Stabilizers and Multipliers Chapter 21,22, 24, 28, 29.
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Transcript of Stabilizers and Multipliers Chapter 21,22, 24, 28, 29.
Stabilizers and Multipliers
Chapter 21,22, 24, 28, 29
Consumption and Investment Expenditure are Sensitive to the
Business Cycle
• Multiplier Effect: When household income increases, household consumption will also increase.
• Financial Accelerator Effect: Download When business cycle conditions improve, business cash flow also improves. Businesses, especially those without access to financial markets, rely on cash flow for financing.
Expenditure is a Feedback Loop
• Consumption and Investment Expenditure are determined by household and corporate income.
• Income is determined by the value added of output in the economy.
• Output (at a given wage level) will be determined by demand for expenditure.
Multiplier Effect
IncomeIncome
ProductionProduction
SavingsSavings
ConsumptionConsumption
Multiplier Effect 2
IncomeIncome
ProductionProduction
SavingsSavings
ConsumptionConsumption
Multiplier Effect 3
IncomeIncome
ProductionProduction
SavingsSavings
ConsumptionConsumption
Multiplier Effect in the Open Economy
• Multiplier feedback is moderated by international trade.
• Some of the extra expenditure generated by extra income/cash flow will be spent on imports and thus not generate extra demand for domestic goods.
• Multiplier effect smaller in economies that spend a high fraction of their income on imported goods.
Multiplier Effect: Open Economy
IncomeIncome
ProductionProduction
SavingsSavings
ConsumptionConsumption
ImportsImports
Investment & Business Cycles
• Corporate & residential investment tends to be one of the most pro-cyclical economic variables though rising real rates during boom may tend to ameliorate these effects.
• Reasons:– Investment may be a driver of business cycles
due to animal spirits or advances in technology.– Financial Accelerator Effect
Stabilizers
Monetary Policy
Channel of Monetary Policy
• When the central bank increases the monetary base, the money supply will increase.
• Banks have excess liquidity which they use to make more loans.
• The supply of liquidity will exceed demand and banks must compete to attract borrowers who will hold this liquidity only at a lower interest rate.
Dynamics of Monetary Transmission
• Money supply expansion reduces interest rates
• Lower interest rates implies an increase in borrowing and affects demand for interest sensitive goods.
• Lower interest rates increase demand for US$ in forex market depreciating the exchange rate.
• Aggregate demand shifts out. Given fixed input prices this increase in demand stimulates output.
Monetary Transmission Mechanism
ECB Web Site
P
YAD
Expansionary Monetary Policy
AD′
ΔI ΔC, ΔNX
P
Y
AD
An Expansionary Cycle Driven by monetary policy
P*
SRAS
YP
AD′1
2
Output Gap
1. Economy at LT YP.
2. Monetary Policy Cuts Interest Rate
3. Investment rises. The AD curve shifts out.
4. Tight labor markets. SRAS returns to long run equilibrium
3
Interest Rate Management
• In most economies around the world, the central bank does not simply act to maintain a fixed money supply.
• Rather, they adjust money supply to maintain and manage interest rate changes in response to business cycle conditions.
Monetary Policy
• In the US (and Euroland and Japan and most OECD economies), the central bank sets monetary policy by picking a short-run interest rate they would like to prevail.
• In HK, the central bank sets monetary policy by picking a fixed exchange rate.
U.S. Central bank cuts interest rates during recessions
P
YY* AD
Demand Driven Recession w/ Counter-cyclical
monetary policy
P*
SRAS
YP
AD′
1
2
1. Economy in a recession. Fed detects deflationary pressure
2. Monetary Policy Cuts Interest Rate
3. Investment increases spending to shift the AD curve back to long run equilibrium Recessionary Gap
P
Y
AD
Demand Driven Expansion w/ Counter-cyclical
monetary policy
P*
SRAS
YP
AD′
1
2
Inflationary Gap
1. Economy in expansion. Fed detects inflationary pressure
2. Monetary Policy Raises Interest Rate
3. Investment decreases spending to shift the AD curve back to long run equilibrium
Taylor Rule• Economist named John Taylor argues that
US target interest rate is well represented by a function of
1. current inflation
2. Inflation GAP: current inflation vs. target inflation
3. Output Gap: % deviation of GDP from long run path
• Function: Inflation Target π* = .02
*1 12 2.025 ( )TGT
t t t ti Output Gap
The Taylor Rule Download
What should be the current Fed Funds rate? Will they be increasing it soon?
• Step 1. Find Inflation Rate
• Step 2. Find Output Gap
• Step 3. Calculate Taylor Rule implied rate and compare with current rate.
