class: center, middle, inverse, title-slide # Fiscal Policy and Financial System ## Week 11 ### Krisna Gupta ### 26 April 2021 (updated: 2021-05-03) --- ## Recap on last week Short run impact of shocks: | shock type | shifts | P | Y | | --- | --- | --- | --- | | Positive demand | `\(\overrightarrow{AD}\)` | `\(\Uparrow\)` | `\(\Uparrow\)` | | Negative demand | `\(\overleftarrow{AD}\)` | `\(\Downarrow\)` | `\(\Downarrow\)` | | Positive supply | `\(\overrightarrow{SRAS}\)` | `\(\Downarrow\)` | `\(\Uparrow\)` | | Negative supply | `\(\overleftarrow{SRAS}\)` | `\(\Uparrow\)` | `\(\Downarrow\)` | --- .s[ ## Recap on last week - In the short-run, wage does not change (sticky wage): - when economy expand (ie, when Y `\(\Uparrow\)`), unemployment go down (more jobs created). - In the long-run, wage follows prices: - when price went up, wage goes up in the long-run. - when price went down, wage goes down in the long-run. - These mechanisms returns `\(Y\)` and unemployment back to their potential/natural level. ] --- ## This week - The effect of fiscal policy - Financial system - the central bank --- class: middle, center # Fiscal Policy --- ## Fiscal policy - Basically related to government expenditure (APBN+APBD) - The government gets its revenue from (mostly) taxes - Disburse the money through government projects and subsidy transfers - What we consider **fiscal policy** are: - increase/decrease government expenditure. - changes in taxes. - changes in government debt. --- ## Fiscal policy - Recall the basic equation of GDP: `$$GDP=C+I+G+X-IM$$` - Increasing government expenditure `\(=G \Uparrow\)` - Decreasing income taxes: - More money for people to consume `\(=C \Uparrow\)` - More money for business to invest `\(=I \Uparrow\)` --- ## Expansionary fiscal policy - When there's negative demand shock, the economy enters a recession ($Y \Downarrow$) - Unemployment `\(\Uparrow\)` as the economy works under-capacity. - Government can speed up returns to the potential output level `\(Y_P\)` by using **expansionary fiscal policy** such as: - Increase government spending - tax cuts. - Increase in government transfers (_bansos_,_subsidi_). --- ## Contractionary fiscal policy - On the contrary, an overheat economy causes a big increase in prices. - `\(Y \Uparrow\)` in the short run but inflation can be uncontrollable and a bubble may burst. - Government can reduce the speed of price hike by using **contractionary fiscal policy** like: - Reduce government spending. - Increase taxes. - Reduce government transfers. --- ## Does it work? - Expansionary fiscal policy should be done during a recession: - During a recession, economy runs below capacity. - Only the government can spend without fear of the future. - In general, Indonesian economists are agree to high spending during a recession. - It may not work to offset a **supply shock**, but most recessions are caused by **demand shock**. --- ## Government spending vs tax cut - We have learned that taxes distort perfect markets. - lowering taxes reduce DWL. - However, some arguments can be made for government spending: - Some will only spend some, but not all (saving instead). - Government spending can be 100% purchases. - (Income) Tax cut can be ineffective in a country where most people doesn't pay tax. --- ## Ricardian equivalence - Without altering tax, increased government spending must come from **debt** which creates **government deficit**. - Those debt needs to be paid in the future by **rising taxes**. - Forward looking people knows this. They might reduce consumption and save to pay the future taxes. -- - This is called **Ricardian Equivalent**: income from government consumption will be saved to pay future taxes, eliminating effects of expansionary policy. --- ## Ricardian equivalent - In the short-run, people will not save equals to the future tax. - They can spread their saving in to a longer time-span. - Most people will not even aware about how to calculate the debt and the tax needed to pay them in the future. - Therefore, Ricardian equivalent is not a big problem. --- ## Lags in fiscal policy - Expansionary fiscal policy is also a race against time. - There are reasons why government disbursement is slow: - Lack of data on who to transfers - Inefficient bureaucracy - Disbursement that is too slow risks overheating and inflation if the economy already