Fiscal Policy in the Is-Lm Model
FISCAL POLICY – VF 461
WARRANTER : VRATISLAV IZÁK
YEAR 2002
FACULTY OF FINANCE AND ACCOUNTING
UNIVERSITY OF ECONOMICS, PRAGUE
SYLLABUS HAS BEEN ELABORATED IN THE FRAMEWORK OF
A DEVELOPMENT PROGRAM OF THE MŠMT
AIM :
The aim of the course is to make the students acquainted with short, medium and long run aspects of fiscal policy, with its microeconomic background and macroeconomic consequences. Both conventional (keynesian) and classical approaches are carefully evaluated
CREDITS : 2 (2/0)
13 lectures (28 hours)
COMPLETION : written examination
Titles of the themes :
1) Fiscal policy in the IS-LM model
2) Fiscal policy in the AS-AD model
3) The impact of expectations on the fiscal policy
4) Fiscal policy in an open economy
5) Saving, budget deficits and capital accumulation
6) Fiscal deficits, financial crisis and high inflation
7) The case of Ricardian equivalence
8) Supply side policies
9) Fiscal policy and political decision making
10) The implications of the government budget constraint
11) Structural and cyclically adjusted deficits
12) Fiscal policy in a monetary union
13) Fiscal policy in an economy in transition
Literature :
Basic:
1) Barro R.: The Ricardian Approach to Budget Deficits, Journal of Economic Perspectives, 2/1989, p.37-54
2) Barro R., Grilli V.: European Macroeconomics, Macmillan, London, 1994, ISBN 0-333-57764-7
3) Blanchard O.: Macroeconomics, Prentice Hall, New Jersey, 2000, ISBN 0-13-017395-9
4) European Economy-Public Finances in EMU, 3/2001, 80p.
5) Giorno C., Richardson P., Roseveare D., van den Noord P.: Estimating potential output, output gaps and structural budget balances, OECD, WP 152/1995, 53p.
6) Gordon R.: Macroeconomics, Addison-Wesley Longman, New York, 1997, ISBN 0-321-01438-3
7) How to Measure the Fiscal Deficit: Analytical and Methodological Issues, edited by M. Blejer and A. Cheasty, IMF, Washington, 1993
Supplementary:
1) Alesina A., Perotti R.,: Fiscal Adjustment in OECD countries: Composition and Macroeconomic Effects, IMF, WP 70/1996, 46p.
2) Caselli F., Giovannini A., Lane T.,: Fiscal Discipline and the Cost of Public Debt service: Some Estimates for OECD countries, IMF WP 55/1998, 22p.
3) Elmendorf D., Mankiw G.: Government Debt (Ch. 23) in Handbook of Macroeconomics, Vol.I, Elsevier, 1999
4) Izak V.: Fiscal Policy: The Necessary but Not Sufficient, Ch.3 in Lessons in Economic Policy for Eastern Europe from Latin America, edited by G.Mac Mahon, Macmillan, London, St. Martin´s Press, New York, 1996, ISBN 0-312-12647-6
5) Knot k.: Fiscal Policy and Interest Rates in the European Union, E. Elgar, Cheltenham, UK, 1996
6) Noord van den P.: The Size and Role of Automatic Fiscal Stabilizers in the 1990´s, OECD, WP 230/2000, 29p.
7) Perkins J.: Budget Deficits and Macroeconomic Policy, 1997
8) Tanzi V.: The Budget Deficit in Transition, IMF Staff Papers, 3/1993,p.697-707
For the student´s convenience lecture notes (approximately 100 pages) summarizing the main content of the themes are at the disposal
FISCAL POLICY IN THE IS-LM MODEL
THEME 1
a) After working through theme 1 you should understand the interaction among demand, aggregate production and income in the simple model of income determination in the short run. The role of fiscal policy in this model is a clear one. Increases in government spending and decreases in taxes both increase output. Looking at goods and financial markets together we create a framework to think about how output and the interest rate are determined in the short run. To most economists the IS-LM model still represents an essential building block-one that, despite its simplicity, captures much of what happens in the economy in the short run.
