EC2B3 Topic 6 Monetary and Fiscal Policy Flashcards
What is the primary goal of monetary policy?
To manage the economy by controlling the money supply and interest rates.
Monetary policy aims to achieve macroeconomic objectives such as controlling inflation, consumption, growth, and liquidity.
What is fiscal policy?
Government policy regarding taxation and spending to influence the economy.
Fiscal policy involves adjustments in government spending levels and tax rates to monitor and influence a nation’s economy.
What are the two main types of monetary policy?
Expansionary and contractionary monetary policy.
Expansionary policy aims to increase the money supply, while contractionary policy seeks to decrease it.
True or False: Fiscal policy is primarily concerned with the money supply.
False.
Fiscal policy focuses on government spending and taxation rather than the money supply.
Fill in the blank: __________ monetary policy involves lowering interest rates to stimulate economic activity.
Expansionary.
Lowering interest rates makes borrowing cheaper, encouraging spending and investment.
What is the role of the central bank in monetary policy?
To implement monetary policy and regulate the money supply.
The central bank uses tools like interest rates and reserve requirements to influence economic conditions.
List three tools used in monetary policy.
- Open market operations
- Discount rate
- Reserve requirements
These tools help manage liquidity and influence overall economic activity.
What is the primary objective of fiscal policy?
To influence economic activity through government spending and taxation.
It aims to achieve a stable economic environment and promote growth.
True or False: Contractionary fiscal policy involves increasing government spending.
False.
Contractionary fiscal policy typically involves decreasing spending or increasing taxes.
Fill in the blank: __________ policy can be used to combat inflation by reducing money supply.
Contractionary.
It helps to stabilize prices by curbing excessive spending and borrowing.
What are the potential effects of expansionary fiscal policy?
- Increased aggregate demand
- Higher employment
- Economic growth
This policy is often used during economic downturns to stimulate activity.
What is the relationship between monetary policy and inflation?
Monetary policy can be used to control inflation by adjusting interest rates.
Higher interest rates typically reduce spending and investment, which can help lower inflation.
List two challenges associated with implementing fiscal policy.
- Time lags in policy implementation
- Political constraints
These challenges can delay the effectiveness of fiscal measures.
What is the concept of ‘crowding out’ in fiscal policy?
When government spending leads to a reduction in private sector investment.
Increased government borrowing can raise interest rates, making it more expensive for businesses to invest.
Fill in the blank: The __________ effect describes the impact of monetary policy on the economy through interest rates.
Interest rate.
Changes in interest rates affect consumer and business spending decisions.
What is the yield curve
Interest rate maturity relationship of bonds
Assumptions of one and two period government bonds
As
- Bond that pays one unit of money next time period
Bond pays one unti of money two time periods in the future
Prices; V1 and V2
Yields; i and I:
V1 = 1 / (1+i) and V2 = 1/ (1+I)^2
Nominal return of investing one unit of money into 1 and 2 period bonds. after one period.
can buy 1/V1 of One period bond:
% return is (1-V1)/V1 = i
return = yield as bond held to maturity
can buy 1V2 of two period bonds:
bond now worth V1’ = 1/(1 + i’)
return = I + (I - i’) (1+ I / 1 + i’)
Is it best to hold one or two period bonds
- uncertain; dep on future yield of i’ which is unknown
- Two bond generally riskier
in equilibium both willingly held
What is the primary assumption of the expectations theory of long-term interest rates
Investors only care about expected returns - ‘risk neutral’
all bonds must be held in equilibrium –> bond prices ajudst soo all bonds have expected same return
Thus there is a connection between shortn and long term rates
Expected return on two period bond
as long as i’ and I not too large
(I - i’)(1+I / 1+i’) = I - i’
thus 2I - i’
therefore expected return = 2I - i’e
i’e denotes expected value of the future one period yield i’
given expectations theory of IR and the expected two period bond return.
what is the long term rate and implications for CB MP
Risk netural investors hold either bond in equilibrium
so
I = (i + i’e) / 2
I is average of current and expected future short term rates until bond maturity
Implies CB can use MP through expectations as well as i
Implications of expectations theory for shape of the yield curve
expectations theory equation
i’e - i = 2(I -i)
- upward sloping (I>i) –> rates will rise (i’e>i)
- downward sloping (I< i ) –> rates will fall (i’e < i)
- flat yield curve (I=i) –> no change in rates (i’e = i)
What is the problem of time inconsistency
Policymaker gains at current time through believeable future policy action
Policymaker does not gain by implementation in the future
What are the consequences of stimulus
Higher inflation is anticipated which causes expectations to rise and PC shift upwards
Worsens attainable combinations of inflation and real GDP
MP has an inflation bias as once at 0 inflation again incentivised to go above
time inconsistency of low inflation target
Methods to commit to low inflation or goals
- CB Independence
- Policy framework focusing on inflation
- Accountable for low inflation rate
