Escolar Documentos
Profissional Documentos
Cultura Documentos
12
LEARNING OBJECTIVES
After reading and studying this chapter, you should be able to:
Understand that both fiscal and monetary policy can be used
to stabilize the economy in the short run.
Understand that the output effect of expansionary fiscal policy
is reduced by crowding out: Increased government spending
increases interest rates, reducing investment and partially
offsetting the initial expansion in aggregate demand.
Understand that the slope of the LM curve has an important
bearing on the effectiveness of fiscal and monetary policy.
MONETARY AND FISCAL
POLICY IN THE VERY
SHORT RUN
here are many interesting examples of the effects of monetary and fiscal
policy on the economy. For example, the long period of deficit-financed
expansionary fiscal policy that started in the early 1970s contributed to
strong GDP growth. We have previously discussed the severe recessions of
the early 1980s and 1990s, when monetary policy makers chose to raise interest rates
and the economy went into a downturn.
Figure 12-1 illustrates one of the most recent responses of the economy to mon-
etary policy intervention. In 1997 and 1998, real GDP was growing at an average
annual rate of approximately 4 percent. The governor of the Bank of Canada con-
sidered this growth to be to be excessively strong and, therefore, began to slowly raise
interest rates. Notice in Figure 12-1 how, by the beginning of 2001, output growth
began to slow in response to these interest rate increases. However, after the events of
September 11, 2001, output fell dramatically. In response to this, interest rates were
lowered in an equally dramatic fashion. The result was a strong rebound in output
growth in early 2002.
In this chapter we use the IS-LM model developed in Chapter 11 to show how
monetary policy and fiscal policy work. These are the two main macroeconomic
policy tools the government can call on to try to keep the economy growing at a rea-
sonable rate, with low inflation. They are also the policy tools the government uses
to try to shorten recessions, as in 1991, and to prevent booms from getting out of
hand. Generally speaking, fiscal policy has its initial impact in the goods market, and
monetary policy has its initial impact mainly in the assets markets. However, because
the goods and assets markets are closely interconnected, both monetary and fiscal
policies have effects on both the level of output and interest rates.
Figure 12-2 will refresh your memory about our basic framework. The IS curve
represents equilibrium in the goods market. The LMcurve represents equilibrium in
the money market. The intersection of the two curves determines output and interest
rates in the very short run, that is, for a given price level. Expansionary monetary
policy moves the LM curve to the right, raising income and lowering interest rates.
T
90-DAY TREASURY BILL RATE AND REAL GDP GROWTH, QUARTERLY, 19972002 FIGURE 12-1
Between 1997 and
2001, monetary policy
raised interest rates in
order to slow output
growth. However, after
the events of September
11, 2001, monetary
policy was forced to
lower interest rates to
prevent output from
falling further.
SOURCE: Treasury bill: CANSIM II V122484; real GDP: CANSIM II V1992259..
234 P A R T 4 The Economy in the Very Short Run: Spending and the IS-LMModel of Economic Activity
235 C H A P T E R 1 2 Monetary and Fiscal Policy in the Very Short Run
Contractionary monetary policy moves the LM curve to the left, lowering income
and raising interest rates. Expansionary fiscal policy moves the IS curve to the right,
raising both income and interest rates. Contractionary fiscal policy moves the IS
curve to the left, lowering both income and interest rates.
MONETARY POLICY
For the purposes of this chapter, monetary policy will be defined as any choice made
by the Bank of Canada concerning the level of the nominal money stock. Figure 12-2
describes the case of expansionary monetary policy, which is defined as an increase
in the nominal money stock.
The initial equilibrium is at point E, which corresponds to a real money supply
of M
/P
1
bi)
G
1 c
1
(1 t)
(1)
Note that G
1
, in equation (1). The income tax rate, t, is part of the multiplier. Thus,
both government spending and the tax rate affect the IS schedule.
An Increase in Government Spending
We now show, in Figure 12-4, how a fiscal expansion raises equilibrium income and
the interest rate. At unchanged interest rates, higher levels of government spending
increase the level of aggregate demand. To meet the increased demand for goods,
output must rise. In Figure 12-4, we show the effect of a shift in the IS schedule. At
each level of the interest rate, equilibrium income must rise by
G
times the increase
in government spending. For example, if government spending rises by 100 and the
multiplier is 2, equilibrium income must increase by 200 at each level of the interest
rate. Thus, the IS schedule shifts to the right by 200.
