(16) Monetary and Fiscal Policy Flashcards
LOS 18. a: Compare monetary and fiscal policy.
Fiscal policy is a government’s use of taxation and spending to influence the economy. Monetary policy deals with determining the quantity of money supplied by the central bank. Both policies aim to achieve economic growth with price level stability, although governments use fiscal policy for social and political reasons as well.
LOS 18. a: Compare monetary and fiscal policy. Budget surplus
A budget surplus is a period when income or receipts exceed outlays or expenditures. A budget surplus often refers to the financial states of governments; individuals prefer to use the term ‘savings’ instead of the term ‘budget surplus.’ A surplus is an indication that the government is being effectively managed.
A budget surplus might be spent to make a purchase, pay off debt or save for the future. A city government that has a surplus may use the money to render improvements to a local decaying park, for example.
When expenditures exceed income, the outcome is a budget deficit, which is funded by borrowing funds and paying interest on the borrowed money, similar to an individual spending more than he earns and carrying a balance on a credit card. A balanced budget exists once expenditures equal income.
As of 2016, the U.S. government has undergone nine budget surpluses. The Clinton administration eliminated a large budget deficit, resulting in a surplus. A surplus is a positive value and is the sum by which government revenues are greater than government spending during a set period, usually a fiscal year. For example, June 2016 was the most recent U.S. government budget surplus. The receipts for the year totaled $330 billion, while expenditures for the year were $323 billion. This resulted in a budget surplus of approximately $6 billion.
LOS 18. a: Compare monetary and fiscal policy. Budget deficit
A budget deficit is an indicator of financial health in which expenditures exceed revenue. The term budget deficit is most commonly used to refer to government spending rather than business or individual spending, but can be applied to all of these entities. When referring to accrued federal government deficits, the deficits are referred to as the national debt.
LOS 18. a: Compare monetary and fiscal policy. Monetary policy
Monetary policy consists of the actions of a central bank, currency board or other regulatory committee that determine the size and rate of growth of the money supply, which in turn affects interest rates. Monetary policy is maintained through actions such as modifying the interest rate, buying or selling government bonds, and changing the amount of money banks are required to keep in the vault (bank reserves).
The Federal Reserve is in charge of monetary policy in the United States.
LOS 18. a: Compare monetary and fiscal policy. Expansionary (or accommodative or easy)
When a central bank (such as the Federal Reserve) attempts to expand the overall money supply to boost the economy when growth is slowing (as measured by GDP). This is done to encourage more spending from consumers and businesses by making money less expensive to borrow by lowering the interest rate. Furthermore, the Federal Reserve also has the authority to purchase Treasuries on the open market to infuse capital into a weakening economy.
Also known as an “easy monetary policy”.
LOS 18. a: Compare monetary and fiscal policy. Contractionary (or restrictive or tight)
Central banks around the world use monetary policy to regulate specific factors within the economy. Central banks most often use the federal funds rate as a leading tool for regulating market factors. Tightening policy occurs when central banks raise the federal funds rate, and easing occurs when central banks lower the federal funds rate.
The federal funds rate is used as a base rate throughout global economies. It refers to the rate at which federal banks lend to each other and is also known as the discount rate. An increase in the federal funds rate is followed by increases to borrowing rates throughout the economy. Rate increases make borrowing less attractive as interest payments increase with increasing rates. It affects all types of borrowing including personal loans, mortgages and interest rates on credit cards. An increase in rates also makes saving more attractive as savings rates also increase in an environment with tightening policy.
LOS 18. b: Describe functions and definitions of money.
Money is defined as a widely accepted medium of exchange. Functions of money include a medium of exchange, a store of value, and a unit of account.
LOS 18. b: Describe functions and definitions of money. Money
What is ‘Money’
Money is an officially-issued legal tender generally consisting of notes and coin, and is the circulating medium of exchange as defined by a government. Money is often synonymous with cash and includes various negotiable instruments such as checks. Each country has its own money that is used as a medium of exchange within that country.
