EMAND-SIDE EQUILIBRIUM: INCOME AND THE INTEREST RATE . 63 to the total exogenously given real money supply, ‘1/Po. Because of the geometric nature of the 45° triangle, the transactions demand and the speculative demand always add up to the total money supply on each axis, so that this 45° line directly represents money market equilibrium condition (7). Any point on this 45° line gives a transactions demand plus a speculative demand that just add up to the total money supply. We can now locate in the northeast quadrant of Figure 4-10 the r,y pairs that maintain the money market in equilibrium. At a given level of income such as yo, we can find transactions demand for money from the k()) function. By following the dashed line we subtract this from supply, 14/Po, to see what level of speculative demand this implies if the money market is to be in equilibrium. This level of speculative demand shows us, in turn, the level of interest rate ro that will maintain thé money market in equilib: with income level yo. Having located one money market equilibrium pair, (ro, Vo), we can locate another by beginning with y-, in Figure 4-10, Repeating this process traces out the line that describes the set ofr, y pairs that maintains money market equilibrium. This is the LM curve in Figure 4-10. Thus, we can see that the LM curve represents the pairs of r and y that will keep the money market in equilibrium with a given level of the money supply, M, and a given price level, P. By differentiation of the equilibrium condition, equation (7), and inspec- tion of the results, we 2 see that the slope of the LM curve is positive: M Lye k= art kay. Po Thus, along the money market equilibrium curve LM, Since k’ > 0 and I' <0, (dr/dy) > 0, that is, the LM curve is positively sloped SHIFTING THE LM CURVE This four-quadrant diagram is useful in analyzing the effects of changes in exogenous variables or shifts in the speculative demand or transactions demand functions on the equilibrium values of r and y in the money market. Looking back to Figure 4-9, for example, we see that an increase in the money supply creates an excess supply of money at the old level of income and interest rate. This excess supply pushes the equilibrium interest rate down, given the income level. Z In Figure 4-10, an increase in the money supply will shift the 44/Pp line out. With the increase in the real money supply, at any given level of income, corresponding to a given level of transactions demand, there is room within the money supply for an increased speculative demand. This implies, for money market equilibrium, a lower interest rate at each income level. This increase in the money supply thus shifts the LM curve to the right.sp pt a 9 a te so RSie vat tt pec Pee eee Eepethp os dea aremceremt eeegotcnenisate maaan eae congener ncesmenca tet ROmSvav uit etree ESTA aie Equilibrium in the Product and Money Markets zm ‘We hare now devived mo pees of gromete appara One gts the ‘huliom pis or andy tbe prodot markct™ine IS cone and te ‘her ee the quit pir of nthe mney market AF ‘ine By psc to carver a heme quadrant i by sovieg ‘Sonos ) and hsinsaneony we con bathe sleet he ‘ura abt arts te ineeton othe Sap EAeares he meet rt, nome al bat ry tn Pure 4, by marci 2 ‘bin adr onexratharror thecaroe sk "Toes how hemo roves toward equiva i bei om 4 soegulsom passa, comer he plae gram of Figure 4 Iran fists potent cote fans tend fo ove hooray toward thelScane hy ongng Why he portato beng athe Scare,DEMAND-SIDE EQUILIBRIUM Figure 412 | i) Disequilibrium in the product and money markets. : INCOME AND THE INTEREST RATE 65 for the given value of r and i(r), ex ante (s + 1) > (i + g), So y'is falling. Thus, at point A in Figure 4-12, y would be moving left along the horizontal arrow. Just reverse the argument for points left of the JS curve. Ifan initial r, y point is not on the LM curve, it tends to move vertically toward the LM curve, with r changing. Why? If the point is below the LM “curve, for the given y there is an excess demand for money and supply of bonds, pushing bond prices down and r up. So at point A in Figure 4-12, r would be moving up along the vertical arrow. Reversing the argument would give downward movement from points above the LM curve. ‘Combining the discussion of movements from disequilibrium r, y pairs above gives us the pairs of arrows in Figure 4-12 showing movement in each of the quadrants marked off by the JSLM intersection. Note that in each quadrant one of the arrows pulls the motion toward the equilibrium intersection. Consider now movement from point A. There y is falling because ex ante (s+) >(i +g), and r is rising because of excess demand in the money market. When the economy's r,)' pair reaches the LM curve, r is no longer changing since the money market is in equilibrium, but y is still falling, so the ry point moves left. Then when the r, point hits the 1S curve, r is falling, but y' is not changing: so the trajectory is down. The movement continues until the equilibrium ro,y’o point is reached. The product’ and money markets thus interact to bring the economy toward the equilibrium intersection. Their interaction can be described as follows: Excess demand Reduced demand in mopey market -» Rising r~ Falling i-» Falling y + in money market »pey market — Rising r—> Falling i~ Falling yin mowExcess ving Retocas in prodget mate» Paling y- Fling Ring tov nig Inoter wor we now haves dani proce occuring nthe bacon ‘inthe elim contin The exes demand thetroney ke, Seely en the tere rt, and, ough