MEE-7-Fiscal - Monetary Policy-Final (2021) - Class

MACROECONOMIC
ENVIRONMENT
7. Fiscal And
Monetary Policy
The Composition of Output
and the Policy Mix
• Table summarizes the analysis of the effects of expansionary monetary and
fiscal policy on output and the interest rate (assuming not in a liquidity trap or
in the classical case).
• Monetary policy operates by stimulating interest-responsive components of AD.
• Fiscal policy operates through G and t. Impact depends upon what goods the
government buys and what taxes and transfers it changes.
– Increase in G increases C along with G; reduction in income taxes increases
C.
and the Policy Mix
• Figure shows the policy problem of
reaching full employment output,
Y*, for an economy that is initially at
[Insert Figure 11-8 here]
point E, with unemployment.
– Should a policy maker choose:
⮚ Fiscal policy expansion,
moving to point E1, with
higher income and higher
interest rates.
⮚ Monetary policy expansion,
resulting in full employment
with lower interest rates at
point E2.
⮚ A mix of fiscal expansion
and accommodating
monetary policy resulting in
an intermediate position.
and the Policy Mix
• All of the policy alternatives
increase output, but differ
significantly in their impact on [Insert Figure 11-8 here]
different sectors of the economy →
problem of political economy
• Given the decision to expand
aggregate demand, who should get
the primary benefit?
– An expansion through a decline
in interest rates and increased
investment spending?
– An expansion through a tax cut
and increased personal
consumption?
– An expansion in the form of an
increase in the size of the
government?
Indian Economy, 2013-2014
Application of IS-LM & AD
i
LM
LM’
India in 2013-14
Increase in GDP = 4.5% pa
Increase in rate of interest = from 7% to 8%
i1
Increase in price level = from 6.9% to 10.2%
i2
Money supply increase = 13% pa (tight)
Fiscal deficit = 7.5% pa (huge)
IS’
IS
Y1 Y2 Y
P
AS India in 2014 -15
P1 Increase in gdp = 6%
P2 Decrease in roi = 8% to 6%
AD2
Decrease in Inflation rate = 10% to 6%
AD1
Money supply increase = 16% (easy)
FD decreased = 4% pa
Y1 Y2 Y
POLICY MEASURES DURING PANDEMIC
•RBI undertook several liquidity enhancing measures to manage liquidity situation in the
economy. These measures, inter alia, included injection of durable liquidity of more than `2.7
lakh crore through Open Market Operation (OMO) purchases between February 6-December
4, 2020, `20,000 crore through two purchase auction OMOs in State Development Loans
(SDLs), `1 lakh crore via Targeted Long Term Repo Operations (TLTROs) of up to three years’
tenor, `1.25 lakh crore through Long Term Repo Operations (LTROs) conducted in February-
March 2020, reduction in the Cash Reserve Ratio (CRR) requirement of banks from 4 per cent
of net demand and time liabilities (NDTL) to 3 per cent with effect from March 28, 2020
augmenting primary liquidity in the banking system by about `1.37 lakh crore, raising banks’
limit for borrowing overnight under the Marginal Standing Facility (MSF).
•The fiscal policy response of the Government of India to the pandemic was distinct from other
countries in that the demand stimulus was introduced in a phased manner with prior focus on
measures to provide a cushion for the poor and vulnerable sections of society and to the
business sector (especially the MSMEs). This included one of the world’s largest foodgrains
distribution programme, direct cash transfers to 42 crore individuals, more than 20 crore
Women Jan Dhan accounts, cash support to building and construction workers, `30,000 crore
additional emergency working capital funding for farmers through NABARD, additional pension
payments, provision for free gas cylinders, additional allocation under MGNREGS, as well as
government guarantees for credit, postponement of financial deadlines etc.
Current Fiscal Deficit
Fiscal deficit is targeted at 6.8% of GDP in

2021-22, down from the revised estimate of
9.5% in 2020-21 (4.6% in 2019-20). The
government aims to steadily reduce fiscal
deficit to 4.5% of GDP by 2025-26.
US Economy, 1993-2000
Clinton Greenspan Policy Mix (Deficit Reduction and
Monetary Expansion)
i
LM
LM’ 1991 1992 1993 1994 1995 1996 1997 1998
i1
BS -3.3 -4.5 -3.8 -2.7 -2.4 -1.4 -0.3 +0.8
i2 GDP -0.9 2.7 2.3 3.4 2.0 2.7 3.9 3.7

