fiscal and monetary policy

1. Fiscal andFiscal and
Monetary PolicyMonetary Policy

2. Fiscal and Monetary Policy
The Nature of Fiscal
Policy

3. THE NATURE OF FISCAL POLICY
The purpose of fiscal policy
correcting a fundamental disequilibrium
fine tuning
Government finances
budget deficits and surpluses
financing a deficit
the PSNCR

4. UK public-sector deficits/surpluses: 1979–2001UK public-sector deficits/surpluses: 1979–2001

5. UK public-sector deficits/surpluses: 1979–2001UK public-sector deficits/surpluses: 1979–2001

6. UK public-sector deficits/surpluses: 1979–2001UK public-sector deficits/surpluses: 1979–2001

7. UK public-sector deficits/surpluses: 1979–2001UK public-sector deficits/surpluses: 1979–2001

8. Annualgrowthrate(%)UK general government expenditure as % of GDP
34
36
38
40
42
44
46
48
50
1970 1975 1980 1985 1990 1995 2000

9. Annualgrowthrate(%)UK general government expenditure as % of GDP
34
36
38
40
42
44
46
48
50
1970 1975 1980 1985 1990 1995 2000

10. H General public services 4.4%
I Housing, etc 3.6%
J Recreation, etc 1.7%
K Environment 0.9%
1991 1999
UK general government expenditure by function (%)
H General public services 5.1%
I Housing, etc 1.5%
J Recreation, etc 1.0%
K Environment 0.7%

11. H General public services 4.4%
I Housing, etc 3.6%
J Recreation, etc 1.7%
K Environment 0.9%
1991 1999
UK general government expenditure by function (%)
H General public services 5.1%
I Housing, etc 1.5%
J Recreation, etc 1.0%
K Environment 0.7%

12. General government deficits/surplusesGeneral government deficits/surpluses
and debt as % of GDPand debt as % of GDP

13. General government deficits/surplusesGeneral government deficits/surpluses
and debt as % of GDPand debt as % of GDP

14. THE NATURE OF FISCAL POLICY
The purpose of fiscal policy
correcting a fundamental disequilibrium
fine tuning
Government finances
budget deficits and surpluses
financing a deficit
the PSNCR
the national debt and public-sector debt

15. Getting budget deficits down?
-3
-1
1
3
5
7
9
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Budgetdeficitsasa%ofGDP

16. France
-3
-1
1
3
5
7
9
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Budgetdeficitsasa%ofGDP Getting budget deficits down?

17. FranceGermany
-3
-1
1
3
5
7
9
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Budgetdeficitsasa%ofGDP Getting budget deficits down?

18. FranceGermany
Italy
-3
-1
1
3
5
7
9
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Budgetdeficitsasa%ofGDP Getting budget deficits down?

19. Spain
FranceGermany
Italy
-3
-1
1
3
5
7
9
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Budgetdeficitsasa%ofGDP Getting budget deficits down?

20. Spain
FranceGermany
Italy
Belgium
-3
-1
1
3
5
7
9
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Budgetdeficitsasa%ofGDP Getting budget deficits down?

21. Spain
FranceGermany
Italy
Netherlands
Belgium
-3
-1
1
3
5
7
9
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Budgetdeficitsasa%ofGDP Getting budget deficits down?

22. 30
35
40
45
50
55
60
65
70
75
80
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
National Debt
(as % of GDP)
National Debt

23. 30
35
40
45
50
55
60
65
70
75
80
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
National Debt
(as % of GDP)
National Debt
UK

24. 30
35
40
45
50
55
60
65
70
75
80
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
USA
National Debt
(as % of GDP)
National Debt
UK

25. 30
35
40
45
50
55
60
65
70
75
80
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
Euro
area
USA
UK
National Debt
(as % of GDP)
National Debt

26. THE NATURE OF FISCAL POLICY
Public-sector deficits or surpluses and
the government’s fiscal stance
fiscal stance and the state of the economy
the structural balance
Automatic fiscal stabilisers
tax stabilisers
benefits stabilisers