the ivestment fon bea Flas tc. Tin term redone he treats dead tmoney, norkng to eliminate te wi acer demand Eval Oe Sonomy sets toward he egallsiom ry pope EFFECT OF AN WOREASE IN Inthe shoe example we assumed tha the proses began fom 2 pi of ‘esr ad moved toward equim rf Now stun al we begin tan nl pout of equim and tha the pverent eis [Rtece spending onde to rae cee By ug dngren rch #2 gure decane at hie bes cane out giving ager pots fate equine foray gien rhs shits repeeted By hea © Tistas Fgued-9 Athenee fe interest erg neonate ‘enough he mites proces Th eee nome cases an eee Inte dua for ranacfons lanes Tr ces nee mand in he ‘money markt, asi Fane mane ane thor thrown out ‘Sera cong pl essen Pie 12 Evento Decree imvetnen ir fron ofrand/ < Othe inceneinequitei reader esocions goin Inher wea te ees govern ‘pen spending eases spa dplaenest of pvateimestnent. Tb Splat sae fan the meena of We oral ates 8 {eds both randy rs fom then equator postion'EMAND-SIDE EQUILIBRIUM: INCOME AND THE INTEREST RATE 67 Another way to look at the effect of the.increase in g is that the govern- ment decision to spend more means it will have to increase borrowing. It does this by selling government bonds. Because the money supply is fixed and the government raises the level of its demand for money. demand exceeds supply in the money market. Interést rates go up along with incomes and the movement shown in Figure 4-13 begins. We see that equilibrium income goes up because of the increase in g. This means that more tax revenue will accrue to the government than at the earlier equilibrium level. This increase in tax revenue will cover part of the increased government expenditure. so that the amount the government borrows will be less than the increment to expenditure. EFFECT OF AN INREASE IN M sy As an alternative to increasing g to increase income. the government might increase the money supply. By examination of Figure 4-10, we can sec that this will result in an outward shift of the LM curve. which will move the economy toward higher income at,lower interest rates. The increase in the :. Money supply creates excess supply in the money market, pushing r down. 2 This, in turn, increases investment demand, raising +. The increase in income will, of course, increase the demand for money. But the increase in demand will not offset the increased supply, so that interest rates will still go down. Thus, the main difference between the effects of increasing g or increasing M to raise the level of income in the economy is where the interest rate ends up. An increase in goverpment spending raises interest rates, while an increase in the money supply lowers interest rates. For this reason, the two “tools"— fiscal policy changes in g or tax rates and monetary policy changes in M—are usually used together to achieve a desired mix of income expansion and control of interest rates. Chapter 5 looks at the effects of monetary and fiscal policy’on the demand side of the economy in more detail. First, we will derive the economy's demand curve from the [SLM apparatus. come and. the Price Level on the Demand Side In the previous section we saw how the intersection of the JS and LM curves determines the equilibrium level of income and the interest rate, given the price level Po. Now we can dériye the economy's demand curve by varying P and seeing what happens to the equilibrium real income level, v. ‘The two equilibrium conditions we have developed so far, for the product and money markets, are- (y= 19) +1) = i) +9 (8) and a” . pat 60). @)“Thee ate two equation in thre arisen, pend Inthe SEM aps Teshunad Ps be gnen ropanisy cineatng one rte ad {eived or te equbriom value of and ate teseton of ‘ire~equaton 6} the Lif eure meqeton "To naz te elects of pe level changes a eultviom yo tend ie ofthe econery ie ea se igre 14 This epee ‘Boney rare fot drat agra blithe LAY crea then oe Frpots ont 15 eri of equation (fo os equllbtst re ee {heal poe lel Py Wee te comple EA gram a Gee ure here becuse the rie level P oes ot ete inte equation Be products equim condition but fda enter epeaton OST Schaar in i ttt point he carve nh os st Seppose now tom he itl pice evel Pn Figure 14 ich gulact rae he pe lee! eae to By edge eal ee ply 01/8, Ascanbesentn Figure 14 ish the Leet Jeo ei and moves the eae pli to 7.7. Why 8s? “The pi evel increase reduced he eal money apply This means any te rel iso ee the tensactons ere Tor ove ‘ede the money fe for spslatve demand For the math ‘hen thee ates mst right for any gen ecm evel tas ‘rere we nl pe Py So ben the peeve ieee for whe ‘estore real one soppy sss and ets demand bested ne:MANO-SIDE EQUILIBRIUM: INCOME ANO THE INTEREST RATE 69 money market. This can be seen by increasing P in Figure 4-9. This excess demand raises interest rates, reducing investment demand and equilibrium income. Gradually the economy settles toward a new r,,y, equilibrium with the new higher price level P,. As Figure 4-14 shows, the new equilibrium y, is smaller than the initial y, because of the increase in P from Po to P). If, from Po, we had reduced the price level in Figure 4-14, increasing the real-money supply, the equilibrium r,y point would have moved down the stationary IS curve, increasing the equilibrium y level. Thus, varying the (exogenously given, for the time being) price level produces opposite varia- tions in the equilibrium level of output demanded in the economy: As P rises, y falls, and vice versa. This relationship is shown as the economy's demand curce of Figure 4-15. This