Economics 14-15 Flashcards
Monetary & Fiscal Policy 15-16
1
Q
Fiscal Policy
A
Fiscal policy refers to a government’s use of spending and taxation to in fluence economic activity.
2
Q
Balance Budget
A
The budget is said to be balanced when tax revenues equal government expenditures.
3
Q
Budget Surplus
A
A budget surplus occurs when government tax revenues exceed expenditures
4
Q
Budget Deficit
A
budget def icit occurs when government expenditures exceed tax revenues. An increase in the def icit (or a decrease in a surplus) is considered expansionary in that it tends to increase GDP. A decrease in a def icit (or increase in a surplus) is considered contractionary in that it tends to decrease GDP.
5
Q
Monetary Policy
A
- Refers to the central bank’s actions that affect the quantity of money and credit in an economy to in fluence economic activity.
- Monetary policy is said to be expansionary (or accommodative or easy) when the central bank increases the quantity of money and credit in an economy.
- Conversely, when the central bank is reducing the quantity of money and credit in an economy, monetary policy is said to be contractionary (or restrictive or tight).
6
Q
Objectives of Fiscal Policy
A
- In fluencing the level of economic activity and aggregate demand
- Redistributing wealth and income among segments of the population
- Allocating resources among economic agents and sectors in the economy
7
Q
Monetary policy should be used in an attempt to inf luence aggregate demand to counter cyclical movements in the economy. (True/False)
A
False
8
Q
Discretionary fiscal policy
A
refers to the spending and taxing decisions of a national government that are intended to stabilize the economy
9
Q
Automatic Stabilizers
A
- Built-in fiscal devices triggered by the state of the economy.
- For example, during a recession, tax receipts will fall, and government expenditures on unemployment insurance payments will increase. Both of these tend to increase budget de ficits and are expansionary.
- Similarly, during boom times, higher tax revenues coupled with lower outf lows for social programs tend to decrease budget def icits and are contractionary.
10
Q
What are the potential concerns when a government runs fiscal deficits?
A
- High Debt & Interest expenses.
- Ratios of total deficits, annual deficits, and interest expenses to GDP rise too high, it may raise concerns about the country’s solvency.
11
Q
Debt Ratio
A
A country’s debt ratio is the ratio of aggregate debt to GDP. If the real interest rate on government debt exceeds the real GDP growth rate, the debt ratio will increase over time.
12
Q
What are the concerns associated with a country’s fiscal deficit and debt ratio?
A
- Higher deficits lead to higher future taxes, reducing incentives for work and entrepreneurship, and lowering long-term economic growth.
- Loss of market confidence could lead to default or inflation if the government prints money.
- Increased government borrowing can raise interest rates, leading to the crowding-out effect, where private-sector borrowing and investment decrease.
13
Q
What are the arguments against being concerned with the size of a fiscal deficit?
A
- Domestic Debt: If the debt is primarily held by domestic citizens, the problem may be overstated.
- Productive Investment: Debt used to finance productive capital investment may generate future economic gains sufficient to repay it.
- Tax Reform: Fiscal deficits can prompt needed tax reform.
- Ricardian Equivalence: If Ricardian equivalence holds, private-sector savings offset government deficits, making them less concerning.
- Underutilized Capacity: When the economy operates below full capacity, deficits can boost GDP and employment without diverting capital from productive uses.
14
Q
Spending Tools
A
- Transfer Payments
- Current Spending
- Capital Spending
15
Q
Transfer Payments
A
- also known as entitlement programs, redistribute wealth, taxing some and making payments to others.
- Examples include government-run retirement income plans (such as Social Security in the United States) and unemployment insurance bene fits.
- Transfer payments are not included in GDP computations.
16
Q
Current Spending
A
Current spending refers to government purchases of goods and services on an ongoing and routine basis.
17
Q
Capital spending
A
refers to government spending on infrastructure, such as roads, schools, bridges, and hospitals. Capital spending is expected to boost future productivity of the economy.
