The government and fiscal policy (2)

 Why is there a need for government intervention in some economic affairs?

 The private sector could not and would not solve some economic problems such as unemployment and poverty.
 The private sector would always tend to plunge into business and economic activities that generated the best returns for themselves.
 Someone had to create jobs; someone had to build roads and bridges; someone had to provide incentives to private businesses for the
exploration of natural resources, etc.
 The extent with which the government is involved in today’s daily economic life can be seen in the existence of economy-related
government offices (ex. DTI, DA, DOLE, etc.).
The financial power of the government
 The government, when faced with temporary cash problems, could always borrow far easier than any corporation precisely because its
financial position is backed up by all the wealth of the nation’s natural resources.
 The government, when faced with a more permanent cash problem, could always levy heavier taxes and any other similar impositions in
the same way as a corporation could increase its rates for services or prices for its products.
When should government spending increase? Decrease?
a. When private investment is high, government should decrease government spending.
 Increased private invesment ⇒ ↑ demand ⇒ ↑ price
 The government should take funds off the consumers and producers by refraining from heavy government spending.
b. What happens when private investment is low?
Relationship of taxation and the economic cycle
a. What should the government do in terms of tax rate during economic depression?
 Depression ⇒low economic activity (low private investment, low income, low consumption, etc.)
 The government should reduce tax rates to encourage more production and increase consumption and income.
b. What should the government do during an economic boom?
Government and monetary policy

1. What is money?
a. A means of payment or medium of exchange
b. A store of value
c. A unit of account
2. History of money in the Philippines
3. Functions of the BSP
The supply for money
 If the BSP’s money supply behavious is not influenced by the interest rate, the money supply curve is a vertical line. Through open
market operations, the BSP can have the money supply be whatever value it wants.
Grarph….,

The demand for money

 The main reason that people hold money—to buy things.
 “Demand for money” means –
 How much of your financial assets do you want to hold in the form of money, which does not earn interest?
 Nonsynchronization of income and spending
 The mismatch between the timing of money inflow to the household and the timing of money outflow for household
expenses.
 Income arrives only once a month, but spending takes place continuously.

The demand for money

 The quantity of money demanded (the amount of money households and firms want to hold) is a function of the interest rate.
 Because the interest rate is the opportunity cost of holding money, increases in the interest rate reduce the quantity of money that firms
and households want to hold and decreases in the interest rate increase the quantity of money that firms and households want to hold.
Graph…,
Determinants of money demand: Effects of income and the price level
A. What happens to money demand when there is an increase in aggregate output (income), Y?
- An increase in Y means that there is more economic activity. Firms are producing and selling more, and households are earning more
income and buying more. There are more transactions, for which money is needed. As a result, both firms and households are likely to increase
their holdings of money at a given interest rate.
Graph…,

Determinants of money demand: Effects of income and the price level

B. What happens to money demand when there is an increase in the price level?
- Increases in the price level shift the money demand curve to the right. Even though the number of transactions may not have changed, the
quantity of money needed to engage in them has.
Graph….,

Determinants of money demand (Summary)

1. The interest rate: r
 The quantity of money demanded is a negative function of the interest rate.
2. The volume of transactions
a. Aggregate output (income) : Y
- an increase in Y shifts the money demand curve to the right
b. The price leve: P
- an increase in P shifts the money demand curve to the right

The equilibrium interest rate: How is the interest rate determined in the economy?
 The point at which the quantity of money supplied equals the quantity of money demanded determines the equilibrium interest rate in
the economy.
 An excess supply of money will cause households and firms to buy more bonds, driving the interest rate down. An excess of demand for
money will cause households and firms to move out of bonds, driving the interest rate up.
Graph…,

Changing the money supply to affect the interest rate

 If the BSP wanted to increase the interest rate, it would contract the money supply. The supply of money curve would shift to the left,
and the equilibrium interest rate would rise.
Graph….,

Increases in Y and shifts in the money demand curve

 An increase in aggregate output (income) shifts the money demand curve to the right, which raises the equilibrium interest rate.
Graph….,

Changes in price level and shifts in the money demand curve

 What happens to the interest rate when price level rises?

Equilibrium in both the goods and money markets

Links between the goods market and money market

 The goods market and the money market do not operate independently. Events in the money market have effects on the goods market,
and events in the goods market have effects on the money market.
Graph…,
Equilibrium in both the goods and money markets
 In the goods market, there is a negative relationship between the interest rate and output because there is a negative relationship
between the interest rate and planned investment.
 In the money market, there is a positive relationship between the interest rate and output for a fixed money supply because if output
increases, the interest rate must increase to achieve equilibrium in the money market.
 Combining the goods and money markets determines the equilibrium values of both the interest rate and output.

Policy effects in the goods and money markets

 An expansionary fiscal policy is an increase in government spending (G) or a reduction in net taxes (T) aimed at increasing aggregate
output (income) (Y).
 An expansionary monetary policy is an increase in the money supply aimed at increasing aggregate output (income) (Y). An increase in
the money supply leads to a lower interest rate, increased planned investment, increased planned aggregate expenditure, and ultimately
a higher equilibrium level of aggregate output (income) (Y).
 Expansionary policies have been used to lift the economy out of recessions.
 A contractionary fiscal policy is a decrease in government spending or an increase in net taxes aimed at decreasing aggregate output
(income) (Y).
 A decrease in government spending or an increase in net taxes leads to a decrease in Y, a decrease in the demand for money, and a
decrease in the interest rate.
 However, the decrease in Y is somewhat offset by the additional planned investmenr resulting from the lower interest rate.

 Expansionary Fiscal Policy

↑G ⇒ ↑Y ⇒ ↑Md ⇒ ↑r ⇒↓I
 Expansionary Monetary Policy
↑MS ⇒ ↓r ⇒ ↑I ⇒ ↑Y

Policy effects in the goods and money markets

 A contractionary monetary policy is a decrease in the money supply aimed at decreasing Y. The higher interest rate brought about by the
reduced money supply causes a decrease in planned investment spending a lower level of equilibrium output.
 However, the lower equilibrium level of output brings about a decrease in the demand for money, which means the increase in the
interest rate will be less than it would be if we did not take the goods market into account.
 Contractionary policies have been used to fight inflation.

Policy effects in the goods and money markets

 The POLICY MIX is the combination of monetary and fiscal policies in use at a given time.
 There is no rule about what constitutes the best policy mix or the best composition of output.
 In part, one’s preference for a certain composition of output depends on one’s stance concerning such issues as the proper role of
government in the economyu.