To make things easier, let us consider the special case where people hold only bank deposits, which means с = 0. In this case, the multiplier is 1/0 : an increase of a dollar of high-powered money leads to an increase ot 1/0 dollars in the money supply. Assume lurther that 0 0.1, so that the multiplier equals I/O. I = 10. The purpose of what follows is to get more intuition for where this multiplier comes
from, and, more generally, for how the initial increase in central bank money leads to a ten-fold increase in the overall money supply.
Suppose the RBA buys $100 worth of bonds in an open-market operation. It pays the seller—call him seller I—$100. To pay the seller, the RBA creates $100 in central bank money. The increase in central bank money is $100, When we looked earlier at the effects of an open-market operation in an economy in which there were no hanks, this was the end of the story. Here it is just the beginning:
• Seller I (who, we have assumed, doesn't want to hold any currency) deposits the $100 in an account at his bank—call it bank A. This leads to an increase in bank deposits of $100.
• Bank A keeps $100 times 0.1 = $10 in reserves, and buys bonds with the rest, $100 times 0.9 = $90. It pays $90 to the seller of those bonds—call her seller 2.
• Seller 2 deposits $90 in an account in her bank—call it bank B. This leads to an increase in deposits of $90.
• Bank В keeps $90 times 0.1 = $9 in reserves, and buys bonds with the rest, $90 times 0.9 = $81. It pays $81 to the seller ol those bonds, call him seller 3.
• Seller 3 deposits $81 in a current account in his bank, call it bank C.
• And so on.
See Appendix 2 at the ► end of this book for a refresher on geometric series.
Note the parallel between our interpretation of the money multiplier as the result of successive purchases of bonds and the interpretation of the goods market
multiplier ► (Chapter 3) as the result of successive rounds of spending. Multipliers can often be derived as the sum of a geometric series, and be interpreted as the result of successive rounds of decisions. This interpretaton often gives a better intuition for the process at work.
By now, the chain of events should be clear. What is the eventual increase in the money supply? The increase in bank deposits is $100 when seller 1 deposits the proceeds ol his sale of bonds in bank A, plus $90 when seller 2 deposits the proceeds ol her sale of bonds in bank В plus $81 when seller 3 does the same, and so on. Let's write the sum as
$100(1 + 0.9 + 0.92
The series in parentheses is a geometric series, so its sum is equal lo 1/(1 — 0.9) = 10. The money supply increases by $1,000, ten times the initial increase in central bank money.
This derivation gives us another way of thinking about the money multiplier. We can think ol the ultimate increase in the money supply as the result of successive rounds of purchases ol bonds—the first started by the RBA in its open-market operation, the following rounds by banks. Each successive round leads to an increase in the money supply,- eventually the increase in the money supply is equal to ten times the initial increase in the central bank money.
The demand lor money depends positively on the level of income and negatively on the interest rate.
The interest rale is determined by the equilibrium condition that the supply of money be equal ю the demand lor money.
C.ivcn the supply ol money, an increase in income leads to an increase in the demand for money and an increase in the interest rale. An increase in the supply ot money leads to a decrease in the interest rate.
The way the central bank changes the supply ol money is through open-markci operations. Expansionary open-market operations, in which lhe central bank increases the money supply by buying bonds, lead to an increase in the price ol bonds-—equivalently, a decrease in the interest rate. Contractionary open-markcl operations, in which the central bank decreases the money supply hy selling bonds, lead to a decrease in lhe price of bonds—equivalently, an increase in the interest rate. When money includes both currency and bank deposits thai can be used directly for payments, we can think ot the interest rate as determined by the condition that the supply of central bank money be equal to the demand lor central bank money.
• The supply of central hank money is under the control of the central hank. The demand lor central bank money depends on the overall demand lor money, the proportion of money people keep in currency, and the ratio of reserves to deposits chosen by banks.
• The central bank can, and does, decide on a preferred interest rate, varying the supply of central bank money to equal the demand at that interest rate.
• Another, but equivalent, way to think about the determination of the interest rate is in terms of the equality ot the supply and demand lor bank reserves. In Australia, the market lor bank reserves is called the interbank overnight cash market. The interest rate determined in that market is called the cash rate'.
• Yet another way to think about the determination of the interest rate is in terms of the equality ol the overall supply of and overall demand tor money. The overall supply ol money is equal lo central bank money limes the money multiplier.
KEYTERMS
Reserve. Reserve Hank of Australia (RBA), 69
federal Reserve Bank (Ted), 69 money, 69 currency, 70 current accounts, 70 bonds, 70 income, 70 flow, 70 saving, 70 savings, 70
linanciai wealth, wealth, 70 stock, 70
• investment. 70
• linanciai investment, 70
• term deposit, 71
• Ml, 73
• velocity, 73
• LM relation, 75
• open-market operations, 78
• expansionary open-market operation, 78
• contractionary open-market operation, 78
• Treasury bills, T-bills, 78
• financial intermediaries, 80
• (bank) reserves, 80
• reserve ratio, 81
• central bank money, 81
• bank runs, 82
• federal deposit insurance, 82
• bank supervision, 82
• Australian Prudential Regulation Authority (APRA), 82
• narrow banking, 82
• interbank cash market, 86
• cash rate, 87
• money multiplier, 87
• high-powered money, 87
• monetary base, 87
QUESTIONS AND PROBLEMS
Quick check
I. Using the information in this chaptcr, label each of the following statements 'true', 'false' or
'uncertain'. Explain briefly.
a. Income and linanciai wealth are both examples ol stock variables.
b. The term investment, as used by economists, refers to the purchase of bonds and shares of stock.
с The demand lor money doesn't depend on the interest rate, because only bonds earn interest.
d. I he central bank can increase the supply of money by selling bonds in the market lor bonds.
e. The Reserve Bank can determine the money supply, but it cannot determine interest rates—not even the cash rate—because interest rates are determined in the private sector.
I. Bond prices and interest rates always move in opposite directions.
g. Since the Great Depression, the United States has used federal deposit insurance to deal with bank runs. Australia hasn't.
h. Financial innovations are the reason why velocity has increased dramatically in the last fifty years.
2. Suppose that a person's wealth is S50.000 and that her yearly income is S60,000. Also, suppose that her money demand function is given by
M'1 = $Y(0.3"5 - i)
a. What is her demand lor money and her demand lor bonds when the interest rate is 5 per cent? 10 per cent?
b. Explain how the interest rate affects money demand.
c. Suppose that the interest rate is 10 per cent. In percentage terms, what happens for money il her yearly income is reduced by 50 per cent?
d. Suppose that the interest rate is 5 per cent. In percentage terms, what happens lor money il her yearly income is reduced by 50 per cent?
e. Summarise the eflect ol income on money demand. How does it depend on the
3. Consider a bond that promises to pay $100 in one year.
a. What is the interest rate on the bond it its price today is $75? $85? $95?
b. What is the relation between the price ol the bond and the interest rale?
c. If the interest rate is 8 per cent, what is the price ol the bond today?