18
Q
Goals of using Spending Tools
A
- Provide services such as national defense that benef it all the residents in a country.
- Invest in infrastructure to enhance economic growth.
- Support the country’s growth and unemployment targets by directly affecting aggregate demand.
- Provide a minimum standard of living.
- Subsidize investment in research and development for certain high-risk ventures consistent with future economic growth or other goals (e.g., green technology).
19
Q
Direct Taxes
A
Direct taxes are levied on income or wealth. These include income taxes, taxes on income for national insurance, wealth taxes, estate taxes, corporate taxes, capital gains taxes, and Social Security taxes. Some progressive taxes (such as income taxes and wealth taxes) collect revenue for wealth and income redistributing.
20
Q
Indirect Taxes
A
Indirect taxes are levied on goods and services. These include sales taxes, value- added taxes (VATs), and excise taxes. Indirect taxes can be used to reduce consumption of some goods and services (e.g., alcohol, tobacco, gambling).
21
Q
Desirable attributes of tax policy
A
- Simplicity to use and enforce
- Eff iciency, de fined here as minimizing interference with market forces and not acting as a deterrent to working
- Fairness is quite subjective, but two of the commonly held beliefs are horizontal equality (people in similar situations should pay similar taxes) and vertical equality (richer people should pay more in taxes)
- Suf ficiency, in that taxes should generate enough revenues to meet the spending needs of the government
22
Q
Advantages & Disadvantages of Fiscal Policy Tools
A
ADV:
- Social policies (e.g., discouraging tobacco use) can be implemented quickly via indirect taxes.
- Quick implementation of indirect taxes also means that government revenues can be increased without signif icant additional costs.
DISADV:
- Direct taxes and transfer payments take time to implement, delaying the impact of fiscal policy.
- Capital spending also takes a long time to implement; the economy may have recovered by the time its impact is felt.
23
Q
How can the announcement of a future tax increase affect current economic activity?
A
The announcement of a future tax increase may immediately reduce current consumption, which can rapidly achieve the desired goal of reducing aggregate demand.
24
Q
Which fiscal policy tools are most effective in increasing aggregate demand?
A
Spending tools are most effective in increasing aggregate demand because they directly inject money into the economy.
25
Why are tax reductions less effective than spending tools in increasing aggregate demand?
Tax reductions are less effective because people may not spend the entire amount of the tax savings; instead, they might save a portion of it.
26
Why are tax cuts for low-income individuals more effective in boosting aggregate demand?
Tax cuts for low-income individuals are more effective because they have a higher marginal propensity to consume, meaning they are more likely to spend a larger proportion of their income on consumption rather than saving it.
27
Fiscal Multiplier
The f iscal multiplier determines the potential increase in aggregate demand resulting from an increase in government spending:
= 1 / [ 1 - MPC*(1-t) ]
The fiscal multiplier is inversely related to the tax rate (higher tax rate decreases the multiplier) and is directly related to the marginal propensity to consume (higher MPC increases the multiplier).
28
Balanced Budget Mulitplier
The balanced budget multiplier refers to the effect on aggregate demand when the government increases spending and increases taxes by the same amount, leading to a balanced budget overall
see notes
29
Ricardian Equivalence
Ricardian equivalence is the theory that government deficits do not affect aggregate demand because taxpayers anticipate future taxes to repay the debt, leading them to increase current savings and reduce current consumption accordingly.
30
How do increases in current deficits affect taxpayers' behavior according to Ricardian equivalence?
Taxpayers may increase current savings and reduce current consumption to offset the expected higher future taxes, maintaining their preferred consumption pattern over time.
31
What happens to aggregate demand if taxpayers adjust their savings to fully offset the future cost of government debt?
If taxpayers increase current savings by the amount needed to repay the debt and interest, there is no effect on aggregate demand, as predicted by Ricardian equivalence.
32
Under what condition does Ricardian equivalence not hold?
Ricardian equivalence does not hold if taxpayers underestimate their future liability for servicing and repaying the debt, leading to increased aggregate demand despite equal spending and tax increases.
