MACROECONOMICS

To round off this section, we illustrate the benefits of an FIGURE 19-6 An increase in productivity without any increase in remuneration increase in productivity without any concomitant increase in the remuneration of the factors of production (eg capital and labour). By now we know that such a decrease in the costs of AS production can be illustrated by a downward (rightward) shift of the AS curve, as in Figure 19-6. Total real output, income AS , and employment increase and the price level falls. Clearly this is the most desirable of all the possible changes in aggregate supply or aggregate demand. Note, however, that this will be Price level Po achieved only if the remuneration of the factors of production remains unchanged, or if productivity increases faster than the remuneration of the factors of production. 19.2 The monetary transmission mechanism ADo In the Keynesian macroeconomic model developed in Chapters YO Y1 17 and 18 it was assumed that the money stock and the interest Total real production or income rate are fixed. By assuming a fixed money stock and a fixed interest rate we actually eliminated the impact of money and monetary policy. In the AD-AS model developed in the previous The original aggregate demand and supply curves are indicated by AD, and AS,. The original equilibrium is at Eo section we dropped these assumptions and allowed for the with the price level at Po and real output at Yo. An increase in impact of a variable interest rate on aggregate demand. We said productivity without any increase in remuneration lowers that a fall in the interest rate will increase aggregate demand the costs of production. This is illustrated by a downward (illustrated by a rightward shift of the AD curve) and that an shift of the AS curve to AS, . The new equilibrium is indic- increase in the interest rate will reduce aggregate demand ated by E,. Real output increases to Y,, while the price (illustrated by a leftward shift of the AD curve). We now need level falls to P, to examine these links more closely, that is, to examine how changes in interest rates affect total spending, production, income and prices in the economy. The way in which changes in the monetary sector are transmitted to the rest of the economy is called the monetary transmission mechanism. Most textbooks explain the monetary transmission mechanism by starting with an increase in the money stock, which is assumed to be exogenous (ie under the control of the monetary authorities). However, as we explained in Chapter 14, this is not a realistic starting point, since the money stock is not exogenous but endogenous (in the sense of being determined by the interaction between the interest rate and the demand for money). We also explained that the term money supply is a misnomer. Supply is a flow concept and in this case there is no indication of a possible link between the quantity of money "supplied" and any other variable. This does not mean that the money stock is ignored. It is still an important variable in the eco- nomy. The important point, however, is that changes in the monetary sector are triggered by changes in the interest rate (which is for all practical purposes determined by the central bank) and not by (exogenous) changes in the money stock. In other words, the monetary transmission mechanism starts with a change in interest rates, not a change in the money "supply" (as assumed in most textbooks). The traditional treatment of the transmission mechanism is outlined in Box 19-2. This treatment is no longer useful in the South African context, but might still be appropriate in countries where the money stock is largely under the control of the monetary authorities (eg because the financial system is still undeveloped). Note that it is only the initial part of the mechanism that is affected. Once the interest rate changes, the rest of the process is basically the same in both our treatment and the traditional treatment. The links between interest rates, investment spending and the rest of the economy When the Monetary Policy Committee (MPC) of the South African Reserve Bank (SARB) adjusts the repo rate, all other short-term interest rates (eg the prime overdraft rates of the banks) change in the same direction. In our models we use a single interest rate to represent all these rates. The question now is how a change in the interest rate will affect other important variables in the economy such as aggregate demand, aggregate supply, production, income and the price level. This is what the transmission mechanism is all about.As explained in Box 1443 it is aserned in most texthoolrs that the money stock is controlled by the monetary authorities. In other words, it is assumed that the money stock is exogenous, illustrated by a vertical money "supply\" crrve. According to this view, the interest rate is determined by the interaction between the demand for and "supply" of money tie the interest rate is endogenous). Monetary policy is implemented by changing the money stock, which then affects the interest rate and other important variables in the economy (via the interest rate}. The inilid phase of this approach to the monetary transmission mechanism can be explained with the aid of the riagram. The demand for money is represented by l. and the irl'tial money stock MB. The initial equilibrium interest rate is thus in. Suppose the monetary authorities then increase the money stock, illustrated by a rightward shift of the money "supply" curve to M1. The increase in the money stock results in a decrease in the equilibrium interest rate to i1. At the lower interest rate, investment spending will be higher than before, ceteris paribus, and other variables in the economy will also be affected. In other words, the diagram in this box can be