Answer
P_2008_2 121.91P_2007_2 120.00Inflation 0.016Y 11740.3YP 11904.0Output Gap -0.014Inflation Gap -0.004Taylor Rule 0.032Fed Funds Rate 0.02
US Recessions are becoming shorter as stabilization policies were adopted.
Average Length of Contraction
0
5
10
15
20
25
1854-1919 1919-1945 1945-2001
Mo
nth
s
Fiscal Policy
Sources of Revenue HK 2004/2005
Profit Tax24%
Salaries Tax & Property, Other
21%
Investment Income10%
Land Premium & Sales20%
Betting, Fees, Duties25%
HK Government Outlays by Category 2005/06
Economic6%
Education22%
Environment and Food4%
Health13%
Infrastructure10%
Security10%
Social Welfare14%
Support12%
Community Affairs 3%
Housing6%
Fiscal Policy
• The government directly controls its own expenditure and can thereby directly affect aggregate demand.
• The government controls the tax levels and therefore they can indirectly impact the spending of households that pay taxes. – Expansionary policy: Increase spending, cut
taxes.– Contractionary policy: Decrease spending, raise
taxes
Stabilization policy• In an economy subject to shocks to aggregate
demand (animal spirit shocks, external shocks, asset market shocks), the economy will have a self-correcting mechanism.
• However, if this self-correction mechanism takes a long time to work, then government may use policy to speed adjustment.– Use expansionary policy to close a recessionary gap– Use contractionary policy to close an inflationary
gap
P
YY*
AD
Demand Driven Recession w/ Counter-cyclical fiscal policy
P*
SRAS
YP
AD′
1
2
1. Economy in LT equilibrium
2. Demand shifts in
3. Government increases spending to shift the AD curve back
3
Recessionary Gap
P
YY* AD
Demand Driven Expansion w/ Counter-cyclical fiscal policy
P*
SRAS
YP
AD′1
2
1. Economy in LT equilibrium
2. Demand shifts out
3. Government cuts spending to shift the AD curve back 3
Inflationary Gap
Lags and Fiscal Policy
• Administrative lags for fiscal policy may likely be large.• Except in absolute dictatorships, government will have
mechanisms for building a consensus for expenditures. Adjusting this consensus will be time consuming.
• If lags are too long, stabilizing government spending or transfer payments may have a destabilizing effect, shifting out demand after the economy has already recovered.
Automatic Stabilizers
• Taxes are usually collected as a fraction of incomes of households. Even if the government keeps the tax rate unchanged.– When the economy goes into a boom, taxes are
automatically raised mitigating the effects of the boom.
– When the economy goes into a recession, taxes are automatically cut, ameliorating the recession.
Budget Deficit• Governments in most economies issue debt to
make up for shortfalls in revenues in relation to spending.
Budget Deficit = Expenditures – Taxes• Tax collection is cyclical so the budget deficit
tends to be counter-cyclical. • Maintaining a balanced budget over the cycle
means raising taxes in a recession an cutting taxes in a boom which makes the business cycle more extreme.
Procyclical Budget Surplus in HK
-.08
-.04
.00
.04
.08
.12
1990 1992 1994 1996 1998 2000 2002 2004 2006
Budget Surplus (as a % of GDP)Detrended GDP
Most Economies Have Positive Government Debt.
Debt/GDP
020406080
100120140160180
Alb
ania
Be
larus
Bo
tswa
na
Chile
Co
te d
'Ivoire
India
Israe
l
Mo
ngo
lia
Pe
ru
Po
land
Sing
ap
ore
Tha
iland
Turke
y%
Why would a persistent deficit be a problem?
Two Reasons
1. High government borrowing may push up interest rates and crowd out investment
2. High government borrowing means that the interest obligations of the government will rise.
Budget Surplus in USA (as a % of GDP)
-7.00%
-6.00%
-5.00%
-4.00%
-3.00%
-2.00%
-1.00%
0.00%19
75
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
Government Interest Payments per US Resident
$0.00
$100.00
$200.00
$300.00
$400.00
$500.00
$600.00
$700.00
$800.00
$900.00
$1,000.00
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
US
$
Hong Kong Has Traditionally had negative Debt.
Government Wealth
0
100000
200000
300000
400000
500000
600000
700000
800000
Question: Problem with Central Bank Stabilization
• Situation: Economy is in long-run equilibrium, but central bank overestimates potential output.
• Draw outcome if central bank believes that the potential output is higher than it is.
Learning Outcomes
Students should be able to:• Explain the effect of business cycles on different
components of expenditure• Use the Taylor rule to calculate a forecast of U.S. interest
rates. • Explain the uses of counter-cyclical monetary and fiscal
policy in stabilization.• Explain the effect of budget deficits on real interest rates
on capital markets.• Explain the negative effects of long-term budget deficits.