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Short-term stabilisation policy

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					Short-term stabilisation policy
Overview

   How can a rise in consumers’ confidence
    cause a short term boom?
   The effect of government monetary policy
       Using monetary policy to avoid recession
       How monetary policy can create a short-term
        boom
   The inflation-unemployment trade off
How can a rise in consumer confidence
cause a short-term boom?
   Say C increases due to a rise in consumers’
    confidence
        This leads to a fall in saving and a reduction in the
         supply of loanable funds
        This leads to a rise in the interest rate and a fall in the
         quantity of loanable funds demanded (I+ NFI)
        The fall in NFI leads to an appreciation in the real
         exchange rate and a fall in NX
        So the rise in C has led to a fall in I+NX. Overall no
         change in aggregate demand but the interest rate and
         the real exchange rate have risen
     How a rise in C affects the loanable funds
     market
                                                 As consumption
Interest rate = r
                         Supply = SP + (T – G)   increases, private
                                                 savings falls and
                                                 the supply of
                                                 loanable funds
   New r
                                                 falls at any
                                                 interest rate.
 Original r
                                                 This pushes up
                                                 the interest rate
                                                 and crowds out
                                    Demand =     some investment
                                    I + NFI
                                                 (both domestic
                                                 and investment by
                          Q loanable funds       Australians
                                                 overseas)
 How a rise in C affects NX
Real exchange rate
                           NFI original                           As the rise in C
                 NFI new
                                                                  leads to a rise in r
                                                                  and a fall in NFI,
                                                                  this affects the
                                                                  foreign exchange
                                                                  market.
                                                                  The fall in NFI
                                                                  reduces the supply
                                                Net               of AUD. As a
                                                Exports
                                                                  result, the real
                                                                  exchange rate
                                                                  rises, reducing net
                                          Quantity of AUD         exports.
                                          exchanged for foreign
                                          currency
So

   A rise in consumer confidence that increases
    consumption but reduces savings and tends
    to
       Raise real interest rates and crowd out I
       Raise real interest rates and crowd out NFI. But
        this leads to an appreciation of the AUD and a fall
        in NX
But – what about the money market?

   The interest rate has risen and this leads to a fall in
    the demand for less liquid assets. In other words,
    money demand falls
       If the supply of money has not changed then something
        else must change to bring the money market back to
        equilibrium
           This ‘something else’ is the price level. Given the new higher
            interest rate, the aggregate price level P must rise in order to
            raise money demand back to money supply
       Overall, the rise in C has been offset by a fall in I + NX. But
        interest rates, the real exchange rate AND the price level
        have all risen.
 Shift in Aggregate demand due to increase
 in consumers’ confidence      The rise in C leads to
                                                          a rise in interest
Price Level
                                                          rates. For any given
                                                          level of the money
                                                          supply this means
                                                          that money demand
                                                          has fallen. P must
                                                          rise to offset this
                                                          change and return
                                                          the money market to
                                      New                 equilibrium.
                                      Aggregate
                                      Demand
                                                          But this means for
                      Original Ag D
                                                          any level of GDP, the
                                                          price level P must
                                              Quantity
                                              of output   have risen
This change leads to a short term boom
                                            The shift in aggregate
                                            demand leads to a
Price Level
              Long run
                          Short run
                                            rise in the price level.
              Aggregate
              Supply      Aggregate
                          supply            GIVEN PRICE
                          (Given            EXPECTATIONS,
                          expected
                          price P*)         producers and
                                            workers respond to
P*                                          the higher price by
                                            raising output.
                                            e.g. workers see
                                            nominal wages
                                            moving up and work
                                            more overtime, even
                              Quantity of   though their real
                              output
                                            wage has not risen
What happens in the longer term?
              SR Ag S (Expected                        In the longer
Price Level   price = P**)
                                                       term, people’s
                                                       price
P**                               Short run
                                  Aggregate
                                                       expectations
                                  supply               change. As this
                                  (Given
                                  expected
                                                       occurs, the
P*                                price P*)            short run
                                                       supply curve
                                                       moves up and
                                                       the economy
                                                       moves back to
                                                       long run
                                                       equilibrium.
                                         Quantity of
                                         output        The ‘boom’
                                                       corrects itself
The effect of government monetary policy

