Topic OUTLINE

Topic 10:
FISCAL
10.1 FISCAL POLICY

& 10.2 MONETARY POLICY

MONETARY 10.3 CROWDING-OUT EFFECT

POLICY

FISCAL POLICY MONETARY POLICY Tools of Fiscal Policy

DEFINITION Refers to the The behavior of the Central
government’s spending Bank, concerning the money
Expansionary FP:
and taxing behavior or supply. • ↑ government purchases (G) or a ↓ taxes (T)
budget policy. • Increase the consumption
• Shifts the aggregate expenditure (AE) curve upward.

TYPES (i) Expansionary FP (i) Expansionary MP

(ii) Contractionary FP (ii) Contractionary MP
TOOLS Change in: Change in money supply
(i) Government through:
purchases (G) (i) Open market operation
(ii) Net Taxes (T) (OMO)
(ii) Required Reserve Ratio
(RRR)
(iii) Discount rate (DR)
Contractionary FP:
• ↓ government purchases (G) or a ↑taxes (T)
• Decrease the consumption
• Shifts the aggregate expenditure (AE) curve downward.
3 types of budget:
(i) Budget Deficit (G > T)
(ii) Budget Surplus (G < T)
(iii) Balanced Budget (G = T)

Expansionary FP Contractionary FP
FISCAL POLICY
Method An increase in (G) or a A decrease in (G) or an
reduction in (T) aimed at increase in (T) aimed at Expansionary Fiscal Policy Contractionary Fiscal Policy
increasing aggregate decreasing aggregate output • G ↑ @ T↓
output (income) (Y). (income) (Y). • G↓ @ T↑
• AE shift upward (AE0 – AE1)
• AE shift downward (AE0 – AE1)
• Y ↑ (Y0 – Y1) • Y ↓ (Y0 – Y1)
Objective To move an economy out To slow down economy or • ↓ unemployment • ↓ inflation
of a demand pulled inflation.
recession/unemployment AE
and closer to full
Y= AE
employment. AE0 = C+I+G0

Problem Could lead to inflation Could cause unemployment AE1 = C+I+G1

May lead to budget deficit Usually lead to budget surplus.
because need debt to
finance the deficit, this will
burden the next Y
generation. 0 Y1 Y0

1
 Expansionary MP Contractionary MP
Tools of Monetary Policy Method • Buy government • Sell government
securities in OMO securities in OMO
• Decrease RRR • Increase RRR
The central bank can affect the equilibrium • Decrease DR • Increase DR
interest rate by changing the supply of Ø Ms ↑, i ↓, I↑, Y↑. ØMs↓ , i↑, I↓, Y↓.
money using one of its three monetary
tools: Objective To move an economy To slow down economy
out of a or demand pulled
(i) Open market operation (OMO) recession/unemploy inflation.
ment
(ii) Required reserve ratio (RRR)
Problem • Could lead to • Could cause
(iii) Discount rate (DR) inflation unemployment
• May lead to budget • Usually lead to budget
deficit surplus.

Open Market Operation (OMO) Required Reserve Ratio (RRR)

• The purchase and sale by the Central Bank of
government securities in the open market.
• A tool used to expand or contract (reduce) the
amount of the money supply.
Central bank
purchase of Increases Money
government Supply (MS)
securities

Central bank sell of Decreases Money

government Supply (MS)
securities

Expansionary MP
Discount Rate (DR)
RRR
• Banks can borrow funds directly
from the Central Bank.
Bank reserve

Excess reserve
• The interest rate the Central Bank
charges on these borrowed is
called the discount rate.
Money supply

2
 Expansionary Monetary Policy:
Contractionary MP Expansionary MP
i AE Y=AE
i
Discount rate Discount rate Ms0 Ms1
AE1 = C + I1 + G

i0 i0 AE0 = C + I0 + G

Borrowing Borrowing i1 i1
Md I

M0 M1 M I0 I1 I Y0 Y1 Y

Loan out money Loan out money

Ms ↑ → i↓ → I↑ → AE↑ → Y↑
Money supply Money supply

Expansionary Fiscal Expansionary Monetary

Contractionary Monetary Policy: Policy Policy

i i AE Y=AE • Increase (G) and/or

Ms1 Ms0 AE0 = C + I0 + G
decrease (T)
i1 i1 AE1 = C + I1 + G – C ↑, Y↑
– Reduce
i0 i0 unemployment
Md I Y=AE
AE
AE Y=AE
M1 M0 M I1 I0 I Y1 Y0 Y AE1 = C1 + I + G1
AE1 = C + I1 + G
AE0 = C0 + I + G0
AE0 = C + I0 + G

Ms↓ → i↑ → I↓ → AE↓ → Y↓
Y
Y0 Y1 Y
Y0 Y1

Contractionary Fiscal Contractionary Monetary

Policy Policy 10.3 CROWDING-OUT EFFECT
• Decrease (G) and/or • Sell government securities
increase (T) @ increase RRR @
increase DR • The tendency for increases in government
– C ↓, Y↓
– Reduce inflation
– Ms ↓, i↑ , I↓, Y↓. spending to cause reductions in private
– Reduce inflation investment spending.( G↑ ↓I)
AE Y=AE
AE Y=AE
AE0 = C0 + I + G0
AE0 = C + I0 + G • Offset in AD that results when an
AE1 = C1 + I + G1
AE1 = C + I1 + G expansionary fiscal policy raises interest
rate and thereby reduces the investment
spending.
Y
Y1 Y0 Y
Y1 Y0

3
 • Initially economy is operating at
Crowding-out Effect Y0.
• Government implements
expansionary fiscal policy
AE ( ↑G). AE r Ms1 r
• AE will increase and shift Y=AE
Y = AE
upward to AE1.
AE1
AE1 = C + I0 + G1 • Y increases from Y0 to Y1.
AE2 r1
• Government will increase
AE2 = C + I1 + G1 borrowing to implement their AE0 r0
I policy and increase in the Md.
AE0 = C + I0 + G0 • Lead to an increase in the
M d1
G interest rate (i). I
• Therefore decrease in the M d0
Y
investment (I). Y 0 Y2 Y1 M1 M I1 I0 I
• AE will decrease and shift
downward.
• New equilibrium is achieved at G ↑ - AE↑ - Y↑ - Government borrowing↑ - Md↑ - r↑ - I↓ - AE↓ - Y↓
Y2, which is lower than Y1.
Y • Net increases: Y0 – Y2
Y0 Y2 Y1