Transcription
My name is Dr. Storm Kennedy Palmer. I'm the secondary lecturer for this module. Um, and today we are going to be looking at learning unit 9. I assume you did the previous week's session to to look at part A of this, but I'm going to do a quick revision for us as well. Please jump in whenever you have a question. You can either unmute yourself or um, write it in the chat. I'll try to keep an eye open on the chat but yeah if if I don't if I don't see your comment please just unmute yourself and and ask it.
So for this learning unit um in the first session you would have covered the first four learning unit outcomes which were the relation between inflation expected inflation and unemployment the Philips curve the Phillips curve and the natural rates of unemployment and the ISLMPC model. Now we're going to be looking at the adjustment from the short run to the medium run and the impact of fiscal policy using the ISLMPC model.
So remember then when adding the PC curve to the ISLM model, it adds the inflation dynamics showing how changes in output and unemployment affect the change in inflation over time. Together, the ISLMPC curves explain how changes in fiscal policy, which would be government spending or taxation, and monetary policy, which would be repro rate changes, impact the economy's output and inflation in the short run. Thus, in the short run, demand determines output.
So in the short run we can have a situation where output exceeds the natural level of output which is illustrated in this diagram 9.3 from the learning unit. See that the equilibrium level of output y is above y. Our current equilibrium level of output and income is above the natural level. So that means we have a positive output gap meaning that the level of output and income is above the natural level of output in income denoted by yn and the change in inflation is positive meaning inflation is increasing.
So this would be a zero change in inflation. Okay, which doesn't mean that there's no inflation. If the change in inflation is zero, the inflation rate itself could be positive like 6%, but it just when the change in inflation is zero, it means that the inflation rate is remaining at the previous period's inflation rate. So if it were 6% last period, it's 6% again this period because the change is zero. Now this is positive. So imagine this is plus 2% for example. That means that if in the previous period our inflation was 6% we now add two and our inflation rate will be 8%. But as long as it stays as the change in inflation being positive that will keep increasing. So as each period um passes as we go through time the change in inflation is positive. So the actual inflation rate keeps increasing. Whereas if this was zero, the inflation rate whatever it would be would remain that.
So if we think about it, an increasing inflation rate is very detrimental to the economy. So we assume that the central bank's going to take some sort of action resulting in an adjustment. The central bank is going to take some sort of action. Um okay so the central bank is going to take action which is going to result in an adjustment in the medium run where output is equal to the natural level of output. Unemployment is equal to the natural rates of unemployment. Inflation is constant i.e. the change in inflation is zero and the real interest rate is equivalent to the so-called natural rate of interest. That is the medium run where we assume that we are at the natural level of output and income. We assume that because any shortrun deviations will result in a policy action by the central bank.
So in this example, we have a positive output gap where our actual level of output and employment Y is above our natural level, which means that the change in inflation is positive. And as long as the change in inflation is positive, then the inflation rate is going to keep increasing period on period, year on year, whatever period we're dealing with in this particular example. And that means that the central bank because its target is to protect the value of the South African rand. That means not letting hyperinflation take over and degrade the value of the rand. So the central bank is going to come in and increase interest rates to combat this inflation that we're seeing here.
So very important I want you to remember in the short run output can be higher or lower than the natural level of output. We assume that actions taken by the central bank however in the medium run will mean that the level of output and income is equal to the natural level in the medium run.
