Advanced MacroeconomicsModule 3: Empirical models & methods

Monetary and Fiscal Policy

Alessio Moneta

Institute of EconomicsScuola Superiore Sant’Anna, Pisa

amoneta@sssup.it

April 2019

LM in EconomicsScuola Superiore Sant’Anna - Universita di Pisa

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Monetary vs. Fiscal Policy

B Fiscal policy: government actions aimed at influencingmacroeconomic performance through taxes and governmentspending (i.e. purchases of goods and services and transferpayments)

B Monetary policy: government (also central bank) actions aimedat influencing macroeconomic performance though the financialsystem, which comprises markets in which financialinstruments, i.e. records/papers that specify claim to valuablegoods, and money are exchanged.

Although fiscal and monetary policy are indeed of differentnature (e.g. value-laden the former and less involved the latter)and have attracted different emphasis from schools of economicthought, they are quite interrelated.

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Government’s budget constraint

To see the relationship between fiscal and monetary policy it is usefulto study the government’s budget constraint.

B Let’s start from the Production - expenditure identity:

Y = C + I + G + (EX − IM)

Y: GDP, C: consumption, I: investment, EX: exports, IM: imports.

B Disposable-income identity:

YD = Y − T + TR = C + S

YD: disposable income, T: taxes, TR: transfers, S: saving.

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Product-Expenditure Identity, U.S. 2009

Source: Hoover (2012) Intermediate Macroeconomics, Cambridge University Press, Figure 2.6, p. 42.

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Disposable-Income Identity, U.S. 2009

Source: Hoover (2012) Intermediate Macroeconomics, Cambridge University Press, Figure 2.6, p. 42.

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Government’s budget constraint

Thus, from:

Y = C + I + G + (EX − IM) = C + S + T − TR

we get:

[G − T + TR] + [I − S] + [EX − IM] = 0

That is: [government budget deficit] + [private sector deficit] +[foreign sector deficit] = 0

Government’s budget constraint:

G − T + TR = ∆BG + ∆MB

∆BG: changes in stock of public debt held by the private sector, ∆MB: changes in themonetary base

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Government’s budget constraint

The government’s budget constraint shows that fiscal policy (cfr. lefthand side) and monetary policy (cfr. right hand side) are interrelated.

Pure fiscal policy or pure monetary policy are rare.

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The channels of monetary policy

How does the monetary policy affect the real economy?

B Interest-rate channel: it acts on the opportunity cost ofinvestment by firms.

B Credit channel: it acts on the willingness of commercial banks tomake loans to firms and consumers.

B International trade channel: it acts on the exchange rate andhence on the foreign sector deficit.

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Banks Balance Sheet

Central Bank Balance Sheet Commercial bank Balance SheetASSETS LIABILITIES ASSETS LIABILITIES- gov. bonds - banknotes - reserves - deposits- discount loans - reserves - loans - discount loans- coins held by - vault cash - vault cashthe central bank- foreign currency - fixed assets-gold - funds lent -funds borrowed

-net worth -net worth

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Money creation and money multiplier

B Different types of money: currency, M0, M1, M2, etc.

• Euro area (2011): 9%, 14.2%, 50.8%, 91.2% of GDP (respectively)

• US (2011): 7.1%, 17.5%, 14.7%, 64.6% of GDP

B Reserve requirement:

• US: reserves at least 10% transaction accounts

• Euro area: reserves at least 2% saving accounts

B Discount rate and discount window (mostly discouraged)

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Interbank market

B Federal funds market (US): market in which commercial banksborrow central-bank reserves from, or lend central-bankreserved to, another bank (loans are mostly overnight)

NB: Low transaction volume (lack of trust) in this market was amajor contributing factor to the spreading out of the financialcrisis, starting from 9th august 2007.

B The interbank market in Europe is regulated by the EONIA(European Over-Night Index Average). Cfr. also the 3 monthsEurepo (european repurchase agreement) and Euribor (eurointer bank rate)

B EONIA and FFR (Federal funds rate): importance for beingtarget rate and also for determining the credits by banks to theprivate sector.

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Interest rate determination

Source: Hoover (2012) Intermediate Macroeconomics, Cambridge University Press, Figure 16.2 p. 629.

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How does the central bank determine reserves?

B Lending

B Open market operations (i.e. purchasing or selling governmentbonds)

B purchasing/selling of foreign currency

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An Open-Market Operation

Source: Hoover (2012) Intermediate Macroeconomics, Cambridge University Press, Figure 16.2 p. 631.

