Economic Impacts of Savings, Labor Reform, and Monetary Policy
Economic Impacts of Increased Savings
An increase in household’s marginal propensity to save leads to a negative demand shock. As households save more, consumption decreases, causing a decline in production and slowing the economy. The IS curve shifts left. Lower production leads to fewer jobs, increasing unemployment, and decreasing inflation. Falling inflation raises the real interest rate, risking deflation.
To prevent deflation, the central bank should reduce the nominal interest rate, lowering financing costs for companies and boosting investment. Increased consumption and demand will raise production, income, and inflation, boosting employment and returning production to its potential level.
Without intervention, deflation risks persist, with falling production, fewer jobs, and further decreased inflation.
Expansionary fiscal policy, such as reduced taxes, can also help. More disposable income increases consumption and savings, boosting demand and production.
The central bank’s intervention lowers the real interest rate in the medium term, restoring economic stability, aligning prices with expectations, and achieving natural unemployment and potential output.
Labor Market Reform and Firing Costs
Labor market reform reduces firing costs, increasing flexibility but initially raising unemployment as firms adjust. This lowers production costs and reduces inflation, with output temporarily declining. The economy moves below its natural output level, with decreasing inflation.
The central bank should lower interest rates to boost demand and bring output closer to its new, higher natural level. Lower inflation allows expansionary monetary policy to reduce unemployment and restore equilibrium.
Without intervention, the economy could remain below its natural output level, with prolonged high unemployment and low inflation, delaying recovery.
Expansionary measures, like increased government spending or reduced taxes, boost aggregate demand, closing the output gap, increasing employment, and stabilizing inflation.
Fiscal Policy and Government Spending
The government aims to reduce spending by 3 units to eliminate the deficit. This will decrease production by 12 units due to the multiplier effect, shifting the IS curve left.
To prevent output reduction, the central bank can lower the interest rate to stimulate investment, shifting the LM curve downward. The interest rate should be lowered by 5%.
Lower interest rates increase investment but do not change savings, keeping the equation S=I+(G−T) constant.
ECB Interest Rate Impacts on Spain
b) Impacts on Spain of the increase in the ECB interest rate
A reduction in the ECB interest rate increases output and depreciates the euro. Lower rates encourage investment and consumption, shifting the IS curve rightward. Euro depreciation makes exports cheaper and imports more expensive, increasing net exports and raising output. These factors increase aggregate demand.
c) Decrease – Is it a problem or an opportunity?
A decrease in the ECB interest rate provides an opportunity to reduce Spain’s public deficit without lowering output. Lower rates stimulate investment and consumption, increasing output and boosting tax revenue. Depreciation raises net exports, contributing to economic growth and government revenue. This enables the government to reduce spending or increase taxes without harming output.