27. O
G, T
Y
Tax revenue
Gov. expenditure
(incl. benefits)
Y1
DEFICIT
SURPLUS
National income and the size of the public-sector deficit or surplus

28. THE NATURE OF FISCAL POLICY
Public-sector deficits or surpluses and
the government’s fiscal stance
fiscal stance and the state of the economy
the structural balance
Automatic fiscal stabilisers
tax stabilisers
benefits stabilisers
Discretionary fiscal policy

29. THE NATURE OF FISCAL POLICY
Public-sector deficits or surpluses and
the government’s fiscal stance
fiscal stance and the state of the economy
the structural balance
Automatic fiscal stabilisers
tax stabilisers
benefits stabilisers
Discretionary fiscal policy
changing government expenditure

30. THE NATURE OF FISCAL POLICY
Public-sector deficits or surpluses and
the government’s fiscal stance
fiscal stance and the state of the economy
the structural balance
Automatic fiscal stabilisers
tax stabilisers
benefits stabilisers
Discretionary fiscal policy
changing government expenditure
changing taxes

31. A cut in taxes: (a) lump-sum taxes
O
W, J
Y
W1

32. O
W, J
Y
W1
W2
A cut in taxes: (a) lump-sum taxes

33. O
W, J
Y
W1
W2
∆T x mpcd
A cut in taxes: (a) lump-sum taxes

34. A cut in taxes: (b) cut in tax rates
O
W, J
Y
W1

35. O
W, J
Y
W1
W2
A cut in taxes: (b) cut in tax rates

36. O
W, J
Y
W1
W2
∆T x mpcd
A cut in taxes: (b) cut in tax rates

37. Fiscal and Monetary Policy
The Effectiveness of
Fiscal Policy

38. EFFECTIVENESS OF FISCAL POLICY
Effectiveness of automatic stabilisers
adverse supply-side effects
the problem of fiscal drag
Discretionary policy: problems of
forecasting the magnitude of the effect
effects on other injections and withdrawals
crowding out

39. O
W, J
Y
(a) The goods market(a) The goods market
W
J1
Y1
The monetary effects of fiscal policy

40. O O
W, J
Rate of
interest
Y Money
(a) The goods market(a) The goods market (b) The money market(b) The money market
W
J1
Y1
MS
L1
r1
The monetary effects of fiscal policy

41. O O
W, J
Rate of
interest
Y Money
(a) The goods market(a) The goods market (b) The money market(b) The money market
W
J1
Y1
MS
L1
r1
Y2
J2
An expansionary
fiscal policy
The monetary effects of fiscal policy

42. O O
W, J
Rate of
interest
Y Money
(a) The goods market(a) The goods market (b) The money market(b) The money market
W
J1
Y1
MS
L1
r1
Y2
J2
An expansionary
fiscal policy
L2
r2
Effect on the
demand for money
The monetary effects of fiscal policy

43. O O
W, J
Rate of
interest
Y Money
(a) The goods market(a) The goods market (b) The money market(b) The money market
W
J1
Y1
MS
L1
r1
Y2
J2
An expansionary
fiscal policy
L2
Accommodating
increase in the
money supply
MS2
r2
The monetary effects of fiscal policy

44. EFFECTIVENESS OF FISCAL POLICY
Effectiveness of automatic stabilisers
adverse supply-side effects
the problem of fiscal drag
Discretionary policy: problems of
forecasting the magnitude of the effect
effects on other injections and withdrawals
crowding out
size of the multiplier and accelerator
effects

45. EFFECTIVENESS OF FISCAL POLICY
Discretionary fiscal policy: problems of
timing and time lags
various time lags
policy may be destabilising

46. Fiscal policy: stabilising or destabilising?
O
Realnationalincome
Time
1
2
3
4
1
2
3
4
Path (a): no intervention

47. O
Realnationalincome
Time
1
2
3
4
1
2
3
4
Path (a): no intervention
Path (b): policy stabilises
Fiscal policy: stabilising or destabilising?

