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Fiscal andMonetary Policy
Fiscal and Monetary PolicyFiscal and Monetary Policy
The Nature of Fiscal Policy
The Nature of Fiscal Policy
THE NATURE OF FISCAL POLICYTHE NATURE OF FISCAL POLICY
The purpose of fiscal policy correcting a fundamental disequilibrium
fine tuning
Government finances budget deficits and surpluses
financing a deficit
the PSNCR
The purpose of fiscal policy correcting a fundamental disequilibrium
fine tuning
Government finances budget deficits and surpluses
financing a deficit
the PSNCR
UK public-sector deficits/surpluses: 1979–2001
Year 1979 1980 1981 1982 1983 1984
PSNCR (£bn) 12.5 11.4 10.6 5.3 11.1 10.3
% of GDP 6.3 5.0 4.2 1.9 3.7 3.2
Year 1985 1986 1987 1988 1989 1990
PSNCR (£bn) (–ve = surplus) 7.6 2.6 –1.2 –11.5 –9.1 –1.3
% of GDP (–ve = surplus) 2.1 0.7 –0.3 –2.4 –1.8 –0.2
Year 1991 1992 1993 1994 1995 1996
PSNCR (£bn) 7.0 28.6 43.2 39.4 35.4 24.8
% of GDP 1.2 4.7 6.7 5.8 4.9 3.3
Year 1997 1998 1999 2000 2001
PSNCR (£bn) (–ve = surplus) 11.9 –6.4 –1.8 –37.3 –2.7
% of GDP (–ve = surplus) 1.5 –0.7 –0.2 –4.0 –0.3
UK public-sector deficits/surpluses: 1979–2001
Year 1979 1980 1981 1982 1983 1984
PSNCR (£bn) 12.5 11.4 10.6 5.3 11.1 10.3
% of GDP 6.3 5.0 4.2 1.9 3.7 3.2
Year 1985 1986 1987 1988 1989 1990
PSNCR (£bn) (–ve = surplus) 7.6 2.6 –1.2 –11.5 –9.1 –1.3
% of GDP (–ve = surplus) 2.1 0.7 –0.3 –2.4 –1.8 –0.2
Year 1991 1992 1993 1994 1995 1996
PSNCR (£bn) 7.0 28.6 43.2 39.4 35.4 24.8
% of GDP 1.2 4.7 6.7 5.8 4.9 3.3
Year 1997 1998 1999 2000 2001
PSNCR (£bn) (–ve = surplus) 11.9 –6.4 –1.8 –37.3 –2.7
% of GDP (–ve = surplus) 1.5 –0.7 –0.2 –4.0 –0.3
UK public-sector deficits/surpluses: 1979–2001
Year 1979 1980 1981 1982 1983 1984
PSNCR (£bn) 12.5 11.4 10.6 5.3 11.1 10.3
% of GDP 6.3 5.0 4.2 1.9 3.7 3.2
Year 1985 1986 1987 1988 1989 1990
PSNCR (£bn) (–ve = surplus) 7.6 2.6 –1.2 –11.5 –9.1 –1.3
% of GDP (–ve = surplus) 2.1 0.7 –0.3 –2.4 –1.8 –0.2
Year 1991 1992 1993 1994 1995 1996
PSNCR (£bn) 7.0 28.6 43.2 39.4 35.4 24.8
% of GDP 1.2 4.7 6.7 5.8 4.9 3.3
Year 1997 1998 1999 2000 2001
PSNCR (£bn) (–ve = surplus) 11.9 –6.4 –1.8 –37.3 –2.7
% of GDP (–ve = surplus) 1.5 –0.7 –0.2 –4.0 –0.3
UK public-sector deficits/surpluses: 1979–2001
Year 1979 1980 1981 1982 1983 1984
PSNCR (£bn) 12.5 11.4 10.6 5.3 11.1 10.3
% of GDP 6.3 5.0 4.2 1.9 3.7 3.2
Year 1985 1986 1987 1988 1989 1990
PSNCR (£bn) (–ve = surplus) 7.6 2.6 –1.2 –11.5 –9.1 –1.3
% of GDP (–ve = surplus) 2.1 0.7 –0.3 –2.4 –1.8 –0.2
Year 1991 1992 1993 1994 1995 1996
PSNCR (£bn) 7.0 28.6 43.2 39.4 35.4 24.8
% of GDP 1.2 4.7 6.7 5.8 4.9 3.3
Year 1997 1998 1999 2000 2001
PSNCR (£bn) (–ve = surplus) 11.9 –6.4 –1.8 –37.3 –2.7
% of GDP (–ve = surplus) 1.5 –0.7 –0.2 –4.0 –0.3
Ann
ual g
row
th r
ate
(%)
UK general government expenditure as % of GDPUK general government expenditure as % of GDP
34
36
38
40
42
44
46
48
50
1970 1975 1980 1985 1990 1995 2000
Ann
ual g
row
th r
ate
(%)
UK general government expenditure as % of GDPUK general government expenditure as % of GDP
34
36
38
40
42
44
46
48
50
1970 1975 1980 1985 1990 1995 2000
Health 12.3%Education 10.9%
Other 7.3%
Defence 10.1%
Economic Affairs 7.7%
Public order 5.1%
HI
J
K
Social protection 36%
Social protection 39.0%
Health 14.2%Education 11.5 %
Other 14.2%
Defence 7.3%
Economic affairs 6.4%
Public order 5.6%H I
J
K
H General public services 4.4%I Housing, etc 3.6%J Recreation, etc 1.7%K Environment 0.9%
