Lecture 9

FISCAL POLICY
& MONETARY POLICY

References:
N.G. Mankiw, “Principles of Economics”, 8th edition, chapter
20
NEU, “Economics”, chapter 7,8

September 2019
 Understand the definition of monetary policy
 Understand the definition of fiscal policy and the
structure of government budget
 Introduce the income-expenditure model to study
the transmission mechanism of fiscal policy on
aggregate demand
 Explore some limitations of fiscal and monetary
policy
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What is money?
 Definition of money
 Cash
 Bank account
 Functions of money
 Unit of exchange
 Unit of account
 Store of value
 Creation of money
 Central bank
 Commercial banks
Monetary policy
 Central Bank
 Open-market operation  money base
 Reserve requirement  reserve and lending
 Discount rate
 Monetary policy
 Expansionary: MS increases
 Contractionary: MS reduces
 Assuming that money supply is completely determined
by Central Bank
 Tools of Central Bank to control money supply
1. Open market operations

2. Reserve requirement

3. Discount rate

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 Motivations for holding money
 Transaction motivation
 Precautionary motivation
 Speculative motivation

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 Money demand is determined by
several factors.
 Real income Y (+)
 Price level P (+)
 Nominal interest rate i (-)

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 The money market is the market for
money in which the amount supplied
and the amount demanded meet to
determine the nominal interest rate

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 Equilibrium in the Money Market
 According to the theory of liquidity preference introduced by
Keynes:
 The interest rate adjusts to balance the supply and demand for money.

 There is one interest rate, called the equilibrium interest rate, at which
the quantity of money demanded equals the quantity of money
supplied.

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 Interest
Rate

Money
supply

i1

Equilibrium
interest
rate
i2
Money
demand

0 Md Quantity fixed M2d Quantity of

by the Fed Money
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 An increase in the money supply shifts the
money supply curve to the right.
 Purchasing government bond in the financial market
 Reducing discount rate
 Reducing reserve requirement
 Without a change in the money demand curve,
the interest rate falls.

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 Falling interest rates increase the quantity of goods
and services demanded.
 Rise in consumption (wealth effect)
 Rise in investment spending (interest effect)
 Domestic currency depreciates, then net exports will rise
(foreign exchange effect)
 When aggregate demand increases in the context of
sticky prices, the output will increase.

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 (a) The Money Market (b) The Aggregate-Demand Curve
Interest Price
Rate Money MS2 Level
supply,
MS

I 1. When the Fed P

increases the
money supply . . .
2. . . . the i2
AD2
equilibrium
interest rate Money demand Aggregate
falls . . . at price level P demand, AD
0 Quantity 0 Y Y Quantity
of Money of Output
3. . . . which increases the quantity of goods
and services demanded at a given price level.

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 A decrease in the money supply shifts the money supply
curve to the left.
 Selling government bond in the financial market
 Increasing the discount rate
 Increasing the reserve requirement

 Without a change in the money demand curve, the

interest rate rises.

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 Higher interest rate decreases the quantity of
goods and services demanded.
 Decrease in investment spending
 Domestic currency appreciates, then net exports will
reduce
 When aggregate demand decreases in the context
of sticky prices, the output will decrease.

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 Lags effect
 Inside lags: relatively short compared to those for
fiscal policy
 Outside lags: quite long for monetary policy.
 Economists predict it will take at least two years for
most of the effects of an interest rate cut to be felt.

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 Exercise
 In an economy with required reserve rate of 5%, commercial
banks have excess reserve rate of 5%, and everyone hold
money as bank accounts for transaction. The central bank
wants to increase money supply by VND1000 bln
1. How does CB use the tools of monetary policy? (open-
market operation)
2. Use the diagram of money market and AS-AD model to
explain the impact of this policy on interest rate,
investment, aggregate demand, total output and price level
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 Expansionary fiscal policy
 Increase in government spending or decrease in
tax will raise AD, thereby increasing outputs and
creating more employments
 Employed when the economy falls into recession

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 Contractionary fiscal policy
 Decrease in government spending or increase in
tax will reduce AD, thereby decreasing level of
output and price.
 Employed when the inflation rate is too high.

