2.5 Monetary and fiscal Policy Flashcards
Monetary policy
used by the central bank to influence the quantity of money and credit.
Fiscal policy
relates to the government’s taxation and spending.
Historically, these policies have been used with positive and negative impacts on the economy.
Money fulfills three important functions:
Medium of Exchange
Store of Value
Measure of Value
The quantity theory of money
defines the relationship between money and the price level.
M * V = P * Y
M: is the quantity of money
V: is the velocity of money
P: is the average price level
Y: is the real output:
The price of money is?
The Nominal Interest rate
The Fisher effect
states the real rate of interest is stable
Changes in the nominal interest rate are a function of expected inflation
The Roles of Central Banks
- Supplier of Currency
- Banker to Government and Bankers’ Bank
- Lender of Last Resort
–> his provides needed liquidity to banks in difficult situations.
- Regulator of Payments System
–> Procedures must be robust and standardized to handle the millions of daily financial transactions. International coordination is also necessary.
- Conductor of Monetary Policy
–> This is a high-profile role in which the central bank influences the quantity of money and credit in an economy.
- Supervisor of Banking System
- Maintain Foreign Currency Reserves and Gold Reserves
most important objective of central banks
The most important objective is that of maintaining price stability
Expected inflation
represents the level of future inflation expected by economic agents
Unexpected inflation
the most costly.
It includes the expected inflation cost but also creates a wealth transfer between borrowers and lenders.
Lenders will charge higher interest rates or risk premia to compensate for the extra risk of inflation.
It also reduces the information that can be found in market prices (e.g., price change could be due to inflation or increased demand).
Central banks use three primary monetary policy tools:
- Open Market Operations
–> Open market operations involve the purchase and sale of government bonds from commercial banks. If the central bank buys bonds, this increases the reserves of the private sector banks and thus increases the money supply.
- Central Bank’s Policy Rate
–> The central bank can set the official interest rate. It usually sets the rate it will charge when lending to commercial banks. Increasing the rate will reduce the money supply. The name of the refinancing rate varies by countries, such as the refinancing rate in England and the discount rate in the United States. The federal funds rate is the interbank lending rate in the United States.
- Reserve Requirements
–> The central bank can reduce the money supply by increasing the reserve requirement. This is not used much in developed countries because it is disruptive to the bank’s lending practice.
The success of inflation targeting policy depends on three key concepts:
- Central Bank Independence
- Credibility
–> A government with a lot of debt would be inclined to have high inflation. Credibility would be undermined if the government were in charge of managing inflation. If the public believes the central bank will hit its target inflation, this belief can help it happen.
- Transparency
–> Most central banks produce quarterly reports on the economy.
Central Bank Independence
The central bank needs independence from the government to keep politicians out of the way. However, the central bank still has some accountability to the government.
Target independence gives the bank authority to set the interest rate level target.
Operational independence means the bank can get the target level from another branch of government, but it is otherwise not under the influence of the government.
a currency peg
a fixed exchange rate
managed exchange rate policy
allows the value of the domestic currency to float within a specified range relative to the currency to which it is pegged
For this strategy to be successful, investors must believe that the developing economy is credibly committed to the target exchange rate.
dollarization
Other countries simply abandon their domestic currency and adopt the US dollar as their functional currency
Contractionary policy
Policy rate is greater than the neutral rate of interest (to encourage saving rather than spending)
strives to reduce the rate of growth in the money supply and real economy.
This can be done by increasing the policy rate.
contrary: Decreasing the policy rate is an expansionary policy done to increase the rate of growth in the money supply and the real economy.
The policy rate is defined as high or low by comparing it to the neutral rate of interest
Expansionary policy
Policy rate is smaller than the neutral rate of interest (to encourage spending rather than saving)
The components of the nominal interest rate are most accurately described as:
A
a real required return and compensation for expected inflation only.
B
a real required return and a premium for uncertainty about future economic conditions such as real growth and inflation.
C
a real required return, compensation for expected inflation, and a risk premium for uncertainty about future values of economic variables.
a real required return, compensation for expected inflation, and a risk premium for uncertainty about future values of economic variables.
Which of the following statements is most accurate? Fiat money:
A
must be backed by gold reserves.
B
is based on the convertibility principle.
C
derives its value from a government decree.