33
Is the validity of Ricardian equivalence universally accepted?
No, whether Ricardian equivalence holds is an open question and may vary depending on taxpayer behavior and economic conditions.
34
What is discretionary fiscal policy?
Discretionary fiscal policy involves deliberate changes in taxes and government spending to influence aggregate demand and stabilize the economy, as opposed to automatic stabilizers.
35
How does discretionary fiscal policy address economic conditions below full employment?
It is designed to be expansionary by increasing government spending or decreasing taxes to boost aggregate demand and strengthen the economy.
36
What actions are taken during inflationary economic booms under discretionary fiscal policy?
The policy aims to be contractionary by decreasing government spending or increasing taxes to slow the economy and reduce aggregate demand.
37
What are the three types of lags associated with discretionary fiscal policy?
1. Recognition Lag: Time taken to identify the economic problem.
2. Action Lag: Time required to discuss, vote on, and enact fiscal policy changes.
3. Impact Lag: Time between policy enactment and its effects on the economy.
38
Why can fiscal policy sometimes be counterproductive?
Due to the recognition, action, and impact lags, the delays in implementing and realizing the effects of fiscal policy can lead to policies that are out of sync with the current economic conditions, potentially making them counterproductive.
39
What issue arises from misreading economic statistics in relation to fiscal policy?
Misreading economic statistics can lead to using expansionary fiscal policy when the economy is already at full capacity, which can drive inflation higher.
40
Macroeconomic issues that may hinder usefulness of fiscal policy
- Misreading economic statistics
- Crowding-out effect
- Supply shortage
- Limits to deficits
- Multiple Targets
41
What is the crowding-out effect in the context of fiscal policy?
The crowding-out effect occurs when increased government borrowing raises interest rates, which reduces private investment and may lessen the impact of expansionary fiscal policy on aggregate demand.
42
How do supply shortages affect the effectiveness of expansionary fiscal policy?
If economic activity is slow due to resource constraints rather than low demand, expansionary fiscal policy will be ineffective and may lead to higher inflation.
43
What are the limits to expansionary fiscal policy concerning deficits?
If the deficit is already perceived as too high relative to GDP, further expansionary fiscal policy can lead to higher interest rates and worsen the economic situation.
44
What challenge does having multiple economic targets (e.g., high unemployment and high inflation) present for fiscal policy?
Fiscal policy cannot effectively address both high unemployment and high inflation simultaneously.
45
How do economists determine if fiscal policy is expansionary or contractionary?
By examining changes in the budget surplus or deficit. An increase in surplus indicates contractionary policy, while an increase in deficit indicates expansionary policy.
46
What does an increase in a revenue item (e.g., sales tax) typically indicate about fiscal policy?
It is considered contractionary fiscal policy.
47
Why might a deficit not always indicate an expansionary fiscal policy?
A deficit could be a natural outcome of a recession due to increased transfer payments and decreased tax revenue, without any explicit action from the government
48
What is the structural budget deficit (or cyclically adjusted budget deficit)?
It is the deficit that would occur based on current policies if the economy were at full employment, used to gauge the true stance of fiscal policy.
AKA Cyclically Adjusted Budget Deficit
49
Key Role of Central Banks
1. Sole Supplier of Currency
2. Banker to the Government & Other Banks
3. Regulator & Supervisor of Payments System
4. Lender of Last Resort
5. Holder of Gold & Foreign Exchange Reserves
6. Conductor of Monetary Policy
50
Legal Tender/Fiat Currency
Traditionally, money was backed by gold; the central bank stood ready to convert the money into a prespecif ied quantity of gold.
Later on, the gold backing was removed, and money supplied by the central bank was deemed legal tender by law.
Money not backed by any tangible value is termed f iat money.
As long as f iat money holds its value over time and is acceptable for transactions, it can continue to serve as a medium of exchange.
51
Primary Objective of Central Bank
To control inf lation so as to promote price stability. High inf lation is not conducive to a stable economic environment.