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Price level ASLR Price level ASLR
ASSR0
ASSR0

P0
P1 P1
P0 AD1 AD0
AD0 AD1

Y0 Y Output Y1 Y Output

a) Expansionary fiscal policy b) Contractionary fiscal policy

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 Government spending  Government revenue
 Government purchases  Corporate income tax


Current expenditure
 Value added tax

 Capital expenditure  Trade tax

 Transfer payments  Personal income tax

 Interest on the national debt  Social Security tax

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 If government expenditure is greater than
government revenue, then that country runs a
budget deficit. In contrast, it runs a budget
surplus.
 The accumulation of government budget deficit
which is financed by borrowing is called public debt.

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 When examining budget-related figures over time,
it is misleading to use nominal figures since the
price level rises over time.
 If we translate from nominal values into real
values, we find much smaller increases in budget
deficit and public debt.

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 Budget-related figures such as government
spending or the national debt should be
considered relative to a nation’s total income.
 This is why we should always look at these figures
as percentage of GDP

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 Government budget is closely related with economic
fluctuations
 In recession, the budget deficit increases (or budget
surplus decreases) because transfer rises and tax revenue
falls
 In expansion, the budget deficit decreases (or budget
surplus increases) because transfer decreases and tax
revenue rises

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 Government budget is divided into two
components:
 Structural budget is budget position when the economy
is at the potential output
 Cyclical budget is the difference between actual budget
and structural budget due to economic fluctuations

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 The model was developed by the
economist John Maynard Keynes in the
1930s to explore the aggregate
expenditure in more details as well as the
transmission mechanism of fiscal policy.
 It is very useful for understanding
economic fluctuations in the short-run
when prices are sticky, but not in the
long-run

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 Price level
 Assumptions
 Prices are sticky, or the short-run AS P
curve is horizontal. P0

 Then output, or income, is completely

determined by aggregate demand or ASSR0
expenditure.
 This model is just to focus on studying AD0
the demand side without taking supply AD1

side into account. Y1 Y0 Y

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 The aggregate planned expenditure for an open
economy (the general form)
AE = C + I + G + X - IM
 C: consumption by households
 I: planned investment by firms
 G: government purchases of goods and services
 X: exports
 IM: imports

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 Consumption function Consumption

Consumption
C = Ca + MPC×(Y – T) function

 Ca: autonomous consumption,

Slope = MPC
which is not directly dependent
Y
 Y: income/output 45o
 T: income tax Output/Income
 MPC: Marginal Propensity to
Consume; MPC  (0, 1) 32
 Expenditure

 Savings function
S=Y–T–C
Savings function
 S = -Ca + MPS(Y – T) 45o
 MPS: Marginal Propensity Income
to Save
 MPS = 1 - MPC
Slope = MPS

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 Investment function: I = Ia
 Government purchases function: G = Ga
 Exports function: X = Xa
 Imports function: IM = MPM×Y
 MPM: Marginal Propensity to Import
 MPM should be greater than 0 and less than MPC

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 The aggregate planned expenditure function:
AE = C + I + G + X – IM
 AE = Ca + MPC×(Y – T) + Ia + Ga + Xa - MPM×Y
 AE = {Ca + Ia + Ga + Xa - MPC×T} + (MPC-MPM)×Y
 The equilibrium income will be identified by
solving this equation:
Total income Y = total expenditures AE 35
Equilibrium Output

AE
C 450
AE = AE + Y

D
AE0
AE0 = Y0 Equilibrium output
A
AE

Y1 Y0 Y2 Y
 The solution of equilibrium income is:
1
Y   Ca  I a  Ga  X a  MPC  T 
1  MPC  MPM

1  MPC
1  MPC  MPM 1  MPC  MPM

The expenditure multiplier The tax multiplier

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 The fiscal policy becomes more
effective when
 Marginal propensity to consume is greater
 Marginal propensity to import is smaller

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Gov. expenditure Dom. output Income of dom.
increases by 1000 increases by producer increases
USD for domestic 1000 USD by 1000 USD
products

Consumption for Dom. output Income of dom.

dom. products increases by producer increases by
increases by MPC×1000 MPC×1000
MPC×1000

Consumption for Income of dom.

