MONETARY AND FISCAL POLICY IN THE VERY SHORT RUN

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1 C H A P T E R12 MONETARY AND FISCAL POLICY IN THE VERY SHORT RUN 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.

2 234 PART 4 The Economy in the Very Short Run: Spending and the IS-LM Model of Economic Activity T 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 monetary 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 considered 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 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 reasonable 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 LM curve 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. FIGURE DAY TREASURY BILL RATE AND REAL GDP GROWTH, QUARTERLY, 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 V

3 CHAPTER 12 Monetary and Fiscal Policy in the Very Short Run 235 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 Any choice made by the Bank of Canada concerning the level of the nominal money stock. monetary/index.htm 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. Expansionary monetary policy, which increases the nominal money stock, also increases the real money stock, as we assume that the price level is fixed, and shifts the LM curve outward to LM. The new equilibrium is at point E, with a lower interest rate and a higher level of income. This is exactly the result shown in Figure 11-10(b) in Chapter 11. Simply comparing the new equilibrium to the old (which is technically called comparative statics) hides the more interesting story concerning the adjustment path of the economy while it is in transition to the new equilibrium. In order to understand the dynamic adjustment, we make an important assumption: The money market adjusts very rapidly, while the goods market adjusts less quickly. This assumption actually is consistent with observed behaviour of the economy over the very short run. We often observe a change of interest rates engineered by the Bank of FIGURE 12-2 MONETARY POLICY An increase in the real money stock shifts the LM curve to the right.

4 236 PART 4 The Economy in the Very Short Run: Spending and the IS-LM Model of Economic Activity Canada, which is followed, after some time lag, by a change in real economic activity. Now consider the adjustment path to the new equilibrium in Figure Because the money market is assumed to adjust rapidly, the initial response of the economy is to move to point E 1, where the interest rate is lower but output has not yet changed. At point E 1, the money market is in equilibrium (the economy is on the new LM curve) but the goods market is not in equilibrium. In the goods market, the new interest rate, given the existing level of income, Y 0, is too low for equilibrium, so the economy is not on the IS curve. Given the decrease in the interest rate, there is now excess demand for goods, so output starts to increase. In this very short run model, whenever there is adjustment, there will be feedback between the goods and money markets. Notice that as income and output increase, the demand for money increases, which causes interest rates to increase, so the economy moves along the LM curve toward the new equilibrium at E. Therefore, the adjustment path of the economy in response to an increase in the money stock is for interest rates to first decrease, while income and output remain constant. After the interest rate decreases, output begins to increase in response to the interest rate change. While on the path from E 1 to E, output is increasing and interest rates must also increase. It is important to understand that the adjustment of the economy as a result of this monetary policy change is dependent on two general responses. First, monetary policy must have the ability to lower interest rates. The fact that the interest rate decreases to i initially is one measure of the effectiveness of monetary policy in the very short run. Remember from Chapter 11 that (ceteris peribus) the flatter the LM curve, the smaller the interest rate change will be. Second, the ability of monetary policy to change real output in the very short run depends on the interest rate response in the IS curve. It is fairly easy to see from Figure 12-2 that for any given LM shift, output will change more if the IS curve is flatter and less if the IS curve is steeper. liquidity trap A situation that arises when the LM curve is horizontal because the interest elasticity of money demand is infinite. Is There a Situation When Monetary Policy Cannot Lower Interest Rates? The Case of the Liquidity Trap Consider the situation where the interest elasticity of money demand, h, is infinite. Given that we know that the slope of the LM curve is given by the ratio k/h, when h is infinite, the LM curve is horizontal. Remember that the slope of the money demand curve is given by 1/h, so in this situation, the money demand curve is also horizontal. Therefore, when h is infinite, monetary policy cannot shift the LM curve. Put another way, monetary policy has no ability to lower interest rates. The situation described above is the famous liquidity trap. The idea of a liquidity trap arose from the theories of John Maynard Keynes. Keynes himself stated that he was not aware of any practical situation in which the economy would be in a liquidity trap. Technically, a liquidity trap would exist at zero nominal interest rate, and this is something that we do not observe. Given the above discussion, the liquidity trap remained a theoretical curiosity for many years, and was included in textbooks only as a technical exercise, without much real-world appeal. However, a series of events over the past several years has led economists to revive a form of the liquidity trap. In the 1990s, the Japanese economy, which was once one of the most powerful in the world, began to show signs of serious trouble. There were many policy responses to this slowdown, but one of