Now I want to just go over this simple example to make sure there isn't any confusion between the concepts of constant inflation and rising or falling inflation. So for the sake of simplicity, let's say we have a basket of goods in year 1 that costs 100 rand. What will the cost of this same basket be if inflation is 10%. It's easy. We just say 110 divided by 100. Okay. So you can see that it is a 10% increase which gets us to 110 rand. So if our basket cost us 100 rand in year 1, if there's a 10% increase in the following year, that means that the basket is now going to be 110 rand. Here you can see it. There's the inflation rate. Year 1, we have our basket as 100 rand. Inflation rate is 10%. In year two, it will be 110 rand. And if the inflation rate is still 10%, it will carry on into the third period. And as you can see, because our previous our year 1 inflation rate was 10% and our year 2 is 10%, it means the change in inflation was zero. Our inflation is still 10%, which means the prices of our individual goods in this basket still increasing, but the change in inflation is zero. I just I'm I'm illustrating this for you again because I wanted to really sink in the difference between changes in price changes in inflation rate. So just because the change in inflation is zero doesn't mean that the inflation rate is zero. It just means the inflation rate hasn't increased or decreased. It hasn't changed. It's change is zero but it is still a positive inflation rate in this case. Okay.
So now if we assume that inflation rate is still 10%, what is the price of our basket going to be in year 3? You simply say 110 is the basket price times 110 that's 10% divided by 100 this will be 1 2 1 rand in year three. M will you please uh explain the how you got to 121 again for year three please?
>> So literally all I was doing was just adding 10%. So another way that we could do it is perhaps this will be more intuitive. Okay. So we we want to determine our price of goods is 110 rand. We want to determine what it will be if there's a 10% increase in prices. Okay. So got 110 rand is our basket and if we were to times it by 10% 10% is just 110 over 100. So that's why I times it by 110 and then divide it by 100 to get 121 rand for the basket in year three.
>> Does that make sense? Okay. And then if we wanted to go further and say that the inflation rate in year 3 is also 10%. Now what would the basket be worth in year 4? It would be 121 rand this 121 again times 110 for the 10% divided by 100. And now this basket is rand 133 with 10 cents. And here the change in inflation is again zero because it goes from 10% to 10%. So there's a 0% change. So as you can see even when the change in inflation is zero, prices may still be going up. It's depending on what the underlying inflation rate is doing. Yeah, you can see there's my my next row which is that the price of the basket is 121 rand.
So remember that on our Philips curve, inflation is constant where the actual level of output and income equals the natural level of output and income which is this point here where the Philips curve intersects the horizontal axis and at this point the change in inflation is zero. Um so from the example that I used in the previous slide the inflation rate was 10% and the previous period's inflation rate was also 10%. So the change in inflation is indeed zero at this point on the horizontal axis but the actual inflation rate might not be zero and prices may still be going up. At this point businesses and workers expect prices to be stable at a certain level. in this case 10%. And wages and prices are set on these expectations. When everything is balanced, the economy operates at the natural level of employ un unemployment. In other words, the level of unemployment that keeps inflation steady. Inflation is steady in this example because it is not changing. It's remaining at the 10%. It's not increasing, it's not decreasing.
Now let's look at an example of rising inflation. We're going to assume that something changes in the economy in the short run. For example, government increases spending or it decreases taxes. Either an increase in government spending or a decrease in taxes is represented by a rightward shift of the IS curve in the top figure in this example from is to ISA. And for the rest of the example, I refer to an increase in government spending. But it is important to understand that a decrease in taxes will have the same effect on the curve. You can see how the initial equilibrium point at Y on the um is LM model over here corresponds with the natural level of output and income on the PC curve over here YN. So at the initial initial position the change in inflation is constant but now due to an increase in government spending which is why is incre or shifted to the right from IS to ISA. Okay. And that means that temporarily output was higher than the natural level which is called a positive output gap. And at this new equilibrium position, the change in inflation is now positive. So we need to go back to see what does that do for our baskets of goods prices. If we move to here where we now have a positive change in the inflation rate. Let's have a look. Okay. So say for example in year 1 again you've got the same information. Year one price of the goods is 100 rand and our inflation rate is 10%. Then in year two we've got something else going on here. Now we've got a higher inflation rate. It's increased to 