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MACROECONOMICS LECTURE 2. FISCAL POLICY. There are a variety of ways in which policy makers can influence the economy Fiscal policy is the government’s decisions about spending and taxes; it is where the government uses changes in
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MACROECONOMICS LECTURE 2
FISCAL POLICY • There are a variety of ways in which policy makers can influence the economy • Fiscal policy is the government’s decisions about spending and taxes; it is where the government uses changes in government spending or taxes to influence the economy
MODEL SUMMARY Income expenditure model Y National Income C Consumer spending I Investment G Government spending X Spending on Exports M Spending on Imports AE Aggregate Expenditure
MODEL SUMMARY Agg. Expenditure AE = C + I + G + (X-M) Injections I + G + X Withdrawals S + T + M Net Exports (X – M) Disposable Income YD=(1-t)Y Tax revenue T = tY Budget Deficit (G – tY)
AE Expenditure=Income AE=330+0.25Y 440 330 45 Y 440 EQUILIBRIUM NATIONAL INCOME
FISCAL POLICY • To raise the level of economic activity: - raise government spending. The rise in aggregate expenditure raises output
Expansionary Fiscal Policy: Income goes up
withdrawals injections
FISCAL POLICY • To raise the level of economic activity: - lower income tax. Less taxes increases disposable income in the economy
FISCAL POLICY The slope of AE increases
Expansionary Fiscal Policy: Income goes up
withdrawals injections
Conversely: To lower economic activity (Y) - lower government spending - raise taxes Graphically this looks like this…
GOVERNMENT SPENDING • The Government Budget deficit = (Gov spending on good and services) - (indirect tax revenue + direct tax rev) Therefore = Expenditure – Revenue = G – tY
FISCAL POLICY • When considering fiscal policy we need to be aware of: The Multiplier Effect
The MULTIPLIER Effect Y = k x G
MULTIPLIER – You have a go! Knowledge of the multiplier is very useful for policy makers. For example, suppose the Government wishes to raise national income by US$18 billion. If the multiplier is 3, by how much should government spending be increased? Y = k x G 18 3 ??
MULTIPLIER – You have a go! Knowledge of the multiplier if very useful for policy makers. For example, suppose the Government wishes to raise national income by US$18 billion. If the multiplier is 3, by how much should government spending be increased? Y = k x G 18 3 ?? G = US$6 bn D
NEXT TOPIC • As well as using fiscal policy to influence the economy, governments can also use Monetary Policy • In England, the Bank of England is responsible for Monetary Policy • To understand what is meant by Monetary Policy we must first understand what is meant by “Money”
MONEY • Historically many items have served as money e.g. dogs teeth (admiralty islands), sea shells (Africa), gold (19th Century), cigarettes (prisoner of war camps) notes and coins (legal tender) • To serve as “money” an item must fulfill as number of functions…
FUNCTIONS OF MONEY Medium of Exchange Money provides medium for exchange of goods and services; is more efficient than barter, which wastes resources.
BARTER ECONOMY • A barter economy is inefficient: people spend a lot of time and effort finding people who want to swap • As an example of a barter economy, consider the following account of life without money, during the 1800s, from the World Development Report (1989)…
FUNCTIONS OF MONEY Store of value Money can be used to make purchases in the future Unit of Account A unit in which prices are quoted and accounts are kept. Standard of Deferred Payment A unit of account over time: enables borrowing and lending.
FUNCTIONS OF MONEY • Money is any generally accepted means of payment for delivery of goods or the settlement of debt • Notes and coins are “legal tender” so legally they must be accepted as means of payment for goods and services. But how about a current account?
MONEY SUPPLY MONEY SUPPLY value of total stock of money, the medium of exchange, in circulation. M0= notes and coins in circulation outside the BOJ + bank’s cash reserves at the BOJ (narrow money)
MONEY SUPPLY M2 = notes and coins held by the public + dollar retail deposits at JA banks and building societies M4 = M2 + all other private sector interest bearing deposits (including time deposits) of banks and building societies, and certificates of deposits. (broad money)
M0 M2 M4 MONEY SUPPLY
MONEY SUPPLY Deposits form the largest part of M2 and M4. Banks and building societies create money by lending out their excess reserves.
WAYS OF HOLDING WEALTH CASH DEMAND DEPOSITS TIME DEPOSITS BONDS, BILLS GILT EDGED SECURITIES PERPETUITIES SHARES (EQUITIES) MONEY BONDS
WAYS OF HOLDING WEALTH
DEMAND FOR MONEY Why do people hold money? We identify a number of motives for holding their wealth as money (rather than any other form of financial instrument)
DEMAND FOR MONEY Transactions Motive Money is held to finance known transactions Precautionary Motive People hold money to meet unforeseen contingencies
DEMAND FOR MONEY Asset Motive People hold money as a low risk component of a mixed portfolio Precautionary Motive People hold money to exploit a profitable opportunity to invest in bonds which may arise.
DEMAND FOR MONEY How does the “demand for money” change when there is a: Change in the interest rate? Change in income? Change in price?
DEMAND FOR MONEY People hold money up to the point at which the marginal benefit of holding money just equals its marginal cost in interest forgone.
DEMAND FOR MONEY Let us distinguish between: Nominal Money Demand is in terms of so many pounds Real Money Demand is in terms of so many units of goods and services that the money can buy
DEMAND FOR MONEY We can take these findings and construct another curve, the so called “money demand” schedule or the “liquidity preference” curve. As the interest rate rates, money demand falls… As income rises, money demand increases…