4. Suppose that money demand is given by
M'1 = $Y(0.25 - i)
where $Y is $100. Also, suppose thai the supply of money is S20. Assume equilibrium in financial markets.
a. What is the equilibrium interest rate?
b. If the Reserve Bank wants lo increase i by 10 per cent (that is. Irom, say, 2 per ceni to 12 per cent), at what level should it set the supply of money?
Dig deeper
5. Suppose that a person's wealth is 550,000 and that her yearly income is S60,000. Also suppose that her money demand function is given by
MJ = $Y(0.35 - i)
a. Derive the demand for bonds. What is the ellect of an increase in the interest rate by 10 per cent on the demand for bonds?
b. What are the effects ol an increase in wealth on money and on bond demand? Explain in words.
c. What are the effects of an increase in income on money and on bond demand? Explain in words.
d. 'When people earn more money, they obviously will hold more bonds. What is wrong with this sentence?
6. The money multiplier
Suppose lhe following assumptions hold:
1. The public holds no currency.
2. The ratio of reserves to deposits is 0.1.
3. The demand lor money is given by
to her demand to her demand interest rate?
Md = $Y (0.8 - 4/)
Initially, the monetary base is $100 billion and nominal income is $5 trillion.
a. What is the demand for central bank money?
b. Find the equilibrium interest rate by setting the demand tor central bank money equal to the supply ol central bank money.
c. What is the overall supply of money? Is it equal to the overall demand lor money at the interest rate you found in (hi?
d. What is the impact on the interest rate if central bank money is increased to $300 billion?
e. It the overall money supply increases to $3,000 billion, what will be the impact on /? (Hint: Use what you learned in (c).)
t. II the central bank wanted to increase the interest rale by I percentage point, by how much would it have to decrease the supply of central bank money?
7. Bank runs and the money multiplier
During the Great Depression, the 11$ economy experienced many bank runs, to the point where people became unwilling to keep their money in banks, preferring to keep it in cash.
I low would you expect such a shift away from deposits towards currency to affect the size of the money multiplier? (To find what happened to the money multiplier during the Great Depression, go to Chapter 23.)
8. ATMs and credit cards
This problem examines the effect of the introduction of ATMs and credit cards on money demand. For simplicity, lei's examine a person's demand for money over a period of four days. Suppose that, before ATMs and credit cards, this person goes to the bank once at the beginning of each four-day period and withdraws from his deposit account all the money he needs for four days. He spends $4 per day.
a. How much does he withdraw each time he goes to the bank? Calculate this person's money holdings tor days 1 to 4 (in the morning, before lie spends any of the money he withdraws).
b. What is the amount ot money he holds on average?
Suppose now that -with the advent of A TMs he withdraws money once every two days.
c. Answer (a) in this case.
d. Answer (b) in this case.
Finally, with the advent of credit cards, this person pays for all his purchases using his credit card. He withdraws no money until the fourth day, when he withdraws the whole amount necessary to pay for his credit card purchases over the previous four days.
e. Calculate this person's money holdings for days 1 to 4.
f. Answer (b) in this case.
g. Based on your answers to (b), (d and (f), what has been the effect ot ATMs and credit cards on money demand?
9. The velocity of money
Let money demand be given by
M'1 = $УШ)
a. Derive an expression for velocity as a function ol i. How does it depend on i?
b. Look at Figure I in the focus box The demand tor money and the interest rate: The evidence'. What has happened to the velocity of money Irom I960 to 2008?
c. According to Figure I. the interest rate was roughly the same in 1973 as it was in I960. In light of this tact, what do you think explains the increase in the velocity of money from I960 to 1973? (Hint: Look at problem 8.
10. The demand for bands
In this chapter you learned that an increase in the interest rate makes bonds more attractive, so it leads people to hold more of their wealth in bonds, as opposed to money. However, you also learned that an increase in the interest rate reduces the price of bonds.
How can an increase in the interest rate make honds more attractive and reduce their price?
Explore further
11. Current monetary policy
Go lo the RBA website and download the most recent Minutes of the Board lwuno.rba.gov.au/ MonetaryPolicy/RBABoardMinutes). Make sure you get the most recent release.
a. What is the current stance of monetary policy? (Note that policy will he described in terms of increasing or decreasing the cash rate as opposed to increasing or decreasing the money supply.)
b. If the cash rate has changed recently, what does the change imply about the bond holdings ol the RBA? I las the RBA been increasing or decreasing its bond holdings?
Finally, you might want to read the explanation of the RBA Board for the current policy stance. It may not make so much sense now, but keep it in mind for Chapter 5.
We invite you to visit the Blanchard-Sheen page on the Pearson Australia website at
www.pearson.com.au/highered/blanchardsheen3e
for many World Wide Web exercises relating to issues similar to those in this chapter.
FURTHER READINGS
CHAPTER 0
Goods and Financial Markets: The IS-LM Model
I
n Chapter 3 we looked at the goods market. In Chapter 4 we looked at financial markets. We now look at goods and financial markets together. By the end of the chapter, you will have a framework to think about how output and the interest rate are determined in the short run.
In developing this framework, we follow a path first traced by two economists,John Hicks and Alvin Hansen, in the late 1930s and early 1940s. When the economist John Maynard Keynes published his General Theory in 1936, there was much agreement that his book was both fundamental and nearly impenetrable. (Look at it and you will agree.) There were many debates about what Keynes 'really meant'. In 1937, John Hicks summarised what he saw as one of Keynes' main contributions: the joint description of goods and financial markets. His analysis was later extended by Alvin Hansen. Hicks and Hansen called their formalisation the IS-LM model.
Macroeconomics has made substantial progress since the early 1940s.This is why the IS-LM model is treated in Chapter 5 rather than in Chapter 28 of this book. (If you had taken this course forty years ago. you would be nearly done!) Buc to most economists, the IS-LM model still represents an essential building block—one that, despite its simplicity, captures much of what happens in the economy in the short run.This is why the IS-LM model is still taught and used today.
We will put the IS-LM model to work in a variety of contexts.You will see how different types of monetary policy can be easily understood with this simple model. You will also see the short-run outcomes of different monetary and fiscal policy mixes.
The chapter has five sections:
• Section 5.1 looks at equilibrium in the goods market, and derives the IS relation.
• Section 5.2 looks at equilibrium in financial markets, and derives the L/И relation.
• Sections 5.3 and 5.4 put the IS and the LM relations together and use the resulting IS-LM model to study the effects of fiscal and monetary policy, first separately, then together.
• Section 5.5 introduces dynamics, and explores how the IS-LM model captures what happens in the economy in the short run.
5.1 THE GOODS MARKET AND THE IS RELATION
• Demand was defined as the sum of consumption, investment and government spending. We assumed that consumption was a lunciion of disposable income (income minus taxes), and took investment spending, government spending and taxes as given. The equilibrium condition was given by
Y = C(Y - T) + 1 + G
In Chapter 3 we assumed, to simplily the algebra, that the relation between consumption, C, and disposable income, Y— T, was linear. Here, we won't make this assumption, and we use the more general form, С C(Y-T) instead.)
