Fiscal policy
Monetary policy
Macroeconomic CSI: Fiscal and monetary policy responses to the 2008 financial crisis Rodolphe Desbordes
http://www.rodolphedesbordes.com/
Fiscal policy
Monetary policy
Table of Contents I
1
Fiscal policy Fiscal stimulus Impact of budget deficits on public debt Fiscal consolidation
2
Monetary policy Conventional response: an interest rate cut Credit crunch and unconventional responses Macroeconomic policies and the crisis
Fiscal policy
Monetary policy
Fiscal packages
Source: http://www.economist.com/node/13035552?story_id=13035552
Fiscal policy
Monetary policy
The impact of a fiscal stimulus in the IS/PC/MR model Interest rate
PC
PC1
Target
r_L’ C
E?
A
B
E? Deflationary spiral
r_L A
C
D MR
IS’ Fiscal stimulus
IS
Fiscal simulus Output
Ye
Output
Fiscal policy
Monetary policy
Effectiveness of the impact
For the fiscal stimulus to have an impact, the IS curve needs to shift: Precautionary savings: tax cuts may not lead to greater spending if households save the extra income or use it to pay off their debt. Ricardian equivalence: economic agents may recognise that stimulus packages are financed through debt which will have to be later repaid through higher taxes. If they raise their savings rate, the short-term benefits of the stimulus packages will be offset. Overall, it is very hard to determine textcolorredthe actual size of the fiscal multipliers.
Fiscal policy
Monetary policy
Assumed multiplier values by U.S. CBO
Source: http://www.cbo.gov/ftpdocs/115xx/doc11525/05-25-ARRA.pdf
Fiscal policy
Monetary policy
Estimated impact of U.S. fiscal package
Source: http://www.cbo.gov/ftpdocs/115xx/doc11525/05-25-ARRA.pdf
Fiscal policy
Monetary policy
A fiscal stimulus is not enough
Source: http://www.cbo.gov/ftpdocs/100xx/doc10008/03-02-Macro_Effects_of_ARRA.pdf
Fiscal policy
Monetary policy
Cyclical and discretionary fiscal response
Source: http://www.oecd.org/document/61/0,3343,en_2649_34573_2483901_1_1_1_1,00.html
Fiscal policy
Monetary policy
The impact of budget deficits on debt I The government budget’s identity at each period is Gt + |{z}
iBt−1 | {z }
=
Tt + |{z}
Gov. exp. interest Gt Bt−1 +i Pt Yt Pt Yt Bt ∆ Pt Yt Bt Pt Yt
=
taxes new bonds Tt ∆Bt + Pt Yt Pt Yt Gt − Tt Bt−1 +i Pt Yt Pt Yt Gt − Tt Bt−1 (1 + i) + Pt Yt Pt Yt
= = =
∆Bt |{z}
Bt−1 is the outstanding stock of bonds, i.e. the value of the national debt at the beginning of each period. The primary deficit of a country is
Gt −Tt Pt Yt
.
The actual deficit includes the interest i on outstanding debt B Gt −Tt + i Pt−1 . Pt Yt t Yt The change in the debt ratio is equal to the actual deficit.
Fiscal policy
Monetary policy
The impact of budget deficits on debt II We can rewrite
Bt−1 : Pt Yt
Bt−1 Pt Yt Pt−1 Yt−1 Pt Yt
is the inverse of Bt Pt Yt
= '
∆
Bt Pt Yt
=
1 1+π+gY
Bt−1 Pt−1 Yt−1 Pt−1 Yt−1 Pt Yt
.
(1 + i) Bt−1 Gt − Tt + (1 + π + gY ) Pt−1 Yt−1 Pt Yt Bt−1 Gt − T t (1 + i − π − gY ) + Pt−1 Yt−1 Pt Yt
=
(r − gY )
Bt−1 Gt − Tt + Pt−1 Yt−1 Pt Yt
Fiscal policy
Monetary policy
The impact of budget deficits on debt III This equation describes the growth of the debt to GDP ratio ∆
Bt Pt Yt
=
(r − gY )
Gt − Tt Bt−1 + Pt−1 Yt−1 Pt Yt
The debt to GDP ratio depends on 1
2 3
(r − gY ), the difference between the real interest rate and the growth rate of output. Gt −Tt , the primary deficit. Pt Yt Bt−1 Pt−1 Yt−1
the existing ratio of government debt to GDP.
With the economic crisis, the debt to GDP ratio increased because 1 2 3
(r > gY ), since the crisis is a reduction in the growth rate of output. Gt −Tt >0, with the automatic stabilisers and the fiscal stimulus. Pt Yt B
↑ P t−1 , the initial debt ratio increased with the capital injections in t−1 Yt−1 banks (bail-outs).
