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e a Situation Where Monetary Policy Cannot Lower Interest Rates? The Case of the Liquidity Trap Can the LM Curve Be ertical? Classical !cono"ics #$ain %iscal Policy and Crowdin$ &ut #n Increase n 'overn"ent Spendin$ Crowdin$ &ut Is Crowdin$ &ut I"portant? Monetary Policy and the Interest Rate Rule Money Supply Rule and Interest Rate Rule( When Would Policy"a)ers Choose one over the &ther? 'oods Mar)et Shoc)s &nly Money Mar)et Shoc)s &nly Wor)in$ With *ata

Chan e! "r#$ the Pre%i#u! E&iti#n This chapter has +een al"ost co"pletely rewritten, We have introduced the liquidity trap in a "odern perspective and related this to recent events in the -nited States and .apan, We have also "oderni/ed the section on the vertical LM curve and related it to the Classical "odel where it +elon$s, The fiscal policy section has +een rewritten and now follows a "uch "ore lo$ical order, There is a new section on conductin$ "onetary policy accordin$ to an interest rate rule0 and this policy stance is co"pared to the "oney supply rule0 in what could +e ter"ed an accessi+le 1Poole2 e3ercise, Learnin O'(e)ti%e! Students should understand the dyna"ics of ad4ust"ent in the IS5LM "odel followin$ a fiscal or "onetary policy chan$e, Students should understand that the -,S, and .apanese econo"ies have +een descri+ed as +ein$ in a liquidity trap in the recent past Students should understand that a vertical LM curve i"plies a Classical "odel Students should understand the concept of crowdin$ out, Students should +e aware that crowdin$ out is a "atter of de$ree, In the IS5LM "odel0 that de$ree depends on the slopes of the IS5 and LM5curves, Students should +e aware of the li"itations of the static0 short5run nature of the IS5LM "odel, Students should understand how "onetary policy can +e conducted accordin$ to an interest rate rule or accordin$ to a "oney supply rule0 and the situations under which one "ay +e superior to the other,

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A))#$pli!hin the O'(e)ti%e! We +e$in +y discussin$ "onetary policy in +oth co"parative statics and dyna"ic fra"ewor)s, The ad4ust"ent path of the econo"y after a "oney shoc) 9see %i$ure 6:5:; is that interest rates chan$e while inco"e and output re"ain constant0 and su+sequently +oth inco"e and interest rates increase, <ere0 the "oney "ar)et is always in equili+riu"0 while the $oods "ar)et can +e out of equili+riu", These ad4ust"ent assu"ptions "i"ic real world o+servations, Two e3tre"e cases in the operation of "onetary policy are $iven special attention, Monetary policy is powerless to affect interest rates 9and thus the econo"y; in the liquidity trap 9represented +y a hori/ontal LM5curve;, The polar opposite is the Classical case 9represented +y a vertical LM5curve;0 in which a $iven chan$e in "oney supply cannot effect the level of real inco"e, The effectiveness of e3pansionary fiscal policy depends on the a"ount of crowdin$ out that ta)es place0 that is0 on the reduction in private spendin$ 9"ost nota+ly invest"ent; caused +y risin$ interest rates followin$ fiscal e3pansion0 and the e3tent of the crowdin$5out effect depends on the slopes of the IS5 and LM5curves, The flatter the IS5curve and the steeper the LM5curve0 the lar$er the crowdin$5out effect, The factors that deter"ine the slopes of the IS5 and LM5curves have already +een discussed in the previous chapter, &f course0 crowdin$ out can +e avoided +y coordinatin$ "onetary and fiscal policy, This is illustrated in %i$ure 6:5=, Since different "onetary and fiscal policy "i3es vary in their effects on the different sectors of the econo"y0 actual policy choices are often deter"ined +y political preferences, Li+erals often favor increases in $overn"ent spendin$ on education0 4o+ trainin$0 or the environ"ent0 while conservatives tend to favor ta3 cuts, Those advocatin$ rapid econo"ic $rowth favor invest"ent su+sidies and lower interest rates, We finish this chapter with a discussion of "onetary policy conducted accordin$ to an interest rate rule, This is especially relevant in today>s policy environ"ent in +oth Canada and the -,S, In Canada we now have fi3ed announce"ent dates for chan$es in the Ban) rate0 so "onetary policy is well descri+ed as runnin$ an interest rate rule, Students will find the section on co"parin$ an interest rate rule to a "oney supply rule very interestin$0 as this can +e cast in ter"s of policy intervention 9interest rate rule; vs, no policy intervention 9"oney supply rule;, Su e!ti#n! an& Pit"all! Students should +e as)ed to wor) out several e3a"ples of either fiscal or "onetary policy chan$es0 +oth $raphically and with a written e3planation of the ad4ust"ent processes that ta)e place, In doin$ these e3ercises0 students should as) the"selves the followin$ three questions( Which sector is involved0 the e3penditure sector or the "oney sector? This will tell the" which curve will shift0 the IS5curve or the LM5curve, Will the policy chan$e lead to an increase or decrease in national inco"e? This will tell the" whether the respective curve will shift to the ri$ht or left, Is it a parallel shift 9caused +y a chan$e in autono"ous spendin$ or no"inal "oney supply; or is it a chan$e in the slope? The only policy chan$e discussed here that could cause a chan$e in slope is a chan$e in the "ar$inal inco"e ta3 rate 9t;0 which would chan$e the si/e of the e3penditure "ultiplier 9; and therefore the slope of the IS5curve,

