# The impact of monetary and fiscal policies

### From Baripedia

As we saw in the previous chapter, income and employment may in the short term deviate from their level of full employment. Since the long term is made up of a 'succession of short terms', it is important to understand how the government can try to address these deviations in order to stabilize the economy around its level of full employment. We will analyse the mechanisms through which monetary and/or fiscal policies can help to avoid excessive fluctuations in income levels, and thus stabilise the economy.

# Monetary and fiscal policy and the AD

## Monetary policy

In chapter 7 we saw that in most countries monetary policy is controlled by the Central Bank through :

1. open market operations (open market operations);
2. Setting the level of reserve requirements;
3. the refinancing rate at which commercial banks can borrow from the Central Bank (the key or discount rate, the repo rate in England and the discount rate in the United States).

Of these three instruments, the variation in the policy rate is the most commonly used in normal times.

From Chapters 8 and 11 we also know that one of the most important determinants of money demand is the interest rate. In particular, the interest rate represents the opportunity cost of holding money: if the interest rate on other less liquid assets rises, households demand less money => the demand for money is a decreasing function of ${\displaystyle r}$.

At a given price level (short-term view = prices are rigid), the interest rate adjusts to equalize the demand for and supply of money. Any change in the general price level moves the money demand curve in parallel.

## Monetary policy and the AD

The Central Bank can cause a shift in the AD curve through monetary policy: expansive monetary policy = money supply ↑, the interest rate ↓, I↑ , the AD moves to the right.

In the event of a restrictive monetary policy, the money supply ↓, the interest rate ↑, the AD moves to the left.

## Fiscal policy

Fiscal policy is controlled by the government:

1. By changing government spending (${\displaystyle G}$), the government affects the AD directly (not indirectly as when the Central Bank increases the money supply);
2. By changing taxes it affects consumption and/or investment decisions, two components of aggregate demand.

NB: By ${\displaystyle G}$ we mean expenditure on infrastructure (roads, schools, etc.), supplies (machinery, computers, paper, etc.) and the remuneration of public employees (civil servants, police officers, etc.). On the other hand, ${\displaystyle T}$ represents taxes less all social transfers.

The DA moves outwards when ${\displaystyle G}$ increases or ${\displaystyle T}$ decreases . BUT, by how much? → two opposite effects: the Keynesian multiplier and the crowding out.

We talk about the multiplier effect of fiscal policy, because for every franc spent by the government, the AD increases by more than one franc. More precisely, as we saw in chapter 11, the Keynesian multiplier tells us that ${\displaystyle \Delta Y={\frac {1}{1-pmc}}\Delta G}$. (See ch.11 for more details on the Keynesian multiplier.)

## Fiscal policy and crowding out

Fiscal policy may not affect the economy as strongly as Keynes' multiplier predicts: an expansive fiscal policy leads to an increase in the DA, which will cause an increase in GDP in the short term and consequently in the demand for money for transaction purposes. The demand for money shifts to the right and the interest rate increases (cf. the liquidity preference theory of the previous chapter) => investment decreases and therefore the DA decreases.

This is called the crowding out effect, because government spending shifts (crowds out) private investment.

NB: this crowding out effect does not correspond to the reduction in loanable funds from public savings that we studied in chapter 6.

The crowding out effect is added to the Keynesian multiplier. The final impact on ${\displaystyle Y}$ will be greater than the initial increase of ${\displaystyle G}$ if the effect of the Keynesian multiplier is greater than the crowding out effect, and vice versa.

## Remarks

In a way, the Keynesian multiplier is also at work when monetary policy is used: the increase in the supply of money affects the interest rate and thus the investment and consumption of individuals. This first effect will then "multiply" (I↑ → Y↑ → C↑ → Y↑ → C↑ → etc.).

The impact on income of a reduction in flat-rate taxes of an amount x will be smaller than the impact of an increase in public spending of the same amount ${\displaystyle x}$. Indeed, when T falls by x, part of the additional disposable income (${\displaystyle \Delta Yd=x}$) is saved and only part is spent on consumption => the initial displacement of the DA is less than ${\displaystyle x}$. With the same budgetary consequence (${\displaystyle \Delta G=-\Delta T}$), the effect of public spending on income is greater than the effect of taxes: ${\displaystyle \Delta Y={\frac {1}{1-pmc}}\times \Delta G}$ et ${\displaystyle \Delta Y={\frac {pmc}{1-pmc}}\times \Delta T}$, ignoring the ${\displaystyle pmm}$. This also means that a tax-financed fiscal policy that leaves the public deficit constant (${\displaystyle \Delta G=\Delta T}$) still has an effect on ${\displaystyle Y}$.

# Stabilization policies

## Stabilization policies

Exogenous fluctuations in FD mean that the economy can be well below full employment for extended periods of time. This is inefficient and can have significant negative social consequences.