• Using this equilibrium condition, we then looked at the factors that changed equilibrium output. We looked, in particular, at the effects of changes in government spending and of shilts in consumption demand.
The main simplification ol this lirst model was that the interest rate didn't affect the demand for goods. Our first task in this chapter is to remove this simplification, to introduce the interest rate in our model of equilibrium in the goods market. For the time being, we locus only on the effcct of the interest rate on investment and leave a discussion of its effects on the other components of demand to later.
Investment, sales and the interest rate
In Chapter 3 investment was left unexplained—we assumed investment was constant (or exogenous), even when output changed. Investment—spending on new machines and plants or factories by firms— is in fact far from constant, and it depends primarily on two factors:
• The level of sales. A firm lacing an increase in sales needs to increase production. To do so, it may need to buy addirional machines, or to build an additional plant. A firm facing low sales will feel no such need and will spend little, il anything, nil investment.
• The interest rale. Consider a lirm deciding whether to buy a new machine. Suppose that, to buy the new machine, the firm must borrow. The higher the interest rate, the less attractive it is to borrow and buy the machine. At a high enough interest rate, the additional profits from using the new machine won't cover the interest payments, and the new machine won't be worth buying.
The argument still holds ► if the firm uses its own funds. The higher the interest rate, the more attractive it is to lend the funds rather than to use them to buy the new machine.
(5.1)
Г T. it:
>m
5.1), lhe condition for equilibrium in the goods market
To capturc these two effects, we write the investment relation as lollows:
/ - I(Y, i)
Equation (5.1) slates that investment, /, depends on production Y, and the interest rate, i. (We continue ю assume that inventory investment is equal to zero, so sales and production are always equal. As a result, Y denotes sales and il also denotes production.) The positive sign under Y indicates thai an increase in production (equivalently, sales) leads to an increase in investment. The negative sign under the interest rate, /, indicates that an increase in the interest rate leads to a decrease in investment.
The determination of output
See Chapter 16 for ► more on the effects of the interest rate on both consumption and investment.
Taking into account the investment relation becomes
l(Y,i>
(5.2)
Y = C(Y - T
Production (the left side of the equation) must be equal to the demand lor goods the right side). Equation : 5.2 I is our expanded IS relation. We can now look at what happens to output when the interest rate changes.
Start with Figure 5.1. Measure lhe demand for goods on ihe vertical axis. Measure output on the horizontal axis. For a given value ol the interest rate, i, demand is an increasing function of output, lor two reasons:
GOODS AND IINANOAL MARKETS: THfc IS LM MOD: I
chapter S
• An increase in output leads to an increase in income, and so to an increase in disposable income, and so to an increase in consumption; we studied this relation in Chapter 3.
• An increase in output also leads to an increase in investment; this is the relation between investment and production that we have introduced in this chapter.
In short, an increase in output leads, through its ellccts on both consumption and investment, to an increase in the demand lor goods. This relation between demand and output, lor a given interest rate, is represented by the upward-sloping curve ZZ.
Note two characteristics of ZZ in Figure 5.1:
• Since we haven't assumed that the consumption and investment relations in equation (5.2) arc linear, ZZ is in general a curve rather than a line. Thus, we have drawn it as a convex curve in Figure 5.1. All the arguments that follow would apply il it was concave, or il we assumed that the consumption and investment relations were linear, and that ZZ was a straight line instead.
• We have drawn ZZ so that it is llatter than the 45-degree line. Put another way, we have assumed that an increase in output leads to a less than one-tor-one increase in demand.
In Chapter 3, where investment was constant, this restriction naturally followed from the assumption that consumers spend only part ot their additional income on consumption. But now that we allow investment to respond to production, this restriction may no longer hold. When output increases, the sum ot the increase in consumption and the increase in investment could exceed the initial increase in output. Although this is a theoretical possibility, the empirical evidence suggests that it isn't the case in practice. That's why we will assume that the response of demand to output is less than one lor one and draw ZZ llatter than the 45-degree line.
Equilibrium in the goods market is reached at the point where the demand ior goods equals output, so at point A, the intersection of ZZ and the 45-degree line. 1 he equilibrium level ol output is given
by Y.
So lar, what we have done is extend, in straightforward fashion, the analysis ol Chapter 3. But we are now ready to derive the IS curve.
ZZ
N
О
Y
Output, У
-
с
«
Figure 5.1 Equilibrium in the goods market
The demand for goods is an increasing function of output Equilibrium requires that the demand for goods be equal to output
Deriving the IS curve
The demand relation ZZ, has heen drawn in Figure 5,1 (or a given value ol the interest rate. Let's now ask what happens il the interest rate changes.
Suppose that, in Figure 5.2. the demand curve is given by ZZ. and the initial equilibrium is at point A. Suppose now that the interest rate increases Irom its initial value, i, to a new higher value, i". At any level of output the higher interest rale implies a decrease in investment, so a decrease in demand. The demand curve ZZ shifts down to Z': ai a given level ol output, demand is lower. The new equilibrium is at the intersection ot the lower demand curve ZZ' and the 45-degree line, so at point A'. The equilibrium level ol output is now equal to V.
In words: The increase in the interest rale decreases investment, l he decrease in investment leads to a decrease in output, which lurther decreases consumption and investment. In other words, the initial decrease in investment leads to a larger decrease in output through the multiplier effect.
Llsing Figure 5.2, we can find the equilibrium value ol output associated with any value ot the interest rate. The relation between equilibrium output and the interest rate is derived in Figure 5.3.
• Figure 5.3, panel (a> reproduces Figure 5.2. The interest rale, i, implies a level ol output equal to Y. The higher interest rate. /', implies a lower level of output, Y".
• Figure 5.3, panel IT plots equilibrium output Yon the horizontal axis against the interest rate on the vertical axis. Point A in Figure 5.3. panel i b corresponds to point A in Figure 5.3 panel (a), and point A' in Figure 5.3, panel
Equilibrium in the ► goods market
=> I T =» Yl
Can you show ► graphically what the size of the multiplier is! (Hint Look on the vertical axis at the ratio of the decrease in equilibrium output to the initial decrease in investment.)
Equilibrium in the goods market implies that an ^ increase in the interest rate leads to a decrease in output. This relation is represented by the downward-sloping IS curve.
The IS curve represents equilibrium in the goods market. After a shock, it may take some time, perhaps a lew months on average, for goods market equilibrium to be re-established. II a shock means the economy finds itsell to the right ol the /5 curve, output will exceed aggregate demand, and so inventories will build up. Firms will gradually cut their production levels, and so output will adjust down to re-establish goods market equilibrium. At points to the lelt of the IS curve, lhe economy would stiller
Figure 5.2 The effects of an increase in the interest rate on output
An increase in the interest rate decreases the demand for goods at any level of output
GOODS AND HNANIOA; MARKETS: Т) 1С IS LM MODC.
chapter 5
■о с
а Е
V
О
45°
]
Y' Y
Output, Y
(fori' > i)
(а)
ZZ'
Figure 5.3 The derivation of the IS curve
Y' Y
Output, У
Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output The IS curve is downward sloping.
excess demand and so output would he raised accordingly. At given prices, the adjustment process involves output.
