Revisited Fiscal

and Monetary
Policy

Based on Ch 22 and 23

(This PPT is modified based on

Blanchard Ed.7 and it is only
used for teaching in
Undergraduate Class,
Department of Economics
FEB UI)
Outline

12.1.Fiscal Policy
12.1.1.The government budget constraint: deficit, debt, spending, and
taxes
12.1.2. Ricardian Equivalence
12.1.3. The Dangers of High Debt

12.2.Monetary Policy
12.2.1. From money targeting into inflation targeting
12.2.2. The optimal inflation rate
12.2.3. Monetary Policy and Financial Stability

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Why We Should Learn This Part?

• Policy matters for economic welfare

• In real world, policy will influence
macroeconomic performance
• Monetary and fiscal policy are one important
tools of aggregate demand management
• Complexities in economic globalization era
needs the fast and dynamic response from
monetary and fiscal policy

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1. FISCAL POLICY

• Chapter 21 asks two questions: Given the uncertainty about the

effects of macroeconomic policies, wouldn’t it be better not to use
policy at all? And even if policy can in principle be useful, can we
trust policymakers to carry out the right policy? The bottom lines:
Uncertainty limits the role of policy. Policymakers do not always do
the right thing. But with the right institutions, policy does help and
should be used
• Chapter 22 looks at fiscal policy. It reviews what we have learned,
chapter by chapter, and then looks more closely at the implications
of the government budget constraint for the relation between debt,
spending, and taxes. It then considers the implications of high levels
of public debt, a central issue in advanced countries today.

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• What we have learned about fiscal policy:
– Chapter 16: The short-run effects of fiscal policy including the
effects on expectations
– Chapter 18: The effects of fiscal policy when the economy is open
in the goods market
– Chapter 19: The role of fiscal policy in an economy open in both
goods markets and financial markets
– Chapter 21: Problems facing policy makers given the uncertainty
about the effects of policy to issues of time consistency and
credibility
• We have not paid close attention to the government budget
constraint.
– In most advanced economies, the crisis has led to large budget
deficits and a large increase in debt-to-GDP ratios.
– This calls for governments to reduce deficits, stabilize the debt,
and reassure investors.
– The purpose of this part is to review what we have learned
about fiscal policy so far, to explore in more depth the
dynamics of deficits and debt, and to shed light on the
problems associated with high public debt.
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 12.1.1.The government budget constraint:
deficit, debt, spending, and taxes
• The budget deficit equals spending, including real
interest payments on the debt (rBt-1), minus taxes net of
transfers (Gt – Tt):

• Government budget constraint: The change in

government debt during year t equals the deficit during
year t:

the debt at the end of year t equals (1 + r) times the debt at the end of year t - 1 plus the primary deficit
during year t,

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 If primary deficit = 0, and B1=1 ( decrease taxes by 1)
• From equation (22.3), debt at the end of year 2:

and at the end of year 3:

• As long as the primary deficit equals zero, debt

grows at:

(Each year, the government must issue more debt to pay the
interest on existing debt)

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• If debt is fully repaid during year t, then equation
(22.4) becomes:

which implies:

• If government spending is unchanged, a decrease

in taxes must eventually be offset by an increase in
taxes in the future (run a primary surplus)
• The longer the government waits to increase taxes,
or the higher the real interest rate is, the higher
the eventual increase in taxes must be.

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• The legacy of past deficits is higher government
debt today.
• To stabilize the debt, the government must
eliminate the deficit.
• To eliminate the deficit, the government must run
a primary surplus equal to the interest payments
on the existing debt. This requires higher taxes
forever.

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• Now consider the debt-to-GDP ratio (or debt ratio)
instead of the level of debt.
• Divide equation (22.3) by real output

which can be rewritten as:

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• Assume that output Y grows at a constant rate of g:

or

which implies that the increase in the ratio of debt to

GDP is larger:
– the higher the real interest rate
– the lower the growth rate of output
– the higher the initial debt ratio
– the higher the ratio of the primary debt to GDP

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FOCUS: How Countries Decreased Their
Debt Ratios after World War II

• The debt ratios of many countries declined in decades

after World War II.
• The declines in debt were not mainly the result of primary
surplus, but the result of high growth and sustained
negative real interest rates.

