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					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

              Production




Consumption                Income




                                    Savings
        Multiplier Effect 2

              Production




Consumption                Income




                                    Savings
        Multiplier Effect 3

              Production




Consumption                Income




                                    Savings
     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

                    Production




          Consumption            Income




Imports
                                          Savings
  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
    Expansionary Monetary Policy


P




               ΔI ΔC, ΔNX

                            AD′
                AD
                              Y
An Expansionary Cycle Driven by                1. Economy at
       monetary policy                            LT YP.
                                               2. Monetary
                     YP                           Policy Cuts
    P
                                                  Interest Rate
               3            SRAS               3. Investment
                                2                 rises. The
   P*                                             AD curve
                                                  shifts out.
               1                               4. Tight labor
                                         AD′      markets.
                                    AD            SRAS
                                                  returns to
                   Output Gap             Y       long run
                                                  equilibrium
     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
    Demand Driven Recession                1. Economy in
w/ Counter-cyclical monetary policy           a recession.
                                              Fed detects
                         YP                   deflationary
     P                                        pressure
                     2          SRAS
                                           2. Monetary
                                              Policy Cuts
                1                             Interest Rate
    P*
                                           3. Investment
                                     AD′      increases
                                              spending to
                                              shift the AD
                                AD            curve back
                Y*
                                       Y      to long run
             Recessionary Gap                 equilibrium
    Demand Driven Expansion                       1. Economy in
w/ Counter-cyclical monetary policy                  expansion.
                                                     Fed detects
                       YP                            inflationary
     P                                               pressure
                                                  2. Monetary
                                SRAS
                                                     Policy
                                 1                   Raises
    P*
                                                     Interest Rate
                 2                                3. Investment
                                          AD         decreases
                                                     spending to
                                        AD′          shift the AD
                                                     curve back
                     Inflationary Gap         Y      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
    TGT
    i
    t       .025   t    1
                                2    ( t   )  1 2  Output Gapt
                                             *
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             121.91
P_2007_2             120.00
Inflation             0.016
Y                   11740.3
YP                  11904.0
Output Gap           -0.014
Inflation Gap        -0.004
Taylor Rule           0.032
Fed Funds Rate         0.02
 US Recessions are becoming shorter
as stabilization policies were adopted.
                           Average Length of Contraction

          25


          20


          15
 Months




          10


          5


          0
               1854-1919                1919-1945          1945-2001
Fiscal Policy
Sources of Revenue HK 2004/2005
              Land Premium &
                   Sales
                   20%         Profit Tax
                                 24%




 Investment Income
        10%




                                  Salaries Tax &
            Betting, Fees,        Property, Other
                Duties                 21%
                 25%
 HK Government Outlays by
    Category 2005/06
                                 Community Affairs Economic
                       Support
                                      3%              6%
                        12%




Social Welfare
                                                                Education
    14%                                                           22%




      Security
       10%                                                     Environment and
                                                                     Food
                                                                      4%


             Infrastructure                           Health
                  10%               Housing            13%
                                      6%
                  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
Demand Driven Recession                               w/
       Counter-cyclical fiscal policy
                         YP            1. Economy in LT
     P
                     3                    equilibrium
                           1    SRAS
                                       2. Demand shifts
               2                          in
    P*                               3. Government
                                        increases
                                    AD spending to shift
                                        the AD curve
                                AD′     back
                Y*                         Y
             Recessionary Gap
Demand Driven Expansion                                       w/
       Counter-cyclical fiscal policy
                           YP                 1. Economy in LT
     P
                                                 equilibrium
                                      SRAS
                                              2. Demand shifts
                                     2           out
    P*                                       3. Government
                                                cuts spending to
                    1                           shift the AD
                     3                      AD′ curve back
               Y*                        AD
                                                  Y
                         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
    .12


    .08


    .04


    .00


    -.04


    -.08
           1990 1992 1994 1996 1998 2000 2002 2004 2006

                      Budget Surplus (as a % of GDP)
                      Detrended GDP
                                               Turkey
Most Economies Have Positive




                                               Thailand
                                               Singapore
                                               Poland
     Government Debt.




                                               Peru
                                               Mongolia
                                               Israel
                               Debt/GDP




                                               India
                                               Cote d'Ivoire
                                               Chile
                                               Botswana
                                               Belarus
                                               Albania


                                          180
                                          160
                                          140
                                          120
                                          100
                                           80
                                           60
                                           40
                                           20
                                            0
                                           %
 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.
-7.00%
         -6.00%
                  -5.00%
                           -4.00%
                                    -3.00%
                                             -2.00%
                                                      -1.00%
                                                                      0.00%
                                                               1975
                                                               1976

                                                               1977
                                                               1978
                                                               1979
                                                               1980

                                                               1981
                                                               1982
                                                               1983
                                                               1984
                                                               1985
                                                               1986
                                                               1987
                                                               1988
                                                                                 (as a % of GDP)




                                                               1989
                                                               1990
                                                               1991
                                                                              Budget Surplus in USA




                                                               1992
                                                               1993
                                                               1994
                                                               1995
Government Interest Payments per
        US Resident
             $1,000.00

              $900.00

              $800.00

              $700.00

              $600.00
  1996 US$




              $500.00

              $400.00

              $300.00

              $200.00

              $100.00

                $0.00
                         1975
                                1976
                                       1977
                                              1978
                                                     1979
                                                            1980
                                                                   1981
                                                                          1982
                                                                                 1983
                                                                                        1984
                                                                                               1985
                                                                                                      1986
                                                                                                             1987
                                                                                                                    1988
                                                                                                                           1989
                                                                                                                                  1990
                                                                                                                                         1991
                                                                                                                                                1992
                                                                                                                                                       1993
                                                                                                                                                              1994
                                                                                                                                                                     1995
Hong Kong Has Traditionally had negative Debt.

                  Government Wealth


800000

700000

600000

500000

400000

300000

200000

100000

    0
       86

       87

       88

       89

       90

       91

       92

       93

       94

       95

       96

       97

       98

       99

       00

       01

       02

       03
    19

    19

    19

    19

    19

    19

    19

    19

    19

    19

    19

    19

    19

    19

    20

    20

    20

    20
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.

				
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