15%. Which means the change in inflation is 5%. So if we had if say for example this amount over here is sorry that's supposed to be a plus and five. Okay. So that's where the where the five comes from. It is the change in inflation. So because of that increase in government spending, we have an increase in increase in inflation. Why? Because more money is now chasing the same amount of goods. So in our example, the inflation rate rises from 10% to 15%. And the change in inflation is now positive. In this case, it is 5%. Before the increase in government spending, the inflation rate was constant at 10%. So workers and businesses expected prices to rise by 10%. But in reality, prices rose by 15%. Because of this unexpected inflation, businesses can afford to hire more workers since wages are lower in real terms than they expected. Unemployment temporarily falls before the natural rate and by extension output increases above the natural rate. However, people will expect inflation to continue rising because past inflation is generally a good predictor of future inflation and they will continue to demand higher wages next time. So if businesses also anticipate higher costs, they will increase their prices further. So due to this higher than expected inflation rate, wage demands will increase which leads to a further increase in prices. Uh let's assume the inflation rate is now 20%. This results in a cycle where inflation keeps increasing unless unemployment returns to its natural rate. Look what happens to the price of our basket of goods and how quickly prices can rise once the change in inflation is positive. Okay, rising inflation is very damaging to the economy. So we can assume that its mandate of stopping of maintaining price stability, the central bank will step in which takes us to the medium run. Remember what I said to you in the short run the the level of output and income can exceed the natural rate and the level of unemployment can be lower than the natural rate of unemployment. But it is because of the central bank's mandate that we assume that in the medium run it will return back to the natural level because of the actions taken by the central bank to curb these this very damaging rise in inflation.
All right. So now let's look at the medium run. Remember that initially our economy was at in equilibrium at the natural level of output and an increase in government spending resulted in the economy moving to a point where there was a positive output gap since the level of output is above the natural level of output and as such the change in inflation increases. Okay. So looking at the top figure, the central bank then decides to increase the interest rate in reaction to this high inflation and over time there is an upward movement along the IS curve from A to A1 and output decreases. Looking at the bottom figure, you can see that as output decreases, the economy moves down the PC curve from point A to point A1, which is the initial equilibrium condition before the increase in government spending. Remember this is where we were initial equilibrium. Then government spending increases. As a result of that increase in spending, we ended up at a level of output that is above the natural level somewhere to the right, which is a positive output gap. Then in the medium run, the central bank takes action by increasing the policy rate. And due to that there will be a movement upwards along the IS curve until eventually the economy settles at point A1 which is back to the initial equilibrium position. Okay. So this is the initial as well as the medium run equilibrium and this over here is the short run after there was an increase in government spending. Are you all happy with that? Okay, I see your hands up. Thank you. All right, so let's move on.
Let's do this activity together. Please identify the following from this ISLMPC model. One, the value of the natural rate of interest. Two, if the interest rate increases from 2% to 3%, what happens to the output gap? Three, what is happening to the inflation rate at point B? And four, compare the inflation rate at point C with the inflation rate at point A. Do we have any anyone who wants to jump in and try answer question one, which is what is the value of the natural rate of interest?
>> Yes, ma'am.
>> Yes, please go for it, Daniel.
>> Um, so ma'am, the natural rate of interest would be 4%.
>> 100% right. Yeah, it's the interest rate associated with the natural rates of employment or the natural level of output as you correctly identify it is 4%. And that's because we need to look here at our natural level of output and income. And where do we intersect the ISLN curve here at 4%. So you are correct. Thank you, Daniel. Okay.
An increase in the interest rate from 2% to 3%. What will happen to the output gap if the interest rate increases from 2% to 3%. Please go for it.
>> I would say that it looking at the cap it looks like it's decreasing.
>> Mhm. 100%. So when we're moving from 2% to 3% you are quite right. Decreases the output gap. Yes, that's right. because we're going from here, this point over here to 3% which is over here. And it means that the level of output and income is decreasing going towards the natural level. And importantly, the question says what happens to the output gap? The output gap here is positive. And so you're 100% right when you say that the output gap will decrease due to this movement of the interest rate. Okay.