curve is created by changing the price level in Figure 4-14 (from Po to P,) and plotting against the price level the change in income (from yo to 3) caused by the shifting LM curve. The Figure 4-14 demand curve shows that as the price level P increases, the equilibriun output y demanded in the economy decreases. The demand curve is derived by asking what happens to equilibrium output demanded as the price level changes, allowing other variables, such as the interest rate, also to adjust to their equilibrium levels. This brings out an important point. Changes in equilibrium variables on the demand side of the economy as a result of price changes are morements along the demand curve. Changes in exogenous variables on the demand side, such as q or M or the tax schedule, or shifts of functions like the saving function or the transactions demand for money, shift the demand curve. This distinction will become important when we have developed the supply side of the economy and can analyze how changes in exogenous variables shift the demand or supply curve, creating excess demand (or supply), and causing price changes that bring further adjustments along the demand and supply curves. The other important point to notice about the Figure 4-15 demand curve is that it does not reflect the ordinary substitution effect of a rising price reducing demand. Rather, the rising aggregate price level P reduces equilib- rium output demanded, sr, by tightening the money market, raising the interest rate, and thus reducing investment. In the next chapter we use the algebraic and graphical representations of demand-side equilibrium to discuss the effects of monetary and fiscal policy re4l5 . aconomy's demand DoS : nou cow SeenON BATE Fo lange Tis ofts usa ctanceo lv our single model a"workot” ah {Srey theonly way lea the working ove eon tore Selected Readings R.G.D Alen. Saree Tey Yt: St Mri’ re. 157. ‘A Tenens Monetaty Thar onl Fora! Paley ew York: MeGromti, oper {Lies Kaya the Ch” Enns (p13)An Introduction to Monetary and Fiscal Policy Monetary and fiscal policies are generally thought of as demand-management policies. Since they deal with demand management, we can discuss their effects fairly thoroughly now before we go on to the supply side in Chapter 6. The purpose of monetary and fiscal policy, taken together, is to maintain output near full unemployment in the economy and to maintain the existing price level. The appearance of excess demand will probably cause inflation, while an insufficiency of demand will bring at least temporary unemployment sand deflation. In Chapter 4 we derived the economy's demand curve by finding, in the ISLM diagram, the equilibrium level of output demanded at cach price level. This demand curve is shown as DoDo in Figure 5-1. Thus. if the initial price level is Po, the equilibrium output demanded will be s"9. Now suppose the economy has a full-employment output level, 1'-, which is determined by the existing labor force and capital stock. (The determination of the level of yr is discussed at some length later in Part I], and in Part IV.) If, as shown in Figure 5-1, equilibrium output demanded, ¥'o, is more than full-cmploy- ment output, yp, there will be excess demand in the economy, measured by Yo — Jp, and the price level will be bid up, causiig inflation. In this case the ‘object of demand management (monetary and fiscal) policy would be to shift the demand curve down to DD, to eliminate the excess demand without inflation. The case of deficient demand is shown in Figure 5-2. Suppose the demand curve DoDo is initially lower than was shown in Figure 5-1 due, perhaps, to lower investment demand. Then at the initial price level Po, equilibrium output demanded could be less‘than full-employment output yy. creating ~ excess supply, or deficient demand, in the economy. This would tend to push nm .n NATIONAL INCOME DETERMMIATION: THE STATIC FOULIBRNM Woon, ls down tnt east temporarily, cts ueaymentenespondag {Dike shor i demand scared by yy~ yom Fgue 82 ft at {he objective of demantsmansgtment poll wou bef shit the demand ‘ure ap to yby,clinatng me dhationary pap sea mating 1 Emrlaymen. "The goverment can shit theca demand ere by raioalaieg itemenciny at ral atey intrenoeTa the cof eee demand igre the demsndcurccanbeshitedupy a fs pb ners een pref) soar entity fl neat inthe one supp: some comin a {Ee ad money spy change Ts, nb soa, te sane ‘monetary poly i the money sepia the struments of es pot {Pe the eet a ovement prchoe andthe tak ate Tnchaper we rity duced how change athe ote soppy hh the Liteon, whe chnge nthe fal py tremens tthe uve Eh oft changes do bt the demand curve Here we dee {move eal the ees monetary an Gl pty changes on teed ‘stdemand, both grapes apd algal We sev how the soem feof Chapt 3are mde by the Saredating a he moony male Et ow the te of tee uli depends on whee he coma | ‘italy ver fl employment of erection, We ao dacs the ees tt hangs in monary and Lal poly en the composition of expt ht erpaymen the dvsos of orp betmece and go-and kes Sta Took st tome cont isos it macrosonsne uation piAN INTRODUCTION TO MONETARY AND FISCAL POLICY 73 Fiscal Policy Effects on Demand Figure 5-3 Fiscal potiey change in 19% JS curve. In analyzing the effects of fiscal policy changes in g or tax rates on equi- librium output demanded, we use the four-quadrant diagram for the JS curve, shown in Figure 5-3. Since fiscal policy changes do not affect any of the curves underlying the LM curve, we can just add a fixed LM curve to the r,y quadrant in