0:16
Here on the screen, you've got a quadrant of different,
policies from the fiscal side and from the monetary side.
And then in the four squares, we are looking at
how they are combined, and what happens to the economy, okay?
Now, in some cases the prediction is difficult
but we will, we will go through this and,
and the main messages is, what happens in
the real economy as they work against each other.
But first of all we, we will start out with policies that reinforce each other.
Okay.
So you can see if we look at the upper right hand corner of
the quadrant you can see we have
got restrictive fiscal and restrictive monetary policy acting
together, now when this might happen, well
probably when the economy is very overheated
It could happen when inflation has really
accelerated and, and, maybe we're seeing some bubbles.
So we've got a situation of serious over heating and both authorities, the fiscal
and the monetary authorities, even if they're
independent say, this has to slow down.
So, they slam the brakes on the economy in
a sense, with a restrictive fiscal, a restrictive monetary.
Now this could even happen actually in situations that
are not of excessive overheating or large inflationary gap.
I can recall in the 90s when Spain
1:38
was when it had it's separate currency the percatar.
And, they we're using interest rates as we'll talk about in a few minutes, to
keep the percatar strong, because they had a
target for the percata and it kept falling.
At the same time the economy was slipping down into a recessionary gap.
So, as you know, automatically as you
slip into a recessionary gap, the deficit grows.
Okay, so this was about July 1992, the central bank was not independent.
So on the same day in July 1992 the government instructed the
central bank to raise interest rates to keep the percatar from falling.
Because they had this target exchange rate that they
had to keep in the European monetary system, and
at the same time, to stop the problems with
the deficit we used to double from the previous year.
They raise taxes, and cut government spending all
three of these on the same day so
we've got restrictive fiscal with higher taxes, reduce
government spending and restrictive monetary with higher interest rates.
Well this was a doubled [INAUDIBLE] for the economy which
was already weakening and by October it had slipped into recession.
Now that didn't happen because they wanted to
slow the economy down, it happened because there
was some sort of policy mistakes or maybe
policy commitments that they had made in the past.
And they felt obliged to comply, or they felt obliged to control the deficit, and
so they used policies that had a massive restrictive impact on the economy.
We can see these many times if we
look in different countries, and through economic history.
The result, then, if you put together restrictive fiscal,
restrictive monetary, will be a sharp decline in aggregate demand.
If you remember our aggregate demand diagram, both of those policies will
shift the curve, shift the aggregate demand curve inward to the left.
We'll get less inflation, which may be something we want.
We'll also get less output, and so it's likely
that this could push the economy into a recession.
4:14
Why would they do this?
Why would they use two very expansive policies at the same time?
Well, maybe the recession's quite deep.
So if we look at the beginning of the global financial crisis.
If we look at 2009, their are a lot of
countries among them, the United States, the UK, that did this.
In the first stage, saying, we've got to stop this, it's going to be big.
Let's do whatever is in our hands to keep it, the crisis, from becoming deeper.
So in a very deep recessionary gap, you might do this.
You might also do this because the, the government is facing elections soon.
It wants to expand the economy.
It wants to make sure that people feel good and vote for them.
And so, as we mentioned in an earlier
session, the political business cycle that can be
caused by fiscal policy, they want to kind of push
the economy up, so that people support them.
So you might see an expansive fiscal policy for
political reasons and maybe the monetary authority's not independent.
And so they receive instructions for an expansive monetary policy.
If you combine these two expansive policies,
what's likely is that, what is definite, is
that aggregate demand will shift outward to
the right, we don't know exactly how much.
But probably you're going to push the economy out of the recessionary gap
but into an inflationary gap, because this is a powerful combination of policies.
Now it is possible when we think about how
deep the recession was in at the beginning of
this financial crisis in 2009, that the two policies
won't push us all the way up into inflationary gap.
But maybe they'll just get us out of the recessionary gap, and
up toward potential as they did, in a sense, in the United States.
So, those two squares are easy
to understand, the ones with reinforcing policies.
So let's look at the other two which are a
little less intuitive, where we have policies working against each other.
And let's start with the upper left hand corner, where we
have got expansive fiscal and restrictive monetary happening at the same time.
Okay.
This would be when for example maybe the government either is
not controlling its spending, it's very expansive, and the central bank is
saying I don't think such an expansive policy is a good idea
because we are going to have inflation, so they pulled back, okay.
