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 public-sector deficits/surpluses: 1979–2001

UK public-sector deficits/surpluses: 1979–2001

UK public-sector deficits/surpluses: 1979–2001

UK general government expenditure as % of GDP 50

Annual growth rate (%)

48 46 44 42 40 38 36

UK general government expenditure as % of GDP 50

Annual growth rate (%)

48 46 44 42 40 38 36

UK general government expenditure by function (%) H I J K

General public services 4.4% Housing, etc 3.6% Recreation, etc 1.7% Environment 0.9%

1991

H I J K

General public services 5.1% Housing, etc 1.5% Recreation, etc 1.0% Environment 0.7%

1999

UK general government expenditure by function (%) H I J K

General public services 4.4% Housing, etc 3.6% Recreation, etc 1.7% Environment 0.9%

1991

H I J K

General public services 5.1% Housing, etc 1.5% Recreation, etc 1.0% Environment 0.7%

1999

General government deficits/surpluses and debt as % of GDP

General government deficits/surpluses and debt as % of GDP

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

✜

the national debt and public-sector debt

Getting budget deficits down?

Budget deficits as a % of GDP

9 7 5 3 1

Getting budget deficits down?

Budget deficits as a % of GDP

9 7 5 France

3 1

Getting budget deficits down?

Budget deficits as a % of GDP

9 7 5 Germany

3 1

France

Getting budget deficits down?

Budget deficits as a % of GDP

9 Italy

7 5 Germany

3 1

France

Getting budget deficits down?

Budget deficits as a % of GDP

9 7

Spain

Italy

5 Germany

3 1

France

Getting budget deficits down?

Budget deficits as a % of GDP

9

Belgium

7

Spain

Italy

5 Germany

3 1

France

Getting budget deficits down?

Budget deficits as a % of GDP

9

Belgium

7

Spain

Italy

5 Germany

3 1

Netherlands

France

National Debt (as % of GDP)

80 75 70 65 60 55 50 45 40

National Debt

National Debt (as % of GDP)

National Debt

80 75 70 65 60 55 50 45 40

UK

National Debt (as % of GDP)

National Debt

80 75 70 65

USA

60 55 50 45 40

UK

National Debt (as % of GDP)

National Debt

80 75

Euro area

70 65

USA

60 55 50 45 40

UK

THE NATURE OF FISCAL POLICY ■

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 O

Gov. expenditure (incl. benefits) Y1

Y

THE NATURE OF FISCAL POLICY ■

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 ✜

■

Discretionary fiscal policy

THE NATURE OF FISCAL POLICY ■

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 ✜

■

Discretionary fiscal policy ✜

changing government expenditure

THE NATURE OF FISCAL POLICY ■

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 ✜

■

Discretionary fiscal policy changing government expenditure ✜ changing taxes ✜

A cut in taxes: (a) lump-sum taxes W, J

W1

O

Y

A cut in taxes: (a) lump-sum taxes W, J

W1 W2

O

Y

A cut in taxes: (a) lump-sum taxes W, J

W1 W2

∆ T x mpcd

O

Y

A cut in taxes: (b) cut in tax rates W, J

W1

O

Y

A cut in taxes: (b) cut in tax rates W, J

W1

W2

O

Y

A cut in taxes: (b) cut in tax rates W, J

W1

W2

∆ T x mpcd O

Y

Fiscal and Monetary Policy

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

W J1 O

Y1

(a) The goods market

Y

The monetary effects of fiscal policy Rate of interest

W, J

MS

W

r1 L1

J1 O

Y1

(a) The goods market

Y

O

Money (b) The money market

The monetary effects of fiscal policy Rate of interest

W, J

MS An expansionary fiscal policy

W J2 J1 O

Y1

Y2

(a) The goods market

Y

r1 L1 O

Money (b) The money market

The monetary effects of fiscal policy Rate of interest

W, J

MS An expansionary fiscal policy

r2 W J2 J1

O

Y1

Y2

(a) The goods market

Y

Effect on the demand for money

r1 L2 L1 O

Money (b) The money market

The monetary effects of fiscal policy Rate of interest

W, J

MS MS 2 An expansionary fiscal policy

r2 W J2 J1

O

Y1

Y2

(a) The goods market

Y

Accommodating increase in the money supply

r1 L2 L1 O

Money (b) The money market

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

✜

size of the multiplier and accelerator effects

EFFECTIVENESS OF FISCAL POLICY ■

Discretionary fiscal policy: problems of timing and time lags ✜

various time lags

✜

policy may be destabilising

Fiscal policy: stabilising or destabilising?

Real national income

Path (a): no intervention

3 4

3 2

4 2

1

1 O

Time

Fiscal policy: stabilising or destabilising?

Real national income

Path (a): no intervention Path (b): policy stabilises 3 4

3 2

4 2

1

1 O

Time

Fiscal policy: stabilising or destabilising?

