12 Monetary And Fiscal Policy Flashcards
Fiscal policy
Balanced, surplus, deficit
Spending and taxing to affect economic activity.
Balanced -> tax rev = government expenditure
Surplus - >tax rev > exp
Deficit - >gov expenditure > tax rev
Can be used to redistribute income/wealth
Monetary policy
Central bank’s actions that affect quantity of money and credit to affect economy. Expansionary –> central bank increases quantity of money and credit. Contractionary is opposite.
Money
Medium of exchange, Unity of account, store of value.
Broad Money
Narrow money + amount in liquid assets. Narrow money is amount of currency/coin in circulation +balances in checking account.
Money that can be created formula
Money created = new deposit/ reserve requirement.
Money Multiplier
1/Reserve Requirement
Quantity Theory of Money
Quantity of money is some proportion of total spending in economy, implies quantity equation of exchange
Quantity equation of exchange
money supply * velocity = price * real output. MV = PY.
Why monetarists think an increase in money supply leads to proportionate increase in price level.
They think velocity and real output change slowly, not affected by monetary variables. This is the theory of money neutrality.
Demand for Money
Amount that households hold in money. 1. Transaction demand, GDP ^, transactions ^. 2. Precautionary demand. Economy size ^, precautionary ^. 3. Speculative demand, inversely related to returns in market.
Money Supply Curve
Vertical and independent of interest rates.
Interest rates in short term
If interest rates are above equilibrium, people will stop holding money and buy because returns are high. There was an excess supply of real money. Interest rates are below equilibrium, excess demand for real money. Firms/households will sell securities.
Fisher Effect
Nominal interest rate is the sum of the real interest rate and expected inflation. RNom = RReal + E[I] - expected inflation. Add in + RP for risk premium.
Goals of central bank
Supplier of currency, banker, regulator, lender of last resort, holder of gold, conductor of monetary policy.. stability in exchange rates, full exmployment, interest rates.
Objective of central bank
Control inflation to promote price stability.
Pegging
Other countries choose a targel level for the exchange rate of their country to that of another country’s. If their currency ^, they sell domestic currency reserves for dollar to reduce exchange rate.
When unanticipated inflation is higher than expected
Borrowers gain at the expense of lenders as loan payments in the future are made with currency that has less value in real terms.
Monetary policy tools
Policy rate, reserve requirements (decrease allows for more fund availability for lending, which tends to decrease interest rates), Open market operations.
Monetary transmission mechanism
The way a change in monetary policy affects the price level and inflation.
Contractionary Monetary Policy example
EG Short term lending rates ^, cause agg demand to decrease due to low credit purchases. Asset prices decrease as discount rates applied to future expected cash flows are increased. Decreased spending due ot poor economic expectations. Appreciation of domestic currency relative to foreign.
Expansionary Monetary Policy example
- Central bank buys securities, reserves ^. Short term and in turn long term rates decrease. Currency depreciates. Business investment ^. Increase in foreing demand for domestic goods. Agg demand ^ due to consumption, investment and net exports. Inflation, employment and real GDP ^. Asset prices ^.
Qualities of effective central bank
Independence - operational and target ( they define inflation). 2. Credibility. 3. Transparency.
Exchange rate targeting
If my foreign, domestic exchange value falls relative to US dollar, I use foreign reserves to purchase domestic currency (reduce money supply and increase interest rates) to reach target exchange rate.
Neutral interest rate
real trend rate of economic growth + inflation target. Growth rate of the money supply that neither increases/decreases economic growth rate.
Limitations of monetary policy
If peeps believe increase in money supply will reduce inflation due to higher short term rates, the expectation of inflation will cause l-term rates to fall. Vice versa. If demand for money is elastic and individuals still hold, liquidity trap. will occur even and increase in money supply won’t lower short term rates.
Automatic Stabilizers
built in fiscal devices triggered by state of economy. EG during recession, tax receipts fall and unemployment pmt ^.
Objective of fiscal policy
Influence level of economic activity and aggregate demand. Redistribute wealth and income. Allocate resources.
Debt Ratio
Agg debt to GDP
Why you shoul dbe concerned with size of fiscal deficit
- Higher deficits lead to future taxes and dicentives to work. If mkts lose confidence in government, investors won’t refinance debt and gov could default. 3. ^ Gov borrowing ^ interest rates, and firms may reduce borrowing and investing bc gov is taking over “crowding out affect”. Gov borrowing takes over private sector.
Spending tools (fiscal policy)
Transfer payment (take the tax and redistribute wealth. Ugh). Current spending - gov purchase of goods and services. Capital spending - gov spending on infrastructure.
Revenue tools
Direct taxes (income/wealth taxes), indirect taxes - goods and services.
Fiscal multiplier
Determines the potential increase in Agg Demand resuling from ^ in governement spending. Fiscal multiplier = 1/(1-MPC(1-t))
Ricardian equivalence
^ in current deficit mean greater taxes in future. COnsumer knows this, and increase savings and reduces current consumption. Thus no effect on agg demand.
Lags on discretionary fiscal policy
Recognition (policymakers take a while to recognize economic problems). Action - time gov takes to discuss, vote etc. Impact - time between enactment and when effect on economy occurs.
Expansionary Fiscal and Monetary
Interest rates are low and private/public sectors expand.
Contractionary fiscal and monetary
Agg demand and GSP are lower, interest rates are higher. Public/private markets contract.
Expansionary fiscal and contractionary monetary
Agg demand will be higher (fiscal policy), interest rates are higher, gov spending as % of GDP ^.
Contractionary fiscal and expansionary monetary
Interest rates decrease, private consumption and output ^. Gov spending as % of GDP will decrease. Private sector grows.
