islamic economics monetary a nd fiscal policy n.
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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

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Presentation Transcript
  • 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
  • Now Is No Time to Cut Research
  • Bernanke Again Rejects Bank Takeovers
  • California Drought Drives Up Joblessness
what is islm economics
What is ISLM economics?

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”

equilibrium in monetary sector
Equilibrium in Monetary Sector

Levels of income (Y) and interest (r) at which demand for money = supply of money

reality check
Reality Check
  • Do you think Ben Bernanke and Geithner know what the hell is going on?
  • I will try to explain the model that they more or less follow.
what determines s and i
What Determines S and I?

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)

what determines s and i1
What Determines S and I?



Equilibrium in real sector occurs when S(r,Y)=I(r,Y)

One equation, two unknowns

Multiple solutions

Depicted by IS curve

Assumption is that economy is always moving towards equilibrium

why downward sloping
Why downward sloping?

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.

why do people demand money instead of real assets
Why do people demand money instead of real assets?

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?

how is demand for money related to income and interest
How is Demand for Money Related to Income and Interest?

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?

Ben Bernanke?

Equilibrium occurs when L(r,Y)=M

why does lm slope upwards
Why does LM slope upwards?

More income = greater demand for money. Less money available to lend. Higher r required for equilibrium

moving towards equilibrium in lm
Moving Towards Equilibrium in LM


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

combining is and lm
Combining IS and LM

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

how do we use this
How do we use this?

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?

non policy changes is
Non-Policy Changes: IS

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?

non policy changes lm
Non-Policy changes: LM

Increase in liquidity preference


Higher r required to induce lending

Each level of Y associated with higher r on new LM

Shift upward

Same thing occurs from decrease in M (monetary policy)

How can policy counter this?

monetary policy 3 tools fed can use
Monetary Policy: 3 tools Fed can use:

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)

current monetary policy
Current Monetary Policy
  • Discount window from 5.75% August 2007 to ~0% today; Fed funds rate shows similar plunge
  • NYT Headlines from last year:
    • A Rate of Zero Percent From the Fed? Some Analysts Say It Could Be Coming
monetary policy
Monetary Policy

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?

Liquidity trap

When demand is inadequate, firms have excess capacity, increasing money supply (reducing r) has no impact on investments.

'Pushing on a string'

fiscal policy
Fiscal Policy


Reduces demand, contracts economy, drives down interest rates

Government expenditure

Stimulates investment, expands economy

Drives up interest rates if competing with private sector

Crowding out

When economy is at full capacity, government expenditure simply displaces private sector expenditure

This was dominant belief until last year

3 ways for government to spend
3 Ways for Government to Spend

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

nyt description
NYT description
  • “The Federal Reserve, through its power to raise and lower interest rates, exercises more influence over economic growth and the level of employment than any other government entity. That unusual role dates from the 1970s, when the executive branch and Congress pulled back from the use of fiscal tools — vast New Deal spending and targeted tax cuts — as a means of regulating prosperity.”
who controls the fed
Who Controls the Fed?
  • The governors appointed by the president, approved by Congress
  • Chair appointed for 14 years
  • Regional bank presidents “selected by leaders of their communities, particularly bankers.” (NYT)
what is the goal of the fed
What is the goal of the Fed?
  • Officially to target unemployment and inflation
  • “Their main thrust has been to limit inflation, even at the risk of a recession — although they have cut rates when the nation seemed in danger of one, as the Bernanke Fed has recently done.”
  • The Task Ahead: First on To-Do List: Tame Inflation by DAVID LEONHARDT
inflation disinflation deflation
Inflation, Disinflation, Deflation

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.”

fighting deflation
Fighting Deflation
  • Bernanke’s remedies
    • Buying treasury securities with longer maturities
    • Buy up privae debt, e.g. corporate bonds
    • “In effect, the Federal Reserve would be printing more money and injecting it into the economy — a strategy of “quantitative easing,” in Fed jargon.”
fighting inflation
Fighting Inflation

Increase supply

Reduce demand (typical approach)

Fiscal policy

Increase taxes

Decrease spending

Can be targeted

Monetary policy

Raise interest rates: bad for debtors, good for creditors, bad for farming, construction

Decrease money supply

Blunt instrument

Either one can increase unemployment, reduce wages

unemployment and inflation
Unemployment and Inflation

NAIRU and Phelps

Bargaining power of labor vs. capital

Black death

Wage push or Profit push inflation?

Impact on wages

Does this work in global economy?

unemployment and national income
Unemployment and National Income
  • Positive feedback loops (vicious circles)
  • Fiscal policies and stability
    • Welfare payments
    • Unemployment insurance
what does fed target
What Does Fed Target?


“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.”

why does fed target inflation
Why does Fed Target Inflation?

Who are the Fed's constituents?

Not elected

Where do Fed reserve governors come from?

Why do stock markets dislike inflation?

Inflation increases uncertainty

Fear of higher interest rates

“In settling on Mr. Bernanke, President Bush ... chose a candidate who would satisfy others -- investors on Wall Street, lawmakers in Congress -- more than himself or his Republican base.”

''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”

impact of policies on scale distribution and allocation
Impact of Policies on Scale, Distribution and Allocation

What should our goals be?

Sustainable Scale

Just Distribution

Efficient allocation


How do we reduce consumption without increasing unemployment, while making poor better off?

What is appropriate balance between market goods and public goods?

monetary policy1
Monetary Policy

Only affects market goods directly

Difficult to simultaneously address scale and distribution

Poor at dealing with public goods, including ecosystem services

Changing reserve requirements

Blunt instrument

fiscal policy1
Fiscal Policy


Can be targeted: 'tax bads, not goods'; 'tax what we take, not what we make'

Reduces overall consumption

Stabilize economy

Can have important impact on scale

fiscal policy2
Fiscal Policy


Research and development

Activities that provide positive externalities: 'subsidize goods, not bads'

fiscal policy3
Fiscal Policy

Government expenditures

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