Real national income

Path (a): no intervention Path (b): policy stabilises Path (c): policy destabilises 3 4

3 2

4 2

1

1 O

Time

EFFECTIVENESS OF FISCAL POLICY ■

■

Discretionary fiscal policy: problems of timing and time lags ✜

various time lags

✜

policy may be destabilising

Side-effects of discretionary fiscal policy

EFFECTIVENESS OF FISCAL POLICY ■

Discretionary fiscal policy: problems of timing and time lags ✜

various time lags

✜

policy may be destabilising

■

Side-effects of discretionary fiscal policy

■

Changing government expenditure versus changing taxes

Fiscal and Monetary Policy

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

Rate of interest

MS

r1

L O

Q1 Money

Rate of interest

The demand for and supply of money MS ' MS

r2

r1

L O

Q2

Q1 Money

VARIETIES OF MONETARY POLICY ■

Techniques to control money supply ✜

preliminary decisions: ✦ statutory

or 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

VARIETIES OF MONETARY POLICY ■

Techniques to control money supply ✜

preliminary decisions: ✦ statutory

or prudent ratios? ✦ what to control: monetary base or broad money?

open-market operations ✜ funding ✜ variable minimum reserve ratios ✜

■

Techniques to control interest rates

VARIETIES OF MONETARY POLICY ■

Techniques to control money supply ✜

preliminary decisions: ✦ statutory

or prudent ratios? ✦ what to control: monetary base or broad money?

open-market operations ✜ funding ✜ variable minimum reserve ratios ✜

■

Techniques to control interest rates ✜

statutory base rates

VARIETIES OF MONETARY POLICY ■

Techniques to control money supply ✜

preliminary decisions: ✦ statutory

or prudent ratios? ✦ what to control: monetary base or broad money?

open-market operations ✜ funding ✜ variable minimum reserve ratios ✜

■

Techniques to control interest rates statutory base rates ✜ operations in discount and repo markets ✜

Bank of England operations in the bill and gilt repo markets to raise interest rates D by banks

Rate of discount

S1 by B. of E.

r1

O

Bills

(a) Bank of England sells more bills

Bank of England operations in the bill and gilt repo markets to raise interest rates

Rate of discount

S1 by B. of E.

S2 by B. of E. D by banks

r2

r1

O

Bills

(a) Bank of England sells more bills

Bank of England operations in the bill and gilt repo markets to raise interest rates Rate of discount / gilt repo rate

D1 by B. of E.

r1 S by banks

O

Bills and gilts

(b) Bank of England buys fewer bills /

Rate of discount / gilt repo rate

Bank of England operations in the bill and gilt repo markets to raise interest rates D2 by B. of E.

D1 by B. of E.

r2

r1 S by banks

O

Bills and gilts

(b) Bank of England buys fewer bills /

VARIETIES OF MONETARY POLICY ■

Techniques to control money supply ✜

preliminary decisions: ✦ statutory

or prudent ratios? ✦ what to control: monetary base or broad money?

open-market operations ✜ funding ✜ variable minimum reserve ratios ✜

■

Techniques to control interest rates statutory base rates ✜ operations in discount and repo markets ✜

■

Credit rationing

Fiscal and Monetary Policy

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

PROBLEMS OF MONETARY POLICY ■

Practical difficulties in short-run control of the money supply ✜

problems with monetary base control ✦ with

statutory cash ratios

✦ without

✜

problems with controlling broad liquidity ✦ with

statutory reserve ratios

✦ without

✜

statutory cash ratios

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

Rate of interest

MS

r1

r

L' L O Money

PROBLEMS OF MONETARY POLICY ■

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

Rate of interest

Assume that the authorities want to reduce the demand for money to Q2

r1 Demand for loans O

Q2

Q1

Loans

Rate of interest

An inelastic demand for loans

A large rise in the rate of interest (to r2) will be necessary

r2

r1 Demand for loans O

Q2

Q1

Loans

PROBLEMS OF MONETARY POLICY ■

Problems with credit rationing Goodhart's law ✜ bank resistance ✜

stifles competition ✜ distortionary effects on economy ✜

■

Problems with controlling interest rates inelastic demand for loans ✜ unstable demand for money ✜

PROBLEMS OF MONETARY POLICY ■

Problems with credit rationing Goodhart's law ✜ bank resistance ✜

stifles competition ✜ distortionary effects on economy ✜

■

Problems with controlling interest rates inelastic demand for loans ✜ unstable demand for money ✜