Table 1 Changes in Debt Ratios Following World War II

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12.1.2. Ricardian Equivalence
Ricardian equivalence proposition (Ricardo-Barro
proposition): Once the government budget constraint is taken
into account, neither deficit nor debt have an effect on
economic activity.
• If a government finances a given path of spending through deficits, private
saving will increase one-for-one with the decrease in public saving, leaving
total saving unchanged.
• Many consumers would save most or all of the tax cut in anticipation of
higher taxes next year.
• But insofar as future tax increases appear more distant and their timing
more uncertain, consumers are in fact more likely to ignore them.

To help assess whether fiscal policy is on track  to judge the direction of fiscal
policy: cyclically adjusted deficit.

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12.1.3. The Dangers of High Debt

Take a country with a high debt ratio, say, 100%. Suppose the real
interest rate is 3% and the growth rate is 2%. Suppose further that the
government is running a primary surplus of 1% of output, so just
enough to keep the debt ratio constant
(3% - 2% )times 100% + (-1) = 0%

Now suppose financial investors start to worry that the government may
not be able to fully repay the debt  the interest rate increases from
3% to 8%. Then, just to stabilize the debt, the government now needs
to run a primary surplus of 6% of output

The spending cuts or tax increases  higher risk of default  further

increase of interest rate  recession  decreasing output

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 Figure 22-2 The Increase in European Bond Spreads

The spreads on Italian and Spanish two-

year government bonds over German
two-year bonds increased sharply
between March and July 2012. At the end
of July, when the European Central Bank
stated that it would do whatever was
necessary to prevent a breakup of the
Euro, the spreads decreased.

Italy and Spain succeeded, with the help

of the ECB, in avoiding bad debt
dynamics and default. What if a
government does not succeed in
stabilizing the debt and enters a debt
spiral? Then, historically, one of two
things happens: Either the government
explicitly defaults on its debt, or the
government relies increasingly on money
finance.

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 The government can also finance itself by printing
money.
• Money finance, debt monetization, or fiscal dominance of monetary
policy: The government issues bonds and then forces the central bank to
buy its bonds in exchange for money.
• Seignorage: The revenue, in real terms, that the government generates
with money creation (∆H).

• The relation between seignorage, the rate of nominal money growth, and
real money balances (relative to GDP):

• This implies that to finance a deficit of say 10% of GDP through

seignorage, given a ratio of central bank money to GDP of 1, the growth
rate of nominal money must be equal to 10%.
• As money growth increases, inflation typically follows. Hyperinflation
refers to very high inflation.

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FOCUS: How Japan Could Stand Such a Huge Debt?

Figure 1 Budget and Debt Projections

Gross public debt of Japan has risen from

70% of GDP in 1992, to 230% of GDP in
2015 because of high expenditures for
transfer payment and lower tax revenue,
slow output, and persistent deflation

How is it bearable? The factor most

frequently quoted is that most of the debt
is financed from domestic sources.
household savings in the form
of bank and postal deposits, insurance
policies, and pension funds were funneled
into government securities through
government financial institutions, private
banks, and insurance companies.

Source: Jones, R. S. and S. Urasawa (2013), “Restoring Japan's Fiscal Sustainability,” OECD
Economics Department Working Papers, No. 1050, OECD Publishing.

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 The Case of Indonesia
Indonesian State Budget
and Deficit

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By Jan 2021, reach
40,2%
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2. Monetary Policy
• For the two decades (a period known as the Great
Moderation) before the crisis, most central banks
had converged toward a framework for monetary
policy, called inflation targeting.
• The inflation targeting framework has two
principles: (1) Keep inflation stable and low; and
(2) follow, explicitly and implicitly, an interest rate
rule.
• This part reviews what we have learned about
monetary policy so far, and describe the logic of
inflation targeting and the use of an interest rate
rule.