If the economy is initially in equilibrium at point E and government spending
rises by 100, we would move to point E if the interest rate stayed constant. At E, the
goods market is in equilibrium in that planned spending equals output. However, the
money market is no longer in equilibrium. Income has increased, and therefore the
quantity of money demanded is higher. Because there is an excess demand for real
balances, the interest rate rises. Firms planned investment spending declines at
higher interest rates, and thus aggregate demand falls off.
What is the complete adjustment, taking into account the expansionary effect of
higher government spending and the dampening effects of the higher interest rate on
private spending? Figure 12-4 shows that only at point E do the goods and money
markets both clear. Only at point E is planned spending equal to income and, at the
same time, the quantity of real balances demanded equal to the given real money
stock. Point E is therefore the new equilibrium point.
Crowding Out
Comparing E to the initial equilibrium at E, we see that increased government
spending raises both income and the interest rate. But another important compar-
ison is between points E and E, the equilibrium in the goods market at unchanged
interest rates. Point E corresponds to the equilibrium we studied in Chapter 11,
when we neglected the impact of interest rates on the economy. In comparing E and
E, it becomes clear that the adjustment of interest rates and their impact on aggre-
gate demand dampen the expansionary effect of increased government spending.
Income, instead of increasing to level Y, rises only to Y.
240 P A R T 4 The Economy in the Very Short Run: Spending and the IS-LMModel of Economic Activity
12-2
www.fin.gc.ca/access/
ecfisce.html
241 C H A P T E R 1 2 Monetary and Fiscal Policy in the Very Short Run
The reason that income rises only to Y rather than to Y is that the rise in the
interest rate from i
0
to i reduces the level of investment spending. We say that the
increase in government spending crowds out investment spending. Crowding out
occurs when expansionary fiscal policy causes interest rates to rise, thereby reducing
private spending, particularly investment.
What factors determine how much crowding out takes place? In other words,
what determines the extent to which interest rate adjustments dampen the output
expansion induced by increased government spending? By drawing for yourself dif-
ferent IS and LMschedules, you will be able to show the following:
Income increases more and interest rates increase less, the flatter the LM
schedule.
Income increases less and interest rates increase less, the flatter the IS schedule.
Income and interest rates increase more the larger the multiplier,
G
, and thus
the larger the horizontal shift of the IS schedule.
In each case, the extent of crowding out is greater the more the interest rate increases
when government spending rises.
Is Crowding Out Important?
How seriously must we take the possibility of crowding out? Here, three points must be
made. The first point is also an important warning. In this chapter, as in the two pre-
ceding chapters, we are assuming an economy with prices given, in which output is
EFFECTS OF AN INCREASE IN GOVERNMENT SPENDING
FIGURE 12-4
Increased government
spending increases
aggregate demand,
shifting the IS curve to
the right.
crowding out
Occurs when expansionary
fiscal policy causes
interest rates to rise,
thereby reducing private
spending, particularly
investment.
below the full employment level. In these conditions, when fiscal expansion increases
demand, firms can increase the level of output by hiring more workers. But in fully
employed economies, crowding out occurs through a different mechanism. In such
conditions, an increase in demand will lead to an increase in the price level. The
increase in price reduces real balances. (An increase in P
/P
.) This
reduction in the real money supply moves the LM curve to the left, raising interest
rates until the initial increase in aggregate demand is fully crowded out.
The second point, however, is that in an economy with unemployed resources,
there will not be full crowding out because the LMschedule is not, in fact, vertical. A
fiscal expansion will raise interest rates, but income will also rise. Crowding out is
therefore a matter of degree. The increase in aggregate demand raises income, and
with the rise in income, the level of saving rises. This expansion in saving, in turn,
makes it possible to finance a larger budget deficit without completely displacing pri-
vate spending.