b) Fiscal policy in a model of income determination
. A fiscal expansion and a fiscal contraction
The dynamic effects of a change in fiscal policy
Policy mix (monetary and fiscal policy)
c) Fiscal policy in a model of income determination, where consumption, investment
and government expenditure are all exogenous variables. In equilibrium aggregate
demand equals income and the multiplier is deduced. Fiscal policy in this model
analyses what happens to output if autonomous spending (government expenditure)
changes. A fiscal expansion occurs when government purchases increase or when
taxes are cut. A fiscal contraction occurs when government purchases are cut or when
taxes are increased. Both expansion and contraction cause a change in income and
the interest rate. Policy mix (a combination of monetary and fiscal policies) is
sometimes used for a common goal.
d) In equilibrium, when aggregate demand equals income we solve one equation with
one unknown. The solution for the equilibrium level of output yields the important
concept of the multiplier. It means, e.g., that every one crown change in government expenditure causes a „multiplied“ change in equilibrium output. To summarize, e.g. a fiscal contraction will cause a reduction in income (due to a reduction in demand), a lower interest rate (due to a reduction in demand for money), a reduction in consumption and saving via the reduction in disposable income and an ambiguous effect on investment (the lower interest rate causes an increase in the investment and the lower income causes a reduction in investment). The dynamic effects of an increase in government expenditure are: their increase causes an increase in demand; firms respond by slowly increasing income; as soon as income begins to increase, money demand rises and the interest rate rises to maintain financial markets equilibrium; therefore as income increases, the economy moves along the LM curve. Income continues to increase (and the interest rate rises) until the new equilibrium is reached. Monetary policy can accommodate fiscal expansion. In this case the central bank must increase the money supply as money demand increases to keep the interest rate at the initial level. This will shift the LM curve down and the new equilibrium will be reached at higher output level.
Summarizing, in the IS-LM model fiscal policy is the most effective when investment demand is independent of the rate of interest (the IS curve is vertical and there is no crowding out) and when money demand is completely elastic with respect to the interest rate (the liquidity trap, the LM curve is horizontal).
e) model IS-LM, IS equation, LM equation, fiscal expansion, fiscal contraction, monetary-fiscal policy mix
f) homework:
Suppose the economy is represented by the following equations:
Md = 6 Y – 120 i Ms = 5400
C = 180 + 0,7 (Y – T) T = 400 G = 400 I = 100 – 18 i + 0,1 Y
a. Write out the equation for equilibrium in the goods market, Solve for the equilibrium level of output.
b. Write out the equation for equilibrium in the financial market. Solve for the equilibrium level of the interest rate.
c. Substitute the expression for i (in part b) into your equation for y in part a. Calculate the overall equlibrium level of output.
d. Calculate the equilibrium i by substituting the value of Y (from c) into your equation in(b).
e. At this equilibrium what is the level of C and I ?
f. Calculate the new equilibrium value of Y, i, C and I when G increases by 10 (from 400 to 410). What happened to investment as a result of this fiscal expansion ?
g. Using the original values of the variables, calculate the new equilibrium values of Y, i, c and I when M increases by 200 (from 5400 to 5600). What happened to investment as a result of this monetary expansion ?
FISCAL POLICY IN THE AS -AD MODEL
THEME 2
a) To think about the determination of output in both the short run and in the medium run
requires taking into account equilibrium in all markets (goods, financial and labour).
We do so by deriving two important relations: the aggregate supply relation which captures the implications of equilibrium in the labour market and the aggregate demand relation which captures the implications of equilibrium in both the goods and financial markets. Then we are able to look at the effects of fiscal policy in the short and medium run. We will see that in the medium run changes in fiscal policy have no effect on output and are simply reflected in a different composition of spending.
