Macroeconomics II: ISLM Framework, Monetary, and Fiscal Policy,
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The document provides an overview of the IS-LM framework for macroeconomic analysis. It discusses the relationship between goods markets and money markets, and how equilibrium is reached. It also outlines the derivation of the IS and LM curves and how they are used to show equilibrium between interest rates and income. Fiscal and monetary policies can be used to shift the curves and achieve different macroeconomic outcomes like increasing output. The document contains several chapters that cover these topics at a conceptual level.
Macroeconomics II: ISLM Framework, Monetary, and Fiscal Policy,
- 1. IS – LM Framework, Fiscal and Monetary Policy Macroeconomics II W. A. Upananda Former Assistant Professor/Senior Lecturer
- 2. Why IS (Goods) and LM (Money) Equilibrium? • We need goods and services to satisfy our endless needs although availability of money is limited; similarly we need money to purchase goods and services that we needed. • Then it is important to understand the behaviour of markets where these goods and money are circulating. Demand for goods and supply of money determine the equilibrium level which in turn determine the general price level of a country.
- 3. Chapter One IS-LM Framework and General Equilibrium • Contents: IS-LM Framework – Money market (LM) – Commodity Market (IS) • Learning Objectives – Describe money market and commodity market – Derivation of IS and LM curve
- 4. IS-LM Framework • IS-LM framework attempts to describe equilibrium between goods market and money market. • Goods market is defined as equality between savings and investments. Saving is function of Income while investment is inverse function of rate of interest. When product market is in equilibrium I = S.
- 5. Money Market : LM • Market equilibrium attained when demand of money (L) equated the supply of Money (M) or L=M. • Money is used for transactions, precautions, and speculations. Demand for money is divided into L1 which covers transaction demand and precautionary demand while L2 stands for speculative demand. Speculative demand for money is inverse functions of Interest rate. In equilibrium L=M which meet the equilibrium of goods market where I = S.
- 6. Overview of IS-LM Framework Asset Market Goods Market Money Supply Output or goods supply Income Demand for Money Aggregate Demand Fiscal Policy Autonomous spending
- 7. Commodity Market Equilibrium Derivation of IS Curve Savings Savings I = S Income Investment Interest IS curve Interest Income Investment
- 8. Motives of Keeping Money Retrieved from: http://bilbo.economicoutlook.net/blog/?p=25090 • Transactions motive – people need money to engage in daily transactions. Thus the demand for liquidity will be some proportion of total national income. • Precautionary motive – at times major events occur that need to be resolved through transactions – for example, maintaining a cash balance to pay for engine repairs on a car. • Speculative motive – People used money in times of uncertainty over movements in interest rates. They have a choice between holding money which earns no interest return or purchasing an interest-bearing asset, which has less liquidity. .
- 9. Financial Wealth of Individuals and of an economy • Nominal financial wealth (W)/price level (P) = Real financial wealth = W/P; • Demand for real balance (L) and demand for bond (V) equate the financial wealth of a an individual. Similarly, the financial wealth of an economy can be written as • W/P = M/P (demand for money) + P • Money supply has to derive with respect to the demand for money.
- 10. Fundamentals of deriving LM curve • Demand for money is created only by transaction demand and speculative demand. • Speculative demand is inversely related to rate of interest. • National income is determine with respect to the transaction demand for money. • Transaction demand and speculative demand react in opposite direction.
- 11. Money Market Equilibrium: Derivation of LM Curve Transaction Demand ransaction Demand Income Speculative demand for Money Interest (i) LM curve interest Income Speculative demand for Money
- 12. Chapter Two Goods and Money Market Equilibrium IS Curve Interest LM Curve Equilibrium Income (Yo)
- 13. IS-LM Framework in Detail Retrieved from:http://bilbo.economicoutlook.net/blog/?p=25090 By changing interest rate income level could also be changed
- 14. Monetary Policy • Monetary policies deals with real quantity of money which influence level of income and interest rate. • Central Bank of Sri Lanka manipulate the quantity of money by relative supply of money and bonds. When CBSL buys bonds prices will be high and the yield will be lower making interest rate fall. Then public will not hold bonds then the circulation of money increases.