5 CHAPTER 12 Monetary and Fiscal Policy in the Very Short Run 237 the most interesting was the intervention on the part of the Japanese central bank, which aggressively lowered Japanese interest rates in an attempt to stimulate the economy, much along the lines depicted in Figure However, the intervention did not produce the desired result because, even though the Japanese central bank was successful in lowering interest rates, output did not respond. In Figure 12-2, we would explain this as a very steep, or vertical, IS curve. In spite of this lack of success, the Japanese central bank continued to put downward pressure on interest rates. The failure of this policy promoted The Economist to publish an article entitled Is Japan in a Liquidity Trap? After this series of events, the concept of a liquidity trap took on a new realworld meaning: An economy is sometimes said to be in a liquidity trap when interest rates are so low that a central bank has no scope to lower them further. Notice that this is somewhat different than the technical condition for a liquidity trap outlined above. One important difference is that in the modern version of a liquidity trap, the central bank can raise interest rates, something that cannot be done in the earlier technical version of a liquidity trap. For another important event that gave rise to the question of a liquidity trap, see the following Policy in Action feature. The level of aggregate supply is the amount of output the economy can produce given the resources and technology available. The Liquidity Trap in Canada and the United States The aggregate supply tradeoff between price and output represents firms In this decisions chapter, to we raise discussed or lower prices how the when liquidity demand trap for has output taken rises on or new falls. meaning in modern macroeconomics, describing a situation in which monetary policy The level would of like aggregate to lower demand interest is rates the total but may demand have for no goods scope to to con- do so. After the events of September 11, 2001, there was a general fear that the economies of Canada and the United States would slip into a severe recession. In response to this, the Bank of Canada and the Federal Reserve Board very quickly began lowering interest rates. In a short period of time, interest rates in each country were at a 40-year low. The hope was that this sudden large drop in interest rates would stimulate output. This immediately gave rise to the question of whether interest rates were low enough to generate some growth on the output side, and if not, could monetary policy lower interest rates any further. That is, were the two economies each in a liquidity trap? In Canada, the lowering of interest rates had the desired effect, as output growth rebounded strongly in the first quarter of However, in the United States, output growth remained sluggish and there was talk of the U.S. economy entering a period of deflation, when prices would be falling. Of course, this led to more calls for a lowering of interest rates in the United States and more talk of the U.S. economy experiencing a liquidity trap.

6 238 PART 4 The Economy in the Very Short Run: Spending and the IS-LM Model of Economic Activity Can the LM Curve Be Vertical? Classical Economics Again Can the LM curve be vertical? The answer to this question is that, technically, the LM curve could be vertical if either the interest elasticity of money demand is zero or the income elasticity of money demand is infinite. We can dismiss the latter of these two possibilities immediately. 1 The interest elasticity of money demand could possibly be zero but, in this case, the money demand curve would be vertical and the money supply curve would also be vertical, as depicted in Figure Therefore, there would either be no equilibrium, as shown in Figure 12-3, or an infinite number of equilibria in the special case where the money demand and money supply curves coincide. Neither of these cases is very appealing from an economic modelling point of view. That is, if the interest elasticity of money demand is zero, then there is no manner in which to determine the equilibrium interest rate in the money market, which leaves the model with no sensible role for the interest rate in the very short run. FIGURE 12-3 THE MONEY MARKET WHEN h = 0 When the interest elasticity of money demand (h) is zero, the money demand curve is vertical. Since the money supply curve is also vertical, there is either no equilibrium (as shown here) or an infinite number of equilibria if the money demand and money supply are superimposed. It is helpful to think of this problem in terms of markets and prices. The money market, like any other market, has a price that coordinates supply and demand. In the long run Classical model studied in Chapter 3, the quantity theory of money was assumed to hold. In that model, if there was, for instance, an increase in the nominal money stock, then the price level would increase. Therefore, the price of money was assumed to be (the inverse of) the general price level. 2 When we moved to the Keynesian IS-LM model in this chapter, we assumed that the price level was fixed and, therefore, the quantity theory of money could not hold. In the Keynesian IS-LM 1 The income elasticity of money demand is relevant only over a range of 0 < k 1. See Chapter 16 for a discussion of this point. 2 It may be helpful to have another look at Box 11-3 in Chapter 11.