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Bernanke 1986

Bernanke, B. (1986) ”Alternative explanations of the money-incomecorrelation.” Carnegie-Rochester Conference Series on Public Policy.US data 1953:1 - 1984:4

• Y: log real GNP

• P: GNP deflator

• G: government spending (defence)

• B: monetary base

• M: M1

• C: total commercial bank loans (logs)

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Bernanke 1986 (cont’d)

Identification scheme:

Bt = f (Gt, Mt, Pt, Yt)

Ct = f (Bt, Pt, Yt)

Mt = f (Bt, Pt, Yt)

Pt = f (Yt)

Y = f (Gt, Ct − Pt, Mt − Pt)

Results: credit shock positive effects on output.

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The conduct of monetary policy

B Goal of central banks: low and stable inflation or fullemployment?

B Different targets of central bank actions: interest rates (cfr. 1950s- 1960s), money growth (1970s-1980s), inflation (1990s)

B Rules vs. discretion

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Taylor rule

John Taylor (1993) “Discretion versus Policy Rules in Practice”,Carnegie-Rochester Conference Series on Public Policy

B Taylor rule:

it = r∗t + πt + α(πt − π∗t ) + β(yt − y∗t )

where

it: target nominal interest rate (e.g. target federal funds rate);

r∗t : natural rate (or desired rate) of interest

πt: inflation

π∗t : target rate of inflation

yt: log GDP

y∗t log potential output

Taylor’s assumption (for the period 1987-1992): r∗t = π∗t = 0.02, α = β = 0.5

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Taylor rule

B Taylor (1993): descriptive rule

B Is it an optimal rule?

B Benchmark for policy maker

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Does the Fed follow a Taylor rule?

Source: Hoover (2012) Intermediate Macroeconomics, Cambridge University Press, Figure 16.13 p. 659.

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Fiscal policy

Fiscal policy is the set of actions that determine the levels ofgovernment spending and taxes and that together determine the sizeof the government budget deficit. (cfr. Hoover 2012: Ch. 13.2)

It can be:

• discretionary: chosen to achieve a particular result consideringthe observed specific situation;

• automatic: built in the tax or spending program;

• short run and countercyclical: targeted to get out from recessionsand avoid overheating of the economy during recoveries.

• long run: targeted to growth.

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The IS curve

The IS curve shows the combinations of output and the interest rate such thatplanned expenditures equals actual expenditures. In a closed economy:

Y = C + I + G = c0 + cy(1 − ty)Y + A − ar + G,

where c0 is autonomous consumption, cy is the marginal propensity toconsume, ty is the portion of income Y that is taxed, A is future profitability,aa constant term, r the real interest rate, and G government purchases. Wehave:

Y =1

1 − cy(1 − ty)[c0 + (A − ar) + G]

The term 11−cy(1−ty)

is called the multiplier.

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The IS curve

In particular we have: for r = 0, Y = c0+A+G1−cy(1−ty)

(intercept of the IS curve onthe Y-axis).

For Y = 0, r = c0+A+Ga (intercept of the IS curve on the r-axis).

The IS curve as a function of r is

r =c0 + A + G

a−

1 − cy(1 − ty)

aY.

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IS-LM scheme

i

Y

IS

LM

IS−LM model

Source: Romer (2001) Advanced Macroeconomics.

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Automatic fiscal policy

Taxes may act as automatic stabilizers attenuating fluctuations.

B Automatic stabilizers are embodied in the shape and position ofthe IS curve.

Cfr. the term ty in the multiplier: 11−cy(1−ty)

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Discretionary Fiscal Policy

B Discretionary fiscal policy can be done:

• choosing the level of government spending

• setting tax rates (targeting the tax take).

B Discretionary fiscal policy causes changes in position of the IScurve

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Fiscal Stimulus

Source: Hoover (2012) Intermediate Macroeconomics, Cambridge University Press, Figure 17.1 p. 686.

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Countercyclical Fiscal Policy

B Reactions to aggregate-demand shocks (affecting aggregateexpenditures) and to aggregate-supply shocks (affectingpotential output).

B Problems of countercyclical fiscal policy:

• Misperception between demand and supply shock

• Fiscal policy may take time to have its positive effects.

• Problems of coordination between national and regional (local)budgets.

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Demand Shock

Source: Hoover (2012) op.cit., Fig. 17.2 p. 688.

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Supply Shock

Source: Hoover (2012) op.cit., Fig. 17.3 p. 689.

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A Mixed Demand-Supply Shock

Source: Hoover (2012) op.cit., Fig. 17.4 p. 690.

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Fiscal policy in the long run

• Government’s budget constraint:

G − T + TR = ∆BG + ∆MB

∆BG: changes in stock of public debt held by the private sector, ∆MB: changes inthe monetary base

• Monetization of the deficit: fiscal policy resulting in a deficitfinanced through the creation of monetary base.

debasement, inflation tax and seigniorage

risks of hyperinflation

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Taxes and Spending over time

Source: Hoover (2012) op.cit., Fig. 17.5 p. 698.