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The followin$ si"plified description of the ad4ust"ent process in response to an increase in $overn"ent purchases 9'; "ay +e used( ' up AAB C up AAB the IS5curve shifts ri$ht AAB " d up AAB i up AAB I down AAB C down, E""e)t* Y #e! up+ i #e! up, IS: i i: i6 IS6 LM

@ C6 C: C The followin$ si"plified description of the ad4ust"ent process followin$ an increase in real "oney supply "ay +e used( "s up AAB i down AAB I up AAB C up AAB the LM5curve shifts ri$ht AAB " d up AAB i up, E""e)t* Y #e! up+ i #e! &#,ni IS LM6 LM: i6 i:

@ C6 C: C

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When these si"plified ad4ust"ent processes a+ove are presented to students0 they are often confused, In order to help students $et over his confusion0 you "ay want to e3plain the difference +etween co"parative statics and dyna"ics, In ter"s of the a+ove dia$ra"s0 the co"parative statics are fairly si"ple(

#n increase in $overn"ent spendin$ will increase +ooth the interest rate and inco"e, #n increase in the "oney supply will lower the interest rate and increase inco"e,

In order to discuss the dyna"ics0 we need to i"pose an ad4ust"ent assu"ption( the "oney "ar)et always clears quic)ly while the $oods "ar)et clears slowly, In ter"s of the a+ove dia$ra"s0 for the fiscal policy ad4ust"ent0 the "ove"ent is always alon$ the LM curve, %or the "onetary ad4ust"ent0 the econo"y follows the path $iven in %i$ure 6:5: in the te3t, *iscussin$ actual events with which students should +e at least so"ewhat fa"iliar always "a)es the theoretical "aterial co"e to life and $ets students to participate "ore actively in class, The ISDLM "odel is a perfect "odel for discussin$ the policy interventions surroundin$ the events of Septe"+er0 :@@6, In +oth Canada and the -,S,0 "onetary policy +eca"e quite e3pansionary0 so interest rates went down, In Canada0 this had the desired effect0 as output went up, <owever0 in the -,S, output did not i""ediately respond, Consu"er confidence "ay have +een so +adly sha)en0 that this IS curve could have +een 9te"porarily; vertical, In this case it would not "atter how low interest rates were0 output 4ust would not respond, &f course0 this also leads to a discussion of the possi+ility that the -,S, was in a liquidity trap at that ti"e, When discussin$ "onetary acco""odation of e3pansionary fiscal policy0 the followin$ point should +e "ade( Within an IS5LM fra"ewor)0 that is0 as lon$ as prices are assu"ed to +e fi3ed0 the .an/ #" Cana&a can prevent crowdin$ out fairly easily +y e3pandin$ "oney supply, <owever0 as soon as prices are allowed to vary0 such policy "ay lead to a hi$her price level, In this case0 crowdin$ out cannot +e avoided since a hi$her price level i"plies lower real "oney +alances0 which provide upward pressure on interest rates, It is also i"portant that students understand why fiscal policy has a "uch s"aller "ultiplier effect in the IS5LM "odel than in the si"ple Eeynesian "odel of inco"e deter"ination that was presented in Chapter 6@, In the IS5LM fra"ewor)0 the e3tent of crowdin$ out clearly depends on the slopes of the IS5 and LM5curves, !ven thou$h the factors deter"inin$ these slopes are covered in Chapter 660 it "ay +e +eneficial to "ention the" here a$ain, Instructors also "ay want to assi$n +oth Chapter 66 and Chapter 6:0 si"ultaneously0 since Chapter 66 lays the theoretical fra"ewor) for the IS5LM "odel0 while Chapter 6: provides its practical application, Students will find that Section 6:57 on the interest rate rule is very relevant, Monetary policy in +oth Canada and the -,S, could +e accurately descri+ed as followin$ an interest rate rule, It is i"portant to point out the "eanin$ of two different hori/ontal LM curves( for a liquidity trap0 "onetary policy cannot affect the econo"yF for an interest rate rule0 policy has chosen to "a)e the LM curve hori/ontal0 and could 4ust as easily choose another interest rate, Therefore0 in the case of a hori/ontal LM curve due to an interest rate rule0 "onetary policy is very effective, Students will also find that the discussion of a "oney supply rule vs, an interest rate rule is very relevant, This discussion can always +e cast in ter"s of a 1no intervention policy2 9"oney supply rule; vs, a 1co"plete intervention policy2 9interest rate rule;, This could lead to interestin$ discussion concernin$ the role of "onetary policy in the short run,

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S#luti#n! t# the Pr#'le$! in the Te0t'##/* Di!)u!!i#n 1ue!ti#n!* 6, Technically0 althou$h it is difficult to show this at this level0 the opti"al policy will depend on the relative slopes of the IS and LM curves, <owever0 the $eneral results could +e applied here( if the shoc)s to the $oods "ar)et are relatively +i$$er0 then a "oney supply rule is superiorF if the shoc)s to the "oney "ar)et are lar$er then an inters rate rule is superior, The +etter students "ay point out that if you really do not )now0 then a policy where there is "ini"al intervention 9"oney supply rule; is pro+a+ly the safest policy, :, The IS5curve is vertical0 if invest"ent spendin$ is totally interest insensitive, This is called invest"ent insufficiencyF in this case the "onetary "ultiplier is /ero, Since the para"eter + in the invest"ent equation equals /ero0 the equation chan$es fro" I A Io 5 +i to I A Io,