- 15. Autonomous Expenditure/Consumption Extracted from Investopedia • An autonomous expenditure describes the components of an economy's aggregate expenditure that are not impacted by that same economy's real level of income. • The classical economic theory states that any rise in autonomous expenditures will create at least an equivalent rise in aggregate output, such as GDP, if not a greater increase. • Autonomous consumption is defined as the expenditures that consumers must make even when they have no disposable income to be purchased, regardless of how much money is coming in.
- 16. Manipulation of Quantity of Money to Increase output Interest LM1 LM2 IS Output
- 17. Liquidity Trap situation where monetary policy become ineffective • When public is prepared to hold all money supplied at certain interest rate LM curve become horizontal which make monetary policy ineffective. When LM curve become vertical interest rate has no effect and demand for money is depends on level of output.
- 18. Fiscal Policy • Fiscal policy deals with government spending. • When monetary policy is ineffective government spending may increase output LM Interest rate Multiplier Yo Y1 Output
- 19. Crowding out Effect Situation where government spending has no effect on output • This is the case when government spending has no effect on output. LM curve remain vertical and demand for money remained the same. • Reason for this situation may be that effect of government spending may offset by the reduced investment spending.
- 20. Chapter Three Money and Its Functions • Contents: Nature, and functions of money, supply of money in Sri Lanka. • Definition: money is medium of exchange. • Functions: Medium of exchange, standard of value, store of value, standard for differed payment (money to be paid in future), dynamic force of economy.
- 21. Factors affecting Money Supply • Three factors may influence Money supply: – Outstanding net domestic credit extended to government and private sector – Net foreign asset held by com. banks: Foreign currency in hand; balance due from abroad, export bills, and overdraft from aboard. – Difference between non-monetary assets and liabilities.
- 22. Sri Lankan Experience in Money Supply • 1. 1950- 1960: Fair degree of price stabiity; 1961-1969 is characterized by monetary restrictions. • 2. 1970- 1977: emergence of inflationary pressure and low capital accumulation. Overall Financial reforms with liberalized economy.
- 23. Chapter Four Intermediary Role of Bank • Contents: Banking history; financial intermediary; Banking system in Sri Lanka • Definition of Bank: A bank or banker is a person or institution carrying on the business of receiving money and collecting draft for customers subject to obligation of honoring cheques drawn upon them form time to time by customers. • Functions of a bank: Safeguard and transfer funds; lend facilities; guarantee credit worthiness; exchange money.
- 24. Financial Intermediary model Financial Claims Financial intermediation Maturity transaction Aggregation Risk transformation Financial Claims Borrowers Savings
- 25. Banking System in Sri Lanka • Commercial banking: Bank of Kandy in 1828 and Bank of Ceylon in 1841. in 1961,People’s Bank established after replacing cooperative federal bank. Later in the 19th century, branches of foreign banks established to serve plantation sector and its exports. Reorganized bank of Ceylon under ordinance No. 39 of 1939. Commercial Bank of Ceylon Ltd.. In 1907 and Hatton National Bank in 1970 were established as private commercial banks. • With trade liberalization in 1977, de-regulation, imposed inviting more competition. Total number of commercial bank increased from 12 to 23. • By 2017 Sri Lankan banking sector is comprised of – Licensed Commercial Banks – Registered Finance Companies – Licensed Specialized Banks
- 26. Asset Distribution in Sri Lankan Banking Sector
- 27. Chapter Five Money Creation • Money creation: Total cash deposits are not utilized and remaining cash could be advanced to other customers which becomes an asset for the bank. Reserve ratio is determine the percentage that could be advanced. • Deposit coefficient: 1/ r; where r is the Reserve ratio.
- 28. Chapter Six Money and Prices: Theory and Practice • Contents: Relationship between money and prices; quantity of Money (M); Velocity of Circulation (V), Price level (P); Output (Q); Keynesian and monetarist views; and limitation of monetary theory. • Objectives: How money and price related; effect of money supply on price level; Understand Keynesian and monetarist theories; Limitations of Monetary theories.