From the end of the Second World War, economic stabilization has been an explicit goal of all governments of developed countries.

The idea of an active stabilization policy is that the government should intervene in the private economy (using its monetary or fiscal policy) to stabilize aggregate demand.

Economists are divided on the appropriateness of such interventions (see The Economist, 14.02.2008).

## Stabilisation policies: pros and cons

For: According to economists in favour of state intervention (Keynes and economists of his school), crises are often caused by feelings of pessimism that become self-fulfilling. A credible fiscal policy can break these vicious circles and avoid serious consequences for society (including long recessions).

Cons: Excessive information needs and a slow political system mean that governments often react too late with fiscal policy, thus further destabilising the economy (expansive intervention takes effect when the economy is already in recovery).

Delays due to :

• Delays in perception;
• Delays in decision;
• Delays in effectiveness.

## Automatic stabilizers

Economists opposed to government intervention (monetarists and real business cycle economists) argue that governments should instead rely on automatic stabilizers:

• When ${\displaystyle T}$ depends on ${\displaystyle Y}$, ${\displaystyle T}$ falls when ${\displaystyle Y}$ falls, which acts in the same way as an active expansive fiscal policy.
• Government transfers increase during a recession (e.g. unemployment benefits), and this increases disposable income in times of crisis.

Automatic stabilisers will allow the economic system to absorb shocks spontaneously and return to full employment.

## Effects of fiscal policy

Reminder: the multiplier effect (active in both cases) is slowed down by the crowding-out effect.

## Public debt financing

The government can finance its spending through taxes, through the issuance of bonds, through the creation of money (in the latter case, there is a risk of a negative spiral leading to hyperinflation).

Public debt, like any other debt, loses value in real terms in the presence of inflation (a large part of the debt that European countries contracted after the Second World War was worthless in real terms). (which has been "melted down" by sustained inflation).

Ricardian equivalence: a tax cut financed by an increase in debt does not force consumers to consume more → inefficiency of expansive fiscal policy. According to the Ricardian equivalence principle, consumers will rather save in anticipation of a future tax increase.

## Effects of monetary policy

Reminder: in the long term, an increase in the supply of money causes a proportional increase in prices.

## Conduct of monetary policy

As discussed in the chapter on money and the banking system, the main problem with the use of expansive monetary policy is that, in the long run, it results in a proportional increase in the general price level and creates inflation, with the level of output set at its full employment level (see also Chapter 14).

At the beginning of this chapter we saw that, when monetary policy is used to stabilise the economic system (short-term view), the increase in the money supply spreads its effects on the real economy by lowering the interest rate (${\displaystyle r}$, or ${\displaystyle i}$, ↓, ${\displaystyle I}$↑ and ${\displaystyle AD}$↑). There are situations in which the nominal interest rate ${\displaystyle i}$ is already equal to zero (or close to zero) and monetary policy loses all its effectiveness: any further increase in the supply of money has no impact on the interest rate and thus on aggregate demand. When this phenomenon occurs, we speak of a liquidity trap (see also chapter 14).

## Liquidity trap

As Keynes had already noted in the 1930s, for an interest rate below a certain critical value, it is possible that the preference of economic agents for liquidity is "virtually absolute", in the sense that almost everyone prefers to hold cash. In this case, monetary policy loses all its effectiveness.

In situations of widespread uncertainty or pessimism, individuals hold liquidity and an injection of money into the banking system will not be able to reduce the interest rate and thus revive economic activity.

Intuition: when the interest rate is very low, individuals expect it to rise and nobody wants to hold securities (nobody wants to end up with assets whose price falls once the market interest rate finally rises).

Example: Japan in the second half of the 1990s.

# Summary

Since both monetary and fiscal policy can affect the DA, the government uses them to try to stabilize the economy.

Economists disagree on the desirable level of government intervention.

The Central Bank can affect the DA with its monetary policy: an increase (reduction) in the money supply results in an outward (domestic) shift of the DA.

The government can affect the DA with its fiscal policy: an increase in public spending or a decrease in taxes will cause the DA to move outwards (a decrease in public spending or an increase in taxes will cause the DA to move inwards). When the government changes the level of public spending or taxation, the final DC shift may be smaller or larger than the initial change in the level of public spending or taxation: the Keynesian multiplier effect amplifies the initial effect; the crowding-out effect reduces the initial effect.

The expansive fiscal policy achieved by a tax cut could, in some cases, be ineffective: Ricardian equivalence.

Expansionary monetary policy could, in some cases, be ineffective: liquidity trap.

# Annexes

• A stimulating notion, The Economist, 14.02.2008
• Paul Krugman: Extrait du livre Pourquoi les Crises reviennent toujours? Pages 25-30, l’exemple de la crise de la coopérative de baby-sitting de Capitol Hill.