# hori/ontal LM5curve will also render "onetary policy ineffective, This is called the liquidity trap, In this case0 "oney de"and is totally interest elastic0 and the para"eter h in the "oney de"and equation is assu"ed to +e infinitely lar$e, The fiscal policy "ultiplier is /ero if the LM5curve is vertical, This case is called the classical case0 and "oney de"and 9and "oney supply; is assu"ed to +e totally interest insensitive, Since the para"eter h in the "oney de"and equation equals /ero0 the equation chan$es fro" L A )C 5 hi to L A )C,

Gone of these three cases is very li)ely to occur, <owever0 so"e econo"ists assert that .apan in the late 688@>s and Canada in the 'reat *epression were in0 or close to0 the liquidity trap, 7, # liquidity trap is a situation in which the pu+lic is willin$ to hold0 at a $iven interest rate0 as "uch "oney as the Ban) of Canada is willin$ to supply, In this case0 the LM5curve is hori/ontal and "onetary policy is totally ineffective, %iscal policy 9which will shift the IS5curve; is clearly the +etter choice to sti"ulate the econo"y in such a situation0 since no crowdin$ out will occur, This "eans that fiscal policy will have its "a3i"u" effect, ?, Crowdin$ out occurs when an increase in $overn"ent spendin$ raises interest rates0 which reduces private spendin$ 9especially invest"ent;, %or e3a"ple0 an increase in $overn"ent purchases 9'; will increase inco"e 9C; and therefore consu"ption 9C;F +ut +ecause the interest rate 9i; will increase0 the level of invest"ent spendin$ 9I;0 and "ost li)ely also net e3ports 9GH;0 will decrease0 chan$in$ the co"position of '*P, So"e de$ree of crowdin$ out will always occur as lon$ as the LM5curve is upward slopin$0 that is0 in all cases e3cept the liquidity trap, The steeper the LM5curve is0 the $reater the de$ree of crowdin$ out, This i"plies that if the LM5curve is steep "onetary policy will +e "ore effective than fiscal policy in sti"ulatin$ national inco"e, =, In this case0 the LM5curve is vertical, Money de"and and "oney supply would +e co"pletely interest inelastic, The Eeynesian ISDLM "odel is pro+a+ly inappropriate for discussin$ this case, It is hard to see how you can have a sensi+le equili+riu" with two vertical curves, In a Classical "odel0 fiscal

6?7

policy would only chan$e the allocation of inco"e0 and "onetary policy would only chan$e the price level, I, #ssu"e the $overn"ent finances an increase in $overn"ent spendin$ +y +orrowin$ fro" the pu+lic 9the Treasury sells $overn"ent +onds to finance the increase in the +ud$et deficit;, The increase in the de"and for credit +y the $overn"ent will lead to an increase in interest rates, If the Ban) of Canada is worried a+out hi$h interest rates0 it "ay "oneti/e the +ud$et deficit0 that is0 +uy the $overn"ent +onds that the pu+lic now holds, This will in4ect "oney into the econo"y0 and interest rates will drop a$ain0 so no crowdin$ out of private spendin$ "ay occur0 at least in the short run, In an IS5LM "odel0 the e3pansionary fiscal policy will shift the IS5curve to the ri$ht0 while the Ban) of Canada>s action will shift the LM5curve to the ri$ht, This "eans that the #*5curve will shift further to the ri$ht than would have +een the case if the Ban) of Canada had not acco""odated the e3pansionary fiscal policy, But this causes "ore upward pressure on the price level, In a recession0 when there is little inflationary pressure0 such a fiscalD"onetary policy "i3 "ay +e +eneficial and cause only a s"all increase in the price level, <owever0 if the econo"y is close to full e"ploy"ent0 then we can e3pect a si$nificant increase in the price level, In the lon$ run0 when the #S5curve is vertical0 there will +e total crowdin$ out0 whether the Ban) of Canada "oneti/es the increase in the +ud$et deficit or not, J, # co"+ination of restrictive fiscal policy and e3pansionary "onetary policy will not si$nificantly affect a$$re$ate de"and or inco"e0 and neither will e3pansionary fiscal policy co"+ined with restrictive "onetary policy, <owever0 the first policy "i3 will decrease interest rates0 while the latter will increase interest rates, Therefore the co"position of output will +e different in each case, The first co"+ination will shift the IS5curve to the left and the LM5curve to the ri$ht0 in which case inco"e will re"ain rou$hly the sa"e while interest rates will +e reduced, # ta3 increase will lower consu"ption while increasin$ invest"ent spendin$ due to lower interest rates, The second co"+ination will shift the IS5curve to the ri$ht and the LM5curve to the left0 leavin$ inco"e rou$hly the sa"e0 while increasin$ interest rates, This will decrease the level of invest"ent spendin$0 while either $overn"ent spendin$ or consu"ption 9throu$h a ta3 cut; will increase, &ther considerations "ay involve the effect of a $iven policy "i3 on the +ud$et surplus and the value of the dollar 9and therefore net e3ports;, The first policy "i3 will increase the +ud$et surplus, Lower interest rates "ay also lead to an outflow of funds0 which will lower the value of the dollar0 leadin$ to an increase in net e3ports, The second policy "i3 will decrease the +ud$et surplus, <i$her interest rates "ay lead to an inflow of funds0 which will increase the value of the dollar0 leadin$ to a decrease in net e3ports, Appli)ati#n 1ue!ti#n!* 6, If the $overn"ent wants to chan$e the co"position of '*P towards invest"ent and away fro" consu"ption without chan$in$ the level of a$$re$ate de"and0 it needs to i"ple"ent a co"+ination of restrictive fiscal policy and e3pansionary "onetary policy, #n increase in personal inco"e ta3es or a decrease in transfer pay"ents will reduce consu"ption and thus a$$re$ate de"and, The IS5curve will shift to the left0 leadin$ to a decrease in the level of output and the interest rate, To increase output to its ori$inal level0 the Ban) of Canada can underta)e e3pansionary "onetary policy, This will shift the LM5curve to the ri$ht0 leadin$ to a further decrease in the interest rate0 thus sti"ulatin$ invest"ent0 and0 in turn0 a$$re$ate de"and, If the intersection of the new IS5 and LM5curves is at the sa"e inco"e level as previously0 then the decrease in the interest rate will have sti"ulated invest"ent spendin$ sufficiently to e3actly offset the decrease in consu"ption, 9Gote( The ta3 increase can +e