Does anyone want to have a go at question three which is what is happening to the inflation rate at point B? Remember it's not asking about what is happening to the change in the inflation rate. It's saying what is happening to the inflation rate at point B.
>> So there's been a change in the inflation rate um at point C. um it's it's it's lower than at point A.
>> Okay. So let's let's have a look here. According to this diagram, we start off at a positive output gap at point A. Okay. And then we move to point B. At point B, the change in the inflation rate is positive 2%. positive because it's above the horizontal. So we can say that whatever the inflation rate is, it is going to be increasing by 2% as long as the economy remains at point B. As long as we stay at point B, the inflation rate is going to continue to increase by 2%. Because there is a positive output gap. Does that make sense?
Please repeat that again ma'am.
>> Okay. So I think we need to just once again make sure we understand the difference between the inflation rate which is what this question is asking for and the change I just use a triangle cuz that that means change in inflation. Um I'm using a capital I but guess I should use this little pi symbol that they use in the axis. Um so that is the change in the inflation rate. If the change in inflation rate is positive2 it means that whatever the inflation rate is it's going to keep increasing by 2% each period. And because we aren't given any information about what the inflation rate is, we can't say, oh, it was 10% in the previous period, so this period it must be 10% plus 2%, right? Meaning 12% inflation rate. But we don't know what the inflation rate was. All we know is that the change in inflation is positive. So that's all we can comment on. So all we can say is that when the economy is at point B the change in inflation is positive 2% which means that the inflation rate will increase by 2%. If we go back to here you can see that here the inflation rate is 15% but the change in inflation is five. The inflation rate is 20%, but the change in inflation is two. We in this example, we're not told what the inflation rate is. All we're told is that this change in inflation is 2%. That's all we're told. So, all we can comment is that the inflation rate would have increased by 2%. Does that make sense?
>> Thank you very much. It does, ma'am.
>> Okay, great. So yeah, I just want you to keep this little table in mind and remember that the change in inflation, the delta, the triangle is what we what we include in this column over here. And it's the difference between the previous periods inflation and the current period's inflation. In this case, um 15 - 10 is 5%, 20 - 15 5%. We don't know what the inflation rate was in the in the activity that we're looking at. All we know is that the change is plus two.
So, ma'am, in essence, what the change in inflation might indicate is that the growth is going to be that figure 2%. So a change in inflation if we only have that information is an indication that the inflation is going to change by 2%. Yeah, that's all we know.
>> Thank you.
>> Yeah. So, we can't we can't comment on what the underlying inflation rate is. All we know is that it's going to increase by 2%. As long as the economy stays at point B, it's going to keep increasing by 2%. Okay, great. I see the thumbs up there. Okay, great. Then last question.