Shifts of the IS curve
Note that the IS curve in Figure 5.3 is drawn lor given values ol taxes, T, and government spending. G. Changes in cither Tor G will shilt the IS curve.
To see how, consider Figure 5.4. The IS curve gives the equilibrium level ol output as a function ol the interest rate. It is drawn lor given values ol taxes and spending. Now consider an increase in taxes, from T to V. At a given interest rale, say, I, disposable income decreases, leading to a decrease in consumption, leading in turn to a decrease in the demand for goods and a decrease in equilibrium
Figure 5.4 Shifts of the IS curve
An increase in taxes shifts the IS curve to the left
output. The equilibrium level ol output decreases Irom Y to Y". Put another way, the IS curve shilts to For a given ► thc |c|t At any interest rate, the equilibrium level of output is lower than it was before the increase in
T t => У I. An increase taxes.
More generally, any factor that, for a given interest rate, decreases the equilibrium level of output leads the IS curve to shilt to the left. We have looked at an increase in taxes. But the same would hold lor a decrease in government spending, or a decrease in consumer confidence (which decreases consumption given disposable income). In contrast, any factor that, lor a given interest rate, increases the equilibrium level of output—a decrease in taxes, an increase in government spending, an increase in consumer confidence—leads the IS curve to shift to the right. Let's summarise:
• Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output. This relation is represented by the downward-sloping IS curve.
In Section S.4 we will introduce an alternative monetary policy that is a more realistic description of what happens in ^ Australia today—the central bank chooses a particular value of the interest rate, and then adjusts M to achieve it
• Changes in factors that decrease thc demand for goods given the interest rate shift thc IS curve to the eft. Changes in lactors that increase the demand lor goods given the interest rate shift the IS curve to the right.
5.2 FINANCIAL MARKETS AND THE Ш RELATION
Let's now turn to financial markets. We saw in Chapter 4 that financial markets are in equilibrium when there is equality of the supply of and demand tor money:
M = $YL(t)
in taxes shifts the IS curve to the left
The variable .VI on the left side is the nominal money stock. We will ignore here the details of the money-supply process that we saw in Section 4.3. and simply think ol the central bank as controlling jVI directly. Through open-market operations—buying and selling bonds tor money—the central bank can conduct its monetary policy. Until Section 5.4. we will assume that the central bank chooses a particular value of M leaving the interest rate to be determined in market equilibrium.
The right side gives the demand lor money, which is a function ol nominal income, $Y, and of the nominal interest rate, i. As we saw in Section 4 I an increase in nominal income increases the demand for money, and an increase in the interest rate decreases the demand for money. Equilibrium requires that money supply (thc left side of the equation 1 be equal to money demand (the right side of the equation).
©
Real money, real income and the interest rate
The equation M - $YL(i) gives a relation between money, nominal income and the interest rate. It will be more convenient here to rewrite it as a relation between real money (that is, money in terms ol goods), real income (that is, income in terms of goods) and the interest rate.
4 From Chapter 2: Nominal GDP = Real GDP multiplied by the GDP deflator $Г=ГР. Equivalently Real GDP Nominal GDP divided by the GDP deflator $Y,P=Y.
M. P
(5.3)
M*
Figure 5.5 The effects of an increase in income on the interest rate
An increase in income leads, at a g.ven interest rate, to an increased demand for money. Given the money supply, this ieads to an increase in the equilibrium interest rate.
Recall that nominal income divided by thc price level equals real income, Y. Dividing both sides of the equation by the price level, P, gives
YL(i)
I lence, we can restate our equilibrium condition as the condition that the real money supply—that is, thc money stock in terms of goods, not dollars—be equal to the real money demand, which depends on real income, Y, and the interest rate, /'.
The notion of a real demand tor money may feel a bit abstract, so an example may help. Think not ol your demand tor money in general but just of your demand for coins. Suppose you like to have coins in your pocket to buy four cups of coffee during the day. Il a cup costs $1, you will want to keep about $1 in coins: this is your nominal demand for coins. F.quivalently, you want to keep enough coins in your pocket to buy four cups ol coffee. This is your demand for coins in terms ol goods—here in terms ot cups of coffee.
From now on, we will refer to equation (5.3 as the LAI relation. The advantage ol writing things this way is that real income. Y. appears on the right side of the equation instead ol nominal income, $Y. And real income (equivalently, real output is the variable we focus on when looking at equilibrium in the goods market. To make the reading lighter, we will refer to the left and right sides ol equation (5.3 simply as money supply' and money demand, rather than the more accurate but heavier real money supply' and real money demand'. Similarly, we will reler to Yas income rather than real income .
Deriving the LM curve
GOODS AND FINANCIAL MARKETS: THE iS LM MODEL
chapter 5
To see the relation between output and thc interest rate implied by equation (5.3 ). let's begin by looking at Figure 5.5. Let the interest rate be measured on the vertical axis and (real) money be measured on the horizontal axis. ( Real) money supply is given by the vertical line at Af/P, and is denoted ,\f\ For a given
level of (real) income, Y, (real ' money demand is a decreasing function ol the interest rate. It is drawn as the downward-sloping curve denoted M1'. Except ior the lact that we measure real rather than nominal money on the horizontal axis the figure is similar to f igure -1.3 in Chapter 4. The equilibrium is at point A. where money supply is equal to money demand and thc interest rate is equal to i.
Now consider an increase in income Irom V to V, which leads people to increase their demand tor money at any given interest rate. Money demand shilts to the right, to M'1'. For the rest ot this subsection, lets ignore the central bank and imagine that the money stock is given. Then the new equilibrium would be at .4', with a higher market-determined interest rate, i". Why docs an increase in income lead to an increase in the interest rate? When income increases, money demand increases. But il the money supply is given, the interest rate must go up until the two opposite ellects on the demand for money—the increase in income that leads people to want to hold more money, and the increase in the interest rate that leads people to want to hold less money—cancel each other. At that point, thc demand for money is equal to the unchanged money supply, and financial markets are again in equilibrium.
Now we can derive the LAI curve, which by definition gives thc value of thc interest rale associated with any value of income tor a given money slock and price level. This definition says nothing about the monetary policy of the central bank—we will begin to think about that in ihe next subsection. The LM relation is derived in Figure 5,6.
• Figure 5.6, panel • Figure 5.6, panel h plots the equilibrium interest rate i on the vertical axis against income on the horizontal axis. Point .4 in Figure 5.6, panel (Ы corresponds to points in Figure 5.6, panel (a), and point Л' in Figure 5.6, panel (b) corresponds to point A' in Figure 5.6, panel (a). More generally, equilibrium in financial markets implies that the higher the level ol output, the higher the demand for money, and therefore the higher the equilibrium interest rate.