The third point is that with unemployment and, thus, a possibility for output to
expand, interest rates need not rise at all when government spending rises, and there
need not be any crowding out. This is true because the monetary authorities can
accommodate the fiscal expansion by an increase in the money supply. Monetary
policy is accommodating when, in the course of a fiscal expansion, the money supply is
increased in order to prevent interest rates from increasing. Monetary accommodation
is also referred to as monetizing budget deficits, meaning that the Bank of Canada prints
money to buy the bonds with which the government pays for its deficit. When the
Bank of Canada accommodates a fiscal expansion, both the IS and the LMschedules
shift to the right, as in Figure 12-5. Output will clearly increase, but interest rates
need not rise. Accordingly, there need not be any adverse effects on investment.
242 P A R T 4 The Economy in the Very Short Run: Spending and the IS-LMModel of Economic Activity
MONETARY ACCOMMODATION OF A FISCAL EXPANSION FIGURE 12-5
If the Bank of Canada
increases the money
supply when there is a
fiscal expansion, both
the IS and the LM
curves shift to the right.
Because interest rates
do not rise, there is no
crowding out.
monetary
accommodation
The central bank prints
money to buy the bonds
with which the
government pays for its
deficit.
243 C H A P T E R 1 2 Monetary and Fiscal Policy in the Very Short Run
In the Policy in Action feature in Chapter 11, we discussed how tight monetary policy
and loose fiscal policy could lead to high interest rates. This is generally called the
policy mix.
The policy mix of the early 1980s featured highly expansionary fiscal policy and
tight money. The tight money succeeded in reducing the inflation rate at the expense
of a serious recession. The continued expansionary fiscal policy then drove a recovery
during which real interest rates increased.
This recovery continued until mid-1988, when both the Bank of Canada and the
U.S. Federal Reserve Board, fearing that inflation was rising again, began to tighten
monetary policy again, and interest rates began rising. The table below shows that the
real interest rate reached 7 percent in 1989 and 8.1 percent in 1990, which forced
the economy into a recession in 1990 and 1991. In 1992, inflation fell dramatically
from 5.6 percent to 1.5 percent. Also, in 1992, the Bank of Canada allowed interest
rates to drop and a modest recovery began. This recovery was aided by the continua-
tion of full employment deficits throughout the 1990s.
An interesting feature of this recession and recovery is the behaviour of the unem-
ployment rate. You can see from the table below that the unemployment rate increased
from 1988 to 1992. After 1992, the unemployment rate remained above 10 percent
until the late 1990s.
The Policy Mix
12-2
BOX
MONETARY POLICY AND THE INTEREST RATE RULE
Until now, we have made the assumption that monetary policy is conducted by
making discrete changes in the money supply, so that the nominal money supply was
an exogenous variable. In this case, we specified the behaviour of monetary policy as
M
s
= M
-
(2)
THE RECESSION OF THE EARLY 1990S
(PERCENT)
1988 1989 1990 1991 1992
Nominal interest rate 9.4 12.0 12.8 8.8 6.5
Real interest rate 5.4 7.0 8.1 3.2 5.0
Full-employment deficit 4.0 3.9 3.9 3.6 3.0
Unemployment rate 7.7 7.5 8.1 10.4 11.3
GDP growth 4.9 2.4 0.2 1.9 0.76
Inflation 4.0 5.0 4.7 5.6 1.5
12-3
This type of policy stance is technically known as a money supply rule.
Now imagine a situation where the money demand curve is subject to random
shocks. As an example, suppose there was a major world event that caused people to
hold a great deal of moneyperhaps because they felt that they would not be able to
liquidate other forms of wealth fast enough. This type of event would suddenly
increase the demand for money, as illustrated in Figure 12-6.
The initial equilibrium is at point E, with an interest rate of i
1
. The shock to
money demand shifts the money demand curve to L. If the Bank of Canada con-
tinues to run policy according to a money supply rule, the interest rate will rise to i
2
.
Suppose that the Bank of Canada, for whatever reason, felt that the economy
should not be subject to as large of an interest rate change as given by the movement
from i
1
to i
2
. In response to this shock, the Bank of Canada could increase the money
supply when the interest rate goes up, which would make the interest rate increase
smaller than in the absence of the money supply increase. For instance, in Figure 12-6,
the Bank of Canada could change the money supply to M
1
(M
s
M
-
) (4)
where the slope of the money supply curve is given by 1/. Therefore, the more the
Bank of Canada reacts, the larger is and the flatter the money supply curve is. (Of
course, the reverse is also true.) The effects of running policy in this manner are
shown in Figure 12-7, where you can see that the interest rate change under a money
supply rule (i
0
i
2
) is greater than the interest rate change if the central bank con-
ducts policy according to equation (4) (i
0
i
1
).