1991 1999
UK general government expenditure by function (%)UK general government expenditure by function (%)
H General public services 5.1%I Housing, etc 1.5%J Recreation, etc 1.0%K Environment 0.7%
Health 12.3%Education 10.9%
Other 7.3%
Defence 10.1%
Economic Affairs 7.7%
Public order 5.1%
HI
J
K
Social protection 36%
Social protection 39.0%
Health 14.2%Education 11.5 %
Other 14.2%
Defence 7.3%
Economic affairs 6.4%
Public order 5.6%H I
J
K
H General public services 4.4%I Housing, etc 3.6%J Recreation, etc 1.7%K Environment 0.9%
1991 1999
UK general government expenditure by function (%)UK general government expenditure by function (%)
H General public services 5.1%I Housing, etc 1.5%J Recreation, etc 1.0%K Environment 0.7%
General government deficits (–)or surpluses (+)
General government debt
Average1990–95
Average1996–2001
Average1990–95
Average1996–2001
Belgium –6.4 –1.8 128.9 117.3
France –4.3 –2.4 48.5 64.3
Ireland –2.6 +2.2 84.2 52.4
Italy –10.2 –2.7 115.4 115.5
Japan –0.8 –5.7 68.8 108.7
Netherlands –4.2 0.0 75.8 64.2
Sweden –6.1 +1.2 65.3 67.8
UK –5.3 –0.4 52.1 57.4
USA –4.5 +0.1 72.9 66.0
Euro area –5.1 –1.9 66.8 75.7
General government deficits/surplusesand debt as % of GDP
General government deficits (–)or surpluses (+)
General government debt
Average1990–95
Average1996–2001
Average1990–95
Average1996–2001
Belgium –6.4 –1.8 128.9 117.3
France –4.3 –2.4 48.5 64.3
Ireland –2.6 +2.2 84.2 52.4
Italy –10.2 –2.7 115.4 115.5
Japan –0.8 –5.7 68.8 108.7
Netherlands –4.2 0.0 75.8 64.2
Sweden –6.1 +1.2 65.3 67.8
UK –5.3 –0.4 52.1 57.4
USA –4.5 +0.1 72.9 66.0
Euro area –5.1 –1.9 66.8 75.7
General government deficits/surplusesand debt as % of GDP
THE NATURE OF FISCAL POLICYTHE NATURE OF FISCAL POLICY
The purpose of fiscal policy correcting a fundamental disequilibrium
fine tuning
Government finances budget deficits and surpluses
financing a deficit
the PSNCR
the national debt and public-sector debt
The purpose of fiscal policy correcting a fundamental disequilibrium
fine tuning
Government finances budget deficits and surpluses
financing a deficit
the PSNCR
the national debt and public-sector debt
Getting budget deficits down?Getting budget deficits down?
-3
-1
1
3
5
7
9
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001Bud
get d
efic
its a
s a
% o
f GD
P
France
-3
-1
1
3
5
7
9
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001Bud
get d
efic
its a
s a
% o
f GD
PGetting budget deficits down?Getting budget deficits down?
FranceGermany
-3
-1
1
3
5
7
9
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001Bud
get d
efic
its a
s a
% o
f GD
PGetting budget deficits down?Getting budget deficits down?
FranceGermany
Italy
-3
-1
1
3
5
7
9
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001Bud
get d
efic
its a
s a
% o
f GD
PGetting budget deficits down?Getting budget deficits down?
Spain
FranceGermany
Italy
-3
-1
1
3
5
7
9
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001Bud
get d
efic
its a
s a
% o
f GD
PGetting budget deficits down?Getting budget deficits down?
Spain
FranceGermany
Italy
Belgium
-3
-1
1
3
5
7
9
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001Bud
get d
efic
its a
s a
% o
f GD
PGetting budget deficits down?Getting budget deficits down?
Spain
FranceGermany
Italy
Netherlands
Belgium
-3
-1
1
3
5
7
9
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001Bud
get d
efic
its a
s a
% o
f GD
PGetting budget deficits down?Getting budget deficits down?