Equilibrium in financial ► markets: for given
M, Г T =» i t.
Whether or not interest rates actually do rise with higher economic activity will depend on the central bank's monetary policy response. ►
• This relation between output and lhe interest rate is represented by lhe upward-sloping curve in Figure 5.6, panel b . This curve is called the LM curve. Economists sometimes characterise this relation by saying higher economic activity puts pressure on interest rates. Make sure you understand the steps behind ibis statement.
Ms
\
\ 1 A' \
\ J
Md'
\ (for Y' >Y) ;
A
^M"1 (for Y)
MIP
(Real) Money, MIP
(a)
Figure 5.6 The derivation of the LM curve
Equilibrium in finoncial markets implies that, for a given money stock, the interest rate is an increasing function of the level of income. The LM curve is upward sloping.
GOODS AND FINANCIAI MARKHb. I ML IS LM MODL.
chapter 5
Shifts of the LM curve
We have derived the LM curve in Figure 5.6 taking both thc nominal money stock, M, and the price level. P—and. by implication, their ratio, the real money stock, M/P—as given. Changes in M/P, whether they come horn changes in the nominal money stock, M. or from changes in the price level P, will shift the LM curve.
To see how, let us look at Figure 5.7 and consider an increase in the nominal money supply, from iVl to M', so that, at the same price level the real money supply increases from M/P to M'/P. Then, at any level ot income—say, V—the interest rate consistent with equilibrium in linanciai markets is lower going down Irom i to, say, /'. The LM curve shilts down, from LM to LM'. By the same reasoning, at any level ol income, a decrease in the money supply leads to an increase in the interest rate. It leads the LM curve to shift up. Lets summarise:
• Equilibrium in linanciai markets implies that, for a given real money supply, an increase in the level ol income, which increases the demand lor money, leads to an increase in the interest rate. This relation is represented hy the upward-sloping LM curve.
• Increases in the money supply shilt the LM curve down decreases in the money supply shift the LM curve up.
< For given У, M/P T 1 i.
Why do we think about shifts of the IS curve to the left and to the right. * but about shifts of the LM curve up or down? We think of the goods market as determining У given i; so we want to know what happens to У when an exogenous variable changes. У is on die horizontal axis and moves right or left.We think of financial markets as determining i given У: so we want to know what would need to happen to i when an exogenous variable changes, i is on the vertical axis and moves up or down.
5.3 PUTTING THE /SAND THE LM RELATIONS TOGETHER
IS relation: LM relation:
Y M
We now put the IS and LM relations together. At any point in time in short-run equilibrium, the supply of goods must be equal lo the demand lor goods. And the supply ot money must be equal to the demand lor monev. Both the IS and the LM relations must hold.
С
C(Y - 71 - l(Y,i) YL(i)
Figure 5.7
Shifts in the LM curve
LM
(for MIP)
Income, У
An increase in money leads the LM curve to shift down.
Figure 5.8 plots both the LS curve and the LM curve on one graph. Output—equivalently, produc¬tion or income—is measured on the horizontal axis. The interest rate is measured on the vertical axis.
Any point on the downward-sloping IS curve corresponds to equilibrium in thc goods market. Any point on the upward-sloping LM curve corresponds to equilibrium in financial markets. Only at point A arc both equilibrium conditions satislied. That means point A, with associated level ol output У and interest rate i = /„• is the overall equilibrium, the point at which there is equilibrium in both the goods market and the linanciai markets.
The IS and I.M relations that underlie Figure 5.8 contain a lot of information about consumption, investment, money demand, monetary policy and equilibrium conditions. But you may ask: So what il the equilibrium is at point Л? How does this lact translate into anything directly useful about the world? Don't despair: Figure 5.8 holds the answer to many questions in macroeconomics. Used properly, it allows us to study what happens to output and the interest rate when thc central bank decides to change its monetary policy stance, or when the government decides to increase taxes, or when consumers become more pessimistic about the future, and so on.
Let's now see what the IS-LM model can do.
Fiscal policy, output and the interest rate
Decrease in G -T e Suppose the government decides to reduce the budget deficit, and does so by increasing taxes while fiscal contraction« keeping government spending unchanged. Such a change in fiscal policy is often called a fiscal fiscal consolidation. ► contraction or a fiscal consolidation (An increase in the deficit, either due lo an increase in govern¬ment spending or to a decrease in taxes, is called a fiscal expansion i What arc thc effects of this fiscal Increase in G-T » ► contraction on output, on its composition and on the interest rate? fiscal expansion.
Figure 5.8 UVI
The IS-LM model
Я ь.
(Л £ ч
ч // /у /у
V
g 'о ж
1 ч* ef IS
У
Output (Income), У
Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output This is represented by the IS curve. Equilibrium in financial markets implies that an increase in output requires an increase in the interest rate, given the money stock. This is represented by the LM curve. Only at point A, which is on both curves, are both goods and financial markets in equilibrium.
In answering this or any question about the effects of changes in policy, always go through the following three steps:
1. Ask how this change affects goods and linanciai markets' equilibrium relations—how it shifts the IS or the LM curve.
2. Characterise the effects of these shifts on the intersection ot the IS and the LM curve, and thus on the equilibrium.
3. Describe the effects in words.
With time and experience, you will often be able to go directly to step 3,- by then you will be ready to give an instant commentary on the economic events of the day. But until you get to that level of expertise, go step by step.
• Going through step I. the first question is how the increase in taxes affects equilibrium in the goods market—that is. how it affects the IS curve.
I el's draw, in Figure 5.9, panel i a), ihe IS curve corresponding to equilibrium in the goods market before the increase in taxes. Now take an arbitrary point, В on this IS curve. By construction of the IS curve, output, YB( and ihe corresponding interest rate iR, are such that thc supply ol goods is equal to the demand lor goods.
Ai the interest rate, ip, ask what happens to output il taxes increase from T lo T'. We saw the answer in Section 5.1. Because people have less disposable income, the increase in taxes decreases consumption, and, through the multiplier, decreases output. Ai interest rate i'p, output decreases Irom Yp to Yt-. More generally, at any interest rate, higher laxes lead lo lower output—the IS curve shifts to the left, from IS to IS'.
Next, lets see if anything happens to the LM curve. Figure 5.9, panel ib> draws the LM curve corresponding to financial-markets equilibrium before lhe increase in laxes. Take an arbitrary point, F, on this LM curve. By construction ol the LM curve, the interest rate, iy, and income, Y(, are such that the supply of money is equal to the demand for money.
What happens lo the LM curve when taxes are increased? The answer: Nothing. At the given level of income, Yr. the interest rate at which the supply of money is equal lo the demand lor money is the same as before, namely, ir. In other words, because taxes don't appear in the LM relation, they don't affect the equilibrium condition. They don't alfcct thc LM curve. Taxes enter equation <5.2 so, when laxes change, the IS curve shifts. But taxes don't enter equation (5.3), so the LM curve doesn't shilt.
