Knowledges macroeconomics (Eleventh edition): Part 2

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www.downloadslide.net C HAPTER 11 Monetary and Fiscal Policy CHAPTER HIGHLIGHTS • Both fiscal and monetary policy can be used to stabilize the economy. • The effect of fiscal policy is reduced by crowding out: Increased government spending increases interest rates, reducing investment and partially offsetting the initial expansion in aggregate demand. • As illustrative polar cases: In the case of the liquidity trap the LM curve is horizontal, fiscal policy has its maximum strength, and monetary policy is ineffective. In the classical case the LM curve is vertical, fiscal policy has no effect on output, and monetary policy has its maximum strength. dor75926_ch11_248-282.indd 248 03/11/10 3:21 PM www.downloadslide.net CHAPTER 11•MONETARY AND FISCAL POLICY 249 America’s economy crashed in 2008. Figure 11-1 shows the movement of the unemployment rate and the federal funds rate (the Fed’s key interest rate) during the end of the boom and through the Great Recession. As seen from Figure 11-1, the Federal Reserve drove the federal funds rate as low as the rate could go to stimulate the economy during the downturn. The rate fell from 5 percent in August 2007 to 2 percent in August 2008 to 0.16 percent in August 2009. In addition, the president and Congress enacted tax cuts and major new spending programs in early 2008. In this chapter we use the IS-LM model developed in Chapter 10 to show how monetary policy and fiscal policy work. These are the two main macroeconomic policy tools the government can call on to try to keep the economy growing at a reasonable rate, with low inflation. They are also the policy tools the government uses to try to shorten recessions, as in 1991, 2001, and 2007–2009, and to prevent booms from getting out of hand. Fiscal policy has its initial impact in the goods market, and monetary policy has its initial impact mainly in the assets markets. But because the goods and assets markets are closely interconnected, both monetary and fiscal policies have effects on both the level of output and interest rates. Figure 11-2 will refresh your memory of our basic framework. The IS curve represents equilibrium in the goods market. The LM curve represents equilibrium in the money market. The intersection of the two curves determines output and interest rates in the short run, that is, for a given price level. Expansionary monetary policy moves the LM curve to the right, raising income and lowering interest rates. Contractionary monetary policy moves the LM curve to the left, lowering income and raising interest rates. Expansionary fiscal policy moves the IS curve to the right, raising both income and 12 10 Percent 8 Unemployment Rate 6 4 Federal Funds Rate 2 0 I II III IV 2005 I II III IV 2006 I II III IV 2007 I II III IV 2008 I II III IV 2009 I 2010 Months FIGURE 11-1 THE GREAT RECESSION. The recession began in 2007 and ended in 2009. Very sharp drops in interest rates were aimed at limiting the depth and length of the recession. (Source: Bureau of Labor Statistics; Federal Reserve Economic Data [FRED II].) dor75926_ch11_248-282.indd 249 03/11/10 3:21 PM www.downloadslide.net 250 PART 3•FIRST MODELS i Interest rate LM E i0 IS 0 Y0 Y Income, output FIGURE 11-2 IS-LM EQUILIBRIUM. interest rates. Contractionary fiscal policy moves the IS curve to the left, lowering both income and interest rates. 11-1 MONETARY POLICY In Chapter 10 we showed how an increase in the quantity of money affects the economy, increasing the level of output by reducing interest rates. In the United States, the Federal Reserve System, a quasi-independent part of the government, is responsible for monetary policy. The Fed conducts monetary policy mainly through open market operations, which we study in more detail in Chapter 16. In an open market operation, the Federal Reserve buys bonds (or sometimes other assets) in exchange for money, thus increasing the stock of money, or it sells bonds in exchange for money paid by the purchasers of the bonds, thus reducing the money stock. We take here the case of an open market purchase of bonds. The Fed pays for the bonds it buys with money that it can create. One can usefully think of the Fed as “printing” money with which to buy bonds, even though that is not strictly accurate, as we shall see in Chapter 16. When the Fed buys bonds, it reduces the quantity of bonds available in the market and thereby tends to increase their price, or lower their yield— only at a lower interest rate will the public be prepared to hold a smaller fraction of its wealth in the form of bonds and a larger fraction in the form of money. dor75926_ch11_248-282.indd 250 03/11/10 3:21 PM www.downloadslide.net CHAPTER 11•MONETARY AND FISCAL