30
35
40
45
50
55
60
65
70
75
80
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
National Debt(as % of GDP)
National DebtNational Debt
30
35
40
45
50
55
60
65
70
75
80
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
National Debt(as % of GDP)
National DebtNational Debt
UK
30
35
40
45
50
55
60
65
70
75
80
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
USA
National Debt(as % of GDP)
National DebtNational Debt
UK
30
35
40
45
50
55
60
65
70
75
80
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
Euroarea
USA
UK
National Debt(as % of GDP)
National DebtNational Debt
THE NATURE OF FISCAL POLICYTHE NATURE OF FISCAL POLICY
Public-sector deficits or surpluses and the government’s fiscal stance fiscal stance and the state of the economy the structural balance
Automatic fiscal stabilisers tax stabilisers benefits stabilisers
Public-sector deficits or surpluses and the government’s fiscal stance fiscal stance and the state of the economy the structural balance
Automatic fiscal stabilisers tax stabilisers benefits stabilisers
O
G, T
Y
Tax revenue
Gov. expenditure(incl. benefits)
Y1
DEFICIT
SURPLUS
National income and the size of the public-sector deficit or surplusNational income and the size of the public-sector deficit or surplus
THE NATURE OF FISCAL POLICYTHE NATURE OF FISCAL POLICY
Public-sector deficits or surpluses and the government’s fiscal stance fiscal stance and the state of the economy the structural balance
Automatic fiscal stabilisers tax stabilisers benefits stabilisers
Discretionary fiscal policy
Public-sector deficits or surpluses and the government’s fiscal stance fiscal stance and the state of the economy the structural balance
Automatic fiscal stabilisers tax stabilisers benefits stabilisers
Discretionary fiscal policy
THE NATURE OF FISCAL POLICYTHE NATURE OF FISCAL POLICY
Public-sector deficits or surpluses and the government’s fiscal stance fiscal stance and the state of the economy the structural balance
Automatic fiscal stabilisers tax stabilisers benefits stabilisers
Discretionary fiscal policy changing government expenditure
Public-sector deficits or surpluses and the government’s fiscal stance fiscal stance and the state of the economy the structural balance
Automatic fiscal stabilisers tax stabilisers benefits stabilisers
Discretionary fiscal policy changing government expenditure
THE NATURE OF FISCAL POLICYTHE NATURE OF FISCAL POLICY
Public-sector deficits or surpluses and the government’s fiscal stance fiscal stance and the state of the economy the structural balance
Automatic fiscal stabilisers tax stabilisers benefits stabilisers
Discretionary fiscal policy changing government expenditure changing taxes
Public-sector deficits or surpluses and the government’s fiscal stance fiscal stance and the state of the economy the structural balance
Automatic fiscal stabilisers tax stabilisers benefits stabilisers
Discretionary fiscal policy changing government expenditure changing taxes
A cut in taxes: (a) lump-sum taxesA cut in taxes: (a) lump-sum taxes
O
W, J
Y
W1
O
W, J
Y
W1
W2
A cut in taxes: (a) lump-sum taxesA cut in taxes: (a) lump-sum taxes
O
W, J
Y
W1
W2
DT x mpcd
A cut in taxes: (a) lump-sum taxesA cut in taxes: (a) lump-sum taxes
A cut in taxes: (b) cut in tax ratesA cut in taxes: (b) cut in tax rates
O
W, J
Y
W1
O
W, J
Y
W1
W2
A cut in taxes: (b) cut in tax ratesA cut in taxes: (b) cut in tax rates
O
W, J
Y
W1
W2
DT x mpcd
A cut in taxes: (b) cut in tax ratesA cut in taxes: (b) cut in tax rates
Fiscal and Monetary PolicyFiscal and Monetary Policy
The Effectiveness of Fiscal Policy
The Effectiveness of Fiscal Policy
EFFECTIVENESS OF FISCAL POLICYEFFECTIVENESS OF FISCAL POLICY
Effectiveness of automatic stabilisers adverse supply-side effects
the problem of fiscal drag
Discretionary policy: problems of forecasting the magnitude of the effect effects on other injections and withdrawals
crowding out
Effectiveness of automatic stabilisers adverse supply-side effects
the problem of fiscal drag
Discretionary policy: problems of forecasting the magnitude of the effect effects on other injections and withdrawals
crowding out
O
W, J
Y
(a) The goods market
W
J1
Y1
The monetary effects of fiscal policyThe monetary effects of fiscal policy
O O
W, JRate of interest
Y Money
(a) The goods market (b) The money market
W
J1
Y1
MS
L1
r1
The monetary effects of fiscal policyThe monetary effects of fiscal policy
O O
W, JRate of interest
Y Money
(a) The goods market (b) The money market
W
J1
Y1
MS
L1
r1
Y2
J2
An expansionaryfiscal policy
The monetary effects of fiscal policyThe monetary effects of fiscal policy
O O
W, JRate of interest
Y Money
(a) The goods market (b) The money market
W
J1
Y1
MS
L1
r1
Y2
J2
An expansionaryfiscal policy
L2
r2
Effect on thedemand for money
The monetary effects of fiscal policyThe monetary effects of fiscal policy
O O
W, JRate of interest
Y Money
(a) The goods market (b) The money market
W
J1
Y1
MS
L1
r1
Y2
J2
An expansionaryfiscal policy
L2
Accommodatingincrease in themoney supply
MS2
r2
The monetary effects of fiscal policyThe monetary effects of fiscal policy
EFFECTIVENESS OF FISCAL POLICYEFFECTIVENESS OF FISCAL POLICY
Effectiveness of automatic stabilisers adverse supply-side effects
the problem of fiscal drag
Discretionary policy: problems of forecasting the magnitude of the effect effects on other injections and withdrawals
crowding out
size of the multiplier and accelerator effects
Effectiveness of automatic stabilisers adverse supply-side effects
the problem of fiscal drag
Discretionary policy: problems of forecasting the magnitude of the effect effects on other injections and withdrawals
crowding out
size of the multiplier and accelerator effects
EFFECTIVENESS OF FISCAL POLICYEFFECTIVENESS OF FISCAL POLICY
Discretionary fiscal policy: problems of timing and time lags
various time lags
policy may be destabilising
Discretionary fiscal policy: problems of timing and time lags
various time lags
policy may be destabilising
Fiscal policy: stabilising or destabilising?Fiscal policy: stabilising or destabilising?
O
Rea
l nat
iona
l inc
ome
Time
1
2
3
4
1
2
3
4
Path (a): no intervention
O
Rea
l nat
iona
l inc
ome
Time
1
2
3
4
1
2
3
4
Path (a): no intervention
Path (b): policy stabilises
Fiscal policy: stabilising or destabilising?Fiscal policy: stabilising or destabilising?
O
Rea
l nat
iona
l inc
ome
Time
1
2
3
4
1
2
3
4
Path (a): no intervention
Path (c): policy destabilisesPath (b): policy stabilises
Fiscal policy: stabilising or destabilising?Fiscal policy: stabilising or destabilising?
