ubea 1013: economics 1 chapter 11: fiscal & monetary policy 11.1 the multiplier effect 11.2 the...

1

UBEA 1013: ECONOMICS

CHAPTER 11: CHAPTER 11: FISCAL & MONETARY POLICYFISCAL & MONETARY POLICY

11.1 The Multiplier Effect11.1 The Multiplier Effect

11.2 11.2 The Fiscal Policy The Fiscal Policy

11.3 11.3 The Monetary Policy The Monetary Policy

11.4 11.4 Fiscal versus Monetary Fiscal versus Monetary

11.5 Crowding-out Effect 11.5 Crowding-out Effect

2


11.1 The Multiplier Effect11.1 The Multiplier Effect

Multiplier is the ratio of the change in the equilibrium level of output to a change in some autonomous variable.

An autonomous variable is a variable that is assumed not to depend on the state of the economy that is, it does not change when the economy changes.

Autonomous variable (I, G, T)

Effect to Aggregate

Expenditure / Output / Income

Multiplier

(direct or indirect impact)

3


Y = C + I + GY = (a + bY) + I + GY (1 – b) = a + I + GY = (a + I + G) [1/(1 – b)] ………… Equation 11.1

Since, b = MPCY = (a + I + G) [1/(1 – MPC)] orY = (a + I + G) [1/MPS]

Multiplier:Multiplier:

Planned Investment: Planned Investment: [1/(1 – MPC)] or [1/MPS] Government Spending: Government Spending: [1/(1 – MPC)] or [1/MPS]Autonomous Consumption: Autonomous Consumption: [1/(1 – MPC)] or [1/MPS]

Tax multiplier???Tax multiplier???

4


Y = C + I + GY = [a + b(Y-T)] + I + GY = [a + bY – bT] + I + GY (1 – b) = a – bT + I + GY = (a – bT + I + G) [1/(1 – b)] ………… Equation 11.2

Since, b = MPCY = (a – bT + I + G) [1/(1 – MPC)] orY = (a – bT + I + G) [1/MPS]

Multiplier:Multiplier:

Tax multiplier = – b / (1 – b)Tax multiplier = – b / (1 – b) = – MPC / (1 – MPC)= – MPC / (1 – MPC) oror

= – MPC / MPS = – MPC / MPS

5


11.2 The Fiscal Policy11.2 The Fiscal PolicyKeynesian school of thought.

Fiscal tools: Spending & taxes (Government budget)

Two categories of fiscal policy:

i. Expansionary fiscal policy: Increase G and/or cut down TTo stimulate economyCould cause inflationMay lead to budget deficit (need debt to finance the deficit – burden the next generation)

6


Two categories of fiscal policy:

ii. Contractionary fiscal policy: Decrease G and/or increase down TTo slow down economy or reduce demand-

pulled inflationCould cause unemploymentUsually lead to surplus budget

Government spending /

Taxes

Effect to Aggregate

Expenditure / Output / Income

Multiplier

(G: direct /T: indirect impact)

7


Government Spending (G):In an economy with a MPC

of 0.75, a $50 billion increase in government

spending (G) magnifies the aggregate expenditure four

times higher through the multiplier effect. It is

illustrated numerically and graphically as follow:

∆Y = ∆G X [multiplier] = ∆G X [1/(1 – MPC)]

= 50 X [1/(1 – 0.75)] = 50 X [4] ∆Y = $200 billion

8


Taxes (T):In an economy with a MPC of 0.75, a $50 billion of tax cuts magnifies the aggregate expenditure three times

higher through the multiplier effect.

∆Y = ∆T X [multiplier] = ∆T X [MPC/(1 – MPC)] = 50 X [0.75/(1 – 0.75)] = 50 X [3] ∆Y = $150 billion

Compare to government spending effect:Increase $50 billion in G causes increase of $200 billion in Y

9


Balance Budget:Increase in G = Decrease in TDecrease in G = Increase in T

∆ = $50 billion +∆G = – ∆T

∆Y = + G effect –T effect = + $200 billion – $150 billion = + $50 billion (= ∆)

Why????

10


T multiplier + G multiplier

= [– (MPC) / (MPS)] + [1 / (MPS)]= (1 – MPC) / (MPS)= MPS / MPS= 1

If both G & T increase by (∆G = ∆T):∆Y = (∆T)[– (MPC/MPS)] + (∆G)[1/MPS] = (∆G)[– (MPC/MPS)] + (∆G)[1/MPS] = (∆G)[1/MPS][1 – MPC] = (∆G)[1/MPS][MPS]∆Y = ∆G = ∆T

If both G & T increase by $50 billion (∆G = ∆T), MPC = 0.75: ∆Y = (∆T)[– (MPC/MPS)] + (∆G)[1/MPS]∆Y = (50)[– (0.75/0.25)] + (50)[1/0.25] = (50)[– (3)] + (50)[4] = – 150 + 200 = 50∆Y = ∆G = ∆T = $50 billion

11


11.3 The Monetary Policy11.3 The Monetary Policy

Monetarist of thought.

Monetary tools: Money supply (M) & Interest rate (r) (Central Bank)

Two categories of monetary policy:

i. Easy/Expansionary monetary policy: Increase M – interest rate will dropEffect investmentEffect local currency and net export

12


ii. Tight/Contractionary monetary policy: Decrease M – interest rate will riseEffect investmentEffect local currency and net export

The central bank can affect the equilibrium interest rate by changing the supply of money using one of its three monetary tools:

i) Reserve ratioii) Discount rateiii) Open market operation (buy or sell government securities from banks and public)

13


r0

r1

r0

r1

• An increase in the supply of money lowers the rate of interest.

• As investment has a negative relationship with interest rate (refer Chapter 10), lower interest rates, will increase investment (from I0 to I1).

14


C + I1 (r1) + G

C + I0 (r0) + G

Y0 Y1

MS up, Interest rate down,Investment up, AE up (AE curve shift up),Y up.

At the initial equilibrium level of national income, Y0, planned

aggregate expenditures are now more than national output. Firms begin to experience an unexpected reduced in their stocks.

This signals them to increase output, generating higher income.

Higher income results in higher spending (multiplier process).

15


International Sector (Export & Import):

Increase in M Interest rate fall Investor earning lower IR

Seek better investment abroad

Sell local currency Buy foreign currency

Exchange rate fall (depreciate)

Local (foreign) product cheaper (more expensive)

Net export increase

16


Initial at Y0

G increase, Y increase

Y increase,Md increase

Md increase,r increase, Investment fall

Planned AE shift down

Y1 fall back to Y*

Crowding out Effect

End

ubea 1013: economics 1 chapter 11: fiscal & monetary policy 11.1 the multiplier effect 11.2 the...

Documents