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

IncomeIncome

ProductionProduction

SavingsSavings

ConsumptionConsumption

Multiplier Effect 2

IncomeIncome

ProductionProduction

SavingsSavings

ConsumptionConsumption

Multiplier Effect 3

IncomeIncome

ProductionProduction

SavingsSavings

ConsumptionConsumption

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

IncomeIncome

ProductionProduction

SavingsSavings

ConsumptionConsumption

ImportsImports

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

YAD

Expansionary Monetary Policy

AD′

ΔI ΔC, ΔNX

P

Y

AD

An Expansionary Cycle Driven by monetary policy

P*

SRAS

YP

AD′1

2

Output Gap

1. Economy at LT YP.

2. Monetary Policy Cuts Interest Rate

3. Investment rises. The AD curve shifts out.

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

3

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

P

YY* AD

Demand Driven Recession w/ Counter-cyclical

monetary policy

P*

SRAS

YP

AD′

1

2

1. Economy in 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 Recessionary Gap

P

Y

AD

Demand Driven Expansion w/ Counter-cyclical

monetary policy

P*

SRAS

YP

AD′

1

2

Inflationary Gap

1. Economy in expansion. Fed detects inflationary pressure

2. Monetary Policy Raises Interest Rate

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

*1 12 2.025 ( )TGT

t t t ti Output Gap

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.

Answer

P_2008_2 121.91P_2007_2 120.00Inflation 0.016Y 11740.3YP 11904.0Output Gap -0.014Inflation Gap -0.004Taylor Rule 0.032Fed Funds Rate 0.02

US Recessions are becoming shorter as stabilization policies were adopted.

Average Length of Contraction

0

5

10

15

20

25

1854-1919 1919-1945 1945-2001

Mo

nth

s

Fiscal Policy

Sources of Revenue HK 2004/2005

Profit Tax24%

Salaries Tax & Property, Other

21%

Investment Income10%

Land Premium & Sales20%

Betting, Fees, Duties25%

HK Government Outlays by Category 2005/06

Economic6%

Education22%

Environment and Food4%

Health13%

Infrastructure10%

Security10%

Social Welfare14%

Support12%

Community Affairs 3%

Housing6%

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

P

YY*

AD

Demand Driven Recession w/ Counter-cyclical fiscal policy

P*

SRAS

YP

AD′

1

2

1. Economy in LT equilibrium

2. Demand shifts in

3. Government increases spending to shift the AD curve back

3

Recessionary Gap

P

YY* AD

Demand Driven Expansion w/ Counter-cyclical fiscal policy

P*

SRAS

YP

AD′1

2

1. Economy in LT equilibrium

2. Demand shifts out

3. Government cuts spending to shift the AD curve back 3

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

-.08

-.04

.00

.04

.08

.12

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

020406080

100120140160180

Alb

ania

Be

larus

Bo

tswa

na

Chile

Co

te d

'Ivoire

India

Israe

l

Mo

ngo

lia

Pe

ru

Po

land

Sing

ap

ore

Tha

iland

Turke

y%

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.

Budget Surplus in USA (as a % of GDP)

-7.00%

-6.00%

-5.00%

-4.00%

-3.00%

-2.00%

-1.00%

0.00%19

75

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

Government Interest Payments per US Resident

$0.00

$100.00

$200.00

$300.00

$400.00

$500.00

$600.00

$700.00

$800.00

$900.00

$1,000.00

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

US

$

Hong Kong Has Traditionally had negative Debt.

Government Wealth

0

100000

200000

300000

400000

500000

600000

700000

800000

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.