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co"+ined with an invest"ent su+sidy, In this case0 the IS5curve will not shift as far to the left as +efore,; The followin$ dia$ra" shows the effect of a decrease in transfer pay"ents 9TR; that is co"+ined with an increase in "oney supply 9MDP;, The ad4ust"ent process is as follows( 655B:( TR AAB C AAB C AA "d AAB i AAB I AAB C , E""e)t* Y an& i , :55B7( 9MDP; up AAB i AAB I AAB C AAB "d AAB i C#$'ine& e""e)t* i IS: 6 i6 : i: 7 i7 Y a'#ut the !a$e an& i IS6 LM6 LM: E""e)t* Y an& i ,

@ C: C6 C :, # cut in the inco"e ta3 rate will flatten the IS5curve and shift it to the ri$ht, Both the level of inco"e and the interest rate will increase, If the Ban) of Canada increases "oney supply to )eep the interest rate constant0 then the LM5curve will also shift to the ri$ht0 "a3i"i/in$ the "ultiplier effect0 since no crowdin$ out will ta)e place, <owever0 if "oney supply is held constant0 then the LM5curve will not shift and the overall effect of this fiscal e3pansion on inco"e will +e wea)ened0 since the increase in the interest rate will crowd out invest"ent,

6?=

i IS6

i: 6 i6 7

@ C6 C: C7 C The ad4ust"ent process is as follows( 655B:( t AAB C AAB C AA "d AAB i up AAB I AAB C down, :55B7( 9MDP; AAB i AAB I AAB C AAB "d AAB i C#$'ine& e""e)t* Y an& i a'#ut the !a$eA&&iti#nal Pr#'le$!* 1- True #r "al!e2 3h42 5Fi!)al p#li)4 i! $#re e""e)ti%e ,hen the intere!t !en!iti%it4 #" $#ne4 &e$an& i! l#,er-5 %alse, If "oney de"and is totally independent of interest rates0 the LM5curve is vertical, This is the classical case, # chan$e in $overn"ent spendin$ has no effect on output0 since there is co"plete crowdin$ out, Clearly0 in the case of a nor"al 9upward5slopin$; LM5curve0 less crowdin$ out will occur and inco"e will $o up as $overn"ent spendin$ increases, But the "ore interest insensitive "oney de"and is0 that is0 the steeper the LM5curve is0 the s"aller the increase in inco"e will +e0 due to a lar$er crowdin$ out effect, 2- C#$$ent #n the "#ll#,in !tate$ent* 5Cr#,&in #ut i! )#$plete ,hen $#ne4 &e$an& i! per"e)tl4 intere!t inela!ti)-5 Crowdin$ out refers to the fact that an increase in pu+lic spendin$ "ay lead to a decrease in private spendin$0 thus da"penin$ the output e3pansion, #n increase in $overn"ent spendin$ raises interest rates0 which leads to a reduction in invest"ent spendin$, When "oney de"and is perfectly interest inelastic0 the LM5curve is vertical at the level of real output that clears the "oney "ar)et, #n increase in $overn"ent spendin$ will sti"ulate inco"e and encoura$e people to hold "ore "oney +alances, The e3cess de"and for "oney will cause interest rates to rise to the level at which equili+riu" in the "oney "ar)et is restored, If "oney de"and is perfectly interest inelastic0 the rise in interest rates will not lower the quantity of "oney de"anded, Instead0 inco"e will have to $o +ac) to its ori$inal level +efore the "oney E""e)t* Y an& i -