Figure 5-3, giving an initial equilibrium point ro, vo, corresponding to an initial price level. Fiscal policy changes will then shift the 1S curve along the given LM, changing equilibrium output demanded, y, and the interest rate as well. Since the initial price level is held constant throughout, these changes in equilibrium output demanded, at a given price level, represent horizontal shifts in the demand curve equal to the change in equilibrium output. Thus, in analyzing fiscal policy shifts, we will also refer to Figure 5-4, which shows the demand curve Dy which corresponds to the initial 1S curve in Figure 5-3, [ Sp, with initial P, aftd y, corresponding to Jo in Figure 5-3. ‘Now suppose with the initial level of government purchases gp and tax schedule to in Figure 5-3, the resulting output level yo is below full cmploy- ment. Then fiscal policy can increase equilibrium output, shifting the de- mand curve to the right, either by increasing g, or by shifting the tax schedule down. CHANGES IN GOVERNMENT SPENDING, g Consider first an increase in government. purchases by Ag from go to g, with the tax schedule, unchanged at (a8 shown in Figure 5-3. The inerease ee ite:u mee sn gaa dieaty oral ONP an togh he moti uber age PSS arena mating Sees Jar ficial See see foe Pegi nnn ie eseert hin ees Sikes ea Ga Moat a tehocnen mnie A thee ‘Sensei fs demaer Car ohh “Rut the interest ate rt rae Koen ry following the x. With + Siked tefl ney aos ate ma th domed {eg ines rae the goverment Sf, meresaing the aot of Does ‘eteemne ih Tek mrt ee ane {tabs nent tend soppy ras inert tsa the bod mare he SHEET tania Aton anne stowein Fes pcm ane te Sl a et en eg cia bas pone se Ree ‘STi a tenant prea eons er PORE rato pag aed spin ind Cpa tr {Sue by Se alee eg te fel of meen he edad IEE Want ove ese ele re of opt Send ‘Srna eg te eat Ta ‘and ae omy to DsDy ah mg om yt yt et Percale ‘tet ean sunnah fe iy nee i thc Band SEWER cha cred de ee ‘tic neon ome pending a bls her. Goer aAN INTRODUCTION TO MONETARY AND FISCAL POLICY 15 Figure 5-5 Fiscal policy change in tty): 1S curve. chases have risen, and, with an interest rate increase, the level of investment has fallen, partially offsetting the g increase. We know the offset is only partial because for y to go up in the end, the i + g sum must have risen. Thus, increasing g to raise equilibrium ' shifts the mix of output away from investment and toward g, and also raises consumer spending. CHANGES IN THE TAX SCHEDULE, t(y) Much the same effects on the level of y and r [and thus i(r)] could be ob- tained by permanently reducing tax rates or increasing transfer payments instead of raising government purchases. The main difference between these two expansionary fiscal policy steps is in the resulting mix of output: With an equal effect on y,r, and investment, a tax reduction favors consumer expenditure while a g increase obviously increases the government share of output. ‘The result of a tax reduction is shown in the four-quadrant diagram jof Figure 5-5. Here we essentially assume that the tax schedule is proportional, that is, tol) = Tos Q) so that tax revenues f(y) are a constant fraction, tp, of y. Then the tax cut just reduces the proportional tax rate from to, say, 25 percent, to z,, Say. 20 percent. This simplification will come in handy when we compute the tax rate multiplier a bit later. The downward rotation of the tax schedule increases the level of equi- librium income at any given interest rate. The alert observer might notice 5 oh itg stt6 ‘hat ice he ig Tvl was he sme repartee whe he) ‘ng is ge a higher evel he tx hang wil a9 gp Inter slogestthe ISeaye. Hob 9m y—ey— thay HM) HL @ Re cansee that ifhan gare unchanged andthe acuta dpa Teme yh bine Gesuoption’y oust aces ta wanes ye qual 0) sential wn pin remain sea he age B dapenhte come a tal coe ee ota to ‘eres pole induced nese eset peng hat has ee lees ws he ag conned enter Ir, ere mace equriam otpat ‘edd wo vee oy thou te epi ele the lear in ncn nin cats exo Gand iste ooey smatet rising along LS Tobe bond mare, he reas the eho [perc by te ta et increases Ee apy a bens he poters ent Frees botoning This gore ox borrowing for plat and equipment frst and hor bug ecg tvetn oat pty ‘topenous incense in cone’ spending. teen al dean aE rp sto, andthe were te a toy Te demand cae Shs our much he Same sin Figure 33, with equity eres ‘sca anda a a hat il aboot he sae fice fy and te fSraosiion a he aly Six res aboot he tare beth ese te Soa elt ivesiac hese on whee te hy co gover ‘urhars rosy provides the sat Bal pin souls bee 9 Bae ‘Bane the sae tought The aus bere has ne fom he aa EBtrere rconmamer pending lowing the ses thin as ncresed {Becansumest thre of otpt ntacysnes the nda mailer eects ‘of ayndued andy change sete sei teal mode ‘heen ference nthe Seal competion a tpt hat te ere log the tc cy repel by ances nen hs a poy ‘Seeing te sme ee fy and inte aegis. THE MULTIPLIER FOR g CHANGES “The last section dried the act of goverment pending and tax rte hangs sing mlny the ISEAT diagram. Tae 18 carve fepsets the product mane egultiom condon a FE y= OD HHO, » fn the LAT ce reps te money market egitim condon Fatt, c)‘AN INTRODUCTION TO MONETARY AND FISCAL POLICY 71 t ‘ ely >) cm y yy) a ) () © 2-4 : be 2 : i e ky) Fe is Ke) y @ r cS) Basic function library. , The various functions in equations (3) and (4) are shown in Figures 5-6(a)-(e). The tax and consumption functions both have slopes that are Positive but less than one, that is, 0 0. “ks we saw graphically in the previous