IS curve = monetary policy

B

interest ra

te

income


LM curve

IS curve

A

D

fiscal policy

plus

monetary policy

equals

policy mix

B

C

interest ra

te

income

IS/LM: a false dichotomy.

„We now know that it is not enough to think of the rate of interest as the single link between the financial and industrial sectors of the economy; for that really implies that a borrower can borrow as much as he likes at the rate of interest charged, no aQen-on being paid to the security offered. As soon as one aQends to ques-ons of security, and to the financial intermedi-‐a-on that arises out of them, it becomes apparent that the dichotomy between the two curves of the IS-‐LM diagram must not be pressed too hard.“

John Hicks (1980)

IS/LM 2.0: the Hicksian cure

LM curve

IS curve

A

D

Expansionary fiscal policy expands the range of collateral in the private sector through issuance of addi-onal government bonds which allows it to borrow more from banks.

B

C

interest ra

te

income

IS/LM v. 2.014/€

LM curve

IS curve

interest ra

te

income

Lending to households falls ...

... and lending to NFCs falls as well ...

... while sovereign debt has increased!

hQp://sdw.ecb.europa.eu/quickview.do?SERIES_KEY=121.GST.A.I7.N.B0X13.MAL.B1300.SA.G

Euro area government debt to GDP Euro area 18 (fixed composi-on) -‐ Maastricht assets/liabili-es -‐ General government (ESA95)-‐NCBs -‐ All sectors without general government (consolida-on) (ESA95) -‐ NCBs -‐ Financial stocks at nominal value -‐ Percentage points, series(t)/GDP(t) -‐ Neither seasonally nor working day adjusted

Dichotomy of monetary and fiscal policy

Summary: IS/LM model: complete dichotomy IS/LM model 2.0: posi1ve correla1on IS/LM model v2.014/€: no posi1ve correla1on à What are the links then between monetary and fiscal policy?


What the evidence tells us about the eurozone: -‐  weak loan demand -‐  weak economic growth -‐  (too) low infla-on rate -‐  rising sovereign debt

Bank

Loans to entrepreneurs 100

deposits 100

Entrepreneurs

Loans from bank 100

deposits 100

Consumers

Based loosely on Wicksell (1898), Geldzins und Güterpreise, page 170 ff.

Step 1: Entrepreneurs demand loans from banks given the interest rate. Banks create deposits which are used as money. Creation of I.O.U.s Creation of I.O.U.s

Bank


deposits 100

Entrepreneurs

Loans from bank 100

deposits 100

Consumers

Step 1: Entrepreneurs demand loans from banks given the interest rate. Banks create deposits which are used as money. Step 2: Entrepreneurs pay households to buy their labour and produce.

[production] 100


exchange money vs labor

Bank


deposits 100

Entrepreneurs

Loans from bank 100

deposits 100

Consumers

Step 1: Entrepreneurs demand loans from banks given the interest rate. Banks create deposits which are used as money. Step 2: Entrepreneurs pay households to buy their labour and produce. Step 3: Households buy goods.

[production] 100


exchange money vs goods

Bank


deposits 100

Entrepreneurs

[production] 100

Consumers

Step 1: Entrepreneurs demand loans from banks given the interest rate. Banks create deposits which are used as money. Step 2: Entrepreneurs pay households to buy their labour and produce. Step 3: Households buy goods. Step 4: Entrepreneurs repay bank loans.

deposits 100 Loans from bank 100

Destruction of I.O.U.s

Destruction of I.O.U.s


The ying of aggregate demand...

"If income is to grow, financial markets must generate an aggregate demand that, aside from brief intervals, is ever rising. (..) For real aggregate demand to be increasing, it is necessary that current spending plans be greater than current received income and that some market technique exist by which aggregate spending in excess of aggregate an-cipated income can be financed.“

Minsky (1982)

„The saving of any sector is, by defini-on, the excess of its cur-‐ rent receipts over its current expenditures. But an excess of current receipts over current expenditures (flows) must necessarily imply either a buildup of (stocks of) total assets or a reduc-on of liabili-es (or some combina-on of the two) equal in amount to the excess of current receipts over current expenditures. Thus the saving of any sector must be equal to the change in its total assets minus the change in its liabili-es, which in turn equals the change in its net worth.“

RiQer (1963)

... and the yang of aggregate demand

The sectoral balances approach

•  Some sectors spend more than they receive, whereas other sectors receive more than they spend. While the formers sectors are dissaving, the laQer sectors are saving.

