Fiscal and Monetary Policy of Germany

Fiscal and
Monetary Policy
Fiscal and Monetary Policy
The Nature of Fiscal

Policy
THE NATURE OF FISCAL POLICY
■ The purpose of fiscal policy

✜ correcting a fundamental disequilibrium
✜ fine tuning
■ Government finances
✜ budget deficits and surpluses
✜ financing a deficit
✜ the PSNCR
UK public-sector deficits/surpluses: 1979–2001
UK general government expenditure as % of GDP
50
48
Annual growth rate (%)
46
44
42
40
38
36
UK general government expenditure as % of GDP
50
48
Annual growth rate (%)
46
44
42
40
38
36
UK general government expenditure by function (%)
H General public services 4.4% H General public services 5.1%

I Housing, etc 3.6% I Housing, etc 1.5%
J Recreation, etc 1.7% J Recreation, etc 1.0%
K Environment 0.9% K Environment 0.7%
1991 1999
UK general government expenditure by function (%)
H General public services 4.4% H General public services 5.1%

I Housing, etc 3.6% I Housing, etc 1.5%
J Recreation, etc 1.7% J Recreation, etc 1.0%
K Environment 0.9% K Environment 0.7%
1991 1999
General government deficits/surpluses
and debt as % of GDP
General government deficits/surpluses
and debt as % of GDP
■ The purpose of fiscal policy

✜ correcting a fundamental disequilibrium
✜ fine tuning
■ Government finances
✜ budget deficits and surpluses
✜ financing a deficit
✜ the PSNCR
✜ the national debt and public-sector debt
Getting budget deficits down?
9
Budget deficits as a % of GDP
1
9
France
3
1
9
Germany France
3
1
9
7 Italy
Germany France
3
1
9
7 Spain Italy
Germany France
3
1
9
Belgium
7 Spain Italy
Germany France
3
1
9
Belgium
7 Spain Italy
Germany France
3 Netherlands
1
National Debt National Debt
(as % of GDP)
80
75
70
65
60
55
50
45
40
(as % of GDP)
80
75
70
65
60
55
UK
50
45
40
(as % of GDP)
80
75
70
USA
65
60
55
UK
50
45
40
(as % of GDP)
80
Euro
75 area
70
USA
65
60
55
UK
50
45
40
■ Public-sector deficits or surpluses and

the government’s fiscal stance
✜ fiscal stance and the state of the economy
✜ the structural balance
■ Automatic fiscal stabilisers

✜ tax stabilisers
✜ benefits stabilisers
National income and the size of the public-sector deficit or surplus
G, T
Tax revenue
SURPLUS
DEFICIT Gov. expenditure

(incl. benefits)
O Y1
Y


✜ tax stabilisers
■ Discretionary fiscal policy



✜ tax stabilisers

✜ changing government expenditure


✜ tax stabilisers

✜ changing government expenditure
✜ changing taxes
A cut in taxes: (a) lump-sum taxes
W, J
W1
O
Y
W, J
W1
W2
O
Y
W, J
W1
W2
∆ T x mpcd
O
Y
A cut in taxes: (b) cut in tax rates
W, J
W1
O
Y
W, J
W1
W2
O
Y
W, J
W1
W2
∆ T x mpcd
O
Y
The Effectiveness of
Fiscal Policy
EFFECTIVENESS OF FISCAL POLICY
■ Effectiveness of automatic stabilisers

✜ adverse supply-side effects
✜ the problem of fiscal drag
■ Discretionary policy: problems of
forecasting the magnitude of the effect
✜ effects on other injections and withdrawals
✜ crowding out
The monetary effects of fiscal policy
W, J
J1
O Y1 Y
(a) The goods market

Rate of
W, J interest
MS
r1
W
J1 L1
O Y1 O
Y Money
(a) The goods market (b) The money market

Rate of
W, J interest
MS
An expansionary
fiscal policy
r1
W
J2
J1 L1
O Y1 Y2 O
Y Money