section, the increase in y following an increase in‘g ‘will be smaller in this two-equation model than it was in the simple multiplier models of Chapter 3. We can see this more precisely by developing an expression for the government purchases multiplier that includes this money market effect on i and r. Differentiating the 1S equation (3) we obtain dy =c'+ (dy —1'dy) +i dr,+ dg = c( — t)dy + i'dr + dg. Differentiating the LM equation (4), holding M/P constant, we get O=ldr+Kdy, so that Notice here that the expression ~(k'/l’) is simply the slope of the L}f arm ‘The last equation tells us how much r must rise slong the LA cuvr> maintain market equilibrium with a given increase i iscome. Substituting this expression for dr into the 1S c=erential, we z=: Kw ere dy= (1 —2)aynet owe SETUNANIN: Me BANE EOULIRL He, so thatthe al malig expreson a zi rc) tata Sit 1 ta oe an poste Ch Fa ae Sept). de mai pote, "ihe g super developed ia Chaper 3 was singly 1/0 — c(t — “Tye mle in (9) snr tn rete fhe ons pore {erm the denon Whe te meating of sen Tht snr ht the slope of Les the erase fn hati * eid for money mate elf wh te Sees fo Since get {Re ehane ta comes om a Sanger expres FEY hee thes ihe deren in ovenent tht comes om he res ele cree Yang rbealong the EM cove ‘ke At cares eat wl 20 lope, that = (R= the mal tne in () ald be hese er he og sig of Chapter 3 In Figwe'7, the dione rom Jp to Jy rcaaed By the air {etl wih na mony matt ees ta ih Be net Fae eld constant. The signet yt) ine the all male reution (3 Wch toler The tmobey atk eect Tia the “THE EFFECTIVENESS OF FISCAL POUCY “The mali ora of equation (8) also points ost hat the sa of, the ea paysite oon fever a poly. depend “on whether the rea py snaage inte tae orien fou ‘athe fo lelbemployment out Ths po sua fa Fgore ‘rh shows the een fic ony of gen I ea, Spending on where Geis EA care these ep” ‘A etd eure the LM curve lately a ott ts slope th eneany ea The ger rg sca ply ape eel)AN INTRODUCTION TO MONETARY AND FISCAL POLICY 79 Figure 58 Effectiveness of fiscal policy. equal to I[1 — c(1 — 19], the simple value without any money market effects. But at the initial equilibrium point y,, the LM curve is nearly vertical, with aslope —(K/I’) that is very large. In this case the fiscal policy multiplier is extremely small, approaching zero as the LM curve becomes vertical. Thus, the size of the fiscal policy multiplier depends on the slope of the LM curve at the initial equilibrium point. A given increase in g and shift in 1S will yield a large increase in y, if the economy begins at a point of high unemployment and low interest rates. But if the g increase comes in a tight economy near full employment, there will be little effect on y, with a large increase in r squeezing out an amount of investment demand nearly equal to the g increase. The economic explanation of this difference is as follows: With a given supply of real money balances M/Po (which fixes the position of the LM curve), at the low level of r and y there is, loosely speaking, a lot of money in speculative balarices that can be drawn out to finance a higher Jevel of transactions, that is, a higher y, by a small increase in interest rates. But at the higher level of r and y, at j'2 in Figure 5-8, the amount of funds in spec- ulative balances is very small, and the increase in demand for money from a rising y serves mostly to raise r, reducing investment, rather than bringing funds out of speculative balances in any substantial amount. ‘The main point of this section is that the size of the Ag multiplier itself depends on the initial cyclical position of the economy. Thus it is not sur- prising that some investigators have found the multiplier “unstable” looking at data, say, since World War Il. Of course it is unstable; the data include the initial conditions of the 1958 recession with unemployment at 7 percent and short-term interest rates at 1.8 percent, as well as the boom conditions of 1968 with unemployment at 3.5 percent and short-term rates at 5.3 percent. But the conclusion should not be that fiscal policy is not effective because the multiplier seems unstable. Rather, its effectiveness varies over the cycle, and in anticipating the effects of any given Ag at any given time, a prudent analyst must take into consideration the initial state of the economy rather than simply relying on a multiplier like the I/[1 ~ c(t — tJ] of Chapter 3.sare NOME DETERMIN: 8 STANE EOULENY Hom, Part tne ‘Wa te dereapest ofthe mip fora bend ws, we ca 9p [puny lrg hen mt pes fo epi we rae oe ie sumption hat thax etm proportongl atta wee ay Mea porotnal ange str ee Tue ngs te spe ct Siedhiy wih no efece whatconeron de qalatne sult Ths ot ‘Seen cl ge eee tea to eap the efect of cangng es etait ta eGo 0 inFigue 3 Zi | 4 ‘ain begin wih the IS and LAM guia egestons, recy n)+inte eds) ewes ° Diflecaiating the 1 gution 6) ve at dye eles ~ sad — yi + F4r40 Sela toby ede + Fae “The st mo tert in he spnsble income (y— 7) erent come oe Tie appeoinstion hath ry pas Apa om te LM epuatt (heehave so ths sbi inte the dy eatin ges s ape ell ey eyeAN INTRODUCTION TO MONETARY AND FISCAL POLICY 81 The numerator of the tax rate multiplier in (8) simply converts the tax change into the policy-induced change in consumer expenditure. The term Jdr is the change in disposable income that comes directly from the tax rate change, dc. Then the term cy dz is the change in consumption spending that comes from this change in disposable income, and the minus sign says that when | tax rates go