48. O
Realnationalincome
Time
1
2
3
4
1
2
3
4
Path (a): no intervention
Path (c): policy destabilises
Path (b): policy stabilises
Fiscal policy: stabilising or destabilising?

49. EFFECTIVENESS OF FISCAL POLICY
Discretionary fiscal policy: problems of
timing and time lags
various time lags
policy may be destabilising
Side-effects of discretionary fiscal
policy

50. EFFECTIVENESS OF FISCAL POLICY
Discretionary fiscal policy: problems of
timing and time lags
various time lags
policy may be destabilising
Side-effects of discretionary fiscal
policy
Changing government expenditure
versus changing taxes

51. Fiscal and Monetary Policy
Varieties of Monetary
Policy

52. VARIETIES OF MONETARY POLICY
The policy setting
historical approaches to monetary policy
current approach to monetary policy
Control of money supply over medium
and long term
control of banks’ liquidity ratio
restricting size of PSNCR
Short-term monetary control: the
alternatives

53. The demand for and supply of money
O
Money
Rateofinterest
MS
L
r1
Q1

54. O
Money
Rateofinterest
L
r1
Q1
r2
Q2
MS'
The demand for and supply of money
MS

55. VARIETIES OF MONETARY POLICY
Techniques to control money supply
preliminary decisions:
statutory or prudent ratios?
what to control: monetary base or broad
money?
open-market operations
funding
variable minimum reserve ratios

56. Effect of raising the minimum reserve ratio
from 10% to 20%
Initial position: 10% reserve ratio

57. Effect of raising the minimum reserve ratio
from 10% to 20%
Initial position: 10% reserve ratio
New position: 20% reserve ratio

58. VARIETIES OF MONETARY POLICY
Techniques to control money supply
preliminary decisions:
statutory or prudent ratios?
what to control: monetary base or broad
money?
open-market operations
funding
variable minimum reserve ratios
Techniques to control interest rates

59. VARIETIES OF MONETARY POLICY
Techniques to control money supply
preliminary decisions:
statutory or prudent ratios?
what to control: monetary base or broad
money?
open-market operations
funding
variable minimum reserve ratios
Techniques to control interest rates
statutory base rates

60. VARIETIES OF MONETARY POLICY
Techniques to control money supply
preliminary decisions:
statutory or prudent ratios?
what to control: monetary base or broad
money?
open-market operations
funding
variable minimum reserve ratios
Techniques to control interest rates
statutory base rates
operations in discount and repo markets

61. Bank of England operations in the bill and
gilt repo markets to raise interest rates
O
(a) Bank of England sells more bills
Rateofdiscount
Bills
S1 by B. of E.
r1
D by banks

62. r2
Bank of England operations in the bill and
gilt repo markets to raise interest rates
O
Rateofdiscount
Bills
S1 by B. of E.
S2 by B. of E. D by banks
r1
(a) Bank of England sells more bills

63. S by banks
Bank of England operations in the bill and
gilt repo markets to raise interest rates
O
(b) Bank of England buys fewer bills /
Rateofdiscount/giltreporate
Bills and gilts
D1 by B. of E.
r1

64. Bank of England operations in the bill and
gilt repo markets to raise interest rates
O
Rateofdiscount/giltreporate
Bills and gilts
D1 by B. of E.
r1
D2 by B. of E.
r2
S by banks
(b) Bank of England buys fewer bills /

65. VARIETIES OF MONETARY POLICY
Techniques to control money supply
preliminary decisions:
statutory or prudent ratios?
what to control: monetary base or broad money?
open-market operations
funding
variable minimum reserve ratios
Techniques to control interest rates
statutory base rates
operations in discount and repo markets
Credit rationing