Compare the inflation rate at point C with the inflation rate at point A. Now remember, you can't comment on what the inflation rate is, but what you can say is this inflation rate is the same as this inflation rate. It's higher than, it's lower than. So you can compare the two points. You can't say the inflation rate at this point is 12%. You can't say that because you don't know what the underlying inflation rate is. But given the information in this activity, you can make a comment about comparing the inflation rate at point C with the inflation rate at point A. Would anyone like to take a shot at this? This is probably the hardest question in this set of four questions here because it it looks surpris. So, does anyone want to have a a try or should I go for it? Okay, I'm not seeing anyone unmuting. So, I'm just going to tell you. Okay. So, it's saying compare inflation rate at point C. Let me just get a different color pen now cuz this is compare with point C. The inflation rate at point C versus the inflation rate at point A. Now we have to try and be very logical when we think about these things and think to ourselves what happened first where do we start we start with a because obviously that's that's what happened first is you have a situation where there is a positive output gap now the central bank is taking action to make an adjustment so that the output returns back to the natural level of output and income. And it didn't just increase the interest rate once, it had to do it twice in order to get the economy back at point C to the natural level of output and income. So in terms of a timeline, we start off at A. The central bank increases the interest rate from 2% to 3%. And as a result of those actions, the inflation starts to cool down and we find ourselves at point B. But we're not yet at the natural level of outputed income. So the central bank increases the interest rate again so that the interest rate is now 4%. And through time we eventually adjust back to the output and income level being equal to the natural level of output and income. Once again, we don't know what the actual inflation rate is, but with the information that we're given, we can most definitely make a comparison between what the inflation rate is at point C and what the inflation rate is at point A. At point C, the change in inflation is zero. Easy, right? Which means the inflation rate is constant at this point. It's not increasing. It's not decreasing. However, would you say that the inflation rate at point C is higher than, lower than, or the same as the inflation rate at point A? What would you think? So, at point C over here, is our inflation rate higher than or lower than or the same as point A? Maybe write it in the chat. Okay. Well, we've got we've got we've got an interesting result in the chat. So, we've got two people saying that the inflation rate at point C is lower than at point A. And then we've got two people saying that the inflation rate at point C is higher than at point A. So, you see what I said? This this is actually more complicated than it looks like. And that's because you have to try and order things in how how they take place in time. So in time we start off at point A. Let us make easy example. Okay. So we start off at point A. Let's assume that at the very beginning when we started off for some reason our inflation rate in the country was zero. So let's just assume that at point A our inflation rate was 0%. Then let's assume we stayed at this point for a full period. That means that because the change in inflation is a positive 4%. If we stay at this point for another period in our inflation rate is going to go from 0% to 4% in one period. Okay. Then let's say we take another period to adjust from point A to point B after the central bank increased the interest rate from 2% to 3%. Now let's say we're at 4% here. Okay, 4%, but now we stay there for one period. So we've got to add 2%. So it's going to be 6% by the time it comes down here. And now because the change in inflation is zero, we will stay at that 6% for as long as we're at the natural level of output and income. The inflation rate will remain at 6%. So as you can see, the inflation rate at point C is definitely higher than the inflation rate at point A. Does that make sense? Do you feel do you feel like I've explained that thoroughly enough? Is there anything else you want to go through to see why the inflation rate at point C is higher than the inflation rate at point A? I see a thumbs up. Great.
>> Hi, Miss Kennedy.
>> Yes.
>> Can you hear me?
>> Yeah, I can hear you. Go ahead.
>> Okay. So, I just have a quick question. So, what we should take note of is that we're basically moving backwards. See, I would I would call it being logical and going through time as opposed to framing it as going backwards.
>> Yeah. So, it's all about remembering where we're starting and what happens at each step. Yeah. We don't just adjust from this position to this position overnight and each period the inflation rate is changing. Yeah.
>> Okay. Okay. Okay. Thank you. Thank you.
>> Okay. Great. So ma'am,
>> yep.
>> What you're saying is that ideally when we're trying to answer questions, we should always start at what is our neutral position in trying to answer these questions because if we don't do that then we can miss what the question is actually asking us.
>> Yeah. I really I really want you guys to take from this session the understanding of the adjustment from the short run to the medium run and just to be able to logically follow those steps of okay so let's assume our initial point was um where the level of output and income equals the natural level that means the change in inflation is zero the econ the economy is balanced and it's in equilibrium at that point. Then something happens to push it out of equilibrium. In this example earlier on I used the case of government spending. Okay. So now because of that government spending it pushed our level of output and income above the natural level and that's how we started and that's how and that's how we started at point A. Okay. So, as you can see, this figure up at the top here doesn't show you the increase in government spending while we got to point A. It's just assuming that's where we're at. Something happened to push us out of equilibrium and we're now at a shortrun position where the level of output and income is above the natural level, which means the change in inflation is positive, which means that the inflation rate keeps increasing. And when we're in that sort of situation, something needs to be done by the central bank to push us back to the equilibrium position where our inflation is non accelerating back at level C. Okay? So that's what I want you to think about is what? So we're we're out of the equilibrium position. Why? What happened? Well, we don't necessarily need to know that it was an increase in government spending that led to this position because we're just told that that's what happened. But I want you to in the back of your mind think, okay, so something happened to push this economy out of equilibrium. And as a result, the central bank is going to take action to increase the policy rate until we get back to our equilibrium because this is the nonacelerating inflation rate that we want because as long as that change in inflation is positive, it's going to be
>> Yeah, exactly. It's going to keep going up. So, the central bank wants to bring us back to equilibrium where the change in inflation is zero. Does that make sense?