b) Wage determination in the labour market
Price determination in the labour market
The move from unemployment to output
Putting all markets together – the AS-AD model
Fiscal policy in both the short and medium run
c) Firms respond to an increase in aggregate demand (due to e.g. expansionary fiscal policy) in the medium run. At the center of this adjustment process is the labour market. So we must combine our earlier treatment of goods and financial markets with the knowledge of the labour market. The nominal wage depends on 3 factors (the expected price level, the unemployment rate and a catchall variable that stands for all other variables that affect the outcome of wage setting. In price setting we assume the markup over costs. In the medium run, output tends to return to the natural level and the factors that determine unemployment and output are the factors influencing the movement of wages and prices. Therefore, in the medium run, fiscal policy does not affect output forever, but only temporary, and output returns to its natural level.
d) When firms respond to an increase in aggregate demand due to expansionary fiscal
policy by stepping up production then higher production requires an increase in employment; higher employment leads to lower unemployment; lower unemployment puts pressure on wages; higher wages increase production costs, forcing firms in turn to increase prices; higher prices lead workers to ask for higher wages and so on. This sequence of events can not be ignored, therefore the labour market must be analysed.
Wage determination implies a negative relation between the real wage and the unemployment rate. As many markets are not competitive, firms charge a price higher than their marginal cost-they use a markup of price over cost. To move from unemployment to output we use a simple production function. We know from other courses that associated with the natural level of employment is a natural level of output when the expected price level is equal to the actual price level. Thinking about the determination of output in both the short run and in the medium run requires taking into account equlibrium in all three markets (goods, financial and labour). The aggregate supply relation captures the effects of output on the price level, whereas the aggregate demand relation captures the effect of the price level on output. But the equilibrium output (the intersection of AS and AD ) can be above or below its natural level. Then the dynamics of adjustment must follow. The dynamic effects of changes in fiscal policy-e.g. a decrease in the budget deficit do not affect output forever. Eventually, output returns to its natural level but the price level and the interest rate are now lower than before the shift in fiscal policy. By assumption, government spending is lower than before, consumption is the same, therefore investment must be higher than before deficit reduction-higher by an amount exactly equal to the decrease in the budget deficit. Put another way, in the medium run, a reduction in the budget deficit unambiguously leads to a decrease in the interest rate and an increase in investment.
e) Wage setting relation, price setting relation, natural rate of output, deficit reduction,
adjustment process
THE IMPACT OF EXPECTATIONS ON THE FISCAL POLICY
THEME 3
a) In sharp contrast to the simple models we analysed in the first two themes, we will
show, in this third theme, that a fiscal contraction may, under the right circumstances, lead to an increase in output, even in the short run. How expectations respond to policy are at the center of the story.
b) Expectations and the IS relation
Expectations and the LM relation
Deficit reduction, expectations and output
The Irish example
c) We distinguish several kinds af expectations-animal spirit, adaptive expectations and rational expectations. Our equation for aggregate demand must be reformulated by introducing expected values of income, taxes and the real interest rate. The present and the future are reduced to only two periods: a current period and a future period. Introducing the expected values into the IS relation causes a change in the steepness of this curve. The LM relation is, even after the revision, unchanged and the expected values have no impact on the LM curve known from lecture 1. If firms , households and financial market participants have rational expectations, then, in response to the announcement of a deficit reduction, the output may increase even in the short run. This result is in a contrast with the result in a very simple model in theme 1.
d) In this theme the introduction of expectations into the IS relation shows that: increases in either current or expected future income increase private spending, increases in either current or expected future taxes decrease private spending and increases in either the current or expected future interest rate decrease private spending. The new IS curve is still downward sloping, but is much steeper than the IS curve we drew in the first lecture. Put another way, a large decrease in the current interest rate is likely to have only a small effect on equilibrium output. The effect of the decrease in the real interest rate on output depends on the strength of two effects: the effect of the real interest rate on spending given income and the size of the multiplier. Changes in current taxes or in government spending shift the IS curve. Changes in expected future variables also shift the IS curve. The LM curve has not been modified. How much money one wants to hold today depends on his current level of transactions, not on the level of transactions one expects next year or the year after; there will be time to adjust his money balances to his transaction level if it changes in the future. To summarize: Expectations about the future play a major role in spending decisions. This implies that expectations enter the IS relation.
In the past 10 years several economists have questioned the conclusion of the first
lecture that, in the short run, unless it is offset by a monetary expansion, a reduction of