   Suppose the economy starts to go into a
    recession (e.g. due to a fall in investor
    confidence and a fall in I)
       Can the Reserve Bank help protect the economy
        from recession?
       If so , how?
Monetary policy and a recession

   As I falls, this reduces the demand for
    loanable funds. This tends to reduce the
    interest rate.
   As the interest rate falls, this increases
    money demand.
       If nothing happens to money supply then to
        restore equilibrium in the money market P must
        fall to reduce money demand. This reduces
        aggregate demand at any level of output and
        causes a ‘downturn’ in the economy.
The effect of a fall in investment
Price Level
                            Long run                 As
                            Aggregate    Short run
                            Supply       Aggregate   investment
                                         supply
                                         (Given      falls, this
                                         expected    leads to a
                                         price P*)
                                                     fall in
P*                                                   interest rates
                                                     and a fall in
                                                     P to maintain
                                                     money
                                        Aggregate
                                        Demand       market
               Short run                             equilibrium
              equilibrium
                                                Q
But

   Suppose as interest rates start to fall, the
    Reserve Bank raises the money supply?
       Now as r falls, money demand rises, but money
        supply rises to meet it.
       Money demand rises and the money supply rises.
        There is no disequilibrium in the money market
        and the aggregate demand curve doesn’t change
       The Reserve Bank has stopped the recession by
        raising the money supply
More generally changing the money supply
shifts aggregate demand
   Suppose the Reserve Bank increases the
    money supply. For any given interest rate,
    money demand is now less than money
    supply – the price level P has to rise to return
    the money market to equilibrium.
    But this means that a rise in the money
    supply tends to raise the aggregate demand
    curve. Similarly, a fall in the money supply
    pushes the aggregate demand curve down.
 Short term effect of a rise in money supply
Price Level
              Long run                      A rise in the money
              Aggregate   Short run
              Supply      Aggregate         supply tends to raise
                          supply            aggregate demand.
                          (Given
                          expected
                          price P*)         In the short term,
                                            this leads to greater
P*                                          output, lower
                                            unemployment and
                                            higher prices.
                                            In the long term, the
                                            rise in the money
                                            supply just tends to
                              Quantity of   lead to higher prices
                              output        – the ‘boom’ is short
                                            lived.
The inflation-unemployment trade off

   In the short-term raising the money supply
    leads to a fall in unemployment below the
    natural rate.
   But note that this only ‘works’ because the
    rise in prices caused by the monetary
    expansion is unexpected.
   As expectations change, the short-term
    reduction in unemployment goes away.
   More generally, the Reserve Bank can lower
    unemployment if it increases the rate of
    growth of the money supply
       In the short term, this leads to higher than
        expected inflation, and lower unemployment
           There is a trade off between inflation and unemployment
            – so long as people expect a lower level of inflation
       As people adjust their expectations about inflation,
        the short term benefit goes away – and we are
        just left with higher inflation.
       The short term relationship between inflation and
        unemployment is called the Phillips curve.
The cost of reducing inflation

   Suppose that inflation is at 15% and the economy is
    growing at 2% per annum
       The money supply is growing at 17% per annum
       Everyone expects a 15% rate of inflation
       Unemployment is at the natural rate.
       How can the Reserve Bank lower the inflation rate?
        Easy – just reduce the rate of growth of the money supply
       But – this reverses the Phillips curve effect. In the short
        term, people do not expect the lower inflation. The
        economy contracts and unemployment rises.
       So short term unemployment is the cost of reducing
        inflation
Lessons

   In the short term changes in consumer confidence
    (or investor confidence) can cause a boom or a
    recession
       The effect operates (1) through the money market and (2)
        due to people making ‘errors’ in their supply decisions.
   The Reserve Bank can use monetary policy to
    smooth out recessions and booms
   The Reserve Bank can also use monetary policy to
    lower unemployment in the short term – but this
    leads to long run inflation.

				
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posted:7/3/2012
language:English
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