7 CHAPTER 12 Monetary and Fiscal Policy in the Very Short Run 239 model, the price of money is assumed to be the nominal interest rate. Now, if we assume that the interest elasticity of money demand is zero, then the interest rate is no longer the price of money. In any event, the above theoretical discussion notwithstanding, it is fairly clear that, empirically, the nominal interest rate plays a prominent role in money market adjustment in the very short run, and removing it by assuming that the interest elasticity of money demand is zero would remove our ability to explain very short run movements in the economy. BOX 12-1 A Classical IS-LM Model In this chapter, we have discussed the situation in which the interest elasticity of money demand is zero. In this situation, monetary policy can no longer work through the interest rate channel to affect output in the usual manner described in this chapter. Instead, the money market is actually a Classical money market, which behaves according to the quantity theory of money. This situation gives rise to the Classical IS- LM model shown in the figure below. Notice that in the Classical IS-LM model, the price level is on the horizontal axis, not real income. This is because in a Classical world, the money market determines the price level. On the vertical axis is the real interest rate, which is the important interest rate in a Classical model. In the Classical model, the real interest rate is determined by the interaction of savings and investment, and this is exogenous to the money market. Therefore, the Classical IS-LM model, although logically correct, does not really tell us much. We are asking about the relationship between the real rate of interest and the nominal price level, and in a Classical model, these two variables are not related to each other.

8 240 PART 4 The Economy in the Very Short Run: Spending and the IS-LM Model of Economic Activity ecfisce.html 12-2 FISCAL POLICY AND CROWDING OUT This section shows how changes in fiscal policy shift the IS curve, the curve that describes equilibrium in the goods market. Recall that the IS curve slopes downward because a decrease in the interest rate increases investment spending, thereby increasing aggregate demand and the level of output at which the goods market is in equilibrium. Recall also that changes in fiscal policy shift the IS curve. Specifically, a fiscal expansion shifts the IS curve to the right. The equation of the IS curve, derived in Chapter 11, is repeated here for convenience: 1 Y G (A 1 bi) G (1) 1 c (1 t) Note that G, the level of government spending, is a component of autonomous spending, A 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 comparison 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 aggregate demand dampen the expansionary effect of increased government spending. Income, instead of increasing to level Y, rises only to Y.

9 CHAPTER 12 Monetary and Fiscal Policy in the Very Short Run 241 FIGURE 12-4 EFFECTS OF AN INCREASE IN GOVERNMENT SPENDING 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. The reason that income rises only to Yrather 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 different IS and LM schedules, 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 preceding chapters, we are assuming an economy with prices given, in which output is

10 242 PART 4 The Economy in the Very Short Run: Spending and the IS-LM Model of Economic Activity monetary accommodation The central bank prints money to buy the bonds with which the government pays for its deficit. FIGURE 12-5 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 reduces the ratio M/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 LM schedule 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 private 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 LM schedules shift to the right, as in Figure Output will clearly increase, but interest rates need not rise. Accordingly, there need not be any adverse effects on investment. MONETARY ACCOMMODATION OF A FISCAL EXPANSION 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.