>> Yes. Um, it does, ma'am. Thank you so much.
>> And, and when I say that, then you can also follow the logical steps of Okay. So, we start here, it means that our inflation rate is increasing the whole time we're above here until finally we get to zero. Then our inflation rate stops increasing. But now what happens if our inflation rate becomes negative? So falling inflation or deflation is also problematic. What happens if in year 2 the inflation rate falls to 5% from 10%. It now means that the change in inflation is negative 5%. Okay. The inflation rate was still positive. So our goods still increase in price but at a lower or at a slower rate than before. Now we continue on to another period and we can see that the inflation rate has now gone down to 0% which means that the basket of goods has remained the same. It didn't increase. And on the face of that this looks like a good thing. It looks like the value of our money isn't eroding and we should be happy about that. But zero inflation means the economy is on the edge of deflation or falling prices which can be very dangerous. That's why our reserve bank targets an inflation rate that is positive but still low between 3 to 6% is still the target band. Okay. So now you see what happens in the next period. If our change in inflation remains -5, now the inflation rate is negative and the price of our goods starts falling. Now this is deflation and this is very dangerous as well because deflation discourages spending since prices maybe are going to fall in the future. So you'll rather wait to purchase something till it's cheaper. It increases the real burden of debt and it can lead to a downward spiral of demand, wages, and growth. A deflationary spiral happened during the Great Depression in the 1930s. And luckily for us, it didn't happen in the most recent global financial crisis.
Now, I'd like to explain to you the zero lower bound. So it's a situation where the central bank's policy interest rate is at or near zero and cannot be lowered further to stimulate the economy. This situation happened in the United States and the United Kingdom during the global financial crisis because their central banks were targeting very low inflation and so the interest rate was also very low giving them not very much leeway to lower it further to increase demand. So if you look back on the financial market diagram coming from learning unit 3, the zero lower bound would be any point where the money demand curve intersects the horizontal line and it it cannot go lower than zero. Okay. So anywhere where it starts to touch here and along the horizontal is going to be the zero lower bound where the central bank actually can't decrease the interest rate past that point. And negative nominal interest rates implies that instead of earning interest on bonds, you're going to pay interest on bonds, rendering the demand for bonds negligible. Thus, the nominal interest rate should not be less than zero, constraining monetary authorities by the zero lower bound. This leads to liquidity traps where monetary stimulus doesn't increase spending. In a liquidity trap, the nominal interest rate is close to or at zero, rendering conventional monetary policy ineffective in boosting the level of output and income. And when the economy is at a liquidity trap, people become indifferent between money and bonds. And therefore the money demand curve becomes horizontal at the 0% at the at the horizontal line. Okay.