…
Dom. output
dom. products increases by producer increases
increases by MPC2×1000 by MPC2×1000
MPC2×1000

Y = 1000 + MPC×1000 + MPC2×1000 + MPC3×1000 +

…
1
Y   G
1  MPC
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Income tax Household’s
decreases by income increases
1000 USD by 1000 USD

Consumption for Dom. output Income of dom.

dom. products increases by producer increases by
increases by MPC×1000 MPC×1000
MPC×1000

Consumption for Dom. output Income of dom.

dom. products
increases by
increases by
MPC2×1000
producer increases
by MPC2×1000
…
MPC2×1000

Y = MPC×1000 + MPC2×1000 + MPC3×1000 + …

 MPC
Y   T
1  MPC
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 Assume that initial equilibrium income is 600
billion USD. Now, the policy makers want to
increase the income by 1%. Assume that MPC
= 0.8; MPM = 0.2
1. By how much do policymakers have to increase
government spending to meet this target?
2. By how much do policymakers have to cut tax to
meet this target?
3. By how much do policymakers have to change
government spending and tax to meet this target
while keeping the budget balance unchanged?

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Output increases by bln.6

AE AE = AE + Y
C 450
AE = AE + Y

D
AE0
AE0 = Y0 Equilibrium output
A
AE

B
Increase by 1%

Y1 600 Y2 Y
Increased
government
spending crowds
out consumption

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Increased
government
spending crowds
out investment

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 Poorly timed policies can magnify economic
fluctuations because of lag effects
 Inside lags: refer to the time it takes to formulate a
policy
 Outside lags: refer to the time it takes for the policy to
actually work

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 3 . Perception of
inflationary
pressure

2.
Expansionary 4.
fiscal policy Contractionary
fiscal policy
Full
employme
nt GDP

1. Perception
of recession Inside lags Outside lags Inside lags Outside lags

0 1 2 3 4
Time
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 To improve the effectiveness of policy
 Forecast the economic fluctuations earlier
 Identify the full-employment GDP
 Establish institutions which allow government
to more quickly respond to economic
fluctuations
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 Automatic stabilizers are changes in fiscal policy that
stimulate aggregate demand when the economy goes
into a recession without policymakers having to take
any deliberate action.
 Unemployment insurance benefits
 Progressive tax system: is one tax system in which the
marginal, and therefore average tax rates increase when
income increases.

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III. The combination of
Monetary Policy
and Fiscal Policy

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 Expansionary Monetary Policy
MS increases  i falls  I increases  AE
increases  AD increases
i i AE
AE2
AE1
i1
i1
AE2
i2
i2
AE1

I1 I2 I Y1 Y2 Y
MS1 MS2 M P
MS = MD (AE, Y, P, i)
I = I - br P
AE = C + I + G + NX
AE = AE + αY - br Y1 Y2 Y
 What determines the
effectiveness of Monetary Policy

More effective Less effective

policy policy
Slope of MD steeper flatter

Slope of I Flatter Steeper

Multiplier higher smaller

The slope of AS determines how much the price level

and total output change when there is a change in AD
 Expansionary Fiscal Policy
G increases  AE increases  Multiplier
effect and Crowding out effect
i i AE
AE2
AE1
i1
i1
AE2
AE1

I1 I Y1 Y2 Y
MS1 MS2 M P
MS = MD (AE, Y, P, i)
I = I - br P
AE = C + I + G + NX
AE = AE + αY - br Y1 Y3 Y2 Y
 Multiplier effect vs.
Crowding out effect
P
ΔG

Multiplier Effect

P0
Crowding out Effect

AD0 AD1 AD3 AD2

Y
 Multiplier effect with an
increase in G
P
ΔG

Multiplier Effect

P0 ΔG
m.ΔG

AD0 AD1 AD2

Y0 Y1 Y2 Y
 Multiplier effect with an
reduction in T
P
ΔT.MPC

Multiplier Effect

P0 ΔT.MPC
mT.ΔT

AD0 AD1 AD2

Y0 Y1 Y2 Y
Excercise
 Assume an economy facing with a
shock of AS fall. Let’s determine the
effects of one monetary policy in
controlling total output.
 Expansionary Monetary Policy
MS increases  i falls  I increases  AE
increases  AD increases
i i AE
AE2
AE1
i1
i1
AE2
i2
i2
AE1

I1 I2 I Y1 Y2 Y
MS1 MS2 M P
MS = MD (AE, Y, P, i)
I = I - br P1
AE = C + I + G + NX P0
AE = AE + αY - br Y1 Y0 Y2 Y
For each events in exercise 10,
what policy do you suggest
 In order to stabilize price level to the
initial level?
 In order to stabilize output level to the
initial level?