up, the policy-induced consumption change is negative. The simplifying assumption for the tax multiplier of equation (8) that the tax function t(y)= ty means that the slope of the tax function 1’ is z in this special case (dt(y)/dy = 2). This makes the denominator of the tax multiplier (8) the same as the denominator of the government purchases multiplier (5). Since these two are the same, interpreting the numerator of the tax multiplier, —c’ydz as the direct change in consumption following from a tax change makes the multipliers for tax changes and g changes essentially the same. To get the effect of a g change, dg, or a consumption change induced by dz, —c’ydz, on equilibrium demand-side income and output, we multiply by a r-eu-g4 The similarity between the g and ¢ multipliers tells us that the effects of fiscal policy changes in g or t on the level of total output y will be roughly the same. But there are two major differences between fiscal policy changes in g and in tax rates. First, there will be a difference in the composition of the new equilibrium output. Expanding output by increasing g also will increase the government's share of output. But a tax cut shifts the initial stimulus to a policy-induced increase in consumer spending, raising the share of output going to consumers. Thus the choice between cutting taxes or increasing government purchases to expand output and reduce unemploy- ment will in part depend on a judgment on the relative social benefits of more consumer expenditure as opposed to more resources going into the production of public goods. This was one of the points of debate within the Kennedy administration prior to the proposal of the 1964 tax cut. With unemployment near 6 percent and the economy expanding too slowly, the debate was whether to increase government purchases g, increasing the provision of public goods, or to cut taxes, placing more emphasis on ‘consumer spending. The other major difference between g and t changes stems from the fact that a tax cut will affect the economy only if consumers increase their spending as a result, so that the direct policy-induced consumption stimulus does, in fact, appear. There is always the possibility that consumers will save the additional disposable income, leaving the total s + ¢(y) schedule unchanged with no effect on y. To a certain extent, but in the other direction, this hap- pened with the income tax surcharge in 1968; when the surcharge was passed, raising taxes, consumers paid about half of the additional tax out of saving and half out of consumption, thus reducing the effect on y.“Thigproblem docsnatocot with eure thou sce the povraen can ma sre tat eanges the deed mount Thus thee ‘eta of aclevig the eed ees on pts poly canes ee {evermunprchaies rahe han ak and eater fast Gang ‘Abe i Seow elit perma! tn rate hanger wil foe pee ‘et tha emporayeoanger that may wel be compen cy Shangesie sang ‘THE BALANCED-SUOGET MULTIPLIER ‘Te balance butt mui or gua changes ing and tx evens is edord fot is wa of uty Chae 3 te ious ef money market efecte Te se is ne wi ntroce 4 erent snioe “ution o ie tax shel, namely tat a even ae aed aoe ows} Ths ras the as ofthe eye a eg cane I 20d? ily shape Again we bem with 1S and LA eqn, prv-nines o wa Benne to Dieretinion of) anes ot dye yaa tar eas Sean cated as “The LM cgution (0) ses wx de= (4, aod substation into the equnon yells and te poerament phases an ta teaser aeof el Hin sot ‘yn thelan ception iresthe expaeaalaecebaet ll ete apie co Inoduton of money marke es on investent hough the te ie tar dens i i} fs duel the sl the blanca ote ‘ul the LA care mere fat atthe ait vane o 9 hat nd) were sed then he lope of Lf, wo be eo aAN INTRODUCTION TO MONETARY AND FISCAL POLICY 83 balanced-budget multiplier in (11) would be (1 — c’)/(i — c’) = 1. But with the introduction of the money market we see that as y rises with a balanced change in government purchases and revenues, the demand for money for transactions purposes goes up, raising the interest rate and reducing invest- ment. This partially offsets the initial increase in y, giving a final expansion of y that is less than the initial dg = df. Monetary Policy Effects on Demand To analyze the effects of monetary policy changes in the money supply, M, we will use the four-quadrant LM diagram, shown in Figure 5-10. Since in this section we will be holding the fiscal policy variables and the saving and investment functions behind the JS curve constant, we can add a fixed IS curve to Figure 5-10. This establishes initial equilibrium values of yo and To: given the price level Py and.the initial level of the money supply Mo. Monetary policy changes ini Mf will now shift the LM curve along the given IS curve, changing the interest rate and the equilibrium output de- manded. These changes in output demanded, at the given price level, pro- duce horizontal shifts in the economy's demand curve. This was shown in Figure 5-4, and is reproduced here as Figure 5-11. The DoD demand curve corresponds to the fixed [S in Figure 5-10 and the initial level of the moneyAN INTRODUCTION TO MONETARY AND FISCAL POLICY 85 In the bond market in the background, the central bank increases the money supply by buying bonds (selling money). This increase in bond demand raises bond prices, reducing interest rates. Firms find it easier (and cheaper) to borrow to finance investment projects, so investment demand goes up, moving the economy toward equilibrium at rp. ys. The movement from the old equilibrium yz to the new y, at the