Fiscal policy
Monetary policy
Public debt ratios (% GDP) Greece
Iceland
Ireland
Italy
Spain
Total OECD
United Kingdom
United States
0
50 100 150
0
50 100 150
0
50 100 150
Euro area
y2006
y2010
Source: http://www.oecd.org/document/61/0,3343,en_2649_34573_2483901_1_1_1_1,00.html
Fiscal policy
Monetary policy
The costs of rising public debt Stability of the debt to GDP ratio requires that ∆ PBt Yt t = 0 in the steady-state (all variables are held at their long-run values): B PY
=
T −G PY
=
T −G PY
(r − gY ) (r − gY )
Bt 2010 PY r (%) g (%) 2010 Actual T-G (% GDP) Required T-G (% GDP)
B PY
UK
Greece
0.8 2.3 1.3 -8.8 0.8
1.29 6.6 -3.7 -2 13.16
Fiscal policy
Monetary policy
The dangers of rising public debt Greece or the U.K. needs a large primary surplus to stabilise its debt to GDP ratio, i.e. taxes (T ) must increase or government expenditures (G) must fall. The longer it waits, the larger the fiscal consolidation -the implementation of fiscal policy such as a sustainable debt ratio is achieved, will have to be. BUT: ↓ G and ↑ T may decrease current (lower consumption) and potential growth (lower investment in education)... making even more difficult the stabilisation of debt as the primary surplus must increase. AND: ↓ G and ↑ T is politically unpopular... triggering concerns that the government will default on its debt... leading to a higher interest rate, which worsens the debt burden and is likely to reduce growth... making even more difficult the stabilisation of debt as the primary surplus must increase... which leads to an even higher default risk premium.
Fiscal policy
Monetary policy
Default risk and risk premium
Source: http://www.imf.org/external/pubs/ft/weo/2010/01/
Fiscal policy
Monetary policy
The impact of fiscal consolidation In order to avoid a rising debt burden, fiscal consolidation must occur. Remember that our IS curve is: Y
=
1 [(Co + Ai + G) − ar ] (s + ct − b1 )
Fiscal consolidation involves ↓ G and ↑ T = tY , with negative AD consequences. However, fiscal consolidation may lead consumers and firms to be more confident about the future, leading to ↑ (Co + Ai ). Hence, the direction of the shift of the IS curve is ambiguous. Fiscal consolidation may lead to a lower risk premium and r falls. Hence, the economy may move along the IS curve to a higher output position. Fiscal consolidation may increase or reduce equilibrium output and therefore equilibrium unemployment. For instance, lower unemployment benefits should encourage workers to accept lower nominal wages, leading to a fall in the unemployment rate.
Fiscal policy
Monetary policy
Expansionary austerity: ∆ G−T Y > 1.5% in a boom Country
Spain Spain Finland Finland Finland Greece Ireland Ireland Ireland Ireland Netherlands Norway Norway New Zealand New Zealand New Zealand Portugal Portugal Portugal Sweden
Year of fiscal consolidation
Cut in a slump
Growth higher than before fiscal consolidation
1986 1987 1973 1996 1998 1976 1976 1988 1989 2000 1996 1980 1996 1993 1994 2000 1986 1988 1995 2004
No No No No No No No No No No No No No No No No No No No No
Yes Yes No Yes Yes Yes Yes Yes Yes No Yes No Yes Yes Yes Yes Yes Yes Yes Yes
Fiscal policy
Monetary policy
Expansionary austerity: ∆ G−T Y > 1.5% in a slump
Country
Year of fiscal consolidation
Cut in a slump
Growth higher than before fiscal consolidation
Finland Greece Greece Ireland Norway Norway*
2000 2005 2006 1987 1979 1983
Yes Yes Yes Yes Yes Yes
No No No Yes No Yes
Source: http://www.rooseveltinstitute.org/sites/all/files/not_the_time_for_austerity.pdf. ∗ , Norway did not stabilise its debt to GDP ratio and is therefore not really a case of successful fiscal consolidation.
Given that most OECD countries are in a period of low growth, it is likely that in the short-run, fiscal consolidation will shift the IS curve to the left.
Fiscal policy
Monetary policy
Conventional response: a change in the interest rate
Source: http://www.imf.org/external/pubs/ft/weo/2010/01
Fiscal policy
Monetary policy
Credit crunch and conventional response I Interest rates
r_L’
B
C
r_L’’ C’
E
D
r_L A r_0 r_0’
LD’ L’
L
LD LD’’’ Loans
In normal times, because rL = (1 + m)r0 , a fall in the targeted real interest rate leads to a fall in the real loan interest rate and a rise in higher lending boosting output, generating higher demand for loans until Y = AD [C −→ C 0 −→ D]. However, banks may decide to leave the loan interest rate unchanged. The risk premium has increased or banks seek to increase their profits by increasing their mark-up [C].