POLICY i 251 LM 1 (ΔM/P) k E LM´ Interest rate i0 E´ i’ E1 IS Y0 0 Y’ Y Income, output FIGURE 11-3 MONETARY POLICY. An increase in the real money stock shifts the LM curve to the right. Figure 11-3 shows graphically how an open market purchase works. The initial equilibrium at point E is on the initial LM schedule that corresponds to a real money −− − supply, M冒P. Now consider an open market purchase by the Fed. This increases the nominal quantity of money and, given the price level, the real quantity of money. As a consequence, the LM schedule will shift to LM⬘. The new equilibrium will be at point E⬘, with a lower interest rate and a higher level of income. The equilibrium level of income rises because the open market purchase reduces the interest rate and thereby increases investment spending. By experimenting with Figure 11-3, you will be able to show that the steeper the LM schedule, the larger the change in income. If money demand is very sensitive to the interest rate (corresponding to a relatively flat LM curve), a given change in the money stock can be absorbed in the assets markets with only a small change in the interest rate. The effects of an open market purchase on investment spending would then be small. By contrast, if the demand for money is not very sensitive to the interest rate (corresponding to a relatively steep LM curve), a given change in the money supply will cause a large change in the interest rate and have a big effect on investment demand. Similarly, if the demand for money is very sensitive to income, a given increase in the money stock can be absorbed with a relatively small change in income and the monetary multiplier will be smaller.1 1 The precise expression for the monetary policy multiplier is given in equation (11) in Chap. 10. If you have worked through the optional Sec. 10-5, you should use that equation to confirm the statements in this paragraph. dor75926_ch11_248-282.indd 251 03/11/10 3:21 PM www.downloadslide.net PART 3•FIRST MODELS 252 Consider next the process of adjustment to the monetary expansion. At the initial equilibrium point, E, the increase in the money supply creates an excess supply of money to which the public adjusts by trying to buy other assets. In the process, asset prices increase and yields decline. Because money and asset markets adjust rapidly, we move immediately to point E1, where the money market clears and where the public is willing to hold the larger real quantity of money because the interest rate has declined sufficiently. At point E1, however, there is an excess demand for goods. The decline in the interest rate, given the initial income level Y0, has raised aggregate demand and is causing inventories to run down. In response, output expands and we start moving up the LM⬘ schedule. Why does the interest rate rise during the adjustment process? Because the increase in output raises the demand for money, and the greater demand for money has to be checked by higher interest rates. Thus, the increase in the money stock first causes interest rates to fall as the public adjusts its portfolio and then—as a result of the decline in interest rates—increases aggregate demand. THE TRANSMISSION MECHANISM Two steps in the transmission mechanism—the process by which changes in monetary policy affect aggregate demand—are essential. The first is that an increase in real balances generates a portfolio disequilibrium; that is, at the prevailing interest rate and level of income, people are holding more money than they want. This causes portfolio holders to attempt to reduce their money holdings by buying other assets, thereby changing asset prices and yields. In other words, the change in the money supply changes interest rates. The second stage of the transmission process occurs when the change in interest rates affects aggregate demand. These two stages of the transmission process appear in almost every analysis of the effects of changes in the money supply on the economy. The details of the analyses will often differ—some analyses will have more than two assets and more than one interest rate; some will include an influence of interest rates on other categories of demand, in particular consumption and spending by local government.2 Table 11-1 provides a summary of the stages in the transmission mechanism. There are two critical links between the change in real balances (i.e., the real money stock) and the ultimate effect on income. First, the change in real balances, by bringing about portfolio disequilibrium, must lead to a change in interest rates. Second, that change in interest rates must change aggregate demand. Through these two linkages, changes in 2 Some analyses also include a mechanism by which changes in real balances have a direct effect on aggregate demand through the