So remember from learning unit six that the real interest rate is equal to the nominal interest rate minus the inflation rate. The central bank targets the nominal interest rate as we saw in the previous diagram from the financial market. But the real interest rate is the rate firms consider when demanding loans. So the central bank must consider inflation expectations when deciding on the nominal interest rate. If expected inflation is 3% and the desired real interest rate is 4% then the nominal policy interest rate should be set at 7%. Because it's where the real interest rate equals 4%. If expected inflation is negative 5%. Then the lowest the real policy interest rate can reach is 5%. Because the nominal policy interest rate cannot be negative. So this restriction on the real policy interest rate means that if expected deflation increases the effective real interest rate will increase. The higher the real policy interest rate results in a lower output in income which increases the output gap and further results in additional increases in deflation and so on potentially leading to a deflation spiral. This is um an illustration of a deflation spiral from diagram 9.5 in your learning unit. At the real interest rate R, the level of output and income is below the natural level at the initial equilibrium position A, the output gap is negative and therefore inflation is decreasing. However, assuming that the economy is in a liquidity trap, the real interest rate needed in order to move output towards the natural level may be negative like Rn over here in the diagram. Okay. Thus, the central bank is constrained to lower the real interest rate to zero at which point the level of output in income Y1 is below the natural level. At Y1, the inflation rate is still decreasing and if it becomes negative, it could trigger a deflation spiral. With constant nominal interest rates, each round of a deflation spiral consecutively increases the real interest rate, leading to lower demand and lower output, represented by the arrows in the diagram, moving further away from the natural level of output and income. Fortunately, deflation was limited after the recent financial crisis and an deflation spiral was avoided even though the zero lower bound had been reached. And a possible explanation of this is that inflation expectations remained anchored stopping a rapid downward spiral.
Now let's look at fiscal consolidation. At the very beginning of the session, we looked at an example where governments increase spending in the short run and the central bank responded in the medium run. Now if we look at it the other way around, we can see what happens when government decreases decreases spending or increases taxes in the short run. And in the medium run, the central bank can take action. Why might government decrease spending or increase taxes? Well, currently the government finds itself in a position where it has a large budget deficit and it can either increase taxes or decrease spending. Okay. So let's assume a taxes um increase. This is represented by a leftward shift of the IS curve in our model from IS over here to IS1. Leftward shift that way from A to A1. The economy is initially at point A where output is equal to the natural level of output and income. And after the ice curve shifts to the left, we reach a shortrun equilibrium position where output is below the natural level and the change in inflation is negative. So we moved from here down to here to A1 where there is a negative change in inflation. As the level of output and income decreases and taxes increase, consumption decreases on both counts. And as the level of output decreases, investment also decreases because as we know there's a positive relation between output and investment. So thus in the short run both consumption and investment spending decrease. At point we're at point Y1 with a negative output gap. We see it's associated with a negative change in inflation. And then what happens in the medium run? Well, when output is too low and inflation is decreasing, the central bank is likely to react and decrease the policy rate, i.e. the LM curve shifts downwards from LM to LM1 from LM to LM1 and the economy moves down the curve from A1 to A2 until output is back to potential. At A2, output increases back from Y1 to YN and inflation is again stable. The policy rate needed to maintain output at potential is now lower than before. It decreases from Rn to RN1. At this new equilibrium point, income or output is the same as it was before fiscal consolidation, but taxes are higher, consumption is lower, but not as low as it was in the short run. The real interest rates needed to maintain the natural level of output is now lower than before, decreased from RN to RN1, meaning that investment spending is even higher than before the contractary fiscal policy. In other words, the decrease in consumption is offset by an increase in investment. So demand by implication is unchanged. The medium run position when comparing with the shortrun position looks much better and makes fiscal consolidation look more attractive. Although consolidation may decrease investment in the short run, it increases investment in the medium run. Okay? So this is the opposite of the very first example that I gave you. The first example was the action in the short run was government using some sort of expansionary fiscal policy. Now the government is using a contractionary fiscal policy and the central bank reacts by lowering the policy rate the repo rate as we call it. So by lowering that policy rate, it's now increasing private investment. And so essentially, government spending is crowded out by private spending, which is a good thing. And our level of output and income is back at the initial position, but government has has consolidated its position.
Does anyone have anything to ask? I see we just reached 1:00 now, so I just want to see. I've got I just want to quickly look at the neutrality of money. Then I've got two activities. Um but if you if you need to go now I completely understand.