linked to Figure 19-1 The only real difference between thisview ofthetransmission mechanism and the one explained in the text, is that this one \"WNW starts with an exogenous change in the money stock, which then affects the interest rate, while the more realistic version in the text commences with an exogenous change in the interest rate. The remainder of the process may be similar in bottr cases. A key element of the transmission mechanism is the relationship between the interest rate (3') and investment spending (1}, which is an important component of aggregate spending (A) and aggregate demand (AD). The inverse relationship between the interest rate and investment spending is illustrated in Figure til-Ha). At any particular interest rate, such as in in Figure 19301), there will be a certain level of investment spending (1') in the economy, cateris portions. Suppose the interest rate is now reduced to 1', At this lower interest rate more investment projects will be protable than before. Investment spending (I) will thus increase from In to II. The difference between It and In is indicated as AI. But the process will not stop there. We use two diagrams to illustrate the rest of the process. In Figure lQTEb) we show what will happen in terms of the models derived in Chapters 1'? and 13, where it was assumed thatprices and wages are xed. Since investment spending is an important component of aggregate spending (A), it follows that total spending in the economy will increase, illustrated by an upward shift of the aggregate spending (A) curve from A" to A1_ The amount of the shift (AA) is equal to the change in investment spending (M). Because total spending increases, total production and income (1') will also increase. In Figure lQ-be) this is illustrated by the increase from if, to Y, {ie at\"). Moreover, the increase in Ywill be a multiple of the increase in I. For a given increase in investment {At} the extent of the increase in total production and income (Y) will depend on the size of the multiplier (or). [n symbols: M': MI {as in Chapter 17). This chain of events (or transmission mechanism] can be summarised as follows: In woos-oi: elicit :aY In words: A change in the interest rate leads to a change in investment spending, a change in aggregate spending and a change in total production or income. The transmission mechanism which we have just explained is based on the assumption that prices and wages are xed. Once we drop this assumption, the models of Chapters 1'? and 18 no longer tell the full story. The appropriate model is now the AD-AS model, which was explained in the previous section and is illustrated in FIGURE 19-7 The monetary transmission mechanism (a) Interest rate Eo 0 Investment spending (b) Prices and wages fixed (c) Prices and wages variable A P A = Y ASo TAA Ao Price level Aggregate spending Eo AP Eo AAD AD, 450 AY LAY ADO Yo Yo Y1 Total production, income Total production, income Graph (a) shows the investment function, graph (b) shows the simple Keynesian model and graph (c) shows the AD-AS model. The original equilibrium position in each part is indicated by E- Graph (a) shows that a fall in the interest rate to i will lead to an increase in investment spending to . If prices and wages are fixed, total production or income will increase to Y,, as in graph (b), with the multiplier having its full effect. However, if prices and wages are variable, as in graph (c), production and output will increase by a smaller amount, while the price level also increases, from Po to P. Figure 19-7(c). With the AD-AS model (ie with variable prices and wages) the first part of the transmission mechanism is exactly the same as in the previous model. The only difference is that, since prices are no longer fixed, an increase in aggregate spending (A), which causes an increase in aggregate demand (AD), now results in increases in the price level (P) as well as in total (real) production and income (Y). In Figure 19-7(c) the impact of an increase in investment spending is illustrated by a rightward shift of the AD curve, from AD, to AD,. This results in an increase in the price level, from P, to P, as well as an increase in total production and income, from Yo to Y. Note, however, that since the full impact of the increase in investment spending does not fall on production and income (because prices can increase), the increase in Y in Figure 19-7(c) is smaller than in Figure 19-7(b). In other words, the introduction of variable prices and wages reduces the size of the multiplier.The monetary transmission mechanism with variable prices and wages (ie in terms of the AD-AS model) can be summarised as follows: In symbols: Ai = Al = AA = AAD AP In words: A change in the interest rate leads to a change in investment spending, a change in aggregate spending and a change in aggregate demand. The change in aggregate demand results in a change in total production or income and a change in the price level. The split between AY and AP depends on aggregate supply conditions in the economy (represented by the slope of the AS curve). There are some crucial links in the monetary transmission mechanism. The first is the link between the interest rate and investment spending. If changes in the interest rate do not affect investment spending, the chain breaks down. In other words, if investment demand is completely interest inelastic (illustrated by a vertical investment demand curve) a change in the interest rate will not have any impact on investment spending.