E""e)t* Y an& i -

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"ar)et is +ac) in equili+riu", This "eans that interest rates will have to increase until the level of invest"ent spendin$ has +een reduced +y the sa"e a"ount as $overn"ent spendin$ has +een increased, Therefore the level of output de"anded is unchan$ed and crowdin$ out is co"plete, 6- True #r "al!e2 3h42 5E0pan!i#nar4 $#netar4 p#li)ie! re&u)e '#n& pri)e! in the li7ui&it4 trap-5 %alse, !3pansionary "onetary policies $enerally reduce interest rates and thus increase +ond prices, In the liquidity trap0 however0 interest rates do not chan$e0 since the LM5curve is hori/ontal, If the Ban) of Canada increases the "oney supply throu$h an open "ar)et purchase0 the pu+lic is willin$ to hold all the "oney the Ban) of Canada supplies at the prevailin$ interest rate, Go+ody wants to shift into +onds and thus +ond prices do not chan$e, 8- True #r "al!e2 E0plain 4#ur an!,er5E0pan!i#nar4 "i!)al p#li)4 i! $#re e""e)ti%e ,hen it i! "inan)e& '4 '#rr#,in "r#$ the pu'li) than ,hen it i! $#neti9e&-5 %alse, If the $overn"ent finances an increase in its spendin$ +y sellin$ +onds to the pu+lic0 no chan$e in the supply of "oney will occur0 and the IS5curve will shift without a correspondin$ shift in the LM5curve, &n the other hand0 if an increase in the +ud$et deficit is "oneti/ed0 then "oney supply will increase0 as the central +an) +uys $overn"ent +onds fro" the pu+lic, Therefore0 the LM5curve will also shift to the ri$ht0 leadin$ to lower interest rates than in the first case, Less crowdin$ out will occur and the overall effect on inco"e will +e $reater55at least in the IS5LM "odel0 that is0 the short run, In the lon$ run0 when prices are allowed to +e fle3i+le0 then crowdin$ out cannot +e avoided +y "oneti/in$ the de+t0 since an increase in the price level will lead to lower real "oney +alances and therefore hi$her interest rates, :- True #r "al!e2 3h42 5Cr#,&in #ut i! )#$plete in the li7ui&it4 trap-5 %alse, In the liquidity trap the pu+lic is prepared to hold whatever "oney is supplied at any $iven interest rate, This i"plies that the LM5curve is hori/ontal, If $overn"ent spendin$ rises0 the IS5curve will shift to the ri$ht, Inco"e will rise +ut interest rates will not increase, This "eans that there will +e no crowdin$ out, i IS6 IS:

i6

LM

@ C6 C: C

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;- A!!u$e the #%ern$ent ,ant! t# in)rea!e #utput ,ith#ut )han in intere!t rate!- 3hat /in& #" p#li)4 $i0 ,#ul& 4#u re)#$$en& an& h#, ,#ul& 4#ur p#li)4 $i0 a""e)t the )#$p#!iti#n #" <DP2 E0plain 4#ur an!,er an& the a&(u!t$ent pr#)e!!e! that ta/e pla)e ,ith the help #" an IS=LM &ia ra$# co"+ination of e3pansionary fiscal and "onetary policy will increase output without affectin$ interest rates, !3pansionary fiscal policy will shift the IS5curve to the ri$ht and inco"e and interest rates will +oth increase, !3pansionary "onetary policy will shift the LM5curve to the ri$ht and interest rates will decrease while inco"e increases, Thus we will have an increase in inco"e without a chan$e in interest rates, Since inco"e will increase0 consu"ption will also increase0 +ut since interest rates will not chan$e0 induced invest"ent will not +e affected 9Gote( In a "ore advanced "odel0 an increase in sales e3pectations "ay actually increase the overall invest"ent level, See Chapter 6?;, Therefore the level of invest"ent as a fraction of '*P will decrease0 while consu"ption and $overn"ent purchases will have a $reater share, 9# "ore +alanced $rowth can +e achieved if invest"ent su+sidies are $iven,; 655B:( ' up AAB C up AAB "oney de"and up AAB i up AAB I down AAB C up E""e)t* Y up an& i up :55B7( 9MDP; up AAB i down AAB I up AAB C up AAB "oney de"and up AAB i up, E""e)t* i &#,n an& Y up i IS6 : i: i6 6 7 IS: O%erall e""e)t* Y up an& i )#n!tant, LM6 LM:

@ C6 C: C7 C >- Di!)u!! the e""e)t #" an in%e!t$ent !u'!i&4 #n )#n!u$pti#n- In 4#ur an!,er+ in&i)ate ,hether the e""e)t #n )#n!u$pti#n ,#ul& &i""er i" $#ne4 &e$an& ,ere $#re intere!t !en!iti%e#n invest"ent su+sidy will sti"ulate invest"ent spendin$ and therefore inco"e0 which will lead to an increase in consu"ption, If "oney de"and were "ore interest sensitive0 then the LM5curve would +e flatter and the shift of the IS5curve to the ri$ht would have a lar$er effect on inco"e 9and thus consu"ption;, #s inco"e increases0 so does "oney de"and0 +ut if "oney de"and were "ore interest sensitive0 then a s"aller increase in the interest rate would +e required to +rin$ the "oney sector +ac) to

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equili+riu", Thus0 less crowdin$ out would occur and the overall increase in inco"e or consu"ption would +e $reater, i i7 i: i6 IS6 IS: LM6 LM:

@ C6 C7 C: C

?- 5M#netar4 p#li)4 )ann#t )han e real #utput a! l#n a! in%e!t$ent i! in&epen&ent #" intere!t rate!-5 C#$$ent #n thi! !tate$entWhen invest"ent spendin$ is not affected +y chan$es in the interest rate +ut is deter"ined solely +y chan$es in +usiness e3pectations0 then "onetary policy is ineffective, In this case0 the trans"ission "echanis" +rea)s down and "onetary policy will not +rin$ a+out chan$es in real output, !3pansionary "onetary policy "ay reduce interest rates0 +ut this will not increase the level of invest"ent spendin$ and the econo"y will not +e sti"ulated, In the IS5LM fra"ewor)0 we would have a vertical IS5curve, Thus0 when the LM5curve shifts0 we si"ply see a chan$e in the interest rate0 while the output level re"ains constant, @- A!!u$e in%e!t$ent i! %er4 intere!t inela!ti) an& $#ne4 &e$an& i! %er4 intere!t ela!ti)- 3ith the help #" an IS=LM &ia ra$+ e0plain the e""e)t #" a )ut in the in)#$e ta0 rate AtB #n in%e!t$ent AIB+ $#ne4 &e$an& A$&B+ an& the 'u& et !urplu! A.uSB an& 'rie"l4 e0plain the a&(u!t$ent pr#)e!!Invest"ent is interest inelastic so the IS5curve is steepF "oney de"and is interest elastic so the LM5curve is flat, #n inco"e ta3 cut will shift the IS5curve to the ri$ht and "a)e it flatter, Inco"e and the interest rate will increase, Since the LM5curve is flat0 the interest rate will not increase +y "uch0 so invest"ent will decrease only a little, The +ud$et deficit will increase due to the ta3 cut, <i$her inco"e will lead to "ore "oney de"and +ut a hi$her interest rate will lead to lower "oney de"and, &verall0 "oney de"and will re"ain constant0 since "oney supply hasnLt chan$ed, The ad4ust"ent process can +e descri+ed a follows(

6?8

t C

C i

"d

I C

e""e)t* Y an& i

LM

i: i6 IS6 @

C6 C: C 1C- A!!u$e $#ne4 &e$an& i! %er4 intere!t inela!ti) an& in%e!t$ent i! %er4 intere!t ela!ti)- E0plain h#, the le%el #" !a%in ! ASB+ $#ne4 &e$an& A$&B an& in%e!t$ent AIB ,#ul& 'e a""e)te& i" the #%ern$ent in)rea!e& ,el"are !pen&in If "oney de"and is very interest inelastic0 the LM5curve is very steep0 and if invest"ent is very interest elastic0 the IS5curve is very flat, With a steep LM5curve and a flat IS5curve0 fiscal policy is not very effective0 since "ost of it is crowded out, #n increase in $overn"ent transfer pay"ents 9TR; shifts the IS5 curve to the ri$ht and inco"e and the interest rate increase, Since inco"e has increased0 savin$ has increased and since the interest rate has increased0 invest"ent has decreased, In the end0 "oney de"and cannot +e affected since "oney supply has not chan$ed, The increase in inco"e increases "oney de"and0 +ut the increase in the interest rate +rin$s it +ac) to its ori$inal level0 that is0 in equili+riu" with "oney supply, The ad4ust"ent process that ta)es place is as follows( TR C "d i I C E""e)t* Y i

IS:

Since i increases a lot0 the effect on I is lar$e0 as is the offsettin$ effect 9the crowdin$ out effect; on output 9C;, This "eans that the overall effect on C is s"all,

LM

i6 io IS6 ISo @ Co C6 C

6=@

11- U!e the "#r$al IS=LM $#&el &eri%e& in Chapter 1C t# !h#, al e'rai)all4 h#, the &e ree #" )r#,&in #ut that i! a!!#)iate& ,ith an in)rea!e in #%ern$ent !pen&in A<B i! &eter$ine& '4 the &i""erent para$eter! in the "i!)al p#li)4 $ultiplier A'+ /+ h an& BThe equili+riu" interest rate for the IS5LM "odel was derived in !quation 98; of Chapter 6@ as i A 9)Dh;#o 5 M6D9h N )+;O9MDP;, If we su+stitute this equation into the equation for invest"ent0 we $et I A Io 5 +i A Io 5 +P9)Dh;#o 5 M6D9h N )+;O9MDP;Q0 and therefore we $et I A 5 9+)Dh;9#o; A 5 9+)Dh;PDM6 N )9+Dh;OQ9#o; A 5 M9+);D9h N )+;O9'o;, %ro" this we can see the followin$( If the interest sensitivity of invest"ent 9+; $oes up0 then we have "ore crowdin$ out, If the interest sensitivity of "oney de"and 9h; $oes up0 then we have less crowdin$ out, If the inco"e elasticity of "oney de"and 9); $oes up0 then we have "ore crowdin$ out, If the "ultiplier 9; $oes up0 then we have "ore crowdin$ out, N#te* Since +0 )0 and are in +oth the nu"erator and the deno"inator of the factor precedin$ 9 '; in the equation a+ove0 so"e students "ay have difficulty decidin$ whether this factor $oes up or down as these para"eters increase, #n easy way to find out is to calculate the inverse of this factor0 which is 9h N )+;D9)+; A hD9)+; N 6, #s either )0 0 or + increases0 then this inverse decreases and the factor will increase, 12- I" the #%ern$ent in)rea!e& the in)#$e ta0 rate AtB an& the .an/ #" Cana&a re!p#n&e& '4 in)rea!in the $#ne4 !uppl4+ h#, ,#ul& in%e!t$ent AIB+ !a%in ! ASB an& $#ne4 &e$an& A$&B 'e a""e)te&2 6,5B:, # hi$her inco"e ta3 rate decreases the e3penditure "ultiplier, The IS5curve +eco"es steeper and shift to the left0 so +oth inco"e and the interest rate increase, :,5B7, #n increase in "oney supply shifts the LM5curve to the ri$ht, The interest rate decreases0 leadin$ to an increase in invest"ent and thus inco"e, &verall0 the interest rate will decrease0 +ut it is unclear what will happen to inco"e, # lower interest rate "eans an increase in invest"ent, Since inco"e has not chan$ed "uch0 savin$s hasnLt +een affected "uch0 althou$h it will chan$e in the sa"e direction as inco"e, Since the ta3 rate is lower0 "ost li)ely savin$s will increase, Money de"and has increased0 since "oney supply has +een increased 9the "oney sector has to +e in equili+riu";, The ad4ust"ent processes that ta)e place can +e descri+ed as follows(