Fiscal policy
Monetary policy
Credit crunch and conventional response II: the case of the liquidity trap Interest rates
r_L’
B
C
r_L’’ C’
E
D
r_L A r_0 r_0’
LD’ L’
L
LD LD’’’ Loans
An expansion of loans requires that banks do not ration credit anymore. If that is not the case, no additional lending occurs [C −→ E]. The central bank may try to lower even more r0 . However, r0 = i − π and i ≥ 0. Hence, once the nominal interest rate hits zero, no more conventional monetary easing can be done. This situation is called a liquidity trap or zero-bound.
Fiscal policy
Monetary policy
Credit crunch and unconventional response I: policy duration commitment The central bank only manipulates the short-term nominal interest rate. However, expected long-term interest rates can be interpreted as the average of the one-period interest rates expected to occur over a given period:
E[itn ] =
1 1 1 [it|t + it+1|t + ... + it+n−1|t + rp n
where rp is a risk premium. Hence, if the central bank announces that it will keep short-term interest rates low for a long period of time, long-term interest rates may decline. They are the most relevant for determining investment. For instance the Fed announced in 2008: In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time. http://www.federalreserve.gov/newsevents/press/monetary/ 20081216b.htm.
Fiscal policy
Monetary policy
Credit crunch and unconventional response II: quantitative easing Even if the official interest rate hits the zero bound, nothing prevents the central bank from increasing the monetary base. Quantitative easing arises when the central bank adds more reserves than are required to keep the official interest rate value at zero. 1
The first effect is to add credibility to the commitment of the central bank to keep interest rates low for a long period of time, since it will take time to drain away the excess quantity of reserves in the money market in order to achieve a higher interest rate value.
2
The second effect is to reduce liquidity risk, i.e. the risk of not having enough reserves to meet the bank’s obligations to depositors. However, once a threshold level of excess reserves is reached RD , it is hoped that banks will lend again.
Fiscal policy
Monetary policy
Credit crunch and unconventional response III: qualitative easing Qualitative easing shifts the central bank’s composition of the balance sheet away from default free assets towards riskier assets. The central bank starts buying private securities (corporate bonds/commercial paper or mortgagebacked securities). It also buys long-term government debt. 1
The first effect, especially relevant for companies, is that it provides funding when no alternative source exists.
2
The second effect is to reduce the yield (interest rate) on existing and new bonds since there is a negative relationship between the price of a bond and its interest rate (yield = coupon , e.g.5% = 5/100). price Lower interest rates allow firms to raise funds at a lower interest rate and mortgage rates to be cheaper. Banks are encouraged to lend to firms and consumers because long-term government debt is less attractive. They may also invest in equities, increasing stock prices, wealth and, potentially boost consumption and investment.
Fiscal policy
Monetary policy
Credit crunch and credit easing Quantitative easing is an increase in the size of the balance sheet of the central bank through an increase it is monetary liabilities (base money), holding constant the composition of its assets. Qualitative easing is a shift in the composition of the assets of the central bank towards less liquid and riskier assets, holding constant the size of the balance sheet. The Fed and the Bank of England are engaged in credit easing, i.e. both quantitative and qualitative easing: 1
The size of their balance sheets (total assets or total liabilities) has dramatically increased.
2
They now hold other assets besides government bonds and focus on how the composition of assets affects credit conditions for households and businesses.
Fiscal policy
Monetary policy
Central banks: expansion and composition
Source: http://1.2.3.9/bmi/www.lewrockwell.com/quinn/fed-assets.jpg2 and http://www.bankofengland.co.uk/markets/balancesheet/index.htm
Fiscal policy
Monetary policy
Is Credit Easing working?
Source: http://www.bankofengland.co.uk/publications/other/monetary/TrendsOctober10.pdf
Lending depends on supply of credit and demand of credit. Supply seems to have slightly increased with less rationing and a lower mark-up. However, demand is very weak. Hence credit easing may be working in terms of mitigating the negative impacts of the crisis but it cannot fully offset them.
Fiscal policy
Monetary policy
Macroeconomic policies and depression
Source: http://www.voxeu.org/index.php?q=node/3421
Fiscal policy
Monetary policy
Taking stock. Please answer the following questions: 1
What have you learnt today?
2
What have you understood the best?
3
What have you understood the least?
4
Did you enjoy the lecture? Explain why.
5
Please grade the lecture on a 0-100 scale (poor to excellent).