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What We Have Learned
• Chapter 4: Money demand and money supply and the determination
of the interest rate
• Chapter 5: The short-run effects of monetary policy on output
• Chapter 6: The distinction between the nominal and real interest
rate, and between the borrowing rate and the policy rate
• Chapter 9: The effects of monetary policy in the medium run
• Chapter 14: The distinction between short- and long-term interest
rates
• Chapter 16: The effects of expectations on spending and output, and
the role of monetary policy in this context
• Chapter 19: The effects of monetary policy in an economy open in
both goods markets and financial markets
• Chapter 20: The pros and cons of different monetary policy regimes,
namely flexible exchange rates versus fixed exchange rates
• Chapter 21: The problems facing macroeconomic policy and
monetary policy

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 12.2.1. From money targeting into inflation
targeting
Until the 1980s, the strategy of Monetary Policy was to choose a
target rate of money growth and to allow for deviations from
that target rate as a function of activity.
There is no tight
relation between M1
growth and inflation,
even in the medium
run  making money
growth, via interest
rate, an unreliable
instrument to affect
demand and output

Credit card ( technology ) drive

down Money demand  SR : P
constant, but i increase ; MR : P
double to keep M

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From Money Targeting to Inflation
Targeting
• Recall the Phillips curve equation (8.9):

• Let the inflation target be π* that is also credible, so that

people expect inflation to be equal to the target. The
Phillips curve becomes:

• If the central bank is able to hit its inflation target,

unemployment will be equal to its natural rate.
 Keeping inflation stable is a way of keeping output at
potential.

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 • In the 1990s, John Taylor suggested a rule of the policy
rate it, now known as the Taylor rule:

where i* = rn + π*, which is the rate of interest plus the

target inflation rate; and a and b are coefficient chosen
by the central bank.

When inflation is higher than the target, increase the

policy rate to decrease the pressure on prices; when it is
below the target rate of inflation, decrease the policy
rate.
• If πt = π*, the central bank should set it = i*.
• If πt > π*, the central bank should increase it above i*.
• If ut > un, the central bank should decrease the nominal interest rate.
• The coefficient b reflects how much the central bank cares about
unemployment.

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12.2.2. The optimal inflation rate

• Inflation steadily decreased in advanced economics

from the early 1980s.
• Whether central banks should have aimed for an
inflation rate of about 2% depends on the costs and
benefits of inflation.

Table 23-1 Inflation Rates in the OECD, 1981–2014

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Inflation : Good or Bad ?

• Four main costs of inflation:

– Shoe-leather costs: high inflation  high interest rate 
opp cost of holding money  more “trip” to the bank :
Costs associated with more “trips” to the bank as people
reduce their money balances.
– Tax distortions: High inflation leads to more higher
capital gains taxes and higher income tax
– Money illusion: People appear to make systematic
mistakes in assessing nominal versus real changes in
incomes and interest rates. Test by phycologist and
economists.
– Inflation variability: Higher inflation is typically
associated with more variable inflation, which increases
the risk (uncertainty) of financial assets that promise fixed
nominal payments in the future.

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• Three benefits of inflation:
– Seignorage: Money creation—the ultimate source
of inflation—is one way in which the government can
finance its spending.
– The use of the interaction between money illusion
and inflation in facilitating real wage
adjustments.
To see why, consider two situations: In the first, inflation is 4% and your
wage goes up by 1% in nominal terms—in dollars. In the second,
inflation is 0% and your wage goes down by 3% in nominal terms. Both
lead to the same 3% decrease in your real wage, so you should be
indifferent. The evidence, however, shows that many people will accept
the real wage cut more readily in the first case than in the second case.
-an economy with a higher average inflation rate has
more room to use monetary policy to fight a recession

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 12.2.3. Monetary Policy and Financial Stability

• One example of unconventional monetary policy is

quantitative easing or credit easing: Central banks
buy assets, with the intention of decreasing the
premium on those assets, and thus decreasing the
corresponding borrowing rates with the aim of
stimulating economic activity.
• Central banks finance their purchases through money
creation, leading to an increase in the money supply.

• QE1 (Quantitative Easing 1): The Fed started its first quantitative easing
program in November 2008 by buying certain types of mortgage-based
securities.
• QE2: In November 2010, the Fed started buying longer term Treasury bonds
with the intent of decreasing the term premium on these long term bonds.
• QE3: In September 2012, the Fed purchased more mortgage-based securities
in an effort to decrease the cost of mortgages.