MONETARY POLICY REACTS TO INTEREST RATE CHANGES FIGURE 12-7
If monetary policy
changes the money
supply every time that
interest rates change, as
given by equation (4),
then the money supply
curve is upward sloping,
rather than vertical. In
this situation, there is
less interest rate change
for any given money
demand shift.
Now consider the extreme case where = . In this case, the Bank of Canada
changes the money supply by any amount that is needed, as soon as there is any small
change in the interest rate. In this case, the money supply curve is horizontal and the
shifts in money demand do not cause any change in the interest rate. This is known
as conducting monetary policy according to an interest rate rule. Notice that, under
an interest rate rule, the money supply is endogenous and the interest rate is exoge-
nous.
Now consider deriving an LM curve under the monetary policy of an interest
rate rule. For an LM curve, money supply equals money demand. Our money
demand equation is assumed to be the same as before, and we put this together with
our new money supply curve in Figure 12-8.
interest rate rule
Monetary policy is
conducted according to an
interest rate rule whenever
the money supply is
changed in response to a
change in the demand for
money in order to keep
interest rates constant.
Figure 12-8 shows that, when monetary policy is conducted according to an
interest rate rule, the LM curve is horizontal. It is important to understand that, in
this case, the LMcurve is horizontal by policy design. To make sure that you under-
stand this, contrast the LM curve shown in Figure 12-8 with the liquidity trap dis-
cussed earlier. Remember that, theoretically, the liquidity trap would occur when the
interest elasticity of money demand is infinite. There is nothing that policy can do
about this situation. However, in the case of an interest rate rule, the LMcurve is hor-
izontal because monetary policy makers have chosen to make the interest elasticity
of money supply infinite; that is, they are continually intervening in the money
market. Therefore, in the case of an interest rate rule, monetary policy is capable of
doing something: It acts to hold the interest rate constant. Theoretically, the Bank of
Canada could choose any interest rate it wanted, so the LM curve under an interest
rate rule, even though it is horizontal, can be shifted by policy.
You can think of conducting monetary policy according to a money supply rule
as a special case where = 0, and the LM curve will be the familiar upward-sloping
curve. When policy is conducted according to an interest rate rule, = and the LM
curve is horizontal. These two LMcurves are shown in Figure 12-9.
Money Supply Rule and Interest Rate Rule:
When Would Policy Makers Choose One Over the Other?
The difference between a money supply rule and an interest rate rule is more than
just a textbook exercise. Under a money supply rule, the central bank sets the money
supply and then does nothing else.
3
This is a policy of minimal intervention in the
246 P A R T 4 The Economy in the Very Short Run: Spending and the IS-LMModel of Economic Activity
DERIVING THE LM CURVE UNDER AN INTEREST RATE RULE FIGURE 12-8
If monetary policy is
conducted according to
an interest rate rule,
then the money supply
is changed any time
there is a small change
in the interest rate, and
the LM curve is hori-
zontal.
3
For this section, we rule out discrete, one-time changes in the money supply under a money supply rule.
www.bankofcanada.ca/en/
res/r03-1-ec.htm
247 C H A P T E R 1 2 Monetary and Fiscal Policy in the Very Short Run
money market. Under an interest rate rule, the central bank must be intervening in
the money market at all times. This is an activist monetary policy. (We will discuss
activist policy in detail in Chapter 17.) Therefore, the choice of conducting monetary
policy using a money supply rule or an interest rate rule is a choice of activist stabi-
lization policy (interest rate rule) versus conducting policy by a fixed rule with a min-
imum of interference (money supply rule).