6:49
What happens when those two go together?
Well, its very hard to predict where GDP is going to go because
on of these policies expands the fiscal is shifting agrid demand to the right.
The other, the restricted monetary is shifting it into the left.
So depending which one is bigger, you know with the
information I've given you, there's no way you can predict it.
It's possible the economy will have a mild expansion, if fiscal's
more powerful, it might have a mild contraction, if monetary's more powerful.
They might just cancel each other out, and we stay where we were, right.
Any of those are possible, but what's important about this, is additionally
what's happening to the composition of GDP as these policies combined?
Remember we said in an earlier session that GDP is made up of C + I + G + X - M.
Okay, so GDP is those four elements of aggregate demand.
And when we mix these two policies, those four elements are being affected.
Think this through a little bit.
The expansive fiscal policy is going to raise
the size of government, in the economy, most likely.
Okay.
And the restrictive monetary policy is going to reduce the size
of investment in the economy, because
we've raised interest rates, investors withdraw.
'Kay?
Now, even if the economy stays exactly where it was,
the end result is bigger public sector, smaller private sector.
8:18
Now, this effect might not be very big, but it is important
enough in some cases that we have a term for it in economics.
The term is crowding out.
In other words, the private sector is
being crowded out by the expanded public sector.
We talked about this when we discussed fiscal policy, when we
said it could happen automatically as the government's engaged in deficit spending.
Here it's more intense, because not only is the government expanding
and, you know, sort of pushing out private borrowers in the
money market as interest rates rise, but the monetary authorities actually
also raising interest rates, making it doubly difficult for investors to borrow.
8:57
So, how important is this crowding out, how much actually happens?
There's a huge debate here, but what is likely in this
box, is that we're going to see at the end of
the policy when all of these different changes worked themselves out
through the real economy, a bigger public sector, a smaller private sector.
And this may not be the best thing for the long run growth, and productivity of
the economy because usually the private sector is
better than the public sector, overall, at creating jobs.
At innovating, at raising productivity.
So, you know, this is something crowding out
that we don't want to see for very long periods.
Now, on the lower right hand corner we have the other combination of
the four that we offered here, which is another one of opposing policies.
Policies colliding each other in the real economy.
In this case, we have restrictive fiscal, and expansive monetary.
In other words what's going on here, is maybe something similar
to what we saw in the other box, box three, right?
Where there is, maybe there's a recessionary
gap, maybe there's even an inflationary gap, okay?
But the two authorities are disagreeing on how
to address it for whatever reason and so.
Maybe the government, concerned about its deficit,
okay, is saying, I think I'm going to withdraw.
I'm going to raise taxes, cut government spending.
I have to take care of this deficit.
Alright?
Even though there's a recessionary gap, I need to
prevent my deficit, my debt, from growing too much.
The monetary authority, on the other hand, the
central bank, says, this is a recessionary gap.
I need to stimulate this economy.
And so I'm going to do what I can, which
is acting through the money supply, cut interest rates, okay.
So again, it's hard for us to predict exactly what will
happen to GDP, because the restrictive fiscal is reducing aggregate demand.
Alright?
And the expansive monetary is increasing it.
Will we stay at the same place?
Maybe.
Will we grow a little bit?
It's possible.
Will we shrink a little bit?
It's possible, depending on the relative magnitude of fiscal
and monetary policy and their effects, but what will
happen in this quadrant is we're getting something that,
just to give an opposite term, to crowding out.
Some people call crowding in, okay.
Down in this square what you're finding is the
public sector is withdrawing somewhat because it's cut government spending.
11:24
And the private sector is expanding somewhat because
We've reduces interest rates, and investment is growing.
So as this works its way through the economy we're
going to see a larger role for the private sector, and a
smaller role for the public sector, which also could be
good of course public sector has many things to do, alright.
Some people use this as, you know, you
should always crowd out the, the public sector
instead of the private, get rid of your public, and I don't think that's the case.
The public sector has a lot of things to do, we
need social programs to a certain extent, we need social services.
but, if your private sector comes back in and invests, and raises productivity,
and innovates, and creates jobs, this can be a net positive effect for the economy.
The message, here, is it's not just
where aggregate demand goes, it's the changing composition
of aggregate demand that can make a real
difference through the long run of the economy.
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Gayle AllardProfessor
