ECON20001 Lecture Notes - Lecture 6: Fiscal Policy, Money Supply, Nominal Interest Rate
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IS-LM Model 3
Monetary/Fiscal Policy Interactions
• In practice monetary policy involves interest-rate setting
• Central bank changes money supply to maintain a target interest rate
• MS adjusts endogenously as a result
EXAMPLE
• High output (Y) means higher MD → upward pressure on i
• CBA wants to adjust MS to return to original interest rate
• MS increases so that i decreases
Policy Mixes
Tight = contractionary AND loose = expansionary
HOWARD-MACFARLANE POLICY MIX I
• Fiscal deficit had become and increasing national debt → introduced tight fiscal policy
• Implemented expansionary monetary policy in order to prevent output from falling as a result of
contractionary fiscal policy
• Economy experienced mild growth and low interest rate
Fiscal Contraction
• IS curve shifts left as G falls
• Fall in G reduces Y directly and through multiplier effects
Monetary Expansion
• LM curve shifts down as money supply (M) increases
• Increase in M reduces i and increases I
• Y increases as a result, as well as through multiplier effects
HOWARD-MACFARLANE POLICY MIX II
• Demand for exports pushed out the IS curve
• Both monetary and fiscal were contractionary to prevent economy from being overheated
RODD-STEVENS POLICY MIX
• Shift of IS curve means output reduces largely
• Expansionary fiscal and monetary helped to avoid an overall recession
GILLARD-STEVENS POLICY MIX
• Decided to return fiscal budget to a surplus → contractionary (tight) fiscal policy
• RBA cut interest rate to avoid significant output drop
• Expansionary monetary policy combatted effects of tight fiscal
Effectiveness of Monetary and Fiscal Policy
• Effectiveness refers to the effect of policy on output (Y)
• Slopes determine whether policy mostly changes interest rates (i) or output (Y) → interest-
sensitivities
Document Summary
In practice monetary policy involves interest-rate setting: central bank changes money supply to maintain a target interest rate, ms adjusts endogenously as a result. Example: high output (y) means higher md up(cid:449)a(cid:396)d p(cid:396)essu(cid:396)e o(cid:374) i, cba wants to adjust ms to return to original interest rate, ms increases so that i decreases. Fiscal deficit had become and increasing (cid:374)atio(cid:374)al de(cid:271)t i(cid:374)t(cid:396)odu(cid:272)ed tight fis(cid:272)al poli(cid:272)(cid:455) Implemented expansionary monetary policy in order to prevent output from falling as a result of contractionary fiscal policy: economy experienced mild growth and low interest rate. Fall in g reduces y directly and through multiplier effects. Lm curve shifts down as money supply (m) increases. Increase in m reduces i and increases i: y increases as a result, as well as through multiplier effects. Howard-macfarlane policy mix ii: demand for exports pushed out the is curve, both monetary and fiscal were contractionary to prevent economy from being overheated.