EFFECTIVENESS OF FISCAL POLICYEFFECTIVENESS OF FISCAL POLICY
Discretionary fiscal policy: problems of timing and time lags
various time lags
policy may be destabilising
Side-effects of discretionary fiscal policy
Discretionary fiscal policy: problems of timing and time lags
various time lags
policy may be destabilising
Side-effects of discretionary fiscal policy
EFFECTIVENESS OF FISCAL POLICYEFFECTIVENESS OF FISCAL POLICY
Discretionary fiscal policy: problems of timing and time lags
various time lags
policy may be destabilising
Side-effects of discretionary fiscal policy
Changing government expenditure versus changing taxes
Discretionary fiscal policy: problems of timing and time lags
various time lags
policy may be destabilising
Side-effects of discretionary fiscal policy
Changing government expenditure versus changing taxes
Fiscal and Monetary PolicyFiscal and Monetary Policy
Varieties of Monetary Policy
Varieties of Monetary Policy
VARIETIES OF MONETARY POLICYVARIETIES OF MONETARY POLICY
The policy setting historical approaches to monetary policy
current approach to monetary policy
Control of money supply over medium and long term control of banks’ liquidity ratio
restricting size of PSNCR
Short-term monetary control: the alternatives
The policy setting historical approaches to monetary policy
current approach to monetary policy
Control of money supply over medium and long term control of banks’ liquidity ratio
restricting size of PSNCR
Short-term monetary control: the alternatives
The demand for and supply of moneyThe demand for and supply of money
O
Money
Ra
te o
f in
tere
st
MS
L
r1
Q1
O
Money
Ra
te o
f in
tere
st
L
r1
Q1
r2
Q2
MS'The demand for and supply of moneyThe demand for and supply of money
MS
VARIETIES OF MONETARY POLICYVARIETIES OF MONETARY POLICY
Techniques to control money supply preliminary decisions:
statutory or prudent ratios?what to control: monetary base or broad
money? open-market operations funding variable minimum reserve ratios
Techniques to control money supply preliminary decisions:
statutory or prudent ratios?what to control: monetary base or broad
money? open-market operations funding variable minimum reserve ratios
Liabilities AssetsDeposits £100bn Reserve assets
Advances, etc.£10bn£90bn
Total £100bn Total £100bn
Effect of raising the minimum reserve ratiofrom 10% to 20%
Effect of raising the minimum reserve ratiofrom 10% to 20%
Initial position: 10% reserve ratioInitial position: 10% reserve ratio
Liabilities AssetsDeposits £100bn Reserve assets
Advances, etc.£10bn£90bn
Total £100bn Total £100bn
Effect of raising the minimum reserve ratiofrom 10% to 20%
Effect of raising the minimum reserve ratiofrom 10% to 20%
Liabilities AssetsDeposits £50bn Reserve assets
Advances, etc.£10bn£40bn
Total £50bn Total £50bn
Initial position: 10% reserve ratioInitial position: 10% reserve ratio
New position: 20% reserve ratioNew position: 20% reserve ratio
VARIETIES OF MONETARY POLICYVARIETIES OF MONETARY POLICY
Techniques to control money supply preliminary decisions:
statutory or prudent ratios?what to control: monetary base or broad
money? open-market operations funding variable minimum reserve ratios
Techniques to control interest rates
Techniques to control money supply preliminary decisions:
statutory or prudent ratios?what to control: monetary base or broad
money? open-market operations funding variable minimum reserve ratios
Techniques to control interest rates
VARIETIES OF MONETARY POLICYVARIETIES OF MONETARY POLICY
Techniques to control money supply preliminary decisions:
statutory or prudent ratios?what to control: monetary base or broad
money? open-market operations funding variable minimum reserve ratios
Techniques to control interest rates statutory base rates
Techniques to control money supply preliminary decisions:
statutory or prudent ratios?what to control: monetary base or broad
money? open-market operations funding variable minimum reserve ratios
Techniques to control interest rates statutory base rates
VARIETIES OF MONETARY POLICYVARIETIES OF MONETARY POLICY
Techniques to control money supply preliminary decisions:
statutory or prudent ratios?what to control: monetary base or broad
money? open-market operations funding variable minimum reserve ratios
Techniques to control interest rates statutory base rates operations in discount and repo markets
Techniques to control money supply preliminary decisions:
statutory or prudent ratios?what to control: monetary base or broad
money? open-market operations funding variable minimum reserve ratios
Techniques to control interest rates statutory base rates operations in discount and repo markets
Bank of England operations in the bill andgilt repo markets to raise interest rates
Bank of England operations in the bill andgilt repo markets to raise interest rates
O
(a) Bank of England sells more bills(a) Bank of England sells more bills
Ra
te o
f dis
coun
t
Bills
S1 by B. of E.
r1
D by banks
r2
Bank of England operations in the bill andgilt repo markets to raise interest rates
Bank of England operations in the bill andgilt repo markets to raise interest rates
O
Ra
te o
f dis
coun
t
Bills
S1 by B. of E.S2 by B. of E. D by banks
r1
(a) Bank of England sells more bills(a) Bank of England sells more bills
S by banks
Bank of England operations in the bill andgilt repo markets to raise interest rates
Bank of England operations in the bill andgilt repo markets to raise interest rates
O
(b) Bank of England buys fewer bills / gilts
(b) Bank of England buys fewer bills / gilts
Ra
te o
f dis
coun
t / g
ilt r
epo
ra
te
Bills and gilts
D1 by B. of E.