66. Fiscal and Monetary Policy
Problems of
Monetary Policy

67. PROBLEMS OF MONETARY POLICY
Medium and long-term control over the
money supply: reducing PSNCR
automatic fiscal stabilisers
the desire to cut taxes
difficulty in cutting government
expenditure

68. PROBLEMS OF MONETARY POLICY
Practical difficulties in short-run
control of the money supply
problems with monetary base control
with statutory cash ratios
without statutory cash ratios
problems with controlling broad liquidity
with statutory reserve ratios
without statutory reserve ratios
the effect on interest rates

69. O
Money
Rateofinterest
MS
L
r
L '
r1
The effect on interest rates of a change in demand for money:
money supply kept at fixed level by the authorities

70. PROBLEMS OF MONETARY POLICY
Problems with credit rationing
Goodhart's law
bank resistance
stifles competition
distortionary effects on economy
Problems with controlling interest rates
inelastic demand for loans

71. O
Demand for loans
Q1Q2
Assume that the authorities
want to reduce the
demand for money to Q2
r1
Loans
Rateofinterest An inelastic demand for loans

72. r2
O
Demand for loans
r1
Q1Q2
A large rise in the
rate of interest (to r2)
will be necessary
Loans
Rateofinterest An inelastic demand for loans

73. PROBLEMS OF MONETARY POLICY
Problems with credit rationing
Goodhart's law
bank resistance
stifles competition
distortionary effects on economy
Problems with controlling interest rates
inelastic demand for loans
unstable demand for money

74. PROBLEMS OF MONETARY POLICY
Problems with credit rationing
Goodhart's law
bank resistance
stifles competition
distortionary effects on economy
Problems with controlling interest rates
inelastic demand for loans
unstable demand for money
possible conflict between domestic goals
and exchange-rate goals

75. PROBLEMS OF MONETARY POLICY
Using monetary policy
problems of using it to manage aggregate
demand
using it to keep to a target
inflation
exchange rate
money supply

76. Fiscal and Monetary Policy
ISLM Analysis of
Fiscal and Monetary
Policy

77. Equilibrium in both the goods and money markets
O
Rateofinterest
National income
IS
re
Ye
LM

78. ISLM ANALYSIS OF FISCAL AND MONETARY POLICY
Fiscal policy and ISLM analysis
shifting the IS curve
effect on interest rates and national
income

79. O
Rateofinterest
National income
LM
IS
r1
Y1
ISLM analysis of fiscal and monetary policy

80. O
Rateofinterest
National income
IS1
r1
Y1
IS2
r2
Y2
Expansionary
fiscal policy
LM
ISLM analysis of fiscal and monetary policy

81. Fiscal policy and ISLM analysis
shifting the IS curve
effect on interest rates and national
income
Monetary policy and ISLM analysis
shifting the LM curve
effect on interest rates and national
income
ISLM ANALYSIS OF FISCAL AND MONETARY POLICY

82. O
Rateofinterest
National income
LM1
IS
r1
Y1
LM2
r3
Y3
Expansionary
monetary policy
ISLM analysis of fiscal and monetary policy

83. Fiscal policy and ISLM analysis
shifting the IS curve
effect on interest rates and national
income
Monetary policy and ISLM analysis
shifting the LM curve
effect on interest rates and national
income
Fiscal and monetary policy together
ISLM ANALYSIS OF FISCAL AND MONETARY POLICY

84. LM2
LM1
O
Rateofinterest
National income
IS1
r1
Y1
IS2
Y4
Expansionary
fiscal and
monetary policy
ISLM analysis of fiscal and monetary policy

85. Analysis under Keynesian assumptions
effectiveness of fiscal policy
ISLM ANALYSIS OF FISCAL AND MONETARY POLICY

86. O
Rateofinterest
National income
LM
IS1
Y1
IS2
Y2
Expansionary
fiscal policy
Keynesian analysis of fiscal and monetary policy