• Now lets consider the second step, the determination ol the equilibrium. Let the initial equilibrium in Figure 5.9. panel (c) be at point A, ai ihe intersection of the initial IS curve and the LM curve. The IS curve is ihe same as the IS curve in Figure 5.9, panel (a), and the LM curve is the same as lhe LM curve in Figure 5.9, panel (b).
Alter the increase in taxes, the IS curve shilts lo the left—from IS to IS'. The intersection ol the new IS curve and the unchanged LM curve is at point A' where both output and the interest rale arc- lower. Output falls from Yto Y' and the interest rate falls from i lo ;'. Thus, as the IS curve shifts. the economy moves along the LM curve, from A to A'. The reason these words are italicised is that it is important always to distinguish shifts ol curves (here the shift ol thc IS curve and movements along a curve (here the movement along the LM curve). Many mistakes result from not distinguishing between shifts of and movements along a curve.
• The third and linal step is to loll the story in words. The increase in taxes leads to lower disposable income, which causes people to decrease their consumption. The result through the multiplier effect is a decrease in output and income. The decrease in income reduces the demand for money, leading to a decrease in thc interest rate. The decline in the interest rate reduces, but does not completely ollset, the effect of higher taxes on the demand lor goods.
i Taxes appear in the IS relation <-> Taxes shift the IS curve.
Taxes don't appear n
^ the LAI relation <-> Taxes don't shift the LAI curve. Note the general principle here: a curve shifts in response to a change in an exogenous variable only if this variable appears directly in the equation represented by that curve.
^ A reminder: an exogenous variable is a variable we take as given, unexplained within the model. Here, it is caxes.
If the interest rate d dn't decline, the economy would go from point A to point D in Figure 5.9. panel (c). and output would be direcdy below point D. Because of the decline in the interest rate—which stimulates investment—the decline in activity is only to point A . In Section 5.4.
^ we will see what happens if the central bank chooses to prevent the interest rate from declining.
GOODS AND I iNANOAL MARKETS: Tl ir IS LM MODtl
chapter 5
What happens to the components ol demand? By assumption, government spending remains unchanged: we have assumed that the reduction in the budget delicit takes place through an increase in taxes. Consumption surely goes down: taxes go up and income goes down, so disposable income goes
.8
v 'в a c\
4J J \
S \
О \
V
Ч ls (for T) (for T">T)
yc Output, Y
(a)
LM
о
2
4-1
I
О 1 F
С F i
Output, У
(B)
L/И
\«- \ /
OJ \ /
s
Xm \D у
2 ' S
U С
— i' - Л
V/ \
г>т)
У Y
Output, Y
(c)
An increase in taxes shifts the IS curve to the left, and leads to a decrease in the equilibrium level of output
down on both counts. The question is: What happens to investment? On the one hand, lower output means lower sales and lower investment. On the other, the lower interest rate leads to higher investment. Without knowing more about the exact form ol the investment relation, equation 15.1 I, we cannot tell which effect dominates.
II investment depends (inly on the interest rate, then investment surely increases,- il investment depends only on sales, then investment surely decreases. In general, investment depends on both the interest rate and sales, so we cannot tell. Contrary to what is often staled by politicians, a reduction in the budget deficit doesn't necessarily lead to an increase in investment. The focus box Deficit reduction: Good or bad lor investment? discusses this at more length.
focus
шг- A
г box
We will return to the relation between liscal policy and investment many times in this book, and we will qualify this lirst answer in many ways. But the result that deficit reduction may decrease investment in the short run will remain.
DEFICIT REDUCTION: GOOD OR BAD FOR INVESTMENT?
You may have heard this argument before:'Private saving goes either towards financing the budget deficit or financing investment. It doesn't take a genius to conclude that reducing the budget deficit leaves more saving available for investment, so investment increases.'
This argument sounds simple and convincing. How do we reconcile it with what we just saw—namely, that deficit reduction may decrease rather than increase investment?
To make progress, first go back to Chapter 3, equation (3.10).There we saw that we can also think of the goods-market equilibrium condition as:
Investment - Private saving + Public saving I = S + (T - G)
In equilibrium, investment is equal to private saving plus public saving. If public saving is positive, the government is said to run a budget surplus; if public saving is negative, the go"ernment runs a budget deficit. So, it is true that, given private saving, if the government reduces its deficit—either by increasing taxes or by reducing government spending, so T - G goes up—investment must go up: given S. T - G going up implies that / goes up.
The crucial part of this statement, however, is 'given private saving'. The point is that a fiscal contraction affects private saving as well—the contraction leads to lower output, and so to lower income. As consump¬tion goes down by less than income, private saving also goes down. And it may go down by more than the reduction in the budget deficit, leading to a decrease rather than an increase in investment. In terms of the preceding equation: if S decreases by more than T - G increases, then T will decrease, not increase.
Increase in At » 4 monetary expansion. 4 Decrease in AI « monetary contraction <=> monetary tightening.
For a given price level. P: M increases by 10 per cent => M.'P increases by 4 10 per cent.
Money doesn't appear in the IS relation о Money doesn't shift the * IS curve.
To sum up, a fiscal contraction may decrease investment. Or, looking at the reverse policy, a fiscal expansion—a decrease in taxes or an increase in spending—may actually increase investment.
Monetary policy, output and the interest rate
An increase in thc money supply is called a monetary expansion. A decrease in the money supply is called a monetary contraction or monetary tightening. This is the simplest way of characterising monetary policy. (We will look at other possibilities in the next section.)
Let's take the case of a monetary expansion. Suppose that the central bank increases nominal money, M. To bring this about, it will have to do open-market operations, purchasing bonds in exchange for nominal money. Given our assumption that the price level is fixed, this increase in nominal money leads to a one-for-one increase in real money, .V1/P. Let us denote the initial real money supply by M/P, the new higher one by M'/P, and trace thc effects ol the increase in the money supply on output and the interest rate.
GOODS AND FINANCIAL MARKETS: FHfc ,5 LM MODEL
chapter 5
• Again, the first step is to see whether and how the IS and thc LAI curves shift. Let's look at the IS curve lirst. Thc money supply doesn't directly affect either the supply of or the demand for goods. In other words, AI doesn't appear in the IS relation. Thus, a change in M doesn't shift the IS curve.
The interest rate enters the LM relation, however, so that thc LM curve shifts down when the money supply changes. As we saw in Section 5.2, an increase in money shifts the LM curve down, Irom LM to LAI': at a given level ol income, an increase in money leads to a decrease in the interest rate.
• Thc second step is to see how these shilts affect the equilibrium. The monetary expansion shifts thc LM curve. It doesn t shift the IS curve. Thus, in figure 5.10 the economy moves along the IS curve, and the equilibrium moves from point /1 to point A'. Output increases Irom У to У and the interest rate decreased from it) to i".