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Debt over time

B Government deficit can be decomposed in:

gov. deficit = G+TR−T = primary deficit (PD)+ interest payments

B Evolution of debt BGt :

BGt = BG

t−1 + rt−1BGt−1 + PDt,

where r is the nominal interest rate. We get:

BGt

BGt−1

− 1 = rt−1 +PDt

BGt−1

.

Denoting with the growth rate:

BGt = rt−1 +

PDt

BGt−1

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Debt growth over time in U.S.

Source: Hoover (2012) op.cit., Fig. 17.6 p. 700.

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Functional finance

Abba Lerner (1903-1982) coined the term functional finance toemphasize the view that gov. deficits should be judged according tothe circumstances. Important issues about gov. deficit:

• What is the effect on aggregate demand?

• How does gov. expenditures interact with private expenditure?(crowding out vs. crowding in)

• What is the distribution decision underlying government’sfinancing decisions?

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Debt to GDP ratio

Recall that:

BGt = rt−1 +

PDt

BGt−1

Let’s call pdt =PDtBG

t−1. The growth rate of the ratio of gov. debt to GDP

can be written as:(BG

tptYt

)= rt−1 + pdt − pt − Yt = (rt−1 − pt) + pdt − Yt

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Burda & Wyplosz MACROECONOMICS 6/e

© Oxford University Press, 2012. All rights reserved.

Eurozone USA Japan

Total spending (% of GDP) 50.5 42.3 40.7Public consumption

as % of GDP 21.6 17.0 20.1as % of private consumption 37.5 24.1 34.2

Budget surplus (% of GDP) -6.0 -0.6 -8.1Gross debt (% of GDP) 92.4 93.6 199.7

General Government Spending and Finances: Eurozone, USA, and Japan, 2010

Table17.1

Source: OECD

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Table17.2

Sources: European Economy; OECD Economic Outlook

Government Transfers,

Various Countries,

1960 and 2010

Burda & Wyplosz MACROECONOMICS 6/e

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Table17.3

Source: OECD Economic Outlook

Government Budget Balances as % of GDP

Burda & Wyplosz MACROECONOMICS 6/e

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Figure 17.1 (a)

Sources: OECD Economic Outlook, IMF

Public Debt, Germany and USA (% of GDP)Germany

USA

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Figure 17.1 (b)

Sources: OECD Economic Outlook, IMF

Public Debt, France and UK (% of GDP)France

UK

Burda & Wyplosz MACROECONOMICS 6/e

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Table17.6

Source: OECD Economic Outlook

Gross Public Debt, 1970-2010 (% of GDP)

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Table 17.7

Net Government Indebtedness and Primary Budget Balances, 2010 (% of GDP)

Source: OECD Economic Outlook

*Assuming a 5% real interest rate and a 2.5% real GDP growth rate.

Net Debt in 2010

Primary Budget Surplus in 2010

Required Primary Surplus*to stabilize

absolute debtto stabilize the debt/GDP ratio

Belgium 80.8 –0.9 4.0 2.0

Germany 50.1 –1.3 2.5 1.3

Ireland 59.9 –30.0 3.0 1.5

Italy 99.1 –0.3 5.0 2.5

Netherlands 34.6 –4.1 1.7 0.9

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Economic Growth in Southern Europe, 1980-2010

Table 17.8

Source: IMF

1981 -1985

1986-1990

1991-1995

1996-2000

2001-2005

2006-2010

Greece 0.2 1.3 1.3 3.5 4.0 0.8Italy 1.7 3.1 1.3 1.9 0.9 –0.3Portugal 1.5 6.2 1.9 4.2 0.8 0.5Spain 1.3 4.7 1.7 4.1 3.3 0.9Euro Area n.a. n.a. 1.4 2.7 1.5 0.8EU 1.5 3.1 1.5 2.9 2.0 1.0

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Primary Budget Balances for Selected European Countries, 1995-2010

Table 17.9

Source: OECD

1995 2000 2005 2006 2007 2008 2009 2010

Belgium 3.9 6.2 1.2 3.9 3.3 2.2 −2.6 −1.3

France −2.5 1.1 −0.6 −0.1 −0.4 −0.8 −5.5 −5.5

Germany −6.7 4.0 −1.0 0.8 2.7 2.5 −0.7 −1.1

Greece 4.6 3.6 −0.7 −1.5 −1.9 −4.5 −10.1 −3.2

Ireland 2.5 6.3 2.1 3.2 0.3 −6.9 −13.0 −29.7

Italy 3.3 5.2 0.1 1.1 3.3 2.2 −1.0 −0.3

Portugal −0.4 −0.5 −3.7 −1.5 −0.1 −0.1 −6.6 −4.6

Spain −1.7 2.0 2.5 3.3 3.0 −3.1 −9.9 −7.8

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Table 17.10

Source: Alesina (1988)

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Figure 17.6

Source: OECD

Yields on Different European 10-year Bonds, relative to Germany, 2009-2011 (% per

annum)