* The second important link is between aggregate demand (on the one hand) and the price level and total production or income (on the other). When aggregate demand (AD) changes, the relative impact on the price level (P) and the level of total production or income (Y) will depend on aggregate supply conditions. For example, if the aggregate supply (AS) curve is relatively flat, an increase in AD will result in a relatively large increase in Y' and a relatively small increase in P. On the other hand, if the AS curve is relatively steep, an increase in AD will cause a relatively large increase in P and a relatively small increase in Y. The opposite will occur in both cases when AD decreases. To summarise: The smaller the interest elasticity of investment demand, and also the steeper the AS curve, the less effective an expansionary monetary policy will be as a means of stimulating the economy. However, the steeper the AS curve, the more effective a contractionary monetary policy will be as a means of combating inflation.19.3 Monetary and fiscal policy in the AD-AS framework Monetary and fiscal policy have already been discussed at various places. In this section we summarise some of the earlier discussions and add a few further topics with regard to monetary and fiscal policy. Expansionary and contractionary monetary and fiscal policies Monetary and fiscal policy (sometimes collectively called demand management) can be expansionary or contractionary. An expansionary monetary policy is implemented when the central bank (eg the SARB) reduces the interest rate (eg the repo rate) at which it provides credit to the banks. In terms of the AD-AS model this is illustrated by a rightward (upward) shift of the AD curve. Monetary policy is contractionary when the central bank raises the interest, illustrated by a leftward (downward) shift of the AD curve. An expansionary fiscal policy is applied when the government (in the person of the Minister of Finance) increases government spending (G) and/or reduces taxes (7). This is illustrated by a rightward (upward) shift of the AD curve. Fiscal policy is contractionary when government spending is reduced and or taxes are increased, illustrated by a leftward (downward) shift of the AD curve. Monetary and fiscal policy can also be neutral, in the sense of not being aimed at increasing or decreasing aggregate demand in the economy. However, since we are primarily interested in what would happen if things changed, we do not pay specific attention to a neutral policy stance. While it is in principle always possible for the monetary and fiscal authorities to influence aggregate demand in the economy, the actual outcome of monetary and fiscal policy depends on aggregate supply. As we have seen, a change in AD will sometimes have a relatively greater impact on the price level, and at other times a relatively greater impact on total real production and income in the economy. In practice, it also takes time to formulate and implement monetary and fiscal policies, while a considerable period may also elapse before these policies take effect. We now discuss some of the practical problems associated with monetary and fiscal policies. Monetary and fiscal policy lags Whenever monetary and fiscal policy measures are considered, certain practical problems have to be taken into account. One of the basic difficulties associated with attempts to stabilise the economy by using monetary and or fiscal policy is the existence of delays or lags. Four types of lags can be distinguished: the recognition lag, the decision lag, the implementation lag and the impact lag. THE RECOGNITION LAG This is the lag between changes in economic activity and the recognition or realisation that the changes have occurred. Economic data do not become available immediately - it takes time, for example, to compile the national accounts. Even the consumer price index takes some time to compile. It thus takes time for policymakers to establish or confirm that the economy has moved into a recession or a boom. The recognition lag is the same for monetary and fiscal policy. THE DECISION LAG Once it has been established what is happening, the authorities have to decide how to react. In the case of fiscal policy this means that ministers and officials from different departments, and eventually the Cabinet, have to meet to discuss matters and to consider various policy options. This also takes time. In fact, the most important fiscal policy measures are announced only once a year, in the budget speech of the Minister of Finance (usually in February). With monetary policy the lag is generally much shorter. At the time of writing, the MPC of the SARB was meeting six times a year to consider possible changes in the repo rate. However, nothing prevents the Governor of the SARB from convening a meeting of the MPC at any time, and decisions can be taken within a day or two.THE IMPLEMENTATION LAG Once the decisions have been taken, it takes time to implement them. In the case of fiscal policy, government spending and taxes cannot be changed overnight. Plans have to be drawn up and parliamentary approval usually has to be obtained before the plan can be put into action. Certain changes can only be implemented via the budget and may therefore have to wait up to a year before they can be applied. Income tax rates, for example, are only adjusted annually. In contrast, the implementation lag associated with monetary policy is very short. In fact, when a change in the repo rate is announced, it comes into effect immediately. Thus, as in the case of the de- cision lag, the implementation lag is much shorter for monetary policy than for fiscal policy. THE IMPACT LAG TABLE 19-3 Lags associated with monetary and When the policy measures are introduced, a further period fiscal policy elapses before they actually affect economic behaviour. In the case of fiscal policy, an increase in taxes will, for example, Type of lag Relative length not have its full impact on the economy immediately. The Recognition lag Same for monetary and fiscal policy same