6=6

C i

C I i

"d C

i "d

I i

e""e)t* Y i e""e)t* Y i

O%erall e""e)t* Y 2

i IS:

IS6 6

LM6

LM:

i6 : i: i7 @ C6 Co C

16- 5C#$'inin in)#$e ta0 )ut! ,ith re!tri)ti%e $#netar4 p#li)4 i! )#unterpr#&u)ti%e+ !in)e it ,ill lea& t# a hi her 'u& et &e"i)it an& hi her intere!t rate!- 3hat ,e nee& in!tea& i! a ta0 in)rea!e in )#$'inati#n ,ith e0pan!i#nar4 $#netar4 p#li)4+ !in)e the ta0 in)rea!e ,ill l#,er the 'u& et &e"i)it ,hile the $#ne4 e0pan!i#n !ti$ulate! the e)#n#$4-5 C#$$ent #n thi! !tate$entGeither policy "i3 descri+ed a+ove is li)ely to si$nificantly affect the level of output, # co"+ination of e3pansionary fiscal policy and restrictive "onetary policy will lead to an increase in interest rates +ut it will not si$nificantly affect output, The IS5curve will +eco"e flatter and shift to the ri$ht0 and the LM5 curve will shift to the left, The +ud$et deficit will increase due to the ta3 cut, Restrictive fiscal policy that is co"+ined with e3pansionary "onetary policy will also not si$nificantly affect output0 +ut it will reduce interest rates, 9The IS5curve will +eco"e steeper and shift to the left0 and the LM5curve will shift to the ri$ht,; The ta3 increase will lead to a decrease in consu"ption0 +ut the decrease in interest rates will lead to an increase in invest"ent and a hi$her potential for future econo"ic $rowth, The +ud$et deficit will decrease due to the hi$her ta3 rates, Lower interest rates will also help to finance the e3istin$ national de+t and "ay sti"ulate net e3ports0 since a capital outflow "ay occur that will reduce the value of the dollar, 18- DI" in%e!t$ent i! %er4 intere!t inela!ti)+ then $#!t #" an in)#$e ta0 rate )ut ,ill 'e )r#,&e& #utE there"#re the .an/ #" Cana&a !h#ul& al,a4! !upple$ent a ta0 )ut ,ith an in)rea!e in $#ne4 !uppl4-F C#$$ent #n thi! !tate$ent ,ith the help #" an IS=LM &ia ra$ an& e0plain the a&(u!t$ent pr#)e!!If invest"ent is very interest inelastic0 then the IS5curve is very steep, #n inco"e ta3 cut will shift the IS5 curve to the ri$ht and "a)e it flatter, Therefore inco"e and the interest rate increase, The increase in the interest rate will crowd out only a s"all part of invest"ent0 since invest"ent is very inelastic, If the Ban) of Canada increases "oney supply0 the LM5curve will shift to the ri$ht and inco"e will increase0 while interest rates will $o down, &verall0 we have an increase in inco"e0 +ut interest rates will +e lar$ely

6=:

unaffected, Therefore0 we do not have to worry a+out the crowdin$ out of invest"ent, The ad4ust"ent processes that ta)e place can +e descri+ed as follows( 6,5B:, t C C "d i I C e""e)t* Y an& i e""e)t* Y an& i

1:- 5A )ut in the in)#$e ta0 rate i! n#t an e""e)ti%e ,a4 t# !ti$ulate the e)#n#$4 i" $#ne4 &e$an& i! %er4 intere!t ela!ti)+ !in)e $#!t #" the ta0 )ut ,ill 'e )r#,&e& #ut-5 C#$$ent #n thi! !tate$ent# situation in which "oney de"and is e3tre"ely interest elastic co"es very close to the so5called liquidity trap 9the LM5curve will +e al"ost hori/ontal;, # decrease in the inco"e ta3 rate 9t; will sti"ulate consu"ption and increase national inco"e, The si/e of the e3penditure "ultiplier 9 ; will increase and the IS5curve will +eco"e flatter and shift to the ri$ht, The increase in inco"e will initially induce people to hold "ore "oney +alances and thus provide upward pressure on interest rates, But since "oney de"and is e3tre"ely interest sensitive0 it will ta)e only a very s"all increase in interest rates to +rin$ the "oney sector +ac) to equili+riu", Therefore0 the crowdin$ out effect on invest"ent will +e "ini"al and the ta3 cut will prove to +e very effective in sti"ulatin$ national inco"e, 1;- 5E0pan!i#nar4 $#netar4 p#li)4 'e)#$e! $#re e""e)ti%e a! the intere!t !en!iti%it4 #" in%e!t$ent in)rea!e!-5 C#$$ent #n thi! !tate$ent&ne of the ways "onetary policy affects the level of output de"anded is +y chan$in$ interest rates and there+y the level of invest"ent spendin$, The ad4ust"ent can +e descri+ed as follows( #n increase in "oney supply lowers the interest rate, If invest"ent is very interest elastic0 a lar$e increase in invest"ent spendin$ will follow, This "eans that0 $iven a certain si/e of the e3penditure "ultiplier0 inco"e will chan$e +y "ore than in the case when invest"ent does not respond "uch to a chan$e in interest rates, In other words0 if invest"ent is very interest sensitive0 then we have a flat IS5curve, %or the sa"e chan$e in "oney supply0 the flatter the IS5curve is0 the lar$er the chan$e in real output will +e, The for"al analysis of Chapter 6@ shows that0 if invest"ent +eco"es "ore interest sensitive0 then the value of + increases, This leads to an increase in the "onetary policy "ultiplier0 which is defined as