r1
Bank of England operations in the bill andgilt repo markets to raise interest rates
Bank of England operations in the bill andgilt repo markets to raise interest rates
O
Ra
te o
f dis
coun
t / g
ilt r
epo
ra
te
Bills and gilts
D1 by B. of E.
r1
D2 by B. of E.
r2
S by banks
(b) Bank of England buys fewer bills / gilts
(b) Bank of England buys fewer bills / gilts
VARIETIES OF MONETARY POLICYVARIETIES OF MONETARY POLICY
Techniques to control money supply preliminary decisions:
statutory or prudent ratios?what to control: monetary base or broad money?
open-market operations funding variable minimum reserve ratios
Techniques to control interest rates statutory base rates operations in discount and repo markets
Credit rationing
Techniques to control money supply preliminary decisions:
statutory or prudent ratios?what to control: monetary base or broad money?
open-market operations funding variable minimum reserve ratios
Techniques to control interest rates statutory base rates operations in discount and repo markets
Credit rationing
Fiscal and Monetary PolicyFiscal and Monetary Policy
Problems of Monetary Policy
Problems of Monetary Policy
PROBLEMS OF MONETARY POLICYPROBLEMS OF MONETARY POLICY
Medium and long-term control over the money supply: reducing PSNCR
automatic fiscal stabilisers
the desire to cut taxes
difficulty in cutting government expenditure
Medium and long-term control over the money supply: reducing PSNCR
automatic fiscal stabilisers
the desire to cut taxes
difficulty in cutting government expenditure
PROBLEMS OF MONETARY POLICYPROBLEMS OF MONETARY POLICY
Practical difficulties in short-run control of the money supply problems with monetary base control
with statutory cash ratios
without statutory cash ratios
problems with controlling broad liquiditywith statutory reserve ratios
without statutory reserve ratios
the effect on interest rates
Practical difficulties in short-run control of the money supply problems with monetary base control
with statutory cash ratios
without statutory cash ratios
problems with controlling broad liquiditywith statutory reserve ratios
without statutory reserve ratios
the effect on interest rates
O
Money
Ra
te o
f in
tere
st
MS
L
r
L '
r1
The effect on interest rates of a change in demand for money: money supply kept at fixed level by the authorities
The effect on interest rates of a change in demand for money: money supply kept at fixed level by the authorities
PROBLEMS OF MONETARY POLICYPROBLEMS OF MONETARY POLICY
Problems with credit rationing Goodhart's law bank resistance stifles competition distortionary effects on economy
Problems with controlling interest rates inelastic demand for loans
Problems with credit rationing Goodhart's law bank resistance stifles competition distortionary effects on economy
Problems with controlling interest rates inelastic demand for loans
O
Demand for loans
Q1Q2
Assume that the authoritieswant to reduce the
demand for money to Q2
r1
Loans
Rat
e of
inte
rest
An inelastic demand for loansAn inelastic demand for loans
r2
O
Demand for loans
r1
Q1Q2
A large rise in therate of interest (to r2)
will be necessary
Loans
Rat
e of
inte
rest
An inelastic demand for loansAn inelastic demand for loans
PROBLEMS OF MONETARY POLICYPROBLEMS OF MONETARY POLICY
Problems with credit rationing Goodhart's law bank resistance stifles competition distortionary effects on economy
Problems with controlling interest rates inelastic demand for loans unstable demand for money
Problems with credit rationing Goodhart's law bank resistance stifles competition distortionary effects on economy
Problems with controlling interest rates inelastic demand for loans unstable demand for money
PROBLEMS OF MONETARY POLICYPROBLEMS OF MONETARY POLICY
Problems with credit rationing Goodhart's law bank resistance stifles competition distortionary effects on economy
Problems with controlling interest rates inelastic demand for loans unstable demand for money possible conflict between domestic goals
and exchange-rate goals
Problems with credit rationing Goodhart's law bank resistance stifles competition distortionary effects on economy
Problems with controlling interest rates inelastic demand for loans unstable demand for money possible conflict between domestic goals
and exchange-rate goals
PROBLEMS OF MONETARY POLICYPROBLEMS OF MONETARY POLICY
Using monetary policy
problems of using it to manage aggregate demand
using it to keep to a target
inflation
exchange rate
money supply
Using monetary policy
problems of using it to manage aggregate demand
using it to keep to a target
inflation
exchange rate
money supply
Fiscal and Monetary PolicyFiscal and Monetary Policy
ISLM Analysis of Fiscal and Monetary
Policy
ISLM Analysis of Fiscal and Monetary
Policy
Equilibrium in both the goods and money marketsEquilibrium in both the goods and money markets
O
Ra
te o
f in
tere
st
National income
IS
re
Ye
LM
ISLM ANALYSIS OF FISCAL AND MONETARY POLICYISLM ANALYSIS OF FISCAL AND MONETARY POLICY
Fiscal policy and ISLM analysis
shifting the IS curve
effect on interest rates and national income