applies in the case of a change in government spending, Decision lag Long for fiscal policy, short for although you will recall that government spending has a more monetary policy direct impact on spending, production and income than taxes, Implementation lag Long for fiscal policy, extremely which have an indirect impact (eg via disposable income short for monetary policy and consumption). The impact lag is often referred to as the Impact lag Longer for monetary policy than for outside lag, to distinguish it from the first three types of lags, fiscal policy which together constitute the inside lag (ie the delay from the time a need for action arises until the appropriate policies are implemented). In the case of monetary policy the impact lag s very long. Most economists estimate that it takes between 12 and 18 months (and even up to 24 months) for a change in the repo rate to have its full impact on prices, production, income and employment. It is generally accepted that the impact lag is significantly longer for monetary policy than for fiscal policy. The different lags are summarised in Table 19-3. It should be clear, therefore, that the formulation and implementation of economic policy is no easy task. In fact, by the time the policy measures become effective, circumstances may have changed to such an extent that the measures may even have perverse effects. For example, by the time an expansionary policy comes into effect, the prevailing conditions may call for a contractionary policy. Timing is thus of the utmost importance. If the authorities' timing is wrong, monetary and fiscal policy may prove to have a destabilising, instead of a stabilising, effect on the economy. The practical difficulties we have referred to have led certain economists to recommend that the government should not attempt to achieve too much through monetary and fiscal policy. Their recommendation, therefore, is that monetary and fiscal policy should be as neutral as possible. As far as fiscal policy is concerned, they tend to call for balanced budgets. A balanced budget refers to a situation in which all government spending is financed by taxes, that is, where the budget deficit is zero. With regard to monetary policy, some economists call for stable interest rates, while others call on the monetary authorities to try to achieve low and stable rates of growth in the money stock. The relative effectiveness of monetary and fiscal policy You may have gained the impression that the authorities use either monetary or fiscal policy to guide the economy in a certain direction. What actually happens, or should happen, however, is that the two types of policies should be used in conjunction with each other to pursue the objectives of macroeconomic policy. Nowadays most economists agree that fiscal and monetary policy are both important instruments for stabilising aggregate demand. There are, however, certain circumstances in which the one type of policy may be more successful than the other. Fiscal policy has generally been more successful in stimulating a depressed economy, while monetary policy can be employed with greater assurance to dampen an overheated economy in which inflationary pressures are severe. Apart from the policy lags discussed in the previous subsection, the institutional features of the two sets of policy instruments also have to be taken into account. Fiscal policy is subject to parliamentary approval and the decisions in this respect are normally taken by politicians. Monetary policy, on the other hand, is formulated by the central bank (the Reserve Bank in South Africa), which enjoys a greater degree of autonomy. The pressure on politicians to act in the interest of voters has resulted in fiscal policy being generally aimed at stimulating aggregatedemand, while the Reserve Bank and other central banks tra- FIGURE 19-9 Net exports at different levels of income ditionally take a more conservative and restrictive attitude (a) towards economic policy. X, 2 To achieve macroeconomic objectives such as economic growth and price stability, asuitable combination of the different types of policies instruments has to be applied. Continual consultation between the Reserve Bank, the National Treasury 2> X and other government departments is thus of the utmost X =Z Exports, imports X importance to ensure that different types of economic policies are sufficiently coordinated. This is particularly important x > Z when there are trade-offs between different policy objectives. The policy dilemma in an open economy As indicated earlier, policymakers are often confronted with YB a dilemma, since steps taken to increase production, income Total production, income and employment may raise the general price level, while steps taken to lower the price level may result in lower production (b) and income and increased unemployment. In this section we introduce a further dimension by adding the balance of X =Z payments. Once exports and imports are taken into account, macroeconomic policy becomes even more complicated, particularly in developing countries where economic growth Surplus Deficit requires the importation of capital goods. This additional Price level area area (X > Z) (Z> X) complication is often referred to as a balance of payments constraint. In Chapter 18 we incorporated the foreign sector into the simple Keynesian model. We explained that exports (X) are autonomous with respect to income (Y) and that there is a positive relationship between imports (Z) and income (Y). YB This means that there is a unique level of income at which Total production, income exports are equal to imports, that is, where net exports (X - Z) are zero. This is shown in Figure 19-9. Figure 19-9(a) shows that exports (X) are autonom- In (a) we show that the level of exports