Rate of
W, J interest
MS
An expansionary Effect on the

fiscal policy demand for money
r2
r1
W
J2 L2
J1 L1
O Y1 Y2 O
Y Money

Rate of
W, J interest
MS MS 2
An expansionary Accommodating
fiscal policy increase in the
r2 money supply
r1
W
J2 L2
J1 L1
O Y1 Y2 O
Y Money

■ Effectiveness of automatic stabilisers

✜ adverse supply-side effects
✜ the problem of fiscal drag
■ Discretionary policy: problems of
forecasting the magnitude of the effect
✜ effects on other injections and withdrawals
✜ crowding out
✜ size of the multiplier and accelerator
effects
■ Discretionary fiscal policy: problems of

timing and time lags
✜ various time lags
✜ policy may be destabilising

Fiscal policy: stabilising or destabilising?
Path (a): no intervention

Real national income
4
3
2
4
2 1
O
Time

Path (b): policy stabilises
4
3
2
4
2 1
O
Time

Path (b): policy stabilises
Path (c): policy destabilises

3
4
3
2
4
2 1
O
Time

■ Side-effects of discretionary fiscal

policy

■ Side-effects of discretionary fiscal

policy
■ Changing government expenditure

versus changing taxes
Varieties of Monetary
Policy
VARIETIES OF MONETARY POLICY
■ The policy setting

✜ historical approaches to monetary policy
✜ current approach to monetary policy
■ Control of money supply over medium
and long term
✜ control of banks’ liquidity ratio
✜ restricting size of PSNCR
■ Short-term monetary control: the
alternatives
The demand for and supply of money
MS
Rate of interest
r1
O Q1
Money
The demand for and supply of money
MS ' MS
Rate of interest
r2
r1
O Q2 Q1
Money
■ Techniques to control money supply

✜ preliminary decisions:
✦ statutoryor prudent ratios?
✦ what to control: monetary base or broad
money?
✜ open-market operations
✜ funding
✜ variable minimum reserve ratios
Effect of raising the minimum reserve ratio
from 10% to 20%
Initial position: 10% reserve ratio

Effect of raising the minimum reserve ratio
from 10% to 20%
Initial position: 10% reserve ratio
New position: 20% reserve ratio


money?
✜ funding
■ Techniques to control interest rates


money?
✜ funding

✜ statutory base rates

money?
✜ funding

✜ operations in discount and repo markets
Bank of England operations in the bill and
gilt repo markets to raise interest rates
S1 by B. of E.
D by banks
Rate of discount
r1
O
Bills
(a) Bank of England sells more bills
S1 by B. of E.
S2 by B. of E. D by banks
Rate of discount
r2
r1
O
Bills
(a) Bank of England sells more bills
D1 by B. of E.
Rate of discount / gilt repo rate
r1
S by banks
O
Bills and gilts
(b) Bank of England buys fewer bills /
D1 by B. of E.
D2 by B. of E.
Rate of discount / gilt repo rate
r2
r1
S by banks
O
Bills and gilts
(b) Bank of England buys fewer bills /
✦ what to control: monetary base or broad money?
✜ funding

✜ operations in discount and repo markets
■ Credit rationing
Problems of
Monetary Policy
PROBLEMS OF MONETARY POLICY
■ Medium and long-term control over the

money supply: reducing PSNCR
✜ automatic fiscal stabilisers
✜ the desire to cut taxes
✜ difficulty in cutting government

expenditure
■ Practical difficulties in short-run

control of the money supply
✜ problems with monetary base control
✦ with statutory cash ratios
✦ without statutory cash ratios
✜ problems with controlling broad liquidity

✦ with statutory reserve ratios
✦ without statutory reserve ratios
✜ the effect on interest rates

The effect on interest rates of a change in demand for money:
money supply kept at fixed level by the authorities
MS
r1
Rate of interest
L'
L
O
Money
■ Problems with credit rationing

✜ Goodhart's law
✜ bank resistance
✜ stifles competition
✜ distortionary effects on economy
■ Problems with controlling interest rates

✜ inelastic demand for loans
An inelastic demand for loans
Assume that the authorities

want to reduce the
Rate of interest
demand for money to Q2
r1
Demand for loans
O Q2 Q1
Loans
An inelastic demand for loans
A large rise in the

rate of interest (to r2)
Rate of interest
will be necessary
r2
r1
Demand for loans
O Q2 Q1
Loans