returned to the optimal output. --- ## Long-run implication of Fiscal Policy - Without proper tax revenue, government needs to run a **fiscal deficit** which is financed by **debt**. - Running a deficit and accumulating debt often leads to a more political debate than economics. - Too much debt is problematic because it erodes trust from borrower. - This is the case for Greece and Argentina. - What about Indonesia? --- ## What about Indonesia? .pull-left[  Compared to some countries, Indonesia's tax revenue is very small. Increasing debt is necessary to boos spending] .pull-right[  On the contrary, Indonesia's government debt level is low. Debt from 1998 crisis was paid during the good times of commodity boom.] --- ## However... .s[  Indonesian bond is expensive. at around 6-7% interest rate, this potentially **crowds out** private investment! ] --- .s[ ## COVID recession | Growth in % </Br> (except stated otherwise) | 2019 | 2020 | 2021 | 2022 | | --------------------------------------------- | ---- | ---------- | ---- | ------- | | GDP | 5.0 | -2.1 | 4.9 | 5.4 | | private consumption `\(C\)` | 5.2 | -2.7 | 3.6 | 7.1 | | Government expenditure `\(G\)` | 3.3 | 1.9 | -0.3 | 1.0 | | CPI (inflation) | 3.0 | 1.9 | 2.1 | 3.0 | | Fiscal balance (% GDP) | -2.2 | -6.5 | -5.7 | -4.1 | COVID crushes demand. `\(G\)` helps, and it was financed by debt. ] .xs[Source: OECD (2021), OECD Economic Surveys: Indonesia 2021, OECD Publishing, Paris, https://doi.org/10.1787/fd7e6249-en.] --- ## Fiscal policy during normal times? - During normal times, economy runs at 100% capacity: - government spending will only crowds out private spending. - risks inflation. - Private firms borrows and invest normally. - government's debt rises interest rate which is not good for business. --- ## What about negative supply shock? - For example, oil price increase: - We can't just make oil or quickly change our technology - Fukushima shock: can't just find/make replacement firms. - Negative supply shock leads to **stagflation**: - government has to pick a lesser evil: - reduce inflation or reduce unemployment. --- class: middle, center #The Financial System --- ## The Financial System - So far we have talking about AD-AS, also known as **real sector** (sektor riil). - The other side of the coin is **financial sector**: - We do not consume what it produces. - But we use it for transaction. - We use it to measure everything we do in the real sector. - This time we will learn about money, banking, and the central bank. --- ## Money - Before we use money, we **barter**. - This is inefficient as some goods are: - hard to carry around. - hard to divide. - hard to match. - perishable (decreased in value over time) --- ## Money - Probably the oldest "money" - This is inefficient as some goods are: - hard to carry around. - hard to divide. - hard to match. - perishable (decreased in value over time) - At some point, people used gold and silver to facilitate barter. --- ## Money - However, even gold is hard to carry around especially if you are rich. - People stash their gold in a place called bank, and received "bank note" as a proof that they own the gold. - Normally, one needed to go to bank, take the gold, and transact. - But in the end, people use the bank note itself. This bank note is our today's **currency**. - Nowadays, banks can create money without having to have a gold in their stash. --- ## Money - **Money** is any asset that can easily be used to purchase goods and services. - An asset is called **liquid** if we can easily convert it to **cash**. - We generally consider **cash**, **bank cheques**, and **saving account** as money because they are liquid. - What are considered non-liquid asset? - house, cars, stocks, firms, what else? --- ## Main roles of money 1. **Medium of exchange**. Everyone has to believe in its value. We normally use IDR. Sometimes, foreign money is used. Goods can also be used under certain circumstances. 1. **Store of value**. It has consistent value (not perishable over time) 1. **Unit of account**: the commonly accepted measure individuals use to set prices and make economic calculation. --- ## Types of money 1. **Commodity money** is goods that is valuable to many people. Gold and silver, cigarettes, alcohol. 