real balance effect. The real-balance-effect argument is that wealth affects consumption demand and that an increase in real (money) balances increases wealth and therefore consumption demand. The real balance effect is not very important empirically, because the relevant real balances are only a small part of wealth. The classic work on the topic is Don Patinkin, Money, Interest and Prices (New York: Harper & Row, 1965). dor75926_ch11_248-282.indd 252 03/11/10 3:21 PM www.downloadslide.net CHAPTER 11•MONETARY AND FISCAL POLICY TABLE 11-1 253 The Transmission Mechanism (1) ⎯⎯⎯⎯⎯→ (2) ⎯⎯⎯⎯⎯⎯→ (3) ⎯⎯⎯⎯⎯⎯→ (4) 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. the real money stock affect the level of output in the economy. But that outcome immediately implies the following: If portfolio imbalances do not lead to significant changes in interest rates, for whatever reason, or if spending does not respond to changes in interest rates, the link between money and output does not exist.3 We now study these linkages in more detail. THE LIQUIDITY TRAP In discussing the effects of monetary policy on the economy, two extreme cases have received much attention. The first is the liquidity trap, a situation in which the public is prepared, at a given interest rate, to hold whatever amount of money is supplied. This implies that the LM curve is horizontal and that changes in the quantity of money do not shift it. 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 possibility of a liquidity trap at low interest rates is a notion that grew out of the theories of the great English economist John Maynard Keynes. Keynes himself did state, though, that he was not aware of there ever having been such a situation.4 Historically, the liquidity trap has been a useful expositional device mostly for understanding the consequences of a relatively flat LM curve, with little immediate relevance to policymakers. But there is one situation in which the liquidity trap can be of critical practical concern—that’s when interest rates are so close to zero that they can’t go any lower. We discuss this case in the boxes that follow. 3 We refer to the responsiveness of aggregate demand—rather than investment spending—to the interest rate because consumption demand—think of buying a new car for example—may also respond to the interest rate. Higher interest rates may lead to more saving and less consumption at a given level of income. Empirically, it has been difficult to isolate such an interest rate effect on consumption (at least for consumption of nondurables and services). 4 J. M. Keynes, The General Theory of Employment, Interest and Money (New York: Macmillan, 1936), p. 207. Some economists, most notably Paul Krugman of Princeton, have suggested that Japan’s economy at the turn of the century was in a liquidity trap. See “Japan: Still Trapped” on Krugman’s website (www.princeton. edu/~pkrugman). dor75926_ch11_248-282.indd 253 03/11/10 3:21 PM www.downloadslide.net PART 3•FIRST MODELS 254 BOX 11-1 The Case of the For-Real Liquidity Trap—What Happens When the Interest Rate Hits Zero? No amount of printing money will push the nominal interest rate below zero! Suppose you could borrow at minus 5 percent. You could borrow $100 today, keep it as cash, pay back $95 in a year, and pocket the difference. The demand for money would be infinite! Once the interest rate hits zero, there is nothing further that a central bank can do with conventional monetary policy to stimulate the economy because monetary policy cannot reduce interest rates any further. Figure 1 shows that this is pretty much what happened in Japan in the late 1990s and in the early years of the twenty-first century. Interest rates went from a few percent, down to around .5 percent, and then effectively to zero. The inability to use conventional monetary policy to stimulate the economy in a liquidity trap had long been mostly important as an illustrative example for textbook writers. But in Japan the zero interest rate liquidity trap became a very real policy issue. UNDERNEATH THE ZERO INTEREST RATE LOWER BOUND You will remember that the nominal interest rate has two parts: the real interest rate and expected inflation. As a practical matter, an economy hits a zero interest rate bound when it experiences significant deflation. (Deflation means that prices are dropping or, equivalently, that the inflation rate is negative.) One way for policymakers to avoid the zero interest rate liquidity trap is to pump out enough money to keep inflation slightly positive. Could the United States experience a zero interest rate liquidity trap? Unlikely, but not impossible. But should it occur, Federal Reserve policymakers are prepared to use unconventional monetary policy, such as buying long-term bonds and other assets, to BANKS’ RELUCTANCE TO LEND? In 1991 a different possibility arose to suggest that sometimes monetary policy actions by the Fed might have only a very limited impact on the economy. In step (3) in Table 11-1, investment spending should increase in response to lower interest rates. However, in 1991, as interest rates declined, banks were reluctant to increase their lending. The underlying reason was that many banks had made bad loans at the end of the 1980s, especially to finance real estate deals. When the real estate market collapsed in 1990 and 1991, banks faced the prospect that a significant portion of their existing dor75926_ch11_248-282.indd 254 03/11/10 3:21 PM www.downloadslide.net CHAPTER 11•MONETARY AND FISCAL POLICY 255 pump money into the economy. To quote then Federal Reserve Board governor and later chairman Ben Bernanke, To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. . . . [T]he chances of a serious deflation in the United States appear remote indeed, in large part because of our economy’s underlying strengths but also because of the determination of the Federal Reserve and other U.S. policymakers to act preemptively against deflationary pressures. —Speech before the National Economists Club, Washington, D.C., November 21, 2002 2.5 Interest rate (%) 2 1.5 1 0.5 0 1995 FIGURE 1 1996 1997 1998 1999 2000 2001 2002 2003 2004 JAPANESE INTEREST RATES. (Source: www.economagic.com.) borrowers could not repay in full. Not surprisingly, banks showed little enthusiasm to lend more to new, perhaps risky, borrowers. Rather, they preferred to lend to the government, by buying securities such as Treasury bills. Lending to the U.S. government is as safe as any loan can be, because the U.S. government always pays its debts.5 5 In 1995 the United States came close to suspending debt repayment while the president and Congress played a game of chicken over the federal budget. In the end, no payments were actually missed. (For readers unfamiliar with American slang, “chicken” is a game in which two male adolescents with more hormones than intelligence drive cars head-on at one another at high speed. The first one to turn aside is said to “chicken out”—to show cowardice. If neither turns aside, the results are much like the results of the U.S. government’s failing to pay its debt.) dor75926_ch11_248-282.indd 255 03/11/10 3:21 PM www.downloadslide.net PART 3•FIRST MODELS 256 What Did Happen When the Interest Rate Hit Zero? BOX 11-2 We’ve left Box 11-1 untouched from the previous edition, including—in the interest of fair play—the lines “Could the United States experience a zero interest liquidity trap? Unlikely, but not impossible. But should it occur, Federal Reserve policymakers are prepared to use unconventional monetary, such as buying long-term bonds and other assets…” Figure 1 shows the federal funds rate from April 2008 through April 2010. By late 2008 the interest rate had effectively hit zero. Why? Because the Fed deliberately drove the rate to the bottom to fight the recession. And, just as Ben Bernanke had promised, the Fed bought unconventional assets to stem the financial crisis. 2.4 2.0 1.6 1.2 0.8 0.4 0.0 II III IV 2008 FIGURE 1 I II 2009 III IV I II 2010 FEDERAL FUNDS RATES. (Source: Federal Reserve Economic Data [FRED II].) If banks will not lend to firms, an important part of the transmission mechanism between a Fed open market purchase and an increase in aggregate demand and output is put out of action. Careful study suggested that banks were lending less to private firms than usual for this stage of the business cycle.6 However, many argued that further open 6 See, for example, Ben Bernanke and Cara Lown, “The Credit Crunch,” Brookings Papers on Economic Activity 2 (1991). dor75926_ch11_248-282.indd 256 03/11/10 3:21 PM www.downloadslide.net CHAPTER 11•MONETARY AND FISCAL POLICY BOX 11-3 257 Q: Does the Federal Reserve Set the Interest Rate, or Does It Set the Money Supply? A: YES. According to our discussion here, the Federal Reserve sets the money supply, through open market operations, and this pins down the position of the LM curve. But in the news (and in Chapter 8) one frequently reads that the Fed has either raised or lowered interest rates. How are the two connected? The answer is that, as long as the positions of the IS and LM curves are known to the Fed, the two are equivalent.* i Interest rate LM i0 E IS Y 0 (a) FIGURE 1 PEGGING THE INTEREST RATE. *In practice the positions of the IS and LM curves are not known with absolute precision, and in the short run the difference between setting interest rates and setting the money supply is quite important. We investigate this question in detail in Chapter 16. (continued) dor75926_ch11_248-282.indd 257 03/11/10 3:21 PM
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