Asset Markets & The IS-LM Model.
Topic 5 – Asset Markets & The IS-LM Model
In this note, we are going to provide a link between asset prices and the demand side of the economy. We will consider asset markets such as the stock market or house/ real estate markets and how the impact on aggregate demand. We will emphasize that agents are forward looking in terms of consumption and investment decisions which allows this link to be made.
In addition, if the government is funding spending through running a fiscal deficit, then the funding of this deficit will have implications for AD. If the government is running a deficit, it can fund this by either
- Issuing bonds
- Expanding the nominal money stock
Dt is the fiscal deficit at time t
Gt is government spending at time t
Tt is tax revenue at time t
Bt is the stock of bonds. Therefore ΔBt is the change in the stock of bonds between t and t-1.
Mst is the nominal money stock
Thus, if the public finances are initially in balance (i.e. Gt = Tt) and the government increases spending by £100m then it requires to finance this deficit and can do so in 2 ways
Increase the stock of bonds by ΔBt
Increase the nominal money stock by ΔMst
Note. If the increase in spending is permanent the state will require to find £100m each and every year. This implies either or both
A rising debt-GDP ratio
A rising nominal money stock
Note. If the government funds it’s deficit via bond sales, it will also require to raise additional capital to service the annual interest payments if it wishes to maintain a permanent nominal spend of £100m . Suppose r=10%. In year 2, the govt will require to raise not only £100m but also 10% of £100m. In total, the government needs to raise £110m in year 2 to maintain it’s deficit spend of £100m on public spending programmes. In year 3, the govt will require to raise £100m(1+r)2 = £100m (0.1)2 = £121m. In year t, the government would require to raise £100m(1+r)t-1. Clearly, if the government chooses to finance a deficit by continously issuing bonds, national debt will increase rapidly and problems will eventually arise in terms of servicing this.
2/ Wealth and the Goods Market
When deriving the IS curve, it is conventional to use a consumption function based on Keynes absolute income hypothesis. i.e. Ct = f(yt). This asserts that current consumption depends solely on current income. In economies with developed capital markets this is a poor description of consumer behaviour. A better approach is to assume that agents are ‘forward looking’ when making consumption decisions. Thus, in a 2 period context, we can write
Ct = g(yt, Et(Yt+1))
This states that current consumption depends on current income and expected future income. We can partition income into 2 broad classes
Labour income - yL
Unearned income - yU
Now, unearned income is the stream of future income from the ownership of assets such as equities, bonds and real estate. In properly functioning asset markets, the price of an asset, A, is the present value of the expected income stream,
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Thus, we can write our ‘forward looking’ consumption function as follows
Ct = g(ytL, Et(yt+1L), At)
This ‘life cycle’ model of consumers expenditure states that current consumption depends on current labour income, expected labour income and current (net) wealth. In addition,
Thus, a rise in current earned income increases current consumption as do rises in expected labour income or current (net) wealth. Figure 1 illustrates that, for the ‘short run’ consumption function, an increase in wealth from W0,t to W1,t engenders a rise in consumption from a given level of current earned income. A similar effect can be noted in the case of the ‘long run’ consumption function. Figure 2 highlights that this wealth induced increase in consumption induces a rise in equilibrium y for any given interest rate, i.e. the IS schedule shifts out. This results in higher equilibrium r and y. Figure 3 indicates that a rise in wealth pushes out the AD curve inducing both increased output and a higher price level
3/ Bond Financed Fiscal Deficit
Suppose the Government departs from a balanced budget to a permanent deficit which it intends to finance via bond sales to the private sector.
Step 1/ The increased fiscal injection results in greater equilibrium output for any given interest rate. i.e. the I-S schedule shifts out from I-S0(W0) to I-S1(W0) and both r and y increase crowding out some of the potential stimulus. This is shown in Figure 4 below. However, this is not the end of the story.
Step 2/ The authorities have issued bonds to finance the extra spend. These bonds are held by the private sector who now feel wealthier and consume more. This pushes up the I-S curve to I-S1(W1), where W1 is the new and higher level of private wealth.