1. **Commodity-backed money** is a "paper money" that we can use to redeem a commodity (usually gold). Holders of these bank notes are guaranteed the gold (or other commodity) stated in the notes. 1. **Fiat money** is the money we know today. It only backed by the government's word. --- ## Advantages - **Commodity-backed money** makes transaction quicker than commodity money because a bank can generate more notes than it has gold. - In normal times, people won't redeem 100% of the gold. Banks just need to keep gold enough to satisfy daily demand. - **Fiat money** is even faster because banks do not need to hold anything. Some problems tho: - It's easier for counterfeit money to exists. - Some central banks print too much money which leads to the money losing its value. --- ## Measuring money supply - **M1** is the narrow definition: - consists of cash, traveler's checks, and other checkable bank deposits. - **M2** is a broader definition. It is M1 plus: - saving account and time deposit (deposito). - How much M1 and M2 circulate in the economy is largely controlled by the Central Bank - Bank of Indonesia in our case. --- class: middle, center # Monetary roles of banks --- ## Bank roles - Bank uses **liquid assets** in the form of **deposit** to finance **illiquid investments** of borrowers. - Banks cannot lend all of its assets: it has to store a small fraction in their own vault or in the central bank. - These stored asset is called **bank reserves**. - Bank reserves is not circulated in the market, hence not counted in M1 and M2. - In Indonesia, bank needs to have a reserve equals to **3.5% of its total loan**. - Also called **reserve requirement ratio**. --- ## Bank Runs - In normal times, people usually don't do anything with their saving account. - This way, banks can lend most of the money and reserve some for liquidity. - But if many lenders suddenly would like to withdraw money, bank would not have enough money. - they might have to sell some asset. - When many people wants to withdraw money at the same time, we call it **bank run**. --- ## Bank Runs - Bank runs happen when borrowers hear Bank is near collapsing. - However, just a rumour could create a real collapse if lenders decided to withdraw money together at the same time. - This can be contagious: a lost of faith in one bank could lead to lost of faith to the entire system. - This happened in 1998 when several banks were closed. --- ## Bank regulations 1. **Deposit insurance**. Indonesian depositors is insured (partially) by Lembaga Penjamin Simpanan (LPS) 1. **Capital requirements**. Bank is required to have a minimum capital or asset to be able to operate in Indonesia. 1. **Reserve requirements**. Currently is 3.5% but it used to be higher. It was lowered due to COVID-19 recession. 1. **Discount window**, where the central bank can lend money to private banks so they don't have to sell their asset. --- ## Money Creation - Bank control how much money circulated in the market by moving deposits between loanable funds and its reserves - Suppose Panca has a Rp1 million in his pocket. He decided to deposit it to Bank BeCAk. - Panca give Bank BeCAk his Rp1 million which reduces money supply - But Bank BeCAk credits Panca's account by Rp1 million which increases money supply - Hence no change in money supply --- ## Money Creation - But then Joy come to Bank BeCAk to borrow Rp900k to buy shoes. - Bank BeCAk use its reserve it get from Panca: - Bank BeCAk keep Rp 100k of its reserve, which comes from Panca - Bank BeCAk credits Joy's account Rp900k. - This leads to increased Rp900k in money supply: now there are Rp1.900k of money supply in the market! --- ## Money multiplier - Suppose Joy buy the shoes from Liv. - Liv then deposit the money to another bank named Bank Madara. - Bank Madara adds Rp900k to its reserve. - Also credit Liv's account Rp900k. - But like Bank BeCAk, Bank Madara can loan some of the fund and reducing its reserve! - The more money is circulated, the more expansionary the monetary condition is. --- ## Next week - Money supply is reduced when: - People keep their money out of the financial system - Banks increase its reserves - These are usually happening in an uncertain time: a recession or even worse, a crisis. - Next week, we will learn how money supply and money demand interact with the real sector - We will also learn how Bank Indonesia plays a role in the economy. --- class: middle, center # The End