Fiscal policy and ISLM analysis
shifting the IS curve
effect on interest rates and national income
O
Ra
te o
f in
tere
st
National income
LM
IS
r1
Y1
ISLM analysis of fiscal and monetary policyISLM analysis of fiscal and monetary policy
O
Ra
te o
f in
tere
st
National income
IS1
r1
Y1
IS2
r2
Y2
Expansionaryfiscal policy
LM
ISLM analysis of fiscal and monetary policyISLM analysis of fiscal and monetary policy
Fiscal policy and ISLM analysis
shifting the IS curve
effect on interest rates and national income
Monetary policy and ISLM analysis
shifting the LM curve
effect on interest rates and national income
Fiscal policy and ISLM analysis
shifting the IS curve
effect on interest rates and national income
Monetary policy and ISLM analysis
shifting the LM curve
effect on interest rates and national income
ISLM ANALYSIS OF FISCAL AND MONETARY POLICYISLM ANALYSIS OF FISCAL AND MONETARY POLICY
O
Ra
te o
f in
tere
st
National income
LM1
IS
r1
Y1
LM2
r3
Y3
Expansionarymonetary policy
ISLM analysis of fiscal and monetary policyISLM analysis of fiscal and monetary policy
Fiscal policy and ISLM analysis shifting the IS curve effect on interest rates and national
income
Monetary policy and ISLM analysis shifting the LM curve effect on interest rates and national
income
Fiscal and monetary policy together
Fiscal policy and ISLM analysis shifting the IS curve effect on interest rates and national
income
Monetary policy and ISLM analysis shifting the LM curve effect on interest rates and national
income
Fiscal and monetary policy together
ISLM ANALYSIS OF FISCAL AND MONETARY POLICYISLM ANALYSIS OF FISCAL AND MONETARY POLICY
LM2LM1
O
Ra
te o
f in
tere
st
National income
IS1
r1
Y1
IS2
Y4
Expansionaryfiscal and
monetary policy
ISLM analysis of fiscal and monetary policyISLM analysis of fiscal and monetary policy
Analysis under Keynesian assumptions
effectiveness of fiscal policy
Analysis under Keynesian assumptions
effectiveness of fiscal policy
ISLM ANALYSIS OF FISCAL AND MONETARY POLICYISLM ANALYSIS OF FISCAL AND MONETARY POLICY
O
Ra
te o
f in
tere
st
National income
LM
IS1
Y1
IS2
Y2
Expansionaryfiscal policy
Keynesian analysis of fiscal and monetary policyKeynesian analysis of fiscal and monetary policy
Analysis under Keynesian assumptions
effectiveness of fiscal policy
ineffectiveness of monetary policy
Analysis under Keynesian assumptions
effectiveness of fiscal policy
ineffectiveness of monetary policy
ISLM ANALYSIS OF FISCAL AND MONETARY POLICYISLM ANALYSIS OF FISCAL AND MONETARY POLICY
O
Ra
te o
f in
tere
st
National income
LM1
ISY1Y2
Expansionarymonetary policy
LM2
Keynesian analysis of fiscal and monetary policyKeynesian analysis of fiscal and monetary policy
Analysis under Keynesian assumptions
effectiveness of fiscal policy
ineffectiveness of monetary policy
Analysis under monetarist assumptions
Analysis under Keynesian assumptions
effectiveness of fiscal policy
ineffectiveness of monetary policy
Analysis under monetarist assumptions
ISLM ANALYSIS OF FISCAL AND MONETARY POLICYISLM ANALYSIS OF FISCAL AND MONETARY POLICY
Analysis under Keynesian assumptions
effectiveness of fiscal policy
ineffectiveness of monetary policy
Analysis under monetarist assumptions
ineffectiveness of fiscal policy
Analysis under Keynesian assumptions
effectiveness of fiscal policy
ineffectiveness of monetary policy
Analysis under monetarist assumptions
ineffectiveness of fiscal policy
ISLM ANALYSIS OF FISCAL AND MONETARY POLICYISLM ANALYSIS OF FISCAL AND MONETARY POLICY
O
Ra
te o
f in
tere
st
National income
LM
IS1
Y1Y2
Expansionaryfiscal policy
IS2
Monetarist analysis of fiscal and monetary policyMonetarist analysis of fiscal and monetary policy
Analysis under Keynesian assumptions
effectiveness of fiscal policy
ineffectiveness of monetary policy
Analysis under monetarist assumptions
ineffectiveness of fiscal policy
effectiveness of monetary policy
Analysis under Keynesian assumptions
effectiveness of fiscal policy
ineffectiveness of monetary policy
Analysis under monetarist assumptions
ineffectiveness of fiscal policy
effectiveness of monetary policy
ISLM ANALYSIS OF FISCAL AND MONETARY POLICYISLM ANALYSIS OF FISCAL AND MONETARY POLICY
O
Ra
te o
f in
tere
st
National income
LM1
IS
Y1 Y2
Expansionarymonetary policy
LM2
Monetarist analysis of fiscal and monetary policyMonetarist analysis of fiscal and monetary policy
Fiscal and Monetary PolicyFiscal and Monetary Policy
Fiscal and Monetary Policy in the UK
Fiscal and Monetary Policy in the UK
Growth%
-10
-5
0
5
10
1920 1925 1930 1935 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000-10
-5
0
5
10
15
20
25
30
UK growth, unemployment and inflation: 1920-2002UK growth, unemployment and inflation: 1920-2002
Growth%
-10
-5
0
5
10
1920 1925 1930 1935 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000-10
-5
0
5
10
15
20
25
30
UK growth, unemployment and inflation: 1920-2002UK growth, unemployment and inflation: 1920-2002
GrowthUnemployment
% %
-10
-5
0
5
10
1920 1925 1930 1935 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000-10
-5
0
5
10
15