X is independent ous (ie independent of the level of income (Y)). It also shows of the level of income Y, while the level of imports Z that there is a positive relationship between imports (Z) and increases as Y increases. Exports are equal to imports at YB. YB is also shown in (b). When Y is less than Y: there income (Y) - as Y increases Z also increases. The unique level is a surplus of exports over imports. When Y is greater of income at which net exports (X - Z) are zero is labelled than Y, imports are greater than exports. Any point to the YB and is indicated by a vertical line in Figure 19-9(b). At left of YB thus indicates a surplus on the current account any level of income lower than Y's, exports are greater than of the balance of payments, while any point to the right imports. This can be seen clearly in (a). In (b) we call this the of Ya indicates a deficit. As income moves away from YB. surplus area, since it corresponds to a surplus on the current the surplus or deficit increases. account of the balance of payments. At any level of income greater than Y's imports are greater than exports. This can be seen clearly in (a). In (b) we call this the deficit area, since it corresponds to a deficit on the current account of the balance of payments. As the level of income increases from zero, the surplus falls until it disappears at Y's. Increases in income above ); will be accompanied by increases in the deficit. The level of income (YB), at which net exports are zero, thus serves as a dividing line between the surplus and deficit areas. We now incorporate Y's into the AD-AS model to explain how balance of payments considerations can further complicate economic policy-making. In Figure 19-10 we show aggregate demand (AD), aggregate supply (AS) and the level of income (Y,) at which net exports are zero. We also show the level of income corresponding to full employment. This is indicated by Yr. In the figure the equilibrium level of income (Y.) (determined by AD and AS) is greater than Y,. From Figure 19-9 we know that this means that there is a deficit on the current account of the balance of payments at Y,. The equilibrium level of income (Y.) is also lower than the full-employment level of income (Y,). This means that there is unemployment at Yo- In this particular case, policymakers are confronted with a dilemma. Any measures that they take to raise the level of production and income (to reduce unemployment) will increase the deficit on the current account of the balance of payments. Similarly, any measures taken to reduce the level of income (to reduce the current accountdeficit) will increase unemployment. When the balance of FIGURE 19-10 A policy dilemma payments is introduced into the analysis, matters are therefore even more complicated than before. The dilemma can, of course, be resolved if current account deficits are financed by net inflows of foreign capital, that is, by surpluses on the financial account of the balance of payments. However, countries like South Africa cannot always rely on such inflows and therefore oftenhave to strive towards some balance between exports and Eo imports. Price level The authorities always want to stimulate production and income to reduce unemployment, but balance of payments considerations can prevent such a strategy. This was particularly true in South Africa between 1985 and 1993 when the country experienced large outflows of foreign capital. After AS AD the foreign debt standstill of 1985 the country was forced to repay a substantial portion of its foreign debt. The problem YB Yo was exacerbated by political and economic uncertainty which Total production, income gave rise to further outflows of capital and large deficits on the financial account of the balance of payments. To finance The equilibrium level of income Y, is determined by these deficits, considerable current account surpluses had to aggregate demand AD and aggregate supply AS. be maintained. This meant that income Y had to be kept low YB indicates the level of income at which exports X in order to keep imports Z down. In these circumstances, the equal imports Z. Y, indicates the full-employment authorities could not even afford to let the level of income level of income. At Y, there is unemployment and rise to Y,. The economy had to be kept in the surplus area a deficit on the current account of the balance by maintaining restrictive policies. Balance of payments of payments. Measures to reduce the deficit will considerations thus prevented the authorities from applying the increase unemployment, while measures to reduce policies which they probably would have preferred to apply (to unemployment will increase the deficit. reduce unemployment). This dilemma is a practical example of a balance of payments constraint on economic policy. When faced with such a dilemma or constraint, conventional monetary and fiscal policies have to be supplemented by other policies in an attempt to find a solution.Question 3 [Marks: 25! (1.3.1 The monetary transmission mechanism can be depicted in the form of a graph [1D] or using symbols. Explain, with the aid of symbols, the monetary transmission mechanism when interest rates increase [Note: Prices and wages are variable.} (1.3.2 Explain, using the MilA5 model, how the South African Government can use [15] fiscal policy as a tool to recover from the negative effects of this (SQUID19 pandemic. Your answer must include the following: i The description of the type of fiscal policy required; {4} C An explanation of how the implementation of this tool will work their way through the economy to achieve the desired effect; {5} i The ADAS graph showing the implications of your recommendations. [5] Marks will be awarded for your ability to integrate theory with the scenario provided