Description
This is a presentation explaining about Monetary Policy; Expansionary Monetary Policy; The Liquidity Trap; Vertical LM Curve; Fiscal Policy; Crowding Out; Policy Mix
Monetary Policy
The central bank conducts monetary policy through open market operations. ? In an open market operation, the central bank buys bonds in exchange for money, thus increasing the stock of money (expansionary monetary policy). ? Or it sells bonds in exchange for money paid by the purchasers of the bonds, thus reducing the money stock (contractionary monetary policy / tight monetary policy).
?
Expansionary Monetary Policy ? RBI buys bonds ? reduces the quantity of bonds ? increase bond price and lower their yield ? public would not hold wealth in the form of bonds ? public would be ready to hold a larger fraction in the form of money. ? This increases money supply in the economy ? the LM schedule will shift rightward. ? Leading to a lower interest rate ? higher level of investment spending ? higher level of income. ? If money demand is very sensitive to the interest rate, a given change in the money stock can be absorbed in the assets markets with only a small change in the interest rate. The effect of an open market purchase on investment spending would then be small.
Expansionary Monetary Policy
Monetary Policy: The Transmission Mechanism
Change in real money supply ? Portfolio adjustments lead to a change in asset prices and interest rates. ? Spending adjusts to changes in interest rates. ? Output adjusts to the change in aggregate demand.
?
Monetary Policy: Transmission Mechanism
Change in Money Supply
Interest Rates
Asset Prices
Exchange Rates
Consumption Spending
Investment Spending
GDP
Prices
The Liquidity Trap and Banks’ Reluctance to Lend ? The liquidity trap is a situation when interest rate does not fall further. In which case, public is prepared to hold whatever amount of money is supplied. ? In that case, monetary policy carried out through open market operations has no effect on either the interest rate or the level of income. ? In the liquidity trap, monetary policy is powerless to affect the interest rate: the case of Japan in late 1990s and in the early years of the 21st century. ? If banks are reluctant to increase their lending even at a lower interest also investment would not increase: the case of USA in 1991 and India facing now.
The Classical Case: Vertical LM Curve
The classical case implies that nominal GDP (P*Y), depends only on the quantity of money. ? It shows that LM curve will be vertical. ? A given change in the quantity of money has a maximal effect on the level of income. ? This, when the LM curve is vertical, monetary policy has a maximal effect on the level of income, and fiscal policy has no effect on income.
?
Fiscal Policy
Expansionary: ? government spending ? AD ? output / income. ? But money market is no longer in equilibrium. Income has increased, and therefore the quantity of money demanded is higher. ? Higher money demand ? ? interest rate ? firms’ planned investment spending ? ? AD ? ? Finally, taking into account the expansionary effect of higher government spending and the dampening effects of the higher interest rate on private spending, both interest rate and output increase.
?
Increase in Government Spending
Crowding Out
? ?
? ?
?
In diagram, increased government spending raises both income and the interest rate. adjustment of interest rates and their impact on AD dampen the expansionary effect of increased government spending. increased government spending crowds out investment spending. Crowding out occurs when expansionary fiscal policy causes interest rates to rise, thereby reducing private spending, particularly investment. Crowding out greater, if interest rate increases more when government spending rises.
The Liquidity Trap
If the economy is in the liquidity trap, an increase in government spending has its full multiplier effect on the equilibrium level of income. ? There is no change in the interest rate associated with the change in government spending, and thus no investment spending is cut off. ? There is, therefore, no dampening of the effects of increased government spending on income.
?
The Classical Case and Crowding Out
With a vertical LM curve, ? government spending can not change the equilibrium level of income and raises only interest rate. ? If government spending is higher and output is unchanged, there must be an offsetting reduction in private spending. ? In this case, the increase in interest rates crowds out an amount of private (investment) spending equal to the increase in government spending. ? Thus, there is full crowding out if the LM curve is vertical.
?
Full Crowding Out
Is crowding out important for the economy?
In full-employment situation, ? AD ? ? price level ? ? real balances (money supply) ? ? interest rates until the initial increase in AD is fully crowded out. ? Below full-employment, crowding out is a matter of degree. ? AD ? ? income ? level of savings ? ? finances a larger budget deficit without completely displacing private spending. ? Accommodating monetary policy to prevent interest rates from increasing: Monetizing budget deficits. The RBI prints money to buy the bonds with which the government pays for its debt.
?
Monetary Accommodation of Fiscal Expansion
The Policy Mix: Choice Between Fiscal and Monetary Policies as Tools of Stabilization.
One basis for decision is the flexibility and speed with which these policies can be implemented and take effect. ? Policy effects on AD: Monetary policy operates by stimulating interest responsive components of AD, primarily investment spending. ? Fiscal policy operates in a manner that depends on precisely what goods the government buys or what taxes and transfers it changes. Examples: government spending on defense, reduction in tax, consumption subsidy, investment subsidy (1993, USA).
?
Policy Effects on Income and Interest Rates
Policy Equilibrium Income Equilibrium Interest Rate
Monetary Expansion
+
-
Fiscal Expansion
+
+
Alternative Fiscal Policies
Policies Interest Rate Consumption Investment GDP
Income Tax Cut
+
+
-
+
Government Spending
+
+
-
+
Investment Subsidy
+
+
+
+
Policy Mix: Reaching Full-employment Output
Should the expansion take place through a decline in interest rates and increased investment spending? ? Or should it take place through a cut in taxes and increased personal spending? ? Or should it take the form of an increase in the size of government?
?