• The third step is to say it in words. The increase in money leads to a lower interest rate, which leads to an increase in investment and through the multiplier to an increase in demand and output.
In contrast to the case ot a fiscal contraction, we can tell exactly what happens to the dilferent components ol demand alter a monetary expansion. Because income is higher and taxes are unchanged, disposable income goes up, and so docs consumption. Because sales are higher, and the interest rate is lower, investment aiso unambiguously goes up. So, a monetary expansion is more investment-friendly than a liscal expansion. To summarise:
• You should remember the three-step approach (characterise the shilts, show the effect on the equilibrium, tell the story in words) developed in this section to look at the effects of changes in policy on activity and the interest rate. We will use it throughout the book.
Money appears in the ► LM relation <=> Money shifts the LM curve.
The IS curve ► doesn't shift, but the LM curve shifts down, with equilibrium moving down the IS curve.
Figure 5.10 The effects of a monetary expansion
• Table 5.1 summarises what we have learned about the effects of fiscal and monetary policy. Llse the same method to look at other changes. For example, trace the effects of a decrease in consumer conlidence through its effect on consumption demand, or of the introduction of new, more convenient credit cards through their effect on the demand for money.
LM
(for MlP)
LM'
/ (for M'lP > MlP)
QT rt A
ы 1
i 9
и ®
£j С
Г i 1 А/
1 IS
r У
Output, Y
A monetary expansion leads to higher output and a lower interest rate.
Table 5.1 The effects of changes in fiscal and monetary policy
Movement in Movement in
Shift of IS Shift of LM output interest rate
Increase in taxes left none down down
Decrease in taxes right none up up
Increase in spending right none up up
Decrease in spending left none down down
Increase in money none down up down
Decrease in money none up down up
4 In all developed countries today, monetary policy is conducted by choosing the interest rate rather than the money stock. For countries with less- developed financial sectors, fixing the money stock is the norm.
4 If a central bank wants the interest rate to be lower, it has to conduct open-market operat ons to increase the money stock, which shifts the LM curve down.
GOODS AND HNANCIAI MARKk IS: IHL S LM MODLL
chapter 5
5.4 USING A POLICY MIX
Let's see il there are any implications lor our analysis ol the short-run equilibrium of the IS-LM model. As lar as monetary policy itsell is concerned, there is no dillcrence,- since a monetary policy expansion involves a downward shift in the LM curve, this can occur either hy a central bank choosing a higher nominal money supply and allowing the interest rate to go down or by choosing a lower interest rate allowing the money stock to go up. Hut when it comes to fiscal policy changes (or any other shock lhat shilts the IS curve), the two types of monetary policy yield different conclusions,
"lake the liscal policy contraction that we analysed in Figure 5.9, which is reproduced in Figure 5.11. You saw how equilibrium went from Л to A' assuming that the central bank chose to keep the money slock constant at AI. Now assume instead that thc central hank has chosen to keep the interest rate constant at /' = /<,.
• In the first step of our analysis we see that the fiscal contraction again leads immediately to a shift to the left of the IS curve.
• For the second step, remember that the central bank is now determined to keep the interest rate constant. I his means that thc new short-run equilibrium must be at point D. With output tailing, money demand tails and so ю keep the interest rate unchanged at /,,. the central bank must conduct open-market sales of bonds to reduce the money stock—the LM curve shilts up to LM'. Compare the effects on output of the tiscal contraction lor the two types ot monetary policy. Output falls much more (Y" < Y'l when lhe central hank keeps lhe interest rate unchanged.
• In words: The liscal policy contraction leads to a much lower level ol output it lhe central bank keeps the interest rate constant than il it had kept thc money stock constant and allowed the interest rate lo tall. The reason is that investment would have been stimulated by the tailing interest rate, thus partly compensating for the reduction in aggregate demand from the fiscal contraction.
We get the same conclusion about the short-run effectiveness
of the two types of monetary policy for any exogenous aggregate demand shock.
Fiscal policy shouldn't be ► studied in isolation from monetary po icy.
You can now see that it's not a good idea lo study fiscal policy without considering how monetary policy is conducted. We obtained very different effects ol tiscal policy depending on the type of monetary policy. This is one reason why it is essential to study policy mixes.
Figure 5.11
Output, У
The effects of a fiscal contraction for two types of monetary policy
A fiscal contraction lowers output more if the central bank chooses to keep the interest rate constant rather than the money supply constant
GOODS AND FINANCIAL MARKETS. THE IS-LM MODEL
chapter 5
Sometimes monetary and fiscal policies are used for a common goal. For example, expansionary monetary policy could he used to offset the adverse ellect on the demand for goods of a liscal contraction. This possibility can be seen in Figure 5.11 when the central bank is assumed to control the interest rate. Seeing the lall in output from the tax increase, the central bank could choose to lower the interest rate to, say, ;", which would solten the blow. This was thc case in the 1990s in the United States, where fiscal policy and monetary policy, used in combination, delivered both sustained deficit reduction and output growth.
FOCUS
f \
' BOX
In Australia, Irom 1986 to 2008, five different policy mixes were employed. First, a tight tiscal and tight monetary policy mix delivered a serious recession in the early 1990s. This mix was completely reversed from 1990 to 1996 which began the long boom of thc 1990s and 2000s. For the third mix Irom 1996. liscal policy was progressively tightened over the next decade, while thc Reserve Bank of Australia usually compensated with regular reductions in interest rates until 2002. The fourth mix continued to mid-2008 with the Reserve Bank progressively ratcheting up interest rates, 3 percentage points in all, to reach 7.25 percent in March 2008. These policies delivered a long boom until late 2008. How it was done in Australia, and how much of the credit for the long boom should go to the Howard government, how much to the central hank governor Ian Macfarlane and his successor Glenn Stevens, and how much lo sheer luck is described in the focus box The Australian policy mixes 1986-2008 . The linal mix occurred in late 2008 as monetary and liscal policy switched to be expansionary as a response to the global financial crisis.
THE AUSTRALIAN POLICY MIXES, 1986-2008
The story of Australia's policy mixes can be gleaned from Figure I, which displays the basic numbers for the budget, output growth and interest rates, from 1986 to 2008, with our forecast for 2009.The budget surplus as a percentage of GDP is for all levels of government, and the interest rate is the cash rate.