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• Lender of last resort: A function of the Fed that
provides a bank the liquidity it needs to pay the
depositors without having to sell its assets.
• The crisis has forced central banks to consider
whether they want to provide liquidity to
institutions they do not regulate.
• The consensus is:
– It is risky to wait for a bubble to build up and burst
– To deal with bubbles or dangerous behavior in the financial
system, rather than the interest rate, the right instruments
are macroprudential tools—rules that are aimed directly
at any financial institutions involved

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12.2.4.Current Debate of Macroeconomic Policies in
the World based on latest data and news

• Inflation Targeting Framework plus

• Financial Stability Mandate

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 Monetary Policy Framework in
Indonesia

Source : Central Bank of Indonesia

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ITF Implementation in Indonesia

• ITF is a framework, not a rule

• Basic Principles of ITF:
– BI-Rate/BI 7 day repo rate as monetary target
– A forward looking monetary policy
– As policy communication and transparency
– Strong coordination with the government

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 Bank Indonesia Policy to Set BI 7 day repo (new form of
BI rate)
The BI Rate is the policy rate reflecting the monetary
policy stance adopted by Bank Indonesia and announced
4.80%
to the public.
The BI Rate is announced by the Board of Governors of
4.70% Bank Indonesia in each monthly
Board of Governors Meeting. It is implemented in the
4.60% Bank Indonesia monetary operations conducted by
means of liquidity management on the money market to
4.50% achieve the monetary policy operational target.

4.40%
Bank Indonesia strengthened monetary operations
4.30%
by introducing a new policy rate known as the BI 7-
Day (Reverse) Repo Rate, effective from 19th
August 2016. In addition to the existing BI Rate, the
4.20%
new policy rate does not represent a change of
monetary policy stance.
4.10%
Why did Bank Indonesia introduce a new reference
rate? In order to accelerate the transmission of the
4.00% policy rate to the money market, banking industry
6 6 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7

D
ec
-1 c-1 n-1 n-1 b-1 b-1 r-1 r-1 r-1 r-1 y-1 y-1 n-1 n-1
D
e Ja Ja Fe Fe M
a
M
a
Ap Ap
M
a
M
a Ju Ju -Jul
-1
-Jul
-1 g-1 g-1 p-1 p-1
Au Au Se Se and real sector. The new BI 7-Day (Reverse) Repo
7- 21- 4- 25- 8- 22- 8- 22- 5- 19- 3- 17- 7- 21- 5 19 2- 16- 1- 13-
Rate has a stronger correlation with money market
BI 7 Day Repo PUAB C-P PUAB C - NP PUAB NC- P PUAB NC - NP
rates, is transactional or tradeable on the market and
increases financial market deepening.

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Monetary and Fiscal Coordination in
Indonesia
• With inflation in Indonesia is not only influenced by demand pull, but also cost push
factors, it is vitally important for the Government and Bank Indonesia to coordinate their
actions through integrated macroeconomic policies if inflation targeting is to be effective.
At the policy making level, Bank Indonesia and the Government address this need by
holding regular Coordination Meetings to discuss the latest economic developments.
Similarly, Bank Indonesia is also frequently invited to Cabinet Meetings chaired by the
President of Indonesia to provide opinions on macroeconomic and monetary
developments relevant to achievement of the inflation target. Coordination of fiscal and
monetary policy also takes place in the joint formulation of the State Budget Macro
Assumptions deliberated with the Indonesian Parliament. In other areas, the
Government coordinates debt management operations with Bank Indonesia.
• At the technical level, the coordination between the Government and BI has been
established with the formation of the ministerial level Inflation Targeting, Monitoring
and Control Team (TPI) in 2005. The TPI members include Bank Indonesia and
technical ministries, such as the Ministry of Finance, Coordinating Ministry for the
Economy, National Development Planning Agency, Ministry of Trade, Ministry of
Agriculture, Ministry of Transportation and Ministry of Manpower and Transmigration. In
view of the importance of this coordination, TPI was expanded to the regional level in
2008. Looking forward, the Government and BI envisage even stronger coordination with
the support of ministerial and regional level TPI forums to bring about low, stable
inflation as a platform for sustainable economic growth.

Source : Central Bank of Indonesia

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Summary

• Fiscal Policy and Monetary Policy are the

instrument of demand management
• In fiscal side, we should concern about the
debt sustainability and government deficit
• In monetary side, we should focus on
inflation targeting framework and financial
stability system
• Monetary policy and fiscal policy should
make coordination to get optimal policy mix

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