- 29. Money and prices • Money is the assets which could purchase goods and services while price determines what to produce and how much to produce through the demand created by money supply and its value. • Theory which explains relationship between money and prices: Equation of exchange: • Where M is money supply; V as velocity of income; P as price level and Q final output of the economy. • M1 = Currency held outside banks; demand deposits; other checkable deposits. PQMY
- 30. Income Velocity • Income velocity is defined as the number of time average rupee is spent on goods and services. For example, M1 in 1995 in Sri Lanka was Rs. 75 billion and the GNP (Q) in the same was Rs. 659 billion. Then the income velocity is 659/75= 8.78. Then we can write, • V=GNP/M; V = PQ (output or GNP at current price); • MV = PQ (Fisher equation) ; According to this equation Q could be remained constant even M is increased. Because P (price level) may increased (inflation) to compensate the increased quantity of money.
- 31. Keynesian Monetary Theory • Keynes added third motive, speculative motive, for holding money to existing motives: transaction motive and precautionary motive. • Speculative motive arise as a result of uncertainty of interest rate fluctuation: either to hold or to invest on non-monetary assets. Here, interest rate is the cost of holding money. • Keynes stated that’ increased in money supply may have little or no effect on the price level if the spending generated by interest rate decrease.
- 32. Keynes Monetary theory: an explanation on effect on price Price may increase Business investment and private consumption Decrease in Interest rate Increase in speculative demand Increase in Money supply
- 33. Chapter Seven Fiscal Policy • Contents – Goals of macroeconomics – Full employment, Price stability, and economic growth – Taxation and spending • Objectives – How fiscal policy is used to achive macroeconomic goals – How government spending and tax policy help establish stability – Fiscal policy of Sri Lanka
- 34. Goals of Macroeconomics • Three main objectives – Full employment; Price stability, and economic growth – Full employment (Full employment of Land, labour, capital, and entrepreneurship – Price stability ; absence or mitigation of inflation or deflation – Economic growth: sustained increase in overall productive capacity
- 35. Aggregate Demand and Supply Price Level Real GDP AS Curve Price Level Real GDP
- 37. Fiscal Policy • Fiscal policy deals with Taxation, Government expenditure, borrowing and management of public debt. • Tax cuts : When tax cuts imposed disposable income increases and increases consumption spending which stimulate aggregate demand for goods and services. • Government spending: Government spending will added to NI with multiplier effect which depends on MPC . Consumption multiplier : K = 1/1-MPC • If Rs. 1000 million spent it will add K times of government spending.
- 38. Fiscal Policy • Learning Objectives: • How fiscal policy achieve macroeconomic goals. • How tax policy and government spending help stabilize the economy • How fiscal policy affect economic objectives of government • Brief history of fiscal policy of Sri Lanka • Goals of Macroeconomics: Specifically three to five objectives are there: 1, full employment (land, labor, capital, entrepreneurship). 2. Price stability 3. Economic growth 4. equilibrium in balance of payment 5. Fair distribution of income or minimize inequality in wealth distribution
- 39. Achieving Macroeconomic Goals Price stability Price level Aggregate Demand Aggregate supply AD 2 AD1 Q1 Q2 Real GDP
- 40. Fiscal Policy in Sri Lanka Retrieved from https://www.cbsl.gov.lk/en/economic-and-statistical-charts • Regimes of fiscal policy could be divided into four eras: • 1950- 1960: State’s role in economic activities were limited and confined to welfare while private sector played dominant role. • 1960-1977: Inward looking economic policy and state involvement in infrastructure development activities. Economic growth rate was negative in some years • 1978-1994: By end 1993, 42 state enterprises had been privatized. Further, most of the state-owned plantations were handed over to 22 companies for management. • 1995-2004:In 2001 to 2004, Sri Lanka faced bankruptcy with debt reaching more than 100% of GDP.
- 41. Fiscal policy: 2005- 2017: • Govt. debt declined to 82.9% of GDP in 2009. Sri Lanka’s economy grew at an average 5.8 percent during the period of 2010-2017 (World Bank in Sri Lanka).
- 42. End • Thank you for watching. • Please do not forger to make comments to improve further presentations