20
25
30
UK growth, unemployment and inflation: 1920-2002UK growth, unemployment and inflation: 1920-2002
GrowthUnemployment
Inflation
% %
-10
-5
0
5
10
1920 1925 1930 1935 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000-10
-5
0
5
10
15
20
25
30
UK growth, unemployment and inflation: 1920-2002UK growth, unemployment and inflation: 1920-2002
Unemployment(% of labour
force)
Inflation(% increase in
RPI)
Growth(% increase in
real GDP)
1921–38 13.4 –1.5 2.1
1950–69 1.6 4.0 2.8
1970–99 7.6 8.0 2.0
UK Macroeconomic performance: 1921 – 99UK Macroeconomic performance: 1921 – 99
Unemployment(% of labour
force)
Inflation(% increase in
RPI)
Growth(% increase in
real GDP)
1921–38 13.4 –1.5 2.1
1950–69 1.6 4.0 2.8
1970–99 7.6 8.0 2.0
UK Macroeconomic performance: 1921 – 99UK Macroeconomic performance: 1921 – 99
Unemployment(% of labour
force)
Inflation(% increase in
RPI)
Growth(% increase in
real GDP)
1921–38 13.4 –1.5 2.1
1950–69 1.6 4.0 2.8
1970–99 7.6 8.0 2.0
UK Macroeconomic performance: 1921 – 99UK Macroeconomic performance: 1921 – 99
FISCAL AND MONETARY POLICY IN THE UKFISCAL AND MONETARY POLICY IN THE UK
Attitudes towards demand management
Keynesian demand management in the 1950s and 1960s stop–go policies monetarist criticisms
Demise of fine tuning in the 1970s the causes of stagflation demand management policies in the 1970s the rise of monetarism
Attitudes towards demand management
Keynesian demand management in the 1950s and 1960s stop–go policies monetarist criticisms
Demise of fine tuning in the 1970s the causes of stagflation demand management policies in the 1970s the rise of monetarism
Changein M4 (%)
(1)
PSNCR(£m)
(2)
Inflation(%)(3)
Interest rate:20-year bonds
(4)
Real interestrate
(5)1969 5.1 –527 5.4 9.1 3.71970 11.5 –219 6.3 9.2 2.91971 16.0 1 196 9.4 8.9 –0.51972 23.7 1 829 7.3 9.0 1.71973 22.3 4 121 9.1 10.7 1.61974 11.1 6 447 16.0 14.8 –1.21975 12.4 10 167 24.2 14.4 –9.81976 11.2 8 923 16.5 14.4 –2.11977 14.7 5 474 15.9 12.7 –3.21978 15.0 8 416 8.3 12.5 4.21979 14.1 12 502 13.4 13.0 –0.41980 17.2 11 432 18.0 13.8 –4.21981 20.9 10 573 11.9 14.7 2.81982 12.1 5 547 8.6 12.9 4.31983 12.7 11 070 4.6 10.8 6.21984 13.2 10 342 5.0 10.7 5.71985 13.0 7 625 6.1 10.6 4.51986 15.6 2 630 3.4 9.9 6.51987 16.7 –1 172 4.2 9.5 5.31988 17.3 –11 426 4.9 9.4 4.51989 18.0 –9 131 7.8 9.6 1.81990 11.8 –1 288 9.5 11.1 1.61991 5.8 7 003 5.9 9.9 4.01992 3.6 28 623 3.7 9.1 5.41993 4.6 43 168 1.6 7.9 6.31994 4.7 39 425 2.4 8.1 5.71995 9.9 35 446 3.5 8.3 4.81996 9.5 24 778 2.4 8.1 5.71997 11.9 11 851 3.1 7.1 4.01998 8.3 –6 395 3.4 5.5 2.11999 4.2 –1 781 1.6 4.7 3.12000 8.3 –37 316 2.9 4.7 1.82001 6.7 –2 665 1.8 4.8 2.0
Selected monetary indicators: 1969–2001Selected monetary indicators: 1969–2001
Monetarism in the early 1980s medium-term financial strategy the recession of the early 1980s assessment of the monetarist experiment return to discretion in mid 1980s
Targeting the exchange rate its advantages and disadvantages shadowing the German mark membership of the ERM (1990–2) exit from the ERM
Monetarism in the early 1980s medium-term financial strategy the recession of the early 1980s assessment of the monetarist experiment return to discretion in mid 1980s
Targeting the exchange rate its advantages and disadvantages shadowing the German mark membership of the ERM (1990–2) exit from the ERM
FISCAL AND MONETARY POLICY IN THE UKFISCAL AND MONETARY POLICY IN THE UK
Return to domestic-orientated policies targeting inflation: 1993–7
Policies of the Labour government 1997 fiscal policy
the 'Golden Rule'Comparison with EU Stability and Growth Pact
monetary policyBank of England inflation targetECB targets
effectiveness of recent monetary and fiscal policies
Return to domestic-orientated policies targeting inflation: 1993–7
Policies of the Labour government 1997 fiscal policy
the 'Golden Rule'Comparison with EU Stability and Growth Pact
monetary policyBank of England inflation targetECB targets
effectiveness of recent monetary and fiscal policies
FISCAL AND MONETARY POLICY IN THE UKFISCAL AND MONETARY POLICY IN THE UK
Fiscal and Monetary PolicyFiscal and Monetary Policy
Rules versus Discretion
Rules versus Discretion
RULES VERSUS DISCRETIONRULES VERSUS DISCRETION
Case against discretion time lags
over-correction
government may ignore long-term consequences
Case for rules help to reduce inflationary expectations
create a stable environment for investment and economic growth
Case against discretion time lags
over-correction
government may ignore long-term consequences
Case for rules help to reduce inflationary expectations
create a stable environment for investment and economic growth
RULES VERSUS DISCRETIONRULES VERSUS DISCRETION
Case against rules can cause severe fluctuations in interest
rates and can cause greater instability
which rule to choose?
rules may conflict
rules may become unsuitable
Case for discretion fine tuning can be improved by better
forecasting and quicker-action
Case against rules can cause severe fluctuations in interest
rates and can cause greater instability
which rule to choose?