In order to compare the two policy stances, we assume that the goal of the cen-
tral bank is to minimize the fluctuations in income, and we ask the question: Within
the framework of the IS-LM model, will fluctuations in income be smaller under a
money supply rule or under an interest rate rule? In the IS-LM model, fluctuations
in income can arise from shocks in the goods market (the IS curve fluctuates) or
from shocks in the money market (the LM curve fluctuates). We know that, at any
point in time, the economy is subject to both goods market and money market
shocks. However, this makes analysis very difficult. In order to make this exercise
simple and understandable, we will look first at a situation where there are only
goods market shocks, and then we will look at a situation where there are only money
market shocks.
Goods Market Shocks Only
In this section, we consider the situation where the goods market is subject to shocks,
while the money market is not. Therefore, in this situation, the IS curve is subject to
fluctuations, while the LM curve is not. This is depicted in Figure 12-10.
LM CURVE FOR A MONEY SUPPLY RULE AND FOR AN INTEREST RATE RULE FIGURE 12-9
If monetary policy is
conducted according to
a money supply rule,
then the LM curve has
the familiar upward
slope. If monetary policy
is conducted according
to an interest rate rule,
then the LM curve is
horizontal.
In Figure 12-10, when the IS curve is not subject to a shock, income is at Y
0
,
where either of the LM curves intersects the IS curve marked IS
0
. The IS curve
marked IS
1
pertains to a negative goods market shock, and the curve marked IS
2
per-
tains to a positive goods market shock.
Consider first conducting monetary policy using a money supply rule. In this
case, the IS-LM equilibrium varies between Y
1
and Y
2
. These are the equilibrium
points where the LM(money supply rule) curve intersects the IS
1
and the IS
2
curves.
Now consider conducting monetary policy using an interest rate rule. In this case, the
IS-LMequilibrium varies between Y
3
andY
4
. These are the equilibrium points where
the LM(interest rate rule) curve intersects the IS
1
and the IS
2
curves. Clearly, in this
case, the variance in output is minimized under a money supply rule.
Money Market Shocks Only
The situation of money market shocks only is depicted in Figure 12-11. Notice
immediately from this figure that if the money market is subject to shocks, these do
not affect the LM(interest rate rule), as the interest rate rule was designed to remove
shocks from the money market. Therefore, in a situation of money market shocks
only, and conducting monetary policy according to an interest rate rule, there is no
variance in output. Alternatively, if the money market is fluctuating and the mone-
tary authorities use a money supply rule, income will vary between Y
1
and Y
2
.
Clearly, in this situation, an interest rate rule has the minimum variance in output.
248 P A R T 4 The Economy in the Very Short Run: Spending and the IS-LMModel of Economic Activity
MONETARY POLICY WITH SHOCKS TO THE GOODS MARKET FIGURE 12-10
If monetary policy is
conducted according to
a money supply rule,
income varies between
Y
2
and Y
1
, and if it is
conducted according to
an interest rate rule,
income varies between
Y
3
and Y
4
. In this case,
the variance of income
is minimized by a money
supply rule.
249 C H A P T E R 1 2 Monetary and Fiscal Policy in the Very Short Run
Working with Data
In the introduction to this chapter, we discussed the relationship between the interest
rate and growth in real GDP over the cycle. In Figure 12-1, we graphed the nominal
Treasury bill rate with the growth rate of GDP. Go to CANSIM II and retrieve the
Consumer Price Index (V735319), as well as the other data referred to in Figure 12-1.
Construct the annual inflation rate, quarterly, and then the real rate of interest, quar-
terly. Plot the real rate of interest with the growth rate of GDP over the period
19752002. You should be able to identify the negative relationship between these
two variables, especially during recessions.
Monetary policy affects the economy, first by affecting the interest rate and then
by affecting aggregate demand. An increase in the money supply reduces the
interest rate, increases investment spending and aggregate demand, and thus
increases equilibrium output.
There are two extreme cases in the operation of monetary policy. In the Classical
case, the demand for real balances is independent of the rate of interest. In that
case, monetary policy is highly effective. The other extreme is the liquidity trap, the
case in which the public is willing to hold any amount of real balances at the going
MONETARY POLICY WITH SHOCKS TO THE MONEY MARKET FIGURE 12-11
If monetary policy is
conducted according to
a money supply rule,
income varies between
Y
2
and Y
1
, and if it is
conducted according to
an interest rate rule,
income does not change.
In this case, the vari-
ance of income is mini-
mized by an interest
rule.
