Stabilizers and Multipliers

Chapter 21,22, 24, 28, 29

Consumption and Investment Expenditure are Sensitive to the Business Cycle • Multiplier Effect: When household income increases, household consumption will also increase.

• Financial Accelerator Effect: Download When business cycle conditions improve, business cash flow also improves. Businesses, especially those without access to financial markets, rely on cash flow for financing.

Expenditure is a Feedback Loop

• Consumption and Investment Expenditure are determined by household and corporate income.

• Income is determined by the value added of output in the economy.

• Output (at a given wage level) will be determined by demand for expenditure.

Multiplier Effect

Production Consumption Income Savings

Multiplier Effect 2

Production Consumption Income Savings

Multiplier Effect 3

Production Consumption Income Savings

Multiplier Effect in the Open Economy • Multiplier feedback is moderated by international trade.

• Some of the extra expenditure generated by extra income/cash flow will be spent on imports and thus not generate extra demand for domestic goods.

• Multiplier effect smaller in economies that spend a high fraction of their income on imported goods.

Multiplier Effect: Open Economy

Production Imports Consumption Income Savings

Investment & Business Cycles

• Corporate & residential investment tends to be one of the most pro-cyclical economic variables though rising real rates during boom may tend to ameliorate these effects.

• Reasons: – Investment may be a driver of business cycles due to animal spirits or advances in technology.

– Financial Accelerator Effect

Stabilizers

Monetary Policy

Channel of Monetary Policy

• When the central bank increases the monetary base, the money supply will increase.

• Banks have excess liquidity which they use to make more loans.

• The supply of liquidity will exceed demand and banks must compete to attract borrowers who will hold this liquidity only at a lower interest rate.

Dynamics of Monetary Transmission • Money supply expansion reduces interest rates • Lower interest rates implies an increase in borrowing and affects demand for interest sensitive goods. • Lower interest rates increase demand for US$ in forex market depreciating the exchange rate. • Aggregate demand shifts out. Given fixed input prices this increase in demand stimulates output.

Monetary Transmission Mechanism ECB Web Site

P Expansionary Monetary Policy ΔI ΔC, ΔNX

AD AD ′

Y

P * P monetary policy 3 Y P

SRAS

2 1

Output Gap AD AD ′

Y

LT Y P . 2. Monetary Policy Cuts Interest Rate 3. Investment rises. The AD curve shifts out.

4. Tight labor markets. SRAS returns to long run equilibrium

Interest Rate Management

• In most economies around the world, the central bank does not simply act to maintain a fixed money supply.

• Rather, they adjust money supply to maintain and manage interest rate changes in response to business cycle conditions.

Monetary Policy

• In the US (and Euroland and Japan and most OECD economies), the central bank sets monetary policy by picking a short-run interest rate they would like to prevail. • In HK, the central bank sets monetary policy by picking a fixed exchange rate.

U.S. Central bank cuts interest rates during recessions

w/ Counter-cyclical monetary policy P P * 1 Y * 2 Y P

Recessionary Gap SRAS AD AD ′

Y

a recession. Fed detects deflationary pressure 2. Monetary Policy Cuts Interest Rate 3. Investment increases spending to shift the AD curve back to long run equilibrium

w/ Counter-cyclical monetary policy P P * Y P

SRAS

1

expansion. Fed detects inflationary pressure 2. Monetary Policy Raises Interest Rate

2

Inflationary Gap AD ′ AD

Y

3. Investment decreases spending to shift the AD curve back to long run equilibrium

Taylor Rule • • Economist named John Taylor argues that US target interest rate is well represented by a function of 1. current inflation 2. Inflation GAP: current inflation vs. target inflation 3. Output Gap: % deviation of GDP from long run path Function: Inflation Target π * = .02

i t TGT

 .025

 

t

2 (  

t

 * ) 2

Output Gap t

The Taylor Rule Download

What should be the current Fed Funds rate? Will they be increasing it soon?

• Step 1. Find Inflation Rate • Step 2. Find Output Gap • Step 3. Calculate Taylor Rule implied rate and compare with current rate.

P_2008_2 P_2007_2 Inflation Y YP Output Gap Inflation Gap Taylor Rule Fed Funds Rate

Answer

121.91

120.00

0.016

11740.3

11904.0

-0.014

-0.004

0.032

0.02

US Recessions are becoming shorter as stabilization policies were adopted.