✜ Goodhart's law
✜ bank resistance

✜ unstable demand for money

✜ Goodhart's law
✜ bank resistance

✜ unstable demand for money
✜ possible conflict between domestic goals

and exchange-rate goals
■ Using monetary policy

✜ problems of using it to manage aggregate
demand
✜ using it to keep to a target
✦ inflation
✦ exchange rate
✦ money supply
ISLM Analysis of
Fiscal and Monetary
Policy
Equilibrium in both the goods and money markets
LM
Rate of interest
re
IS
O Ye
National income
ISLM ANALYSIS OF FISCAL AND
MONETARY POLICY
■ Fiscal policy and ISLM analysis

✜ shifting the IS curve
✜ effect on interest rates and national

income
ISLM analysis of fiscal and monetary policy
LM
Rate of interest
r1
IS
O Y1
National income
LM
Expansionary
fiscal policy
Rate of interest
r2
r1
IS2
IS1
O Y1 Y2
National income
MONETARY POLICY

income
■ Monetary policy and ISLM analysis

✜ shifting the LM curve
income
LM1 LM2
Expansionary
monetary policy
Rate of interest
r1
r3
IS
O Y1 Y3
National income
MONETARY POLICY

income
■ Monetary policy and ISLM analysis
✜ shifting the LM curve
income
■ Fiscal and monetary policy together
Expansionary LM1 LM2
fiscal and
monetary policy
Rate of interest
r1
IS2
IS1
O Y1 Y4
National income
MONETARY POLICY
■ Analysis under Keynesian assumptions

✜ effectiveness of fiscal policy
Keynesian analysis of fiscal and monetary policy
Rate of interest
LM
Expansionary
fiscal policy
IS2
IS1
O Y1 Y2
National income
MONETARY POLICY

✜ ineffectiveness of monetary policy

Keynesian analysis of fiscal and monetary policy
Expansionary
monetary policy
Rate of interest
LM1
LM2
IS
O Y1 Y2
National income
MONETARY POLICY

■ Analysis under monetarist

assumptions
MONETARY POLICY


assumptions
✜ ineffectiveness of fiscal policy
Monetarist analysis of fiscal and monetary policy
LM
Expansionary
Rate of interest
fiscal policy
IS2
IS1
O Y1Y2
National income
MONETARY POLICY


assumptions
✜ ineffectiveness of fiscal policy
✜ effectiveness of monetary policy

Monetarist analysis of fiscal and monetary policy
LM1 LM2
Expansionary
monetary policy
Rate of interest
IS
O Y1 Y2
National income
Fiscal and Monetary

Policy in the UK
UK growth, unemployment and inflation: 1920−2002
%
Growth
10
-5
%
Growth
10
-5
% %
Growth
Unemployment
10
-5
% %
Growth
Unemployment
10 Inflation
-5
UK Macroeconomic performance: 1921 – 99
FISCAL AND MONETARY POLICY
IN THE UK
■ Attitudes towards demand
management
■ Keynesian demand management in the
1950s and 1960s
✜ stop–go policies
✜ monetarist criticisms
■ Demise of fine tuning in the 1970s

✜ the causes of stagflation
✜ demand management policies in the 1970s
✜ the rise of monetarism

Selected monetary indicators: 1969–2001
IN THE UK
■ Monetarism in the early 1980s
✜ medium-term financial strategy
✜ the recession of the early 1980s
✜ assessment of the monetarist experiment

✜ return to discretion in mid 1980s
■ Targeting the exchange rate

✜ its advantages and disadvantages
✜ shadowing the German mark
✜ membership of the ERM (1990–2)

✜ exit from the ERM
IN THE UK
■ Return to domestic-orientated policies
✜ targeting inflation: 1993–7
■ Policies of the Labour government
1997
1997
✜ fiscal policy
✦ the'Golden Rule'
✦ Comparison with EU Stability and Growth Pact
✜ monetary policy
✦ Bank of England inflation target
✦ ECB targets
✜ effectiveness of recent monetary and fiscal

policies
Rules versus
Discretion
RULES VERSUS DISCRETION
■ Case against discretion