6=7

9C;D9MDP; A 9+Dh;, N#te* + is also in the deno"inator of the equation for 0 and therefore an increase in + will lower the value of , But the chan$e in is proportionally less than the chan$e in + and thus the value of the "onetary policy "ultiplier will actually increase as + $ets lar$er, 1>- A!!u$e that the $ar inal pr#pen!it4 t# !a%e in)rea!e!- I" the .an/ #" Cana&a ,ant! t# /eep the le%el #" #utput "r#$ "lu)tuatin + !h#ul& it un&erta/e #pen $ar/et pur)ha!e! #r !ale!2 In 4#ur an!,er &i!)u!! the )#$'ine& e""e)t #" the!e )han e! #n the )#$p#!iti#n #" <DP#n increase in the "ar$inal propensity to save 9s A 6 5 c; will decrease the si/e of the e3penditure "ultiplier 9; and therefore the IS5curve will shift to the left and +eco"e steeper, If people save "ore and spend less0 then fir"s will e3perience an increase in unintended inventories, %ir"s will respond to this +y decreasin$ production and national inco"e will decrease, Therefore0 the .an/ #" Cana&a will have to sti"ulate the econo"y +y increasin$ the supply of "oney via open "ar)et purchases 9which will shift the LM5curve to the ri$ht;, #s a result of these two shifts we will have lower interest rates, This "eans that invest"ent as a fraction of '*P will increase0 while consu"ptionLs share of '*P will decrease, 9Lower interest rates "ay also cause an outflow of capital0 which will lower the value of the do"estic currency0 leadin$ to an increase in net e3ports,; 1?- 5In 1@@1+ the tran!$i!!i#n $e)hani!$ 'r#/e &#,n+ !in)e 'an/! ,ere !till !u""erin "r#$ ha%in $a&e 'a& real e!tate l#an! an& ,ere un,illin t# in)rea!e their len&in in re!p#n!e t# the .an/ #" Cana&aG! e0pan!i#nar4 $#netar4 p#li)4-5 C#$$ent #n thi! !tate$entIt is true that "any +an)s had "ade +ad loans in the late 68K@s and were therefore e3tre"ely cautious in their lendin$ in 6886, They preferred to +uy virtually ris)5free $overn"ent +onds, Thus0 even thou$h the .an/ #" Cana&aLs "oney e3pansion led to lower interest rates0 private fir"s had little access to +an) loans and the econo"y was not si$nificantly sti"ulated, But it would +e an e3a$$eration to say that the trans"ission "echanis" had +ro)en down0 since +an) lendin$ finally pic)ed up in 688: after the .an/ #" Cana&a increased its e3pansionary "onetary policy effort, &ne can ar$ue that0 $iven the econo"ic situation at the ti"e0 the .an/ #" Cana&aLs initial policy "easure si"ply was not sufficient to achieve the desired result, 1@- 5I" in%e!t$ent i! %er4 intere!t ela!ti) an& $#ne4 &e$an& i! %er4 intere!t inela!ti)+ then "i!)al p#li)4 i! le!! e""e)ti%e than $#netar4 p#li)4-5 C#$$ent #n thi! !tate$entThe "ore interest elastic invest"ent is0 the flatter the IS5curve will +e, !3pansionary fiscal policy 9a shift of the IS5curve to the ri$ht; +eco"es less effective0 since the crowdin$5out effect +eco"es lar$er, !3pansionary "onetary policy 9a shift of the LM5curve to the ri$ht; +eco"es "ore effective0 since the decrease in the interest rate will now sti"ulate invest"ent to a lar$er de$ree, The "ore interest inelastic "oney de"and is0 the steeper the LM5curve will +e0 since any increase in "oney de"and due to an increase in inco"e now has to +e offset +y a lar$er increase in the interest rate, !3pansionary fiscal policy +eco"es less effective0 since any increase in inco"e will increase "oney de"and and this will have to +e offset +y a lar$er increase in the interest rate0 leadin$ to a lar$er crowdin$5out effect, !3pansionary "onetary policy +eco"es "ore effective0 since the increase in "oney

6=?

de"and needed to +rin$ the "oney sector +ac) into equili+riu" "ust +e achieved pri"arily throu$h an increase in inco"e, The for"al analysis in Chapter 6@ introduces the fiscal and "onetary policy "ultipliers as 9C;D9'; A A DM6 N )9+Dh;O and 9C;D9MDP; A 9+Dh;

respectively, Therefore0 if invest"ent +eco"es "ore interest elastic0 the value of + increases and the value of the fiscal policy "ultiplier decreases0 while the value of the "onetary policy "ultiplier increases, But if "oney de"and +eco"es less interest elastic0 then the value of h and the fiscal policy "ultiplier +eco"e s"aller0 while the "onetary policy "ultiplier +eco"es lar$er,

6==

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