So the neutrality of money refers to the idea that changes in the money supply affect only nominal variables like prices or wages and not real variables like output or employment in the medium run. So if we look at an example in response to the economic shock caused by the CO 19 pandemic the South African Reserve Bank cut the repo rate from 6.25% to 3 1/2% to stimulate the economy. This is represented by a downward shift of the LM curve from LM to LM1. Output increases from the natural level of output to level Y associated with point A1. This is the short-term equilibrium where the output gap is positive and the change in inflation is also positive. So we see that in the short run the lower policy rate stimulates investment and consumption. Then in 2022 inflation started to rise partly due to global supply chain shocks and then it neared the upper band of the Saab's target. the SA began raising interest rates and this is illustrated by a shift from LM1 upwards back to LM. This is the medium run where the economy returns to the potential output level. However, prices and wages are higher. Thus, the medium run effect of monetary expansion was only nominal higher prices and higher wages. It didn't result in real changes to the variables.
Okay. Why is money considered neutral in the medium run? A, because consumers stop responding to price changes. B, because interest rates fall to zero. C, because prices and wages fully adjust to changes in the money supply. Or D, because government spending offsets monetary policy. Does anyone want to take a guess? I'm not seeing anything. So, in the interest of time, um I'll just say the correct answer is C. Prices and wages fully adjust to changes in the monetary supply. In the medium run, price and wage flexibility ensures that real variables return to their natural levels after monetary shock. And question two, why is understanding the neutrality of money important for monetary policy? A, it shows that monetary policy can only affect inflation in the medium run. B, it suggests that monetary policy can reduce long-term unemployment. C. It proves fiscal policy is always better. Or D, it encourages central banks to print more money. Does anyone want to answer that question? Okay, I'm not seeing any hands, so I'll just tell you that the correct answer is A. Since money is neutral in the medium run, central banks use monetary policy mainly to manage inflation, not to permanently boost growth. So that is the concept of the neutrality of money. Okay, it's 13:04, so I'm going to open the floor to questions, then we'll end the session. So, please go ahead. You can also type in the chat if you want to ask a question.
>> Sorry, ma'am.
>> Yes, go for it.
>> Are you able to put your last two slides back on up, please?
>> Which one? The activity or this one?
>> No, the activity one.
>> Mhm.
>> Thank you, ma'am.
>> Are you Are you satisfied that the answer is A?
>> It gives me a chance to be able to go back and try to understand why. Hence I'm saying I'm asking for so that I can bring it to um finality in my mind as to why things are. So hence I'm asking for them. So essentially what we're saying when we look at the the neutrality of money as a concept is we're saying that when the central bank uses monetary policy to be expansionary instead of simply responding in the medium run. If monetary policy is trying to be expansionary, it's only going to result in changes in prices, it's not going to change the real underlying variables. So therefore, it's not it's not sufficient to rely on monetary policy to boost growth permanently because it's not capable of boosting those real variables. it only changes prices in the long run. Okay. So from that that's why we use monetary policy as an inflation um targeting and inflation control. So you have something in the short run which pushes the economy to a level of output and income that's above the natural level of output and income and in response the monetary authorities increase the interest rate in order to bring the economy back to its natural level. So that's why B, C, and D are not correct because essentially the neutrality of money means that if the central bank was trying to boost growth, all it would be doing is printing more money. So that now a coffee costs you 100 rand instead of 15 rand eventually. You're just changing the prices. You're not changing the real values. You're not getting more coffee for your money. you you having to pay more money for the same amount of coffee. Okay. All right. Thanks. I see the thumbs up there. Okay.
Does anyone have any other questions? No. All right. Well, then I think we will end our session there. Thank you for um staying with me and and I hope you have a good week.
>> Thank you, ma'am.
>> Thank you. you. Bye-bye.