✜ time lags
✜ over-correction
✜ government may ignore long-term
consequences
■ Case for rules
✜ help to reduce inflationary expectations
✜ create a stable environment for investment
and economic growth
■ Case against rules

✜ can cause severe fluctuations in interest
rates and can cause greater instability
✜ which rule to choose?
✜ rules may conflict
✜ rules may become unsuitable
■ Case for discretion
✜ fine tuning can be improved by better
forecasting and quicker-action
■ Inflation targeting
✜ use of inflation targets around the world
Who sets explicit targets and monitoring ranges for
the exchange rate, money and inflation
Source: The Use of Explicit Targets for Monetary Policy: Practical Experiences
of 91 economies in the 1990s, (Bank of England, August 1999)
Source: Bank of England
✜ weaknesses of money supply targets
✜ weaknesses of exchange rate targets
✜ relative strength of inflation targets
■ Issues with inflation targets
■ Issues with inflation targets
✜ choice of the target
✦ what level?
✦ central point or ceiling?
■ Issues with inflation targets (cont.)

✜ who sets the target?
✜ changing the target
✜ multiple targets
✦a Taylor rule for setting interest rates
ADI curves based on different Taylor rules
Curve ADI1: based on Taylor rule giving

relatively high weight to stable inflation
.
Rate of inflation (P)
.P 1
b
.P
target
a
ADI1
O Y1 Y0
National income
ADI curves based on different Taylor rules
Curve ADI1: based on Taylor rule giving

relatively high weight to stable inflation
Curve ADI2: based on Taylor rule giving relatively
.
Rate of inflation (P)
high weight to stable real national income
.P 1
b c
.P
target
a
ADI1
ADI2
O Y1 Y2 Y0
National income

✦ targeting inflation and the money supply

✜ basing interest rates on forecasts of
inflation

✜ basing interest rates on forecasts of
inflation
✜ the problem of deflation

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What are some of the tools used in fiscal policy?

What are some of the tools used in fiscal policy?

What are some factors that influence government budget deficits and surpluses?

What are some factors that influence government budget deficits and surpluses?

Fiscal and

The Nature of Fiscal

■ The purpose of fiscal policy

H General public services 4.4% H General public services 5.1%

H General public services 4.4% H General public services 5.1%

■ The purpose of fiscal policy

■ Public-sector deficits or surpluses and

■ Automatic fiscal stabilisers

DEFICIT Gov. expenditure

■ Public-sector deficits or surpluses and

■ Automatic fiscal stabilisers

■ Discretionary fiscal policy

■ Public-sector deficits or surpluses and

■ Automatic fiscal stabilisers

■ Discretionary fiscal policy

■ Public-sector deficits or surpluses and

■ Automatic fiscal stabilisers

■ Discretionary fiscal policy

■ Effectiveness of automatic stabilisers

(a) The goods market

(a) The goods market (b) The money market

(a) The goods market (b) The money market

An expansionary Effect on the

(a) The goods market (b) The money market

(a) The goods market (b) The money market

■ Effectiveness of automatic stabilisers

■ Discretionary fiscal policy: problems of

✜ policy may be destabilising

Path (a): no intervention

Path (a): no intervention

Path (a): no intervention

Path (c): policy destabilises

■ Discretionary fiscal policy: problems of

✜ policy may be destabilising

■ Side-effects of discretionary fiscal

■ Discretionary fiscal policy: problems of

✜ policy may be destabilising

■ Side-effects of discretionary fiscal

■ Changing government expenditure

■ The policy setting

■ Techniques to control money supply

Initial position: 10% reserve ratio

Initial position: 10% reserve ratio

New position: 20% reserve ratio

■ Techniques to control money supply

■ Techniques to control interest rates

■ Techniques to control money supply

■ Techniques to control interest rates

■ Techniques to control money supply

■ Techniques to control interest rates

■ Techniques to control interest rates

■ Medium and long-term control over the

✜ the desire to cut taxes

✜ difficulty in cutting government

■ Practical difficulties in short-run

✜ problems with controlling broad liquidity