87. Analysis under Keynesian assumptions
effectiveness of fiscal policy
ineffectiveness of monetary policy
ISLM ANALYSIS OF FISCAL AND MONETARY POLICY

88. O
Rateofinterest
National income
LM1
IS
Y1Y2
Expansionary
monetary policy
LM2
Keynesian analysis of fiscal and monetary policy

89. Analysis under Keynesian assumptions
effectiveness of fiscal policy
ineffectiveness of monetary policy
Analysis under monetarist
assumptions
ISLM ANALYSIS OF FISCAL AND MONETARY POLICY

90. Analysis under Keynesian assumptions
effectiveness of fiscal policy
ineffectiveness of monetary policy
Analysis under monetarist
assumptions
ineffectiveness of fiscal policy
ISLM ANALYSIS OF FISCAL AND MONETARY POLICY

91. O
Rateofinterest
National income
LM
IS1
Y1Y2
Expansionary
fiscal policy
IS2
Monetarist analysis of fiscal and monetary policy

92. Analysis under Keynesian assumptions
effectiveness of fiscal policy
ineffectiveness of monetary policy
Analysis under monetarist
assumptions
ineffectiveness of fiscal policy
effectiveness of monetary policy
ISLM ANALYSIS OF FISCAL AND MONETARY POLICY

93. O
Rateofinterest
National income
LM1
IS
Y1 Y2
Expansionary
monetary policy
LM2
Monetarist analysis of fiscal and monetary policy

94. Fiscal and Monetary Policy
Fiscal and Monetary
Policy in the UK

95. Growth
%
-10
-5
0
5
10
1920 1925 1930 1935 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
-10
-5
0
5
10
15
20
25
30
UK growth, unemployment and inflation: 1920−2002

96. Growth
%
-10
-5
0
5
10
1920 1925 1930 1935 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
-10
-5
0
5
10
15
20
25
30
UK growth, unemployment and inflation: 1920−2002

97. Growth
Unemployment
% %
-10
-5
0
5
10
1920 1925 1930 1935 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
-10
-5
0
5
10
15
20
25
30
UK growth, unemployment and inflation: 1920−2002

98. Growth
Unemployment
Inflation
% %
-10
-5
0
5
10
1920 1925 1930 1935 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
-10
-5
0
5
10
15
20
25
30
UK growth, unemployment and inflation: 1920−2002

99. UK Macroeconomic performance: 1921 – 99UK Macroeconomic performance: 1921 – 99UK Macroeconomic performance: 1921 – 99UK Macroeconomic performance: 1921 – 99

100. UK Macroeconomic performance: 1921 – 99UK Macroeconomic performance: 1921 – 99UK Macroeconomic performance: 1921 – 99UK Macroeconomic performance: 1921 – 99

101. UK Macroeconomic performance: 1921 – 99UK Macroeconomic performance: 1921 – 99UK Macroeconomic performance: 1921 – 99UK Macroeconomic performance: 1921 – 99

102. FISCAL AND MONETARY POLICY IN THE UK
Attitudes towards demand
management
Keynesian demand management in the
1950s and 1960s
stop–go policies
monetarist criticisms
Demise of fine tuning in the 1970s
the causes of stagflation
demand management policies in the 1970s
the rise of monetarism

103. Selected monetary indicators: 1969–2001

104. Monetarism in the early 1980s
medium-term financial strategy
the recession of the early 1980s
assessment of the monetarist experiment
return to discretion in mid 1980s
Targeting the exchange rate
its advantages and disadvantages
shadowing the German mark
membership of the ERM (1990–2)
exit from the ERM
FISCAL AND MONETARY POLICY IN THE UK

105. Return to domestic-orientated policies
targeting inflation: 1993–7
Policies of the Labour government
1997
fiscal policy
the 'Golden Rule'
Comparison with EU Stability and Growth Pact
monetary policy
Bank of England inflation target
ECB targets
effectiveness of recent monetary and fiscal
policies
FISCAL AND MONETARY POLICY IN THE UK