IS Gr rate(%)
IS’ Roi(%) 7.3 5.5 3.7 3.3 5.0 5.6 5.2 4.8
Y1 Y2 Y
P
Contractionary FP
AS - top income tax rate increased from 28% to 36%
P1 - top corporate tax rate increased from 34% to 36%
P2 - Clinton ended corporate subsidies.
AD2
AD1
Inflation rate averaged 2.6% during 1990s as
compared to 6% earlier.
Y1 Y2 Y
Monetarists
• In 1970s monetarists emerged under Friedman.
• Their belief was that inflation is caused by “too much money

chasing too few goods”.
• They blamed Keynesian policy of too much money to be

created (monetary expansion) as responsible for the
“stagflation” of the 1970s.
• They believe in monetary control and in theory of free markets

(like classicists).
• Economy is self regulating. Governments should not intervene

except to reduce imperfections.
• Rejected Keynesian fiscal policy because it leads to “crowding

out” of the private sector.
Keynesian And Monetarist Views On The
Demand For Money
• Keynesians believe that money and other financial
assets are close substitutes and therefore, a rise in
interest rates will lead to a more than proportionate fall in
the demand for money as people transfer their savings
out of money and into other financial assets. i.e demand
for money is interest – elastic (flat money demand
curve). Consequently they believe that LM curve is also
flat.
• Monetarists believe that demand for money is interest –

inelastic (steep money demand curve). Consequently
they believe that LM curve of an economy is steep.
Keynesian And Monetarist Views On The
Demand For Investment
• Keynesians believe that demand for investment is interest
– inelastic (steep IS curve). They believe that increase in
G will cause a slight increase in roi, but I will decrease
only slightly and thus AD (and Y) will increase
substantially. Alongwith a steep IS curve, a flat LM curve
(because money demand is elastic) makes monetary
policy ineffective in influencing national income. Crowding
out is small & fiscal policy is very effective in influencing
Y.
• According to monetarists, investment is interest – elastic

(flat IS curve). Along with this, a steep LM curve (because
money demand is inelastic) leads to maximum “crowding
out” of private investment on account of higher G and
hence a very small increase in Y i.e. according to
monetarists, fiscal policy is ineffective in influencing
national income. Monetary policy is very effective in
influencing Y.
The Liquidity Trap
• Two extreme cases arise when discussing the effects of
monetary policy on the economy. First is the liquidity
trap.
– Liquidity trap = a situation in which the public is
prepared, at a given interest rate, to hold whatever
amount of money is supplied.
– Implies the LM curve is horizontal. Changes in the

quantity of money do not shift it.
• Monetary policy has no impact on either the
interest rate or the level of income, i.e. monetary
policy is powerless.
• Possibility of a liquidity trap at low interest rates :
Keynes.
The Classical Case
• The opposite of the horizontal LM curve (implies that monetary
policy cannot affect the level of income) is the vertical LM curve.
– If LM is vertical = demand for money is entirely unresponsive
to the interest rate.
– The equation for the LM curve is (1)
M
kY ofhi income
• If h is zero, then there is a unique level
P
corresponding to a given real money supply - VERTICAL
LM CURVE.
• The vertical LM curve is called the classical case (at Yf).

– Rewrite equation (1), with h = 0: (2)
M k ( P Y )
• Implies that nominal GDP depends only on the quantity of
money - quantity theory of money.
The Classical Case
• When the LM curve is vertical
1. A given change in the quantity of money has a maximal effect
on the level of income.
2. Shifts in the IS curve do not affect the level of income.
When the LM curve is vertical, monetary policy has

a maximal effect on the level of income, and fiscal
policy has no effect on income.
• Vertical LM curve implies the comparative effectiveness of