It might make sense to focus on three sectors and their balance of payments iden-ty: ( Sp – I ) + ( T – G ) = ( EX – IM )


( Sp – I ) + ( T – G ) = ( EX – IM ) An increase in aggregate demand can come from more private debt, more public debt or more exports (debt of the ROTW). Y = C + I + G + (EX – IM)


( Sp – I ) + ( T – G ) = ( EX – IM ) An increase in aggregate demand can come from more private debt, more public debt or more exports (debt of the ROTW).* Y = C + I + G + (EX – IM) * Less imports is also possible, but clearly defla1onary as they equal less exports elsewhere, which shi<s the problem from one to the other.


LM curve

IS curve

A

interest ra

te

income

new IS curve

Moving the IS curve = fiscal policy = increase in government debt


LM curve

IS curve

A

interest ra

te

income new LM curve

Moving the LM curve = monetary policy = increase in private sector debt


The elephant in the room:

Why is loan demand so weak?

(Hint: aggregate demand shortall)

„The saving of any sector is, by defini-on, the excess of its cur-‐ rent receipts over its current expenditures. But an excess of current receipts over current expenditures (flows) must necessarily imply either a buildup of (stocks of) total assets or a reduc-on of liabili-es (or some combina-on of the two) equal in amount to the excess of current receipts over current expenditures. Thus the saving of any sector must be equal to the change in its total assets minus the change in its liabili-es, which in turn equals the change in its net worth.“

RiQer (1963)

... and the yang of aggregate demand


A shortall in aggregate demand is caused by a combina-on of these factors: 1)  some sectors have piled up savings and other sectors have

been driven into debt but have now stopped to spend (àmacroeconomic imbalances)

2)  inside some sector some have piled up savings and others have been driven into debt but have now stopped to spend (àinequality)

Central bankers on inequality (1) Mersch/ECB (2014): „S1ll, a central bank with a clear mandate to safeguard price stability needs to act forcefully when push comes to shove. These distribu1onal side-‐effects the need to be tolerated. They are one more reason to recognise that the non-‐standard measures we have introduced have to be temporary.“

Inequality and Economic Policy

hQp://www.ecb.europa.eu/press/key/date/2014/html/sp141017_1.en.html

Central bankers on inequality (1) •  To maintain price stability is the primary objec1ve of the

Eurosystem and of the single monetary policy for which it is responsible. This is laid down in the Treaty on the Func1oning of the European Union, Ar1cle 127 (1).

•  "Without prejudice to the objec1ve of price stability", the Eurosystem shall also "support the general economic policies in the Union with a view to contribu1ng to the achievement of the objec1ves of the Union". These include inter alia "full employment" and "balanced economic growth".

hQps://www.ecb.europa.eu/mopo/intro/objec-ve/html/index.en.html


Central bankers on inequality (2) Yellen/Fed (2014): „The extent of and con1nuing increase in inequality in the United States greatly concern me. The past several decades have seen the most sustained rise in inequality since the 19th century a<er more than 40 years of narrowing inequality following the Great Depression. [...] It is no secret that the past few decades of widening inequality can be summed up as significant income and wealth gains for those at the very top and stagnant living standards for the majority. I think it is appropriate to ask whether this trend is compa1ble with values rooted in our na1on‘s history, among them the high value Americans have tradi1onally placed on equality of opportunity.“


hQp://www.federalreserve.gov/newsevents/speech/yellen20141017a.htm

Correla-on is not causa-on, but as stressed by Hicks, loan demand is backed up by collateral, and given rising prices of financial assets there is a danger that monetary policy might cause shius in the income distribu-on. How would fiscal policy lead to an increase in the amount of deposits?


bank private sector

bonds reserves central bank treasury

reserves bonds

Government exchanges bonds for reserves at central bank ...


reserves deposits deposits net worth

... and pays private sector through bank transfer ...


bank private sector

central bank treasury bonds reserves reserves bonds

widgets

widgets

... with banks preferring to hold interest-‐bearing bonds and the private sector ready to spend the addi-onal deposits created.


bank private sector

central bank treasury bonds reserves widgets bonds

reserves deposits deposits net worth widgets bonds

Alterna-ve: tax cuts leave more deposits with private sector


bank private sector

central bank treasury bonds

deposits deposits taxes bonds

net worth taxes

net worth

Conclusion: •  Euro zone has an aggregate demand problem, so ... •  more exis-ng deposits need to be spend (not QE) or ... •  addi-onal deposits need to be created (fiscal vs monetary

policy) ... •  which would lead to a welcome rise in infla-on via labour

market pressures (and less inequality as a side result) and ... •  more aggregate demand would make monetary policy whole

again (and allow interest rates to rise) ... •  ... if the monetary union can be completed.

Government as the deposit creator of last resort (DCoLR)

•  Scope for coopera-on (policy mix)


the links between fiscal and monetary policy

Economy & Finance

lm curve inde

rate income islm

monetary policy b

dichotomy of monetary

hicksian cure lm curve

scal policy b

d scal policy

rate income lending