original price level Po is also refiected in a shift of the demand curve in Figure 5-11 to DzDz, giving a higher level of equilibrium output demanded at any given price level. Here monetary policy has shifted the demand curve: back in Figure 5-4 it was fiscal policy. The same increase in income could be achieved by an appropriately sized change in any of the three major policy instruments: g, t, or M. The monetary policy increase in M has reduced the interest rate and raised investment and equilibrium output and income. The income increase. with a given tax schedule, has increased consumer spending. while govern- ment purchases remain unchanged. Thus, monetary policy has a different effect on the composition of output than do fiscal policy changes in g or t(y). Here the policy-induced expenditure effect comes through a change in investment demand. Government purchases remain unchanged and con- sumer expenditure goes up only endogenously. We can summarize these compositional effects by looking at the basic national income identity, yeetitg (12) For a given increase in income and output, y, each of the policies gives about the same endogenous consumption increase through the multiplies. ‘The difference lies in the source of the policy-induced expenditure change. An increase in government spending raises g and reduces i somewhat, raising the proportion of g in the use of output relative to c or i in the final equilibrium position. A tax cut gives a direct c increase and also reduces i somewhat, raising the proportion of c. Finally, a money supply increase gives a policy-induced increase in i, raising the fraction of investment in the final equilibrium position. Thus, a choice of which policy instrument to use to expand (or contract) output will, in part, depend on how the policy maker wants the composition of output to change. THE MULTIPLIER FOR CHANGES IN Mf As usual, we can develop the multiplier for changes in M7 on y beginning with the IS and LM equilibrium equations. The product market equation is - yady=t)) +i) +g. (13) The money market equation is m —=m= + k(y) 4) Foam als ko. a4)ra ‘NA. COME DETENWANON Te SAT OUR ee, Siac wear fcsivg on equlbvom demande ouput ad ees inthis caper neate bog Fy consent Tis cer to dant ew vant in 1d m= St Py’ See det due con conde Sai in tra cong inet kines. des wich he ‘sng i moat money supp with hep eel bel eae Ditretatng the Li satin il ees Pa Qo ann toes ant ‘As eu deretaon ofthe 1 eguain ile dps eth ends 4 Far hg constant woth dy = Seng the previous epee br sreeu—as eam as a 6 seu be maples exprenton for he mony soppy cogs dn “ne dentin ofthe riper (15) he same a that for dh aod slp aw eh urea fe ptt ot revou see's Saco, We mit expe ths to tur et {0 bt bangs fa ivetmert nde erty by de Rlering tak tothe = sae soli orion wh a th oer eet Fentater a egal toad sepiy nee ta th ate et {ve ok nth ope tori fm a (1) the expen del St top m nly ade byte meres. Then ee te In iicament wha op ned the menent acess {fom ie eropin net by dn-thepaeyindveré invest Oa So he miper (13:8 the ura alipe iran ines the mid change indo ite by a “The ull on min equation 5) can be merece oreo! pot Figure 512 tthe aleve tame, ye es te Ae‘AN INTRODUCTION TO MONETARY AND FISCAL POLICY Figure 5-12 ‘The money supply multiplier. ‘igure 5-13, phe effectiveness of “ronetary policy. due to dM would reduce r to r;. If the LM curve were flat, so that (K’/I)) = 0, the subsequent increase in y to y, would be equal to it a din. T-ca—")"” But with the positive slope of the new LM curve, L,M,, the y change is reduced to y2 — Yo with the introduction of the 7/1’ term in (13). THE EFFECTIVENESS OF MONETARY POLICY As was the case with fiscal policy, the effectiveness of monetary policy will vary with the cyclical position of the economy. As Figure 5-13 shows, with a given slope of the IS curve, a given shift in the LM curve due to an increase in the money supply will have a greater effect on y at high levels of y and r than at low levels. This can also be seen from the dm multiplier in equation (15). Multiplying both numerator and denominator of (15) by !, which is negative, gives us (16)sci dr endgame teagan Shoes eumariceretes oR te pn en the deem of wb tery larg ro that sn nee a mia Hien heacapetertuanag testy Sencar torsuerrarttay ite Ge in Ba aaa ree ‘Onthcotter ad ery saosin amber apponehing | these th devote (1) il ena ee 2 a he a ‘lei apren hevaue th) = 1. From Figure 1 cer Eri ners ee the) eave tte te Al crv sh ‘eri Thay in hs orn ofthe LAY cue het of anaes ee Wilbe grste snes Bet erm i the denote ew ben {ee itha ara oy soclate balnes be een surese 2 ‘mum bythe high ht simon i ef wed ose Sed te lmion 9 the aval of Sige the een ‘Sons demand wa ut neat ay, 1 te ate othe alpen Titra vei the see yt pile wi dl feet sitpoet inc edition So monetary pbey busts asin ‘Uyenss when the economy at hy eres ad aig + ‘he moncy apy to nance enact tt to SeppeAN INTRODUCTION TO MONETARY AND FISCAL POLICY 89 The Interaction of Monetary and Fiscal Policies Figure 5-15 ‘The effectiveness of , monetary and fiscal “ policy. In the previous sections of this chapter we discussed the relative effectiveness of monetary and fiscal policies in relation to the cyclical position of the economy. The likelihood that the policy instruments g, 1(y), and M differ in the certainty of their results was also mentioned. In addition, it should by now be apparent that changes in these policy instruments can be combined in many different ways to achieve a desired position of the economy's demand