106. Fiscal and Monetary Policy
Rules versus
Discretion

107. RULES VERSUS DISCRETION
Case against discretion
time lags
over-correction
government may ignore long-term
consequences
Case for rules
help to reduce inflationary expectations
create a stable environment for investment
and economic growth

108. RULES VERSUS DISCRETION
Case against rules
can cause severe fluctuations in interest
rates and can cause greater instability
which rule to choose?
rules may conflict
rules may become unsuitable
Case for discretion
fine tuning can be improved by better
forecasting and quicker-action

109. RULES VERSUS DISCRETION
Inflation targeting
use of inflation targets around the world

110. Source: The Use of Explicit Targets for Monetary Policy: Practical Experiences
of 91 economies in the 1990s, (Bank of England, August 1999)
Who sets explicit targets and monitoring ranges for
the exchange rate, money and inflation

111. Source: The Use of Explicit Targets for Monetary Policy: Practical Experiences
of 91 economies in the 1990s, (Bank of England, August 1999)
Who sets explicit targets and monitoring ranges for
the exchange rate, money and inflation

112. Source: The Use of Explicit Targets for Monetary Policy: Practical Experiences
of 91 economies in the 1990s, (Bank of England, August 1999)
Who sets explicit targets and monitoring ranges for
the exchange rate, money and inflation

113. Source: The Use of Explicit Targets for Monetary Policy: Practical Experiences
of 91 economies in the 1990s, (Bank of England, August 1999)
Who sets explicit targets and monitoring ranges for
the exchange rate, money and inflation

114. Source: Bank of England

115. RULES VERSUS DISCRETION
Inflation targeting
use of inflation targets around the world
weaknesses of money supply targets

116. RULES VERSUS DISCRETION
Inflation targeting
use of inflation targets around the world
weaknesses of money supply targets
weaknesses of exchange rate targets

117. RULES VERSUS DISCRETION
Inflation targeting
use of inflation targets around the world
weaknesses of money supply targets
weaknesses of exchange rate targets
relative strength of inflation targets

118. RULES VERSUS DISCRETION
Inflation targeting
use of inflation targets around the world
weaknesses of money supply targets
weaknesses of exchange rate targets
relative strength of inflation targets
Issues with inflation targets

119. RULES VERSUS DISCRETION
Inflation targeting
use of inflation targets around the world
weaknesses of money supply targets
weaknesses of exchange rate targets
relative strength of inflation targets
Issues with inflation targets
choice of the target
what level?
central point or ceiling?

120. RULES VERSUS DISCRETION
Issues with inflation targets (cont.)
who sets the target?
changing the target
multiple targets
a Taylor rule for setting interest rates

121. Y0
O
National income
ADI1
Rateofinflation(P)
.
Ptarget
.
ADI curves based on different Taylor rules
a
Y1
Curve ADI1: based on Taylor rule giving
relatively high weight to stable inflation
P1
. b

122. ADI2
Y0
O
National income
ADI1
Rateofinflation(P)
.
Ptarget
. a
Y2Y1
b c
Curve ADI1: based on Taylor rule giving
relatively high weight to stable inflation
Curve ADI2: based on Taylor rule giving relatively
high weight to stable real national income
P1
.
ADI curves based on different Taylor rules

123. RULES VERSUS DISCRETION
Issues with inflation targets (cont.)
who sets the target?
changing the target
multiple targets
a Taylor rule for setting interest rates
targeting inflation and the money supply

124. RULES VERSUS DISCRETION
Issues with inflation targets (cont.)
who sets the target?
changing the target
multiple targets
a Taylor rule for setting interest rates
targeting inflation and the money supply
basing interest rates on forecasts of
inflation

125. RULES VERSUS DISCRETION
Issues with inflation targets (cont.)
who sets the target?
changing the target
multiple targets
a Taylor rule for setting interest rates
targeting inflation and the money supply
basing interest rates on forecasts of
inflation
the problem of deflation