C H A P T E R S U M M A R Y
www.mcgrawhill.ca/college/dornbusch
interest rate. In that case, changes in the supply of real balances have no impact on
interest rates and therefore do not affect aggregate demand and output.
Taking into account the effects of fiscal policy on the interest rate modifies the
multiplier results of Chapter 8. Fiscal expansion, except in extreme circum-
stances, still leads to an income expansion. However, the rise in interest rates that
comes about through the increase in money demand caused by higher income
dampens the expansion.
Fiscal policy is more effective the smaller the induced changes in interest rates and
the smaller the response of investment to these interest rate changes.
The two extreme cases, the liquidity trap and the Classical case, are useful to
show what determines the magnitude of monetary and fiscal policy multipliers.
In the liquidity trap, monetary policy has no effect on the economy, whereas
fiscal policy has its full multiplier effect on output and no effect on interest rates.
In the Classical case, changes in the money stock change income, but fiscal policy
has no effect on incomeit affects only the interest rate. In this case, there is
complete crowding out of private spending by government spending.
A fiscal expansion, because it leads to higher interest rates, displaces, or crowds out,
some private investment. The extent of crowding out is a sensitive issue in assessing
the usefulness and desirability of fiscal policy as a tool of stabilization policy.
If the central bank wants to minimize fluctuations in the interest rate, it can con-
duct policy according to an interest rate rule, manipulating the money supply
every time interest rates change.
If all of the variation in income arises from fluctuations in the goods market,
then a money supply rule reduces the variance of income. If all of the variation
in income arises from fluctuations in the money market, then an interest rate
rule reduces the variance of income.
1. Most of the time, both the goods market and the money market are subject to shocks
at the same time. How would you think about choosing between an interest rate rule
and a money supply rule in this real-world situation?
2. Discuss the circumstances under which the monetary and fiscal policy multipliers are
each, in turn, equal to zero. Explain in words why this can happen and how likely you
think this is.
250 P A R T 4 The Economy in the Very Short Run: Spending and the IS-LMModel of Economic Activity
K E Y T E R M S
monetary policy, 235
liquidity trap, 236
crowding out, 241
monetary accommodation, 242
money supply rule, 244
interest elasticity of the money
supply, 245
interest rate rule, 245
D I S C U S S I O N Q U E S T I O N S
www.mcgrawhill.ca/college/dornbusch
251 C H A P T E R 1 2 Monetary and Fiscal Policy in the Very Short Run
www.mcgrawhill.ca/college/dornbusch
3. What is a liquidity trap? If the economy was stuck in one, would you advise the use of
monetary or fiscal policy?
4. What is crowding out, and when would you expect it to occur? In the face of substan-
tial crowding out, which will be more successfulfiscal or monetary policy?
5. What would the LMcurve look like in a Classical world? If this really was the LMcurve
that we thought best characterized the economy, would we lean toward the use of fiscal
policy or monetary policy? (You may assume that your goal is to affect output.)
6. What happens when the Bank of Canada monetizes a budget deficit? Is this something it
should always try to do? (Hint: Outline the benefits and costs of such a policy, over time.)
7. We can have the GDP path we want equally well with a tight fiscal policy and an easier
monetary policy, or the reverse, within fairly broad limits. The real basis for choice lies
in many subsidiary targets, besides real GDP and inflation, that are differentially affected
by fiscal and monetary policies. What are some of the subsidiary targets referred to in
this quote? How would they be affected by alternative policy combinations?
1. The economy is at full employment. Now the government wants to change the compo-
sition of demand toward investment and away from consumption without, however,
allowing aggregate demand to go beyond full employment. What is the required policy
mix? Use an IS-LMdiagram to show your policy proposal.
2. Suppose the government cuts income taxes. Show in the IS-LMmodel the impact of the
tax cut under two assumptions: (1) The government keeps interest rates constant
through an accommodating monetary policy, (2) the money stock remains unchanged.
Explain the difference in results.
3. Go to CANSIM and retrieve data on the money stock, M1B, and the 90-day Treasury
bill rate. Calculate the rate of growth of money and plot this with the Treasury bill rate.
Can you relate this graph to any of the monetary policy discussions in this chapter?
A P P L I C A T I O N Q U E S T I O N S