BREAKING DOWN ‘Money’
Also referred to as currency, money is a liquid asset used in the settlement of debts that functions based on the general acceptance of its associated value within an economy. The value of money is not necessarily derived from the materials used to produce the note or coin and, instead, derives based on the amount shown on its face partnered with the public’s willingness to support the value as displayed.
LOS 18. b: Describe functions and definitions of money. Narrow money
What is ‘Narrow Money’
Narrow money is a category of money supply that includes all physical money like coins and currency along with demand deposits and other liquid assets held by the central bank. In the United States, narrow money is classified as M1 (M0 + demand accounts), while in the U.K., M0 is referenced as narrow money.
BREAKING DOWN ‘Narrow Money’
The name comes from the fact that M1/M0 are the narrowest or most restrictive ideas of money that are the basis for the medium of exchange within the economy. This category of money is considered to be the most readily available for transactions and commerce.
The narrow money supply only contains the most liquid financial assets. These funds must be accessible on demand, which generally limits the category to physical notes and coins and funds held in the most accessible deposit accounts.
LOS 18. b: Describe functions and definitions of money. Broad money
What is ‘Broad Money’
Broad money is the most inclusive method of calculating a given country’s money supply. The money supply is the totality of assets that households and businesses can use to make payments or to hold as short-term investments, such as currency, funds in bank accounts and anything of value resembling money. The formula for calculating money supply varies from country to country, but broad money is always the farthest-reaching; narrow money includes fewer elements in the calculation.
BREAKING DOWN ‘Broad Money’
Since cash can be exchanged for many different financial instruments, and it can be placed in various restricted accounts, it is not a simple task for economists to define how much money is currently in a given economy. Therefore, the money supply is measured in many different ways. Economists use a capital letter “M” followed by a number to refer to the calculation that they are using in a given context.
LOS 18. c: Explain the money creation process.
In a fractional reserve system, new money created is a multiple of new excess reserves available for lending by banks. The potential multiplier is equal to the reciprocal of the reserve requirement and, therefore, is inversely related to the reserve requirement.
The total amount of money that can be created is calculated as:
Money created = (new deposit/reserve requirement)
The money multiplier = 1/reserve requirement
LOS 18. c: Explain the money creation process. Promissory notes
What is a ‘Promissory Note’
A promissory note is a financial instrument that contains a written promise by one party (the note’s issuer or maker) to pay another party (the note’s payee) a definite sum of money, either on demand or at a specified future date. A promissory note typically contains all the terms pertaining to the indebtedness, such as the principal amount, interest rate, maturity date, date and place of issuance, and issuer’s signature.
Although financial institutions may issue them (see below), promissory notes are debt instruments that allow companies and individuals to get financing from a source other than a bank. This source can be an individual or a company willing to carry the note (and provide the financing) under the agreed-upon terms. In effect, anyone becomes a lender when he issues a promissory note.
BREAKING DOWN ‘Promissory Note’
The 1930 international convention that governs promissory notes and bills of exchange also stipulates that the term “promissory note” should be inserted in the body of the instrument and should contain an unconditional promise to pay.
In terms of their legal enforceability, promissory notes lie somewhere between the informality of an IOU and the rigidity of a loan contract. A promissory note includes a specific promise to pay, and the steps required to do so (like the repayment schedule), while an an IOU merely acknowledges that a debt exists, and the amount one party owes another. A loan contract, on the other hand, usually states the lender’s right to recourse – such as foreclosure – in the event of default by the borrower; such provisions are generally absent in a promissory note. While it might make note of the consequences of non-payment or untimely payments (such as late fees), it does not usually explain methods of recourse if the issuer does not pay on time.
Promissory notes that are unconditional and saleable become negotiable instruments that are extensively used in business transactions in numerous countries.
A promissory note is usually held by the party owed money. Once the debt has been fully discharged, it must be canceled by tthe payee, and returned to the issuer.
LOS 18. c: Explain the money creation process. Fractional reserve banking
What is ‘Fractional Reserve Banking’
Fractional reserve banking is a banking system in which only a fraction of bank deposits are backed by actual cash on hand and are available for withdrawal. This is done to expand the economy by freeing up capital that can be loaned out to other parties. Many U.S. banks were forced to shut down during the Great Depression because too many people attempted to withdraw assets at the same time.
