Title: ISLaMic Economics: Monetary and Fiscal Policy
1ISLaMic EconomicsMonetary and Fiscal Policy
2What 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
3Macroequilibrium in Real Sector
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5Equilibrium in Monetary Sector
- Levels of income (Y) and interest (r) at which
demand for money supply of money
6Reality Check
- Do you think Ben Bernanke and Henry Paulson know
what the hell is going on? - I will try to explain the model that they more or
less follow.
7What do you want to learn?
- Explanation of complex model that you will need
to review carefully (lecture mode), followed by
discussion of applications (current crisis,
ecological economics) - Simple summary of results of model (brief lecture
mode), followed by more detailed discussion of
applications - You have to learn the model yourself from text
and lecture notes
8What 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)
9What Determines S and I?
- SS(r,Y)
- II(r,Y)
- 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
10Equilibrium?
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12IS Curve
r
13Why downward sloping?
- Low interest more profitable investment
opportunities gt more investment gt 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.
14Why 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 one. Cash is most liquid - What is the cost to holding cash?
- What is the cost of holding non-liquid assets?
15How is Demand for Money Related to Income and
Interest?
- What happens to your demand for cash money as
interest rates increase? - As income increases?
- DML(r,Y)
- Equilibrium occurs when DMSM
- What determines SM?
- Discoveries of silver and gold?
- Ben Bernanke?
- Equilibrium occurs when L(r,Y)M
16LM Curve
17Why does LM slope upwards?
- More income greater demand for money. Less
money available to lend. Higher r required for
equilibrium
18Moving Towards Equilibrium in LM
- MgtL
- 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
19Combining IS and LM
- Two simultaneous equations with two unknowns
- One unique combination of r and Y for which IS,
LM - Equilibrium in real and monetary sector
- We do not assume that economy is in equilibrium,
but rather that it is moving towards it
20Combining IS and LM
21How 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
22Non-Policy Changes IS
- Propensity to Save
- What has happened to US propensity to save?
- SltI for all I, injection into economy (I) gt
leakage (S) for all Y and r on old equilibrium - Income increase until IS again, new equilibrium
- Lower savings rate, but higher income.
- IS curve shifts to right
- More expenditure stimulates investment. IS curve
shifts to right - Paradox of thrift
- Increase in productivity of capital
23Non-Policy changes LM
- Increase in liquidity preference
- LgtM
- 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)
24r
25Monetary 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)
26Current Monetary Policy
- Discount window from 5.75 August 2007 to 1.25
today Fed funds rate shows similar plunge to 1 - NYT Headlines
- A Rate of Zero Percent From the Fed? Some
Analysts Say It Could Be Coming
27Monetary 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 Mnominal 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'
28Fiscal Policy
- Taxation
- Reduces demand, contracts economy, drives down
interest rates - Government expenditure
- Stimulates investment, expands economy
- Drives up interest rates
- Crowding out
- When economy is at full capacity, government
expenditure simply displaces private sector
expenditure
293 Ways for Government to Spend
- Tax and spend
- Spending more than counteracts equal tax
- Surplus taxes gt expenditures
- Borrow and spend
- Greater short term impact than tax and spend
- Deficit expenditures gt 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
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31NYT 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.
32Is this true? Real World Fiscal Policy the
Federal deficit
33Who 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)
34What 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
35Inflation, 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
- Disinflation
- Predicted vs. unpredicted
- Deflation
- More feared than inflation
- Creates incentive not to spend money
36Deflation
- 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.
37Fighting Deflation
- Bernankes 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.
38Fighting 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
39Unemployment and Inflation
- Decreasing Y increases unemployment
- 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?
40Unemployment and National Income
- Positive feedback loops (vicious circles)
- Fiscal policies and stability
- Welfare payments
- Unemployment insurance
41What Does Fed Target?
- Bernanke
- 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.
42Why 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
43- 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
44Impact of Policies on Scale, Distribution and
Allocation
- What should our goals be?
- Sustainable Scale
- Just Distribution
- Efficient allocation
- Stability
- How do we reduce consumption without increasing
unemployment, while making poor better off? - What is appropriate balance between market goods
and public goods?
45Monetary 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
46Fiscal Policy
- Taxes
- 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
47Fiscal Policy
- Subsidies
- Research and development
- Activities that provide positive externalities
'subsidize goods, not bads'
48Fiscal 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