Average Length of Contraction

10 5 0 25 20 15 1854-1919 1919-1945 1945-2001

Fiscal Policy

Sources of Revenue HK 2004/2005 Land Premium & Sales 20% Profit Tax 24% Investment Income 10% Betting, Fees, Duties 25% Salaries Tax & Property, Other 21%

HK Government Outlays by Category 2005/06 Support 12% Community Affairs Economic 3% 6% Social Welfare 14% Education 22% Security 10% Infrastructure 10% Housing 6% Health 13% Environment and Food 4%

Fiscal Policy

• The government directly controls its own expenditure and can thereby directly affect aggregate demand.

• The government controls the tax levels and therefore they can indirectly impact the spending of households that pay taxes. – Expansionary policy: Increase spending, cut taxes.

– Contractionary policy: Decrease spending, raise taxes

Stabilization policy • In an economy subject to shocks to aggregate demand (animal spirit shocks, external shocks, asset market shocks), the economy will have a self-correcting mechanism. • However, if this self-correction mechanism takes a long time to work, then government may use policy to speed adjustment.

– Use expansionary policy to close a recessionary gap – Use contractionary policy to close an inflationary gap

Demand Driven Recession w/ Counter-cyclical fiscal policy P P * 2 3 Y P 1 Y *

Recessionary Gap 1. Economy in LT equilibrium SRAS 2. Demand shifts in AD ′ 3. Government increases AD spending to shift the AD curve back

Y

Demand Driven Expansion w/ Counter-cyclical fiscal policy P P * Y * 1 3 Y P 2

1. Economy in LT equilibrium SRAS 2. Demand shifts out AD 3. Government cuts spending to AD ′ shift the AD curve back

Y

Inflationary Gap

Lags and Fiscal Policy

• Administrative lags for fiscal policy may likely be large.

• Except in absolute dictatorships, government will have mechanisms for building a consensus for expenditures. Adjusting this consensus will be time consuming.

• If lags are too long, stabilizing government spending or transfer payments may have a destabilizing effect, shifting out demand after the economy has already recovered.

Automatic Stabilizers

• Taxes are usually collected as a fraction of incomes of households. Even if the government keeps the tax rate unchanged.

– When the economy goes into a boom, taxes are automatically raised mitigating the effects of the boom. – When the economy goes into a recession, taxes are automatically cut, ameliorating the recession.

Budget Deficit

• Governments in most economies issue debt to make up for shortfalls in revenues in relation to spending.

Budget Deficit = Expenditures – Taxes

• Tax collection is cyclical so the budget deficit tends to be counter-cyclical. • Maintaining a balanced budget over the cycle means raising taxes in a recession an cutting taxes in a boom which makes the business cycle more extreme.

Procyclical Budget Surplus in HK .12

.08

.04

.00

-.04

-.08

1990 1992 1994 1996 1998 2000 2002 2004 2006 Budget Surplus (as a % of GDP) Detrended GDP

Most Economies Have Positive Government Debt.

Debt/GDP 180 160 140 120 100 80 60 40 20 0

Why would a persistent deficit be a problem?

Two Reasons 1. High government borrowing may push up interest rates and crowd out investment 2. High government borrowing means that the interest obligations of the government will rise.

0.00% -1.00% -2.00% -3.00% -4.00% -5.00% -6.00% -7.00% Budget Surplus in USA (as a % of GDP)

Government Interest Payments per US Resident $1,000.00

$900.00

$800.00

$700.00

$600.00

$500.00

$400.00

$300.00

$200.00

$100.00

$0.00

Hong Kong Has Traditionally had negative Debt.

Government Wealth 800000 700000 600000 500000 400000 300000 200000 100000 0 19 86 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03

Question: Problem with Central Bank Stabilization • Situation: Economy is in long-run equilibrium, but central bank overestimates potential output. • Draw outcome if central bank believes that the potential output is higher than it is.

Learning Outcomes

Students should be able to: • Explain the effect of business cycles on different components of expenditure • Use the Taylor rule to calculate a forecast of U.S. interest rates. • Explain the uses of counter-cyclical monetary and fiscal policy in stabilization.

• Explain the effect of budget deficits on real interest rates on capital markets.

• Explain the negative effects of long-term budget deficits.