BREAKING DOWN ‘Fractional Reserve Banking’
Banks are required to keep a certain amount of the cash depositors give them on hand available for withdrawal. That is, if someone deposits $100, the bank can’t lend out the entire amount. That said, it isn’t required to keep the entire amount either. Most banks are required to keep 10% of the deposit, referred to as reserves. This reserve requirement is set by the Federal Reserve and is one of the Fed’s tools to implement monetary policy. Increasing the reserve requirement takes money out of the economy, while a decrease in the reserve requirement puts money into the economy.
LOS 18. c: Explain the money creation process. Excess reserves
What are ‘Excess Reserves’
Excess reserves are capital reserves held by a bank or financial institution in excess of what is required by regulators, creditors or internal controls. For commercial banks, excess reserves are measured against standard reserve requirement amounts set by central banking authorities. These required reserve ratios set the minimum liquid deposits (such as cash) that must be in reserve at a bank; more is considered excess.
BREAKING DOWN ‘Excess Reserves’
Financial firms that carry excess reserves have an extra measure of safety in the event of sudden loan loss or significant cash withdrawals by customers. This buffer increases the safety of the banking system, especially in times of economic uncertainty. Boosting the level of excess reserves can also improve an entity’s credit rating, as measured by rating agencies such as Standard & Poor’s.
The Federal Reserve has many tools in its monetary normalization toolkit. In addition to setting the fed funds rate, it now has the ability to change the rate of interest that banks are paid on required (interest on reserves — IOR) and excess reserves (interest on excess reserves — IOER).
LOS 18. c: Explain the money creation process. Money multiplier
What is the ‘Multiplier Effect’
The multiplier effect is the expansion of a country’s money supply that results from banks being able to lend. The size of the multiplier effect depends on the percentage of deposits that banks are required to hold as reserves. In other words, it is the money used to create more money and is calculated by dividing total bank deposits by the reserve requirement.
BREAKING DOWN ‘Multiplier Effect’
To calculate the effect of the multiplier effect on the money supply, start with the amount banks initially take in through deposits, and divide this by the reserve ratio. If, for example, the reserve requirement is 20%, for every $100 a customer deposits into a bank, $20 must be kept in reserve. However, the remaining $80 can be loaned out to other bank customers. This $80 is then deposited by these customers into another bank, which in turn must also keep 20%, or $16, in reserve but can lend out the remaining $64.
This cycle continues as more people deposit money and more banks continue lending it until finally the $100 initially deposited creates a total of $500 ($100/0.2) in deposits. This creation of deposits is the multiplier effect.
LOS 18. c: Explain the money creation process. Quantity theory of money
What is the ‘Quantity Theory Of Money’
The quantity theory of money is a theory about the demand for money in an economy. The most common version, sometimes called the “neo-quantity theory” or Fisherian theory, suggests there a mechanical and fixed proportional relationship between changes in the money supply and the general price level. This popular, albeit controversial, formulation of the quantity theory of money is based upon an equation by American economist Irving Fisher.
BREAKING DOWN ‘Quantity Theory Of Money’
The Fisher equation is calculated as:
M x V = P x T
Where: M represents the money supply.
V represents the velocity of money.
P represents the average price level.
T represents the volume of transactions in the economy.
Generally speaking, the quantity theory of money assumes that increases in the quantity of money tend to create inflation, and vice versa. For example, if the Federal Reserve or European Central Bank doubled the supply of money in the economy, the long-run prices in the economy would tend to increase dramatically.
Economists disagree about how quickly and how proportionately prices adjust after a change in the quantity of money. The classical treatment in most economic textbooks is based on the Fisher Equation, but competing theories exist.
