ISLaMic Economics: Monetary a nd Fiscal Policy. Headlines. Obama Plans Major Shifts in Spending To Pay for Health Care, Obama Looks to Taxes on Affluent Reports Show More Signs of Downturn Preparing for a Flood of Energy Efficiency Spending Home Sales and Prices Continue to Plummet
Discussed real sector of economy: production and income
Discussed monetary sector
How do the consumers, savers, lenders, borrowers, and monetary authorities interact to determine level of national income and rate of interest?
Rough model. “Economics is a two-digit science”
Levels of income (Y) and interest (r) at which demand for money = supply of money
What happens to savings as income (Y) increases?
Who saves more, the poor or the rich?
What happens to savings as interest rates (r) increase?
Would you save more in a hedge fund at 20% or in government bonds at 2%?
What happens to investment as income increases?
Will firms invest more when people are buying lots of stuff or nothing?
What happens to investment as interest rates increase?
Would you be more likely to start your own business with interest rates at 1% or 20%? (Both rates exist today)
Equilibrium in real sector occurs when S(r,Y)=I(r,Y)
One equation, two unknowns
Depicted by IS curve
Assumption is that economy is always moving towards equilibrium
Low interest = more profitable investment opportunities => more investment => more income
Higher income = more savings
Higher interest = more savings?
Do poor people carry credit card debt at 20%?
When savings are high, interest rates must be low for sectors to balance.
Avoids inconvenience of barter
Transactions demand for money
More income = more transactions = more transactions demand for money
Liquidity preference: we prefer liquid assets to frozen ones. Cash is most liquid
What is the cost to holding cash?
What is the cost of holding non-liquid assets?
What happens to your demand for cash money as interest rates increase?
As income increases?
Equilibrium occurs when DM=SM
What determines SM?
Discoveries of silver and gold?
Equilibrium occurs when L(r,Y)=M
More income = greater demand for money. Less money available to lend. Higher r required for equilibrium
More money available than people want
Use excess to buy non-liquid interest bearing assets, e.g. Bonds
Demand for bonds increases, price increases, interest rate on bond goes down.
Increase in supply of money drives interest rate down
Lower r = lower opportunity cost of holding money, higher demand for money
Lower r = greater Y = higher demand for money
Two simultaneous equations with two unknowns
One unique combination of r and Y for which I=S, L=M
Equilibrium in real and monetary sector
We do not assume that economy is in equilibrium, but rather that it is moving towards it.
Perhaps better to assume that economy is never in equilibrium, but that monetary and fiscal policy are likely to push it in specific directions under certain circumstances
Comparative statics: How do r and Y respond to exogenous changes?
Changes include monetary and fiscal policy as well as liquidity preferences, propensity to save, efficiency of capital investment, etc.
How does the economy move towards equilibrium when policy pushes it away?
Doesn't look at dynamic path
Was current crisis an exogenous change? In the US? Internationally?
Propensity to Save
What has happened to US propensity to save?
In last 50 years? In last 50 weeks?
S>I for all I, injection into economy (I) < leakage (S) for all Y and r on old equilibrium
Income decreases until I=S again, new equilibrium
Higher savings rate, but lower income.
Less expenditure deters investment. IS curve shifts to left
Paradox of thrift
How can policy counter this?
Increase in liquidity preference
Higher r required to induce lending
Each level of Y associated with higher r on new LM
Same thing occurs from decrease in M (monetary policy)
How can policy counter this?
Reserve requirements (within bounds set by congress)
Allows private banks to create more or less money
Interest rates (discount window)
Rate at which Fed loans money to banks
Open market operations: buying and selling government securities (bonds)
Changes money supply.
Goal typically is to increase or decrease overnight interest rates for banks loaning to one another (Fed funds rate)
Increase in M shifts LM curve downwards (to right)
Higher income, lower interest
Decrease in M shifts LM curve upwards (to left)
Why would we want to decrease M?
Real M=nominal M/P
Any other reasons?
When demand is inadequate, firms have excess capacity, increasing money supply (reducing r) has no impact on investments.
'Pushing on a string'
Reduces demand, contracts economy, drives down interest rates
Stimulates investment, expands economy
Drives up interest rates if competing with private sector
When economy is at full capacity, government expenditure simply displaces private sector expenditure
This was dominant belief until last year
Tax and spend
Spending more than counteracts equal tax
Surplus = taxes > expenditures
Borrow and spend
Greater short term impact than tax and spend
Deficit = expenditures > taxes
Borrowing now = taxes in future
Print money and spend
Does not increase interest rates
Threat of inflation
We could increase reserve requirements, give government more control
Is inflation a problem?
Good for debtors, bad for creditors
2% inflation x 7 trillion debt (at fixed interest) = 140 billion “inflation tax”
Also tax on those who hold money (reduce L).
Facilitates price adjustments
Predicted vs. unpredicted
Moderate inflation vs. hyperinflation
Predicted vs. unpredicted
More feared than inflation
Creates incentive not to spend money
NYT Headline (Nov. 1) Fear of Deflation Lurks as Global Demand Drops
NYT 2005, calling Bernanke a safe choice: “The lessons of the Depression sometimes seem to hover behind much of his thinking. Shortly after becoming a Fed governor in 2002, for example, Mr. Bernanke argued forcefully for tough action to head off a possible epidemic of deflation, or downward spiraling prices.”
Reduce demand (typical approach)
Can be targeted
Raise interest rates: bad for debtors, good for creditors, bad for farming, construction
Decrease money supply
Either one can increase unemployment, reduce wages
NAIRU and Phelps
Bargaining power of labor vs. capital
Wage push or Profit push inflation?
Impact on wages
Does this work in global economy?
“he is trying to establish himself as an inflation fighter”
“speaking out on a wide array of topics about the economy as well as about the central bank's need to become more open and to peg policy to publicly stated inflation targets.”
“As both an academic and former Fed governor, he focused on the importance of the Fed's anti-inflation credibility.”
Who are the Fed's constituents?
Where do Fed reserve governors come from?
Why do stock markets dislike inflation?
Inflation increases uncertainty
Fear of higher interest rates
''They needed somebody that everybody, including the financial markets, would react positively to.''
“But Mr. Bernanke had what many outsiders wanted: a world-class reputation among economists; credibility on Wall Street”
What should our goals be?
How do we reduce consumption without increasing unemployment, while making poor better off?
What is appropriate balance between market goods and public goods?
Only affects market goods directly
Difficult to simultaneously address scale and distribution
Poor at dealing with public goods, including ecosystem services
Changing reserve requirements
Can be targeted: 'tax bads, not goods'; 'tax what we take, not what we make'
Reduces overall consumption
Can have important impact on scale
Research and development
Activities that provide positive externalities: 'subsidize goods, not bads'
Can be targeted: welfare for corporations or for the poor?
Public goods or private goods? What offers highest marginal benefits?
Investments in human made vs. natural K
Crowding out in a full world