11 CHAPTER 12 Monetary and Fiscal Policy in the Very Short Run 243 BOX 12-2 The Policy Mix 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 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 continuation of full employment deficits throughout the 1990s. An interesting feature of this recession and recovery is the behaviour of the unemployment rate. You can see from the table below that the unemployment rate increased from 1988 to After 1992, the unemployment rate remained above 10 percent until the late 1990s. THE RECESSION OF THE EARLY 1990S (PERCENT) Nominal interest rate Real interest rate Full-employment deficit Unemployment rate GDP growth Inflation 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)

12 244 PART 4 The Economy in the Very Short Run: Spending and the IS-LM Model of Economic Activity money supply rule A policy stance where the central bank holds the level (or growth rate) of the money supply constant. FIGURE 12-6 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 money perhaps 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 CHANGING THE MONEY SUPPLY WHEN THE DEMAND FOR MONEY SHIFTS If the money supply is increased when the demand for money shifts outward, then the interest rate would not rise as it would if the money supply was not changed. 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 continues 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, and the interest rate would increase to only i 3. If the Bank of Canada did this every time there was a shock to money demand (of course, the shocks could be both positive and negative), the money supply would no longer be completely exogenous but would now have an endogenous component. We could write the money supply equation that describes this stance on monetary policy as M s = M - i ; > 0 (3)

13 CHAPTER 12 Monetary and Fiscal Policy in the Very Short Run 245 interest elasticity of the money supply A parameter that measures how much the central bank changes the money supply in response to an interest rate change. The parameter measures the amount that the central bank increases the money supply in response to an interest rate change. We call the interest elasticity of the money supply. The more that the Bank of Canada reacts to changes in the interest rate, the larger will be. If we want to graph the money supply curve, we can rearrange equation (3). i = 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 conducts policy according to equation (4) (i 0 i 1 ). FIGURE 12-7 MONETARY POLICY REACTS TO INTEREST RATE CHANGES 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. 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. 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 exogenous. 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.

14 246 PART 4 The Economy in the Very Short Run: Spending and the IS-LM Model of Economic Activity FIGURE 12-8 DERIVING THE LM CURVE UNDER AN INTEREST RATE RULE 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 horizontal. res/r03-1-ec.htm 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 LM curve is horizontal by policy design. To make sure that you understand this, contrast the LM curve shown in Figure 12-8 with the liquidity trap discussed 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 LM curve is horizontal 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 LM curves are shown in Figure 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 3 For this section, we rule out discrete, one-time changes in the money supply under a money supply rule.

15 CHAPTER 12 Monetary and Fiscal Policy in the Very Short Run 247 FIGURE 12-9 LM CURVE FOR A MONEY SUPPLY RULE AND FOR AN INTEREST RATE RULE 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. 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 stabilization policy (interest rate rule) versus conducting policy by a fixed rule with a minimum of interference (money supply rule). In order to compare the two policy stances, we assume that the goal of the central 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

16 248 PART 4 The Economy in the Very Short Run: Spending and the IS-LM Model of Economic Activity FIGURE MONETARY POLICY WITH SHOCKS TO THE GOODS MARKET 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. 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 pertains 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-LM equilibrium 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 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 monetary 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.

17 CHAPTER 12 Monetary and Fiscal Policy in the Very Short Run 249 FIGURE MONETARY POLICY WITH SHOCKS TO THE MONEY MARKET 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 variance of income is minimized by an interest rule. 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 Construct the annual inflation rate, quarterly, and then the real rate of interest, quarterly. Plot the real rate of interest with the growth rate of GDP over the period You should be able to identify the negative relationship between these two variables, especially during recessions. C H A P T E R S U M M A R Y 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

18 250 PART 4 The Economy in the Very Short Run: Spending and the IS-LM Model of Economic Activity 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 circumstances, 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 income it 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 conduct 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. monetary policy, 235 liquidity trap, 236 crowding out, 241 K E Y T E R M S 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 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.

19 CHAPTER 12 Monetary and Fiscal Policy in the Very Short Run 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 substantial crowding out, which will be more successful fiscal or monetary policy? 5. What would the LM curve look like in a Classical world? If this really was the LM curve 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? A P P L I C A T I O N Q U E S T I O N S 1. The economy is at full employment. Now the government wants to change the composition 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-LM diagram to show your policy proposal. 2. Suppose the government cuts income taxes. Show in the IS-LM model 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?

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