rules may conflict
rules may become unsuitable
Case for discretion fine tuning can be improved by better
forecasting and quicker-action
RULES VERSUS DISCRETIONRULES VERSUS DISCRETION
Inflation targeting use of inflation targets around the world
Inflation targeting use of inflation targets around the world
Source: The Use of Explicit Targets for Monetary Policy: Practical Experiencesof 91 economies in the 1990s, (Bank of England, August 1999)
Who sets explicit targets and monitoring ranges forthe exchange rate, money and inflation
Who sets explicit targets and monitoring ranges forthe exchange rate, money and inflation
Source: The Use of Explicit Targets for Monetary Policy: Practical Experiencesof 91 economies in the 1990s, (Bank of England, August 1999)
Who sets explicit targets and monitoring ranges forthe exchange rate, money and inflation
Who sets explicit targets and monitoring ranges forthe exchange rate, money and inflation
Source: The Use of Explicit Targets for Monetary Policy: Practical Experiencesof 91 economies in the 1990s, (Bank of England, August 1999)
Who sets explicit targets and monitoring ranges forthe exchange rate, money and inflation
Who sets explicit targets and monitoring ranges forthe exchange rate, money and inflation
Source: The Use of Explicit Targets for Monetary Policy: Practical Experiencesof 91 economies in the 1990s, (Bank of England, August 1999)
Who sets explicit targets and monitoring ranges forthe exchange rate, money and inflation
Who sets explicit targets and monitoring ranges forthe exchange rate, money and inflation
Source: Bank of England
RULES VERSUS DISCRETIONRULES VERSUS DISCRETION
Inflation targeting use of inflation targets around the world weaknesses of money supply targets
Inflation targeting use of inflation targets around the world weaknesses of money supply targets
RULES VERSUS DISCRETIONRULES VERSUS DISCRETION
Inflation targeting use of inflation targets around the world weaknesses of money supply targets weaknesses of exchange rate targets
Inflation targeting use of inflation targets around the world weaknesses of money supply targets weaknesses of exchange rate targets
RULES VERSUS DISCRETIONRULES VERSUS DISCRETION
Inflation targeting use of inflation targets around the world weaknesses of money supply targets weaknesses of exchange rate targets relative strength of inflation targets
Inflation targeting use of inflation targets around the world weaknesses of money supply targets weaknesses of exchange rate targets relative strength of inflation targets
RULES VERSUS DISCRETIONRULES VERSUS DISCRETION
Inflation targeting use of inflation targets around the world weaknesses of money supply targets weaknesses of exchange rate targets relative strength of inflation targets
Issues with inflation targets
Inflation targeting use of inflation targets around the world weaknesses of money supply targets weaknesses of exchange rate targets relative strength of inflation targets
Issues with inflation targets
RULES VERSUS DISCRETIONRULES VERSUS DISCRETION
Inflation targeting use of inflation targets around the world weaknesses of money supply targets weaknesses of exchange rate targets relative strength of inflation targets
Issues with inflation targets choice of the target
what level?central point or ceiling?
Inflation targeting use of inflation targets around the world weaknesses of money supply targets weaknesses of exchange rate targets relative strength of inflation targets
Issues with inflation targets choice of the target
what level?central point or ceiling?
RULES VERSUS DISCRETIONRULES VERSUS DISCRETION
Issues with inflation targets (cont.) who sets the target?
changing the target
multiple targetsa Taylor rule for setting interest rates
Issues with inflation targets (cont.) who sets the target?
changing the target
multiple targetsa Taylor rule for setting interest rates
Y0O
National income
ADI1
Rat
e of
infla
tion
(P).
Ptarget
.
ADI curves based on different Taylor rulesADI curves based on different Taylor rules
a
Y1
Curve ADI1: based on Taylor rule givingrelatively high weight to stable inflation
P1
. b
ADI2
Y0O
National income
ADI1
Rat
e of
infla
tion
(P).
Ptarget
. a
Y2Y1
b c
Curve ADI1: based on Taylor rule givingrelatively high weight to stable inflation
Curve ADI2: based on Taylor rule giving relativelyhigh weight to stable real national income
P1
.
ADI curves based on different Taylor rulesADI curves based on different Taylor rules
RULES VERSUS DISCRETIONRULES VERSUS DISCRETION
Issues with inflation targets (cont.) who sets the target?
changing the target
multiple targetsa Taylor rule for setting interest rates
targeting inflation and the money supply
Issues with inflation targets (cont.) who sets the target?
changing the target
multiple targetsa Taylor rule for setting interest rates
targeting inflation and the money supply
RULES VERSUS DISCRETIONRULES VERSUS DISCRETION
Issues with inflation targets (cont.) who sets the target?
changing the target
multiple targetsa Taylor rule for setting interest rates
targeting inflation and the money supply
basing interest rates on forecasts of inflation
Issues with inflation targets (cont.) who sets the target?
changing the target
multiple targetsa Taylor rule for setting interest rates
targeting inflation and the money supply
basing interest rates on forecasts of inflation
RULES VERSUS DISCRETIONRULES VERSUS DISCRETION
Issues with inflation targets (cont.) who sets the target?
changing the target
multiple targetsa Taylor rule for setting interest rates
targeting inflation and the money supply
basing interest rates on forecasts of inflation
the problem of deflation
Issues with inflation targets (cont.) who sets the target?
changing the target
multiple targetsa Taylor rule for setting interest rates
targeting inflation and the money supply
basing interest rates on forecasts of inflation
the problem of deflation