Presentation ysi amsterdam 2014

breakout presenta-on:

The Links between Fiscal and Monetary Policy

Dirk Ehnts Berlin School of Economics and Law

interest rate

IS/LM: a false dichotomy?

IS curve

LM curve

A

income

interest rate

IS/LM: a false dichotomy?

Moving the IS curve inde-­‐ pendently of the LM curve = fiscal policy

IS curve

B A

income

LM curve

interest rate

IS/LM: a false dichotomy?

Moving the IS curve inde-­‐ pendently of the LM curve = fiscal policy

Moving the LM curve inde-­‐ pendently of the IS curve = monetary policy

IS curve

B A C income

LM curve

interest rate

IS/LM: a false dichotomy?

IS curve

B

LM curve

A C

D

income

fiscal policy

plus

monetary policy

equals

policy mix

IS/LM: a false dichotomy. „We now know that it is not enough to think of the rate of interest as the single link between the financial and industrial sectors of the economy; for that really implies that a borrower can borrow as much as he likes at the rate of interest charged, no aQen-on being paid to the security offered. As soon as one aQends to ques-ons of security, and to the financial intermedi-­‐ a-on that arises out of them, it becomes apparent that the dichotomy between the two curves of the IS-­‐LM diagram must not be pressed too hard.“

John Hicks (1980)

interest rate

IS/LM 2.0: the Hicksian cure Expansionary fiscal policy expands the range of collateral in the private sector through issuance of addi-onal government bonds which allows it to borrow more from banks.

IS curve

B

LM curve

A C

D

income

interest rate

IS/LM v. 2.014/€

IS curve

income

LM curve

Lending to households falls ...

... and lending to NFCs falls as well ...

... while sovereign debt has increased!

Euro area government debt to GDP

Euro area 18 (fixed composi-on) -­‐ Maastricht assets/liabili-es -­‐ General government (ESA95)-­‐NCBs -­‐ All sectors without general government (consolida-on) (ESA95) -­‐ NCBs -­‐ Financial stocks at nominal value -­‐ Percentage points, series(t)/GDP(t) -­‐ Neither seasonally nor working day adjusted

hQp://sdw.ecb.europa.eu/quickview.do?SERIES_KEY=121.GST.A.I7.N.B0X13.MAL.B1300.SA.G

Dichotomy of monetary and fiscal policy Summary:

IS/LM model: complete dichotomy IS/LM model 2.0: posi1ve correla1on IS/LM model v2.014/€: no posi1ve correla1on

à What are the links then between monetary and fiscal policy?

The Links between Fiscal and Monetary Policy

What the evidence tells us about the eurozone:

-­‐ weak loan demand -­‐ weak economic growth -­‐ (too) low infla-on rate -­‐ rising sovereign debt

The Links between Fiscal and Monetary Policy

What the evidence tells us about the eurozone:

-­‐ weak loan demand -­‐ weak economic growth -­‐ (too) low infla-on rate -­‐ rising sovereign debt

Bank Loans to entrepreneurs

Step 1: deposits

100

100 Creation of I.O.U.s

Creation of I.O.U.s Entrepreneurs deposits

100

Loans from bank 100

Consumers

Based loosely on Wicksell (1898), Geldzins und G端terpreise, page 170 ff.

Entrepreneurs demand loans from banks given the interest rate. Banks create deposits which are used as money.

Bank Loans to entrepreneurs

Step 1: deposits

100

100

Entrepreneurs [production] 100

Loans from bank 100

exchange money vs labor Consumers deposits

100

Based loosely on Wicksell (1898), Geldzins und G端terpreise, page 170 ff.

Entrepreneurs demand loans from banks given the interest rate. Banks create deposits which are used as money.

Step 2: Entrepreneurs pay households to buy their labour and produce.

Bank Loans to entrepreneurs

Step 1: deposits

100

100

Entrepreneurs deposits

100

Loans from bank 100

exchange money vs goods Consumers [production] 100

Based loosely on Wicksell (1898), Geldzins und G端terpreise, page 170 ff.

Entrepreneurs demand loans from banks given the interest rate. Banks create deposits which are used as money.

Step 2: Entrepreneurs pay households to buy their labour and produce.

Step 3: Households buy goods.

Bank Loans to entrepreneurs Destruction of I.O.U.s deposits

100

Step 1: deposits

100

100 Destruction of I.O.U.s Entrepreneurs Loans from bank 100

Entrepreneurs demand loans from banks given the interest rate. Banks create deposits which are used as money.

Step 2: Entrepreneurs pay households to buy their labour and produce.

Step 3:

Consumers [production] 100

Households buy goods.

Step 4: Entrepreneurs repay bank loans.

Based loosely on Wicksell (1898), Geldzins und G端terpreise, page 170 ff.

The ying of aggregate demand...

"If income is to grow, financial markets must generate an aggregate demand that, aside from brief intervals, is ever rising. (..) For real aggregate demand to be increasing, it is necessary that current spending plans be greater than current received income and that some market technique exist by which aggregate spending in excess of aggregate an-cipated income can be financed.“

Minsky (1982)

... and the yang of aggregate demand „The saving of any sector is, by defini-on, the excess of its cur-­‐ rent receipts over its current expenditures. But an excess of current receipts over current expenditures (flows) must necessarily imply either a buildup of (stocks of) total assets or a reduc-on of liabili-es (or some combina-on of the two) equal in amount to the excess of current receipts over current expenditures. Thus the saving of any sector must be equal to the change in its total assets minus the change in its liabili-es, which in turn equals the change in its net worth.“

RiQer (1963)

The sectoral balances approach • Some sectors spend more than they receive, whereas other sectors receive more than they spend. While the formers sectors are dissaving, the laQer sectors are saving.