C
derives its value from a government decree.
countries largely abandoned the gold standard in favor of fiat money, which cannot be convertible into any other commodity. It is not backed by gold reserves, but rather derives its value from a government decree.
he proposition that the real interest rate is relatively stable is most closely associated with:
A
the Fisher effect.
B
money neutrality.
C
the quantity theory of money.
A
the Fisher effect.
he Fisher effect is based on the idea that the real interest rate is relatively stable. Changes in the nominal interest rate result from changes in expected inflation.
Often, the government revenue and government expenditures are measured as a percentage of GDP.
There is an automatic stabilizer effect because?
as economic activity decreases, taxation will decrease, and government expenditures will increase.
Some argue there should be no concern about the national debt because:
Much of the debt is owed to domestic lenders.
Some of the debt could have been incurred for capital investment projects.
Beneficial tax changes could be required.
The private sector could increase saving to finance the debt.
Accumulation of debt could be increasing employment.
Some argue there should be concern about the national debt because:
High debt levels could lead to high future tax rates, which may discourage economic activity.
The government may have to print money to service the debt, leading to high inflation.
Government borrowing could crowd out private sector borrowing.
Government spending can take several forms.
Transfer payments are made through the social security system for things such as state pensions, income support for low-income families, and unemployment benefits. They allow the government to redistribute income. They are not a part of GDP or government spending on goods and services.
Current government spending is on such items as health, education, and defense.
Capital expenditures are made on such things as roads, hospitals, and schools.
Government spending can be justified on economic and social grounds:
Provides services like the defense that benefits everyone.
Infrastructure like roads to sustain economic growth.
Guarantee a minimum level of income for poor people.
Help to obtain low inflation and unemployment.
Subsidize high-risk products like new energy
Direct taxes
come from income, wealth, and corporate profits
Direct taxes take longer to change
Indirect taxes
include excise duties on fuel, alcohol, tobacco, and other items.
Indirect taxes can have immediate impact and discourage unwanted behavior
There are four desirable attributes of tax policy.
Simplicity (not easily manipulated)
Efficiency (should not discourage work or investment or interfere with personal choices)
Fairness (this is subjective, but most want the rich to pay more)
Revenue sufficiency
The fiscal multiplier
helps determine how much the output will change for a given change in government spending or taxes
Ricardian equivalence
A government’s effort to stimulate economic activity by running fiscal deficits will be unsuccessful if consumers respond by saving more in anticipation of higher future taxes that will be required to repay the government’s debts
According to this view, deficit spending will only stimulate aggregate demand if individuals fail to anticipate the need for future tax increases correctly.
structural budget deficits
the deficit that would occur if the economy was at full employment.
At lower unemployment, tax revenues would be greater and social transfers lower.
A recognition lag
Difficulties in Executing Fiscal Policy
occurs because it takes time for data to indicate the economy is slowing
The action lag
Difficulties in Executing Fiscal Policy
It then takes time to implement the policy changes
The impact lag
measures how long the actions take to impact the economy
the impact of Easy monetary policy and Easy fiscal policy
Demand rises;
Lower interest rate;
Private and public sector growth
the impact of Tight monetary policy and Easy fiscal policy
Higher output;
Higher interest rate;
Government spending becomes greater proportion of national income
the impact of Easy monetary policy and Tight fiscal policy
Private sector increases;
Public sector shrinks
the impact of Tight monetary policy and Tight fiscal policy
Private & public sector shrink;
Higher interest rate
Studies have shown government spending increases have a much larger impact on GDP than social transfer increases because?
the former are seen as less likely to be reversed
Social transfers are more effective if targeted at lower-income earners rather than distributed evenly to all citizens
Quantitative easing (QE)
one of the few policy options available to central banks when interest rates are zero.
Central banks implement QE by purchasing securities from individuals, institutions, and banks
The objective of QE is to lower interest rates and stimulate economic activity with direct cash transfers
However, economists note that by making large-scale purchases of government bonds, central banks are effectively printing money to fund the budget deficit and abandoning their commitment to independent monetary policy.
Which statement regarding fiscal policy is most accurate?
A
Cyclically adjusted budget deficits are appropriate indicators of fiscal policy.
B
To raise business capital spending, personal income taxes should be reduced.
C
An increase in the budget surplus is associated with expansionary fiscal policy.
A
Cyclically adjusted budget deficits are appropriate indicators of fiscal policy.