✜

possible conflict between domestic goals and exchange-rate goals

PROBLEMS OF MONETARY POLICY ■

Using monetary policy ✜

problems of using it to manage aggregate demand

✜

using it to keep to a target ✦ inflation ✦ exchange ✦ money

rate

supply

Fiscal and Monetary Policy

ISLM Analysis of Fiscal and Monetary Policy

Equilibrium in both the goods and money markets

Rate of interest

LM

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

Rate of interest

LM

r1

IS O

Y1 National income

ISLM analysis of fiscal and monetary policy LM

Rate of interest

Expansionary fiscal policy

r2 r1

IS2 IS1 O

Y1

Y2

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

Monetary policy and ISLM analysis ✜

shifting the LM curve

✜

effect on interest rates and national income

ISLM analysis of fiscal and monetary policy LM1

LM2

Rate of interest

Expansionary monetary policy

r1 r3

IS O

Y1

Y3

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

Monetary policy and ISLM analysis ✜

shifting the LM curve

✜

effect on interest rates and national income

Fiscal and monetary policy together

ISLM analysis of fiscal and monetary policy LM1

Rate of interest

Expansionary fiscal and monetary policy

LM2

r1

IS2 IS1 O

Y1 National income

Y4

ISLM ANALYSIS OF FISCAL AND MONETARY POLICY ■

Analysis under Keynesian assumptions ✜

effectiveness of fiscal policy

Rate of interest

Keynesian analysis of fiscal and monetary policy

LM Expansionary fiscal policy

IS2 O

IS1 Y1

Y2

National income

ISLM ANALYSIS OF FISCAL AND MONETARY POLICY ■

Analysis under Keynesian assumptions ✜

effectiveness of fiscal policy

✜

ineffectiveness of monetary policy

Keynesian analysis of fiscal and monetary policy

Rate of interest

Expansionary monetary policy LM1 LM2

IS O

Y1 Y2 National income

ISLM ANALYSIS OF FISCAL AND MONETARY POLICY ■

■

Analysis under Keynesian assumptions ✜

effectiveness of fiscal policy

✜

ineffectiveness of monetary policy

Analysis under monetarist assumptions

ISLM ANALYSIS OF FISCAL AND MONETARY POLICY ■

■

Analysis under Keynesian assumptions ✜

effectiveness of fiscal policy

✜

ineffectiveness of monetary policy

Analysis under monetarist assumptions ✜

ineffectiveness of fiscal policy

Monetarist analysis of fiscal and monetary policy LM

Rate of interest

Expansionary fiscal policy

IS2 IS1

O

Y1Y2 National income

ISLM ANALYSIS OF FISCAL AND MONETARY POLICY ■

■

Analysis under Keynesian assumptions ✜

effectiveness of fiscal policy

✜

ineffectiveness of monetary policy

Analysis under monetarist assumptions ✜

ineffectiveness of fiscal policy

✜

effectiveness of monetary policy

Monetarist analysis of fiscal and monetary policy LM1

LM2

Rate of interest

Expansionary monetary policy

IS

O

Y1

Y2

National income

Fiscal and Monetary Policy

Fiscal and Monetary Policy in the UK

UK growth, unemployment and inflation: 1920−2002 %

10

5

0

-5

Growth

UK growth, unemployment and inflation: 1920−2002 %

10

5

0

-5

Growth

UK growth, unemployment and inflation: 1920−2002 %

10

5

0

-5

Growth Unemployment

%

UK growth, unemployment and inflation: 1920−2002 %

10

5

0

-5

Growth Unemployment Inflation

%

UK Macroeconomic performance: 1921 – 99

UK Macroeconomic performance: 1921 – 99

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

FISCAL AND MONETARY POLICY 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 ✜

FISCAL AND MONETARY POLICY 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

Fiscal and Monetary Policy

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

RULES VERSUS DISCRETION ■

■

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

RULES VERSUS DISCRETION ■

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)

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)

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)

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

RULES VERSUS DISCRETION ■

Inflation targeting ✜

use of inflation targets around the world

✜

weaknesses of money supply targets

RULES VERSUS DISCRETION ■

Inflation targeting ✜

use of inflation targets around the world

✜

weaknesses of money supply targets

✜

weaknesses of exchange rate targets

RULES VERSUS DISCRETION ■

Inflation targeting ✜

use of inflation targets around the world

✜

weaknesses of money supply targets

✜

weaknesses of exchange rate targets

✜

relative strength of inflation targets

RULES VERSUS DISCRETION ■

■

Inflation targeting ✜

use of inflation targets around the world

✜

weaknesses of money supply targets

✜

weaknesses of exchange rate targets

✜

relative strength of inflation targets

Issues with inflation targets

RULES VERSUS DISCRETION ■

■

Inflation targeting ✜

use of inflation targets around the world

✜

weaknesses of money supply targets

✜

weaknesses of exchange rate targets

✜

relative strength of inflation targets

Issues with inflation targets ✜

choice of the target ✦ what

level?

✦ central

point or ceiling?

RULES VERSUS DISCRETION ■

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

a

target

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 high weight to stable real national income

Rate of inflation (P)

.

.P

1

b

c

.P

a

target

ADI1 ADI2 O

Y1

Y2

Y0

National income

RULES VERSUS DISCRETION ■

Issues with inflation targets (cont.) ✜

who sets the target?

✜

changing the target

✜

multiple targets ✦a

Taylor rule for setting interest rates

✦ targeting

inflation and the money supply

RULES VERSUS DISCRETION ■

Issues with inflation targets (cont.) ✜

who sets the target?

✜

changing the target

✜

multiple targets ✦a

Taylor rule for setting interest rates

✦ targeting

✜

inflation and the money supply

basing interest rates on forecasts of inflation

RULES VERSUS DISCRETION ■

Issues with inflation targets (cont.) ✜

who sets the target?

✜

changing the target

✜

multiple targets ✦a

Taylor rule for setting interest rates

✦ targeting

inflation and the money supply

✜

basing interest rates on forecasts of inflation

✜

the problem of deflation