LOS 18. c: Explain the money creation process. Quantity equation of exchange
What is the ‘Equation Of Exchange’
The equation of exchange is an economic equation that showcases the relationship between money supply, velocity of money, the price level and an index of expenditures. The equation was derived by John Stuart Mill, and based of the early ideas of David Hume. The equation of exchange is as follows:
M x V = P x T
Where:
M = money supply
V = velocity of money
P = average price level of goods
T = index of expenditures (such as the total number of economic transactions)
BREAKING DOWN ‘Equation Of Exchange’
The equation of exchange has two primary uses. It represents a founding principle used by the quantity theory of money, which relates increases in the money supply to increases in the overall level of prices. Additionally, solving the equation for ‘M’ can serve as an indicator of the demand for money.
LOS 18. c: Explain the money creation process. Money neutrality
What is ‘Neutrality Of Money’
The neutrality of money, also called neutral money, says changes in the money supply only affect nominal variables and not real variables. In other words, an increase or decrease in the money supply can change the price level but not the output or structure of the economy. In modern versions of money neutrality theory, changes in the money supply might affect output or unemployment levels in the short run only, but neutrality is still assumed in the long run after money circulates throughout the economy.
BREAKING DOWN ‘Neutrality Of Money’
According to the neutrality of money theory, all markets for all goods clear continuously. Relative prices adjust flexibly and always towards equilibrium. Changes in the supply of money do not appear to change the underlying conditions in the economy. New money does not create or destroy machines, introduce new trading partners or affect existing knowledge and skill. Aggregate supply should remain constant.
LOS 18. d: Describe theories of the demand for the supply of money.
Three factors influence money demand:
- Transaction demand, for buying goods and services
- Precautionary demand, to meet unforseen future needs
- Speculative demand, to take advantage of investment opportunities
Money supply is determined by central banks with one goal of managing inflation and other economic objectives.
LOS 18. e: Describe the Fisher effect.
The fisher effect states that a nominal interest rate is equal to the real interest rate plus the expected inflation rate.
Breaking Down Fisher effect
The Fisher effect equation reflects that the real interest rate can be taken by subtracting the expected inflation rate from the nominal interest rate. In this equation, all the provided rates are compounded.
The Fisher effect can be seen each time you go to the bank; the interest rate an investor has on a savings account is really the nominal interest rate. For example, if the nominal interest rate on a savings account is 4% and the expected rate of inflation is 3%, then the money in the savings account is really growing at 1%. The smaller the real interest rate the longer it will take for savings deposits to grow substantially when observed from a purchasing power perspective.
LOS 18. f: Describe roles and objectives of central banks.
Central bank roles include supplying currency, acting as banker to the government and to other banks, regulating and supervising the payments system, acting as a lender of last resort, holding the nation’s gold and foreign currency reserves, and conducting monetary policy.
Central banks have the objective of controlling inflation, and some have additional goals of maintaining currency stability full employment, positive sustainable economic growth, or moderate interest rates.
LOS 18. f: Describe roles and objectives of central banks. Legal tender
What is ‘Legal Tender’
Legal tender is any official medium of payment recognized by law that can be used to extinguish a public or private debt, or meet a financial obligation. The national currency is legal tender in practically every country. A creditor is obligated to accept legal tender toward repayment of a debt. Legal tender can only be issued by the national body that is authorized to do so, such as the U.S. Treasury in the United States and the Royal Canadian Mint in Canada.
BREAKING DOWN ‘Legal Tender’
Widely accepted currencies such as the U.S. dollar and euro are accepted as legal tender in many nations, especially those where foreign currencies are in short supply. Countries with extensive business and cultural ties may also accept each other’s currencies as legal tender in limited amounts. For example, some U.S. and Canadian merchants located close to the U.S.-Canada border accept both Canadian dollars and U.S. dollars as payment for goods and services.
The popularity of cross-border and online shopping is increasing demand for more forms of legal tender; however, given official objection to such alternatives, these may still be some years away. In May 2013, the governor of Arizona vetoed a bill that would have made gold and silver coins legal tender in the state, in addition to existing U.S. currency. Bitcoin, another popular payment alternative, is a virtual online currency that can be used for a growing number of transactions but is not considered legal tender.
LOS 18. t: Explain the interaction of monetary and fiscal policy.