20-1
-S-
-10-
Budget surplus/GDP
т—I—I—I—i—I—i—i—i—i—i—i—I—I—I—i—I—t—i—i—I—I—I—I
1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
In the mid-1980s, the Australian economy was substantially deregulated and responded well with solid GDP growth. However, there were some downsides; inflation was high, reaching nearly I I per cent in 1986. and Australia's current account deficit at 6 per cent of GDP was a continuing source of angst.The Bob Hawke government decided to tighten fiscal policy over the next three years, achieving a budget surplus of 1.6 per cent of GDP by 1989. In the same period, Governor Bob Johnston at the Reserve Bank of Australia (RBA),
Figure I Five policy mixes for Australia. 1986-2009
The highlighted areas represent the periods of different policy mixes. SOURCES:RBA вийеол.ТаЫс5 EIO.FOI.GIO.
and his successor, Bernie Fraser. decided to tighten monetary policy by pushing the cash rate up to a peak of 17.3 per cent in 1989. So, for the first highlighted period, we had a tight fiscal and a tight monetary policy mix. No prizes for guessing the outcome—GDP growth collapsed and by 1991 had even turned negative. Unemploy¬ment shot up, eventually peaking at I 1.9 per cent in 1993.The treasurer at the time, Paul Keating, who became prime minister of Australia in 1991. commented, perhaps disingenuously, that this was a recession that Australia had to have.
With that tough policy mix, a recession was indeed inevitable. In Figure 2. the fiscal tightening led to a shift leftwards of the IS curve, and the higher interest rates required the LM curve to shift up as the money supply fell.The equilibrium moved from A to A', with output significantly lower.
From 1990 to 1996. Keating and Fraser did an about-face, switching to the second highlighted policy mix. an expansionary fiscal and expansionary monetary policy, hoping that the painful recession of 1991 had beaten down inflation permanently. It turns out that this hope was justified, and in the next few years output growth did really well, with inflation remaining low. This switched mix can be seen as the reversal of the curve shifts in Figure 2, returning the economy from A' to A.
In 1996 a new government was elected, under John Howard, and once again the old worries about the fiscal deficit returned. (For why deficits are so bad, have a peek at Chapter 27.)
The problem facing Howard was this: as desirable as a deficit reduction might be, implementing it might lead to a decrease in demand, and perhaps put the country back into recession. In terms of the IS-LM model, a shift of the IS to the left might lead to a decrease in output, to a recession.
Yet. over the next few years, the federal deficit in Australia was eliminated, with consecutive surpluses from 1998 to 2000. Despite this, the Australian economy continued with its amazing sustained expansion of GDP for sixteen years from 1992—indeed, mirroring what was happening in the United States. How did Howard (and, equivalently. President Clinton in the United States) do it? It was done with the help of the central bankers—Ian Macfarlane in Australia from 1996, and Alan Greenspan, the governor at the Fed from 1987 to 2005—and also with some luck.
It had become clear to policy-makers in Australia in the mid-1990s that the fiscal deficit was too large and was contributing to an ever-worsening current account deficit and foreign debt. (See Chapter 19 for more on this.) The RBA had in part engineered the deep recession of 1990-91. and the federal government and the RBA were becoming satisfied that the inflation bogey of the 1970s and 1980s had been finally beaten. An implicit deal was struck between the government and the bank that if a path of fiscal deficit reduction was followed, the RBA would counteract any adverse effects of a fiscal contraction on output with a more
Figure 2
LM'
LM
IS
Y
Output, У
The tight fiscal
and tight monetary policy mix
~.OODS ANl) IINANCIAt MARKfc IS: I Ht IS-LM MOUtl
chapter S
expansionary monetary policy. Of course, there was no deal, but the RBA's new inflation-targeting monetary policy produced this mix. (Inflation targeting is discussed in great detail in Chapter 26: have a quick look at that now.) In terms of the IS-LM diagram in Figure 3.as deficit reductions took place (leading to a shift to the left of the IS curve, from IS to IS'), the RBA reduced the interest rate, shifting the LAI curve down (from LM to LM'). In effect, the RBA offset the adverse effects of fiscal contraction on activity, to get the economy to go from A to A' rather than to В (which is where the economy would have gone, in the absence of monetary policy expansion).
As the budget surplus package was implemented, the RBA delivered on its implicit promise—interest rates were lowered to under 5 per cent until 2000. The result of this third highlighted policy mix (fiscal contraction and monetary expansion) was a steady output expansion in the face of deficit reduction.
Was the expansion of output from 1996 to 2000 due only to a smart policy mix? No. it was also due to luck. From 1995 on. various factors, from an unusually strong world economy with consumer and firm confidence to a (perhaps too) strong stock market, led to favourable shifts of the IS curve and in turn to strong output growth. This had two implications:
• First, the RBA didn't have to decrease interest rates further: shifts to the right in the IS curve were enough to sustain activity. However, in 2000-01, the RBA felt it had to slightly increase interest rates, so as to prevent the economy from 'overheating' (more on this in the next four chapters).
• Second, the mechanical effect of this strong expansion was to further reduce the deficit. When an economy grows, tax revenues (which depend directly on output) tend to increase, while spending is largely unaffected—the deficit is automatically reduced. (A useful rule of thumb for Australia is that every additional increase in the growth rate of I per cent per year leads to a decrease in the ratio of the deficit to GDP of 0.4 per cent.) Thus, the mechanical effect of sustained growth was a much larger reduction of the deficit than had been anticipated, even by the Howard government.
The fourth highlighted policy mix was from 2002 to 2008, when fiscal policy remained steadily tight with an average surplus of I.I per cent of GDP. while monetary policy was tightened at regular intervals, raising the cash rate from 4.25 to 7.25 per cent. The RBA was responding to the inflation risks of the long period of sustained growth since 1992, which in their view was pushing the Australian economy to its capacity constraint. Inflation did indeed rise alarmingly, reaching 4.5 per cent in June 2008. well outside the RBA's target range.
J I
Y Y' Output, У
Figure 3
The tight fiscal and expansionary monetary policy mix
However, a major source of this rising inflation had come from the supply-side of the economy in the form of higher global raw material and energy prices. (The next chapter introduces an analysis of the supply-side.)
These supply shocks contributed to a global slowdown in economic activity, but had dissipated by mid-2008. On top of this emerged the global financial crisis, which became critical in September 2008.
See also two related focus boxes:'German unification, interest rates and the EMS' in Chapter 20. and 'Anatomy of a crisis:The September 1992 EMS crisis- in Chapter 21. ►
U5 GERMAN UNIFICATION AND THE GERMAN MONETARY-FISCAL
In the face of these powerful shocks, monetary policy and fiscal policy was significantly eased in most countries, including Australia.This gives the fifth highlighted policy mix. In October 2008, the RBA responded by reducing the cash rate by I percentage point to 6 per cent. Fortunately, oil prices fell significantly in late 2008. and the challenge in 2008-09 for Glenn Stevens at the RBA and the new Rudd government is how to maintain positive output growth in the face of the global financial crisis.
Sometimes the monetary-fiscal mix emerges Irom tensions or even disagreements between the government (which is in charge ol liscal policy) and the central hank (which is in charge of monetary policy). A typical scenario is one in which the central hank, disagreeing with what it considers a dangerous liscal expansion, embarks on a course of monetary contraction to offset some of the eilects of fiscal expansion on activity. An example of such a tension occurred in Germany after unification in thc early 1990s, described in thc focus box 'German unification and the German monetary-fiscal tug of war'.
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