monetary policy over fiscal policy.
– “Only money matters” for the determination of output.
– Requires that the demand for money be unresponsive to i -
important issue in determining the effectiveness of alternative
policies.
Degree Of Crowding Out
• The Classical argument explains full crowding out based
on the proposition that the LM curve is vertical at full
employment level of output.
• Consider an economy with given prices, in which the

economy operates below full employment. Under such
conditions, when fiscal expansion increases demand,
firms can increase their output by hiring more workers.
But if the economy is at full employment level, crowding
out becomes a much more realistic possibility because
firms cannot increase their output through additional
hiring. In this situation an increase in demand will lead to
an increase in price level rather than an increase in
output.
Crowding Out
• In an economy with unemployed resources full crowding
out will not occur because the LM curve is not vertical. A
fiscal expansion will raise interest rates, but income will
also rise depending on the slope of the LM curve.
Crowding out, if it occurs, is thus a matter of degree.
• There is evidence of significant crowding out of private

credit by govt borrowing in developing countries.
Exercise
• Suppose the consumption function is given by C = 100 +
0.8Y while investment is given by I = 50.
a) What is the equilibrium level of income?
b) What is the level of saving in equilibrium?
c) If for some reason, output is at the level of 800, what will

be the level of involuntary inventory accumulation?
d) If I rises to 100, what will be the effect on the equilibrium

income?
e) What is the value of the multiplier, α, here?

Exercise
• Suppose we have an economy described by the
following functions:
C=50+0.8YD; I=70; G=200; TR=100; t=0.20
a)Calculate the equilibrium level of income and multiplier in
this model.
b)Calculate the budget surplus(BS).
c)Suppose t increases to 0.25. What is the new eqn
income? The new multiplier?
d)Calculate the change in BS. Would you expect the
change in BS to be more or less if c=0.9 rather than 0.8.
e)Explain why multiplier is one when t=1.
Exercise
Given C=0.8(1-t)Y; t=0.25; I=900-50i; G=800;
L=0.25Y-62.5i; M/ P=500.
a) What is the equation that describes the IS curve?
b) What is the equation that describes the LM curve?
c) What are the equilibrium levels of income and the
interest rate?
d) What is the value of αG multiplier?
e) By how much does an increase in government
spending of ΔG increase the level of income in this
model, which includes the money market?
f) By how much does a change in government spending
of ΔG affect the equilibrium interest rate?
g) Explain the difference between your answers to parts

Exercise
• Show that a given change in the money
stock has a larger effect on output the less
interest-sensitive is the demand for
money.
• How does the response of the interest rate

to a change in the money stock depend on
the interest sensitivity of money demand
(i.e.h)?
Deriving the AD Schedule
• Derive the equation for the AD curve using the equations
for the IS-LM curves: IS : Y G ( A  bi )
1 M
LM : i   kY  
h P
• Substituting LM equation into the IS equation:
 b M 
Y  G  A   kY   
 h P 
h G b G M
 A (3)
h  kb G h  kb G P
• By equating IS and LM, the eqn that we get in terms of i is –

i = kαG A - 1 M
h+kbαG h+kbαG P

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MACROECONOMIC

Fiscal deficit is targeted at 6.8% of GDP in

i2 GDP -0.9 2.7 2.3 3.4 2.0 2.7 3.9 3.7

• Their belief was that inflation is caused by “too much money

• They blamed Keynesian policy of too much money to be

• They believe in monetary control and in theory of free markets

• Economy is self regulating. Governments should not intervene

• Rejected Keynesian fiscal policy because it leads to “crowding

• Monetarists believe that demand for money is interest –

• According to monetarists, investment is interest – elastic

– Implies the LM curve is horizontal. Changes in the

• The vertical LM curve is called the classical case (at Yf).

When the LM curve is vertical, monetary policy has

• Vertical LM curve implies the comparative effectiveness of

• Consider an economy with given prices, in which the

• There is evidence of significant crowding out of private

a) What is the equilibrium level of income?

b) What is the level of saving in equilibrium?

c) If for some reason, output is at the level of 800, what will

d) If I rises to 100, what will be the effect on the equilibrium

e) What is the value of the multiplier, α, here?

g) Explain the difference between your answers to parts

• How does the response of the interest rate

• By equating IS and LM, the eqn that we get in terms of i is –

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