Step 3 Bond financing implies that a greater volume of bonds are issued each year to finance the permanent deficit. Thus, the I-S curve will shift out as wealth increases year after year eventually reaching I-S1(WT).
This process will ultimately draw to a halt for 3 reasons
1/ Eventually prices will start to rise which engenders 2 effects
- Rising prices serve to contract the real money supply which causes the L-M schedule to shift inwards
- Rising prices reduces the real value of wealth which chokes off some of the rise in consumption, reducing AD and output.
2/ The fiscal and wealth stimulus will increase output and therefore tax revenue which serves to cut the deficit.
3/ Rising interest rates reduce the present value of expected income streams thus reducing asset prices and wealth.
Eventually the economy will gravitate towards an equilibrium characterized by a zero deficit. The I-S, L-M model becomes quasi dynamic and the outcome is shown in Figures 4 and 5.
In Figure 4, we abstract from the price effect and the economy reaches a new equilibrium at r = re1 and y = ye1.
In Figure 5 we allow the price level to respond to increased demand. The rising P causes the real money stock to contract which further drives up interest rates. This causes the economy to come to a final equilibrium at re2, ye2.
4/ Are Government Bonds Net Wealth
Robert Barro has ressurected an old idea due to Riccardo which questions the validity of the above analysis by arguing that rational forward looking agents should not regard bonds issued by governments to finance permanent deficits as a net addition to private sector wealth. The argument is quite simple. Eventually the debt incurred will have to be repaid which will involve, ceteris paribus, increased taxation. Barro argued that rational agents would thus increase savings – reduce current consumption in order to meet the inevitable future tax increases.
This so called Riccardian equivalence theorum suggests that deficit financed fiscal expansion will be unable to stimulate an economy and that the effects on aggregate demand will be neutral or perverse. (see accompanying handout). Most mainstream economist would reject the view that deficit financed fiscal measures will have no real effects, at least in the medium term.
5/ Wealth Effects and The Money Market
It can be argued that as wealth increases, so too will money demand for both transactions and precautionary purposes. This has the effect of increasing MD at all rates of interest. i.e. the MD curve shifts out as wealth increases. Given a fixed money stock, this engenders leftward shifts in the L-M function as wealth increases. If this were the case, wealth effects would be causing the I-S curve to shift to the right whilst the L-M curve was simultaneously shifting in. In this case, a bond financed permanent deficit could theoretically result in lower output than prior to the fiscal stimulus. Such an effect would result in a spiral of decreasing real output unless the deficit financed stimulus was accompanied by an expansionary monetary policy.
Such contractionary spirals are not observed in the real world which suggests that wealth effects in the money market are not particularly strong or that this effect is in practice offset by appropriate monetary measures.
6/ Deficit Financing via an Increased MS.
The government can finance a deficit by borrowing from the central bank. This creates new reserve assets which serves to increase the money stock via the bank multiplier. Again, if the deficit is £100m, the MS must be expanded by £100m each and every year.
Step 1/ The fiscal stimulus shifts the I-S curve to the right from I-S0(W0) to I-S1(W0).
Step 2/ The deficit is financed by expanding the money stock which causes the L-M curve to likewise shift to the right.
Step 3/ Again, the model becomes quasi dynamic as each year the MS must be expanded to fund the deficit. The outward shift of the L-M curve will stop due to
- Price effects which erode the real money supply and reduce real wealth.
- Higher income will raise tax revenue and cut the size of the deficit which needs to be financed
Note that the transmission mechanism has altered from that outlined for the basic I-S L-M model
First, note that a change in interest rates impacts on consumption as well as investment. If interest rates rise wealth falls because
- In stock markets, share prices can be viewed as the discounted value of future dividend payments. If interest rates rise, then this may tempt agents to increase the discount rates with which the value shares causing share prices to decline
- In real estate markets, rising interest rates will choke of the demand for mortgages and thus moderate prices in the housing market.
In either case, wealth will decline resulting in reduced consumption from current disposible income. This in turn reduces AD and national income.