Expansionary Policies and the Composition of Output
doc_913461954.pptx
This is a presentation explaining about Monetary Policy; Expansionary Monetary Policy; The Liquidity Trap; Vertical LM Curve; Fiscal Policy; Crowding Out; Policy Mix
Monetary Policy
The central bank conducts monetary policy through open market operations. ? In an open market operation, the central bank buys bonds in exchange for money, thus increasing the stock of money (expansionary monetary policy). ? Or it sells bonds in exchange for money paid by the purchasers of the bonds, thus reducing the money stock (contractionary monetary policy / tight monetary policy).
?
Expansionary Monetary Policy ? RBI buys bonds ? reduces the quantity of bonds ? increase bond price and lower their yield ? public would not hold wealth in the form of bonds ? public would be ready to hold a larger fraction in the form of money. ? This increases money supply in the economy ? the LM schedule will shift rightward. ? Leading to a lower interest rate ? higher level of investment spending ? higher level of income. ? If money demand is very sensitive to the interest rate, a given change in the money stock can be absorbed in the assets markets with only a small change in the interest rate. The effect of an open market purchase on investment spending would then be small.
Expansionary Monetary Policy
Monetary Policy: The Transmission Mechanism
Change in real money supply ? Portfolio adjustments lead to a change in asset prices and interest rates. ? Spending adjusts to changes in interest rates. ? Output adjusts to the change in aggregate demand.
?
Monetary Policy: Transmission Mechanism
Change in Money Supply
Interest Rates
Asset Prices
Exchange Rates
Consumption Spending
Investment Spending
GDP
Prices
The Liquidity Trap and Banks’ Reluctance to Lend ? The liquidity trap is a situation when interest rate does not fall further. In which case, public is prepared to hold whatever amount of money is supplied. ? In that case, monetary policy carried out through open market operations has no effect on either the interest rate or the level of income. ? In the liquidity trap, monetary policy is powerless to affect the interest rate: the case of Japan in late 1990s and in the early years of the 21st century. ? If banks are reluctant to increase their lending even at a lower interest also investment would not increase: the case of USA in 1991 and India facing now.
The Classical Case: Vertical LM Curve
The classical case implies that nominal GDP (P*Y), depends only on the quantity of money. ? It shows that LM curve will be vertical. ? A given change in the quantity of money has a maximal effect on the level of income. ? This, when the LM curve is vertical, monetary policy has a maximal effect on the level of income, and fiscal policy has no effect on income.
?
Fiscal Policy
Expansionary: ? government spending ? AD ? output / income. ? But money market is no longer in equilibrium. Income has increased, and therefore the quantity of money demanded is higher. ? Higher money demand ? ? interest rate ? firms’ planned investment spending ? ? AD ? ? Finally, taking into account the expansionary effect of higher government spending and the dampening effects of the higher interest rate on private spending, both interest rate and output increase.
?
Increase in Government Spending
Crowding Out
? ?
? ?
?
In diagram, increased government spending raises both income and the interest rate. adjustment of interest rates and their impact on AD dampen the expansionary effect of increased government spending. increased government spending crowds out investment spending. Crowding out occurs when expansionary fiscal policy causes interest rates to rise, thereby reducing private spending, particularly investment. Crowding out greater, if interest rate increases more when government spending rises.
The Liquidity Trap
If the economy is in the liquidity trap, an increase in government spending has its full multiplier effect on the equilibrium level of income. ? There is no change in the interest rate associated with the change in government spending, and thus no investment spending is cut off. ? There is, therefore, no dampening of the effects of increased government spending on income.
?
The Classical Case and Crowding Out
With a vertical LM curve, ? government spending can not change the equilibrium level of income and raises only interest rate. ? If government spending is higher and output is unchanged, there must be an offsetting reduction in private spending. ? In this case, the increase in interest rates crowds out an amount of private (investment) spending equal to the increase in government spending. ? Thus, there is full crowding out if the LM curve is vertical.
?
Full Crowding Out
Is crowding out important for the economy?
In full-employment situation, ? AD ? ? price level ? ? real balances (money supply) ? ? interest rates until the initial increase in AD is fully crowded out. ? Below full-employment, crowding out is a matter of degree. ? AD ? ? income ? level of savings ? ? finances a larger budget deficit without completely displacing private spending. ? Accommodating monetary policy to prevent interest rates from increasing: Monetizing budget deficits. The RBI prints money to buy the bonds with which the government pays for its debt.
?
Monetary Accommodation of Fiscal Expansion
The Policy Mix: Choice Between Fiscal and Monetary Policies as Tools of Stabilization.
One basis for decision is the flexibility and speed with which these policies can be implemented and take effect. ? Policy effects on AD: Monetary policy operates by stimulating interest responsive components of AD, primarily investment spending. ? Fiscal policy operates in a manner that depends on precisely what goods the government buys or what taxes and transfers it changes. Examples: government spending on defense, reduction in tax, consumption subsidy, investment subsidy (1993, USA).
?
Policy Effects on Income and Interest Rates
Policy Equilibrium Income Equilibrium Interest Rate
Monetary Expansion
+
-
Fiscal Expansion
+
+
Alternative Fiscal Policies
Policies Interest Rate Consumption Investment GDP
Income Tax Cut
+
+
-
+
Government Spending
+
+
-
+
Investment Subsidy
+
+
+
+
Policy Mix: Reaching Full-employment Output
Should the expansion take place through a decline in interest rates and increased investment spending? ? Or should it take place through a cut in taxes and increased personal spending? ? Or should it take the form of an increase in the size of government?
?
Expansionary Policies and the Composition of Output
doc_913461954.pptx