curve. We end this introductory chapter on monetary and fiscal policy as demand-management tools first by summarizing what has already been said on relative effectiveness and certainty of results. Then we look at the interaction between monetary and fiscal policies in two important cases: first, where they work in opposite directions to change the interest rate and the composition of output at a given level of output; and second, where they work in the same direction to achieve a desired shift in the demand curve and change in y, given Po. THE EFFECTIVENESS AND CERTAINTY OF MONETARY AND FISCAL POLICY The relative effectiveness of monetary and fiscal policy, depending on the shape of the LM curve and the economy's initial position, can be summarized by reference to Figure 5-15. If the economy is in an initial position such as 1,3; of Figure 5-15, an expansionary monetary policy, shifting LM right, may have little effect on y, since at that low interest rate the additional money would be absorbed by speculative balances and not become available to finance a substantial increase in y. On the other hand, at r,,y;, 2 shift in the TS curve will be relatively effective in raising y, since a small increase in the interest rate will release a substantial amount of funds from speculative balances to support an increase in y. ‘At the other extreme, where the economy is very taut with high rand y at r,)>, a fiscal policy shift in IS will be relatively ineffective in changing equilibrium demand-side y. With interest rates very high, speculative balances%0 QUAL NOME BEERUNARON TH TAS EDULE deb casei anet alarms ak genom Sena ve Whee lot anne a ere coumensate incase Tha when the xem ne Societe ‘Theta he tulips fran eronows espender changs — ° i teu-oe oe iste pa Ud dee sa ws nso hr hf eta Sane t-te Prd fs Fang Siraedp dane ictactnge topocut pode tk Seater ae era ad dae uo inet dr BiG cle Ses tenes Sed esp y pn aot rer opens ee eae Ms tee eh hisses nem dpe ne sergmsamlh supg chase ene ee ert Sees at eee ae art Sper RIA Tey ney amps Ss SER ae see ee vaaeton Spe oh ire cane ae ste nn ond ee rth oe Sls acy ect subi a lose Fake poh yaa te fencer red eins mink SECS IEEE Sn ple tect oaAN INTRODUCTION TO MONETARY AND FISCAL POLICY 91 Figure 5-16 A shift in the mix. THE MONETARY-FISCAL POLICY MIX From the discussion of the effects of monetary and fiscal policy changes in this chapter it should be clear that changes in the policy variables can be used to change the level of the interest rate and the composition of output without shifting the demand curve, that is, without changing equilibrium demand- side y at the given Po. For example, in Figure 5-16 (below), it may be that at the going price level Po, the level of output yp yields roughly full employment. But the ro level may be too high because it gives a level of investment, especially in housing, that is too low. In this case, the interest rate may be reduced by putting in a permanent tax increase, shifting IS to 1,5;, and reducing consumption demand. This could be balanced by a money supply increase, lowering the interest rate and stimulating investment demand, bringing the economy back to yo at the lower interest rate r,. This shift in the monetary-fiscal policy mix, tightening the budget and easing the money supply, has shifted the composition of the equilibrium yo. With g fixed, consumer expenditure has been reduced and investment increased. Thus, the policy variables can be changed in opposite directions to change composition without shifting the demand curve, Working the policy variables against each other in this way creates substantial uncertainty about the outcome, especially since the amount of change in each variable will depend on the initial position of the economy. For example, in mid-1968 a mix shift was attempted, with the imposition of an income tax surcharge and a shift to monetary case. With the economy running at very low unemployment and historically high interest rates, we might say that it was in the vertical region of the LM curve when the mix change began. Then the imposition of only a temporary surcharge shifted the TS curve down only slightly, while the monetary expansion shifted LM out substantially, resulting in a shift of the economy's demand curve to the right, increasing output and the rate of inflation and pushing unemployment down even more. Thus, while the policy instruments can be used against each other to change composition, the amounts by which the instruments should changesslldeend onthe conn’ poston nhs should beer bes Hou tugresucha meats atengled "The Yana lve of weet nssied wi he ey nts au msg thatthe objective to sit the demand can Rak Ret foe all he rumen inthe sume decion Eveg he Bets ‘baby fsa in chaning. The stacy, feo, masse SSceraia sto where rwileomz out sn i foresanpie na rece tore the ra poy change” bathe cnn poly cane does Fillet the mene change bie bt he al dost ee “Thissecion feet to terpr ates te of Serta sed coat tha the cleat of talighes phe ablation plc, ‘Tetheoy boty dene ae themalnersehom Butte scaa reac BS ‘onenytoeharesin ish and} suneena so tattheeaeseel Ses ge policy change wal be bard to foreat The eer of Pa ‘eas the sectors ecco fa more Se ag too isk ‘tence But rt we mat tam fo the sop ndsf r econo sod ‘lathe srunaion tate oe vet Pe fel Selected Readings EC Booey “Fr Py ine 204° dren Ear Rr Dee 6 RIES “ota ean Be Ree 1 ae Te Lae Cr Fe eI, Peo RA Mmpane 700 They of Pa Poe Gee ods MG, 5A PA Rite, “The Sale Matenati ffnne Deaton” ro Etre cl ale ii pda be MR