Second, we have already argued that confidence effects can generate spillovers between consumption and investment. Declining investment and consumption can begat further falls in consumption and investment as confidence dissipates. Thus, the transmission mechanism is not something which is wholly predictable. If confidence is strong, a rise in interest rates may fail to check C and I very quickly.
Third, asset prices do not continuously reflect fundamentals. In both housing and equity markets, ‘bubbles’ can emerge which results in the relationship between share prices, house prices and interest rates being imprecise.
Taken together, we can see that monetary policy – either targeting interest rates or controlling the money stock - may not have very predictable or precise effects.
7/ Asset Markets and Investment
So far we have dealt with a simple investment function
It = f(rt) = I0 + crt
In order to link investment to the stock market, we marshall Tobins q. Tobin argued that if the market valuation/capitalisation of a business exceeded the replacement cost of the underlying then it was attractive to issue more share or use retained earnings to expand capacity. This results in a relationship between share prices and investment
It = h(rt, qt)
If q rises due to a buoyant stock market, this results in higher I, AD and output for a given rate of interest i.e. the I-S curve ‘shifts out’. Similarly, buoyant equity prices result in higher output for a given price level i.e. the AD curve shifts out.
In the 1990s, we had the continuation of a long ‘bull’ market in the UK and USA and many other countries. Share prices and market capitalisations rose continuously and dramatically, particularly in the later part of the decade. This phenomenon help explain the strong trend in investment observed for British and US businesses.
Thus, high stock markets valuations also engender increased investment and capacity at any given price level. i.e. the aggregate supply ‘shifts out’ to the right. This is fine if share prices accurately reflect the prospects for all individual companies. Stock prices will reflect the outlook for individual markets and companies, high market valuations reflect these prospects and capital flows to activities exhibiting the best prospects.
As indicated previously, in many bull (and bear) markets, stock prices eventually lose touch with corporate and national fundamentals. This tends to happen universally but can impact on particular sectors. In the 1990s the share prices of technology, telecom and internet stocks exploded resulting in a massive expansion of these sectors, often on a global basis. This generated an expansion of capital in activities for which there was insufficient current and likely demand.
The bubble burst in 1990 and stock prices have been in sharp decline. Much capacity in high technology manufacturing, computer services has proved unwarranted resulting in sharp reductions in supply. In the case of semiconductors, computer and mobile phone manufacturing, the effects of this phenomenon have been particularly marked in Scotland which experienced a sharp increase in activity in these sectors due largely to US multinationals.
Stock markets effects on investment present a source of considerable noise in terms of both aggregate demand and supply, particularly in the short term.
8/ Concluding Remarks
Confidence effects and wealth effects can induce considerable noise into a macro system with developed capital markets. The question of whether the state can use monetary or fiscal policy to stabilise such a system proves problematic. If lax monetary and or fiscal policy are intended to engender a boost to activity, they may engender an unsustainable boom as consumer and business confidence and investor sentiment amplify the intended policy effect.
A good case in point is the UK in the late 1980’s. Lax monetary and fiscal policy expanded demand which engendered high consumer and business confidence which amplified the policy effects. The strong trend in demand boosted house prices, particularly in the south which further boosted wealth and consumer confidence. In addition, there was a buoyant stock market which served to increase consumption, investment and confidence.
The authorities were convinced that the supply side reforms previously introduced would allow the economy to grow at a faster rate than previously without the emergence of the twin inflationary effects of price inflation and a deteriorating trade balance. This notion proved unfounded and by 1988, the government was forced to tighten policy.
This led to faltering output, falling confidence and a slowing and eventual fall in house prices. These adverse demand, confidence and wealth effect eventually resulted in falling output and a prolonged recession. Even when activity and house prices began to recover low consumer and business confidence kept output weak and confounded any attempt to boost the economy by fiscal means.
Arguably, experience of trying to steer a noisy economy led policy makers from an activist perspective and led to the adoption of a policy of using demand policy to target inflation within the context of fiscal rules.