It might make sense to focus on three sectors and their balance of payments iden-ty:

( Sp – I ) + ( T – G ) = ( EX – IM )

The Links between Fiscal and Monetary Policy

( Sp – I ) + ( T – G ) = ( EX – IM )

An increase in aggregate demand can come from more private debt, more public debt or more exports (debt of the ROTW).

Y = C + I + G + (EX – IM)

The Links between Fiscal and Monetary Policy

( Sp – I ) + ( T – G ) = ( EX – IM )

An increase in aggregate demand can come from more private debt, more public debt or more exports (debt of the ROTW).

Y = C + I + G + (EX – IM)

The Links between Fiscal and Monetary Policy

( Sp – I ) + ( T – G ) = ( EX – IM )

An increase in aggregate demand can come from more private debt, more public debt or more exports (debt of the ROTW).*

Y = C + I + G + (EX – IM)

* Less imports is also possible, but clearly defla1onary as they equal less exports elsewhere, which shi<s the problem from one to the other.

interest rate

The Links between Fiscal and Monetary Policy

IS curve

new IS curve

Moving the IS curve = fiscal policy = increase in government debt

LM curve

A

income

interest rate

The Links between Fiscal and Monetary Policy

Moving the LM curve = monetary policy = increase in private sector debt

IS curve

LM curve

A

income

new LM curve

The Links between Fiscal and Monetary Policy

The elephant in the room:

Why is loan demand so weak?

(Hint: aggregate demand shortall)

... and the yang of aggregate demand „The saving of any sector is, by defini-on, the excess of its cur-­‐ rent receipts over its current expenditures. But an excess of current receipts over current expenditures (flows) must necessarily imply either a buildup of (stocks of) total assets or a reduc-on of liabili-es (or some combina-on of the two) equal in amount to the excess of current receipts over current expenditures. Thus the saving of any sector must be equal to the change in its total assets minus the change in its liabili-es, which in turn equals the change in its net worth.“

RiQer (1963)

The Links between Fiscal and Monetary Policy

A shortall in aggregate demand is caused by a combina-on of these factors:

1) some sectors have piled up savings and other sectors have been driven into debt but have now stopped to spend (àmacroeconomic imbalances) 2) inside some sector some have piled up savings and others have been driven into debt but have now stopped to spend (àinequality)

Inequality and Economic Policy Central bankers on inequality (1)

Mersch/ECB (2014): „S1ll, a central bank with a clear mandate to safeguard price stability needs to act forcefully when push comes to shove. These distribu1onal side-­‐effects the need to be tolerated. They are one more reason to recognise that the non-­‐ standard measures we have introduced have to be temporary.“

hQp://www.ecb.europa.eu/press/key/date/2014/html/sp141017_1.en.html

Inequality and Economic Policy Central bankers on inequality (1)

• To maintain price stability is the primary objec1ve of the Eurosystem and of the single monetary policy for which it is responsible. This is laid down in the Treaty on the Func1oning of the European Union, Ar1cle 127 (1).

• "Without prejudice to the objec1ve of price stability", the Eurosystem shall also "support the general economic policies in the Union with a view to contribu1ng to the achievement of the objec1ves of the Union". These include inter alia "full employment" and "balanced economic growth". hQps://www.ecb.europa.eu/mopo/intro/objec-ve/html/index.en.html

Inequality and Economic Policy Central bankers on inequality (2)

Yellen/Fed (2014): „The extent of and con1nuing increase in inequality in the United States greatly concern me. The past several decades have seen the most sustained rise in inequality since the 19th century a<er more than 40 years of narrowing inequality following the Great Depression. [...] It is no secret that the past few decades of widening inequality can be summed up as significant income and wealth gains for those at the very top and stagnant living standards for the majority. I think it is appropriate to ask whether this trend is compa1ble with values rooted in our na1on‘s history, among them the high value Americans have tradi1onally placed on equality of opportunity.“ hQp://www.federalreserve.gov/newsevents/speech/yellen20141017a.htm

Inequality and Economic Policy

Inequality and Economic Policy

Inequality and Economic Policy Correla-on is not causa-on, but as stressed by Hicks, loan demand is backed up by collateral, and given rising prices of financial assets there is a danger that monetary policy might cause shius in the income distribu-on.

How would fiscal policy lead to an increase in the amount of deposits?

The Links between Fiscal and Monetary Policy Government exchanges bonds for reserves at central bank ... central bank reserves

bonds

bank

treasury reserves

private sector

bonds

The Links between Fiscal and Monetary Policy ... and pays private sector through bank transfer ... central bank reserves

bonds

bank reserves

deposits

treasury reserves widgets

bonds

private sector net worth deposits widgets

The Links between Fiscal and Monetary Policy ... with banks preferring to hold interest-­‐bearing bonds and the private sector ready to spend the addi-onal deposits created. central bank bonds

bonds

reserves

widgets

deposits

private sector net worth deposits widgets

bank reserves bonds

treasury

The Links between Fiscal and Monetary Policy Alterna-ve: tax cuts leave more deposits with private sector central bank

treasury bonds net worth

taxes

bank bonds

private sector deposits

deposits

taxes net worth

Government as the deposit creator of last resort (DCoLR) Conclusion:

• Euro zone has an aggregate demand problem, so ...

• more exis-ng deposits need to be spend (not QE) or ...

• addi-onal deposits need to be created (fiscal vs monetary policy) ...

• which would lead to a welcome rise in infla-on via labour market pressures (and less inequality as a side result) and ...

• more aggregate demand would make monetary policy whole again (and allow interest rates to rise) ...

• ... if the monetary union can be completed.

The Links between Fiscal and Monetary Policy • Scope for coopera-on (policy mix)