52
Menu Costs & Shoe Leather Costs
High inflation leads to menu costs (i.e., cost to businesses of constantly having to change their prices) and shoe leather costs (i.e., costs to individuals of making frequent trips to the bank so as to minimize their holdings of cash that are depreciating in value due to inflation).
53
Other Stated Goals of Central Banks
- Stability in exchange rates with foreign currencies
- Full employment
- Sustainable positive economic growth
- Moderate long-term interest rates
54
Target Inflation
The target inf lation rate in most developed countries is a range around 2% to 3%. A target of zero inf lation is not used because that increases the risk of def lation, which can be disruptive for an economy.
55
Pegging
Some developed countries, and several developing countries, choose a target level for the exchange rate of their currency with that of another country, primarily the U.S. dollar.
This is referred to as pegging their exchange rate with the dollar.
If their currency appreciates (i.e., becomes relatively more valuable), they can sell their domestic currency reserves for dollars to reduce the exchange rate.
While such actions may be effective in the short run, for stability of the exchange rate over time, the monetary authorities in the pegging country must manage interest rates and economic activity to achieve their goal. This can lead to increased volatility of their money supply and interest rates.
The pegging country essentially commits to a policy intended to make its inf lation rate equal to the inf lation rate of the country to which it pegs its currency.
56
Monetary Policy Tools
1. Policy Rate
2. Reserve Requirements
3. Open Market Operations
57
What is the policy rate, and how does it affect the economy?
The policy rate is the interest rate at which banks borrow from the central bank. In the U.S., it is the discount rate; in the ECB, it's the refinancing rate; and in the U.K., it's the two-week repo rate. A lower policy rate encourages lending and decreases overall interest rates, while a higher rate discourages lending and increases interest rates.
58
What is a repurchase agreement (repo), and how does it function?
A repo involves the central bank purchasing securities from banks with an agreement to sell them back at a higher price in the future. The difference in price is the effective interest rate, influencing lending and interest rates.
59
What is the federal funds rate, and how is it managed by the Fed?
The federal funds rate is the interest rate banks charge each other for overnight loans of reserves. The Fed sets a target for this rate and uses open market operations to steer it toward the target
60
How do reserve requirements affect the money supply and interest rates?
Increasing reserve requirements reduces the funds available for lending, decreasing the money supply and increasing interest rates. Decreasing reserve requirements increases lending, the money supply, and decreases interest rates. This tool is effective only if banks are willing to lend and customers are willing to borrow.
61
What are open market operations, and what is their impact on the economy?
Open market operations involve the central bank buying or selling securities. Buying securities increases the money supply and decreases interest rates, while selling securities decreases the money supply and increases interest rates. In the U.S., this is the Fed's most commonly used tool.
62
How does the central bank's purchase of securities affect the banking system?
When the central bank buys securities, banks receive cash, which increases their reserves, leading to more funds available for lending and a lower money supply, resulting in decreased interest rates.
63
How does the sale of securities by the central bank affect the economy?
Selling securities reduces the amount of cash in the banking system, decreases reserves, reduces funds available for lending, and lowers the money supply, which tends to increase interest rates.
64
Monetary Transmission Mechanism
The monetary transmission mechanism refers to the ways in which a change in monetary policy, speci fically the central bank’s policy rate, affects the price level and inf lation.
A change in the policy rates that the monetary authorities control directly is transmitted to prices through four channels:
- other short-term rates
- asset values
- currency exchange rates
- expectations.
65
MTM: other short-term rates
Banks’ short-term lending rates will increase in line with the increase in the policy rate.
The higher rates will decrease aggregate demand as consumers reduce credit purchases and businesses cut back on investment in new projects.
66
MTM: Asset Prices
Bond prices, equity prices, and asset prices in general will decrease as the discount rates applied to future expected cash flows are increased. This may have a wealth effect because a decrease in the value of households’ assets may increase the savings rate and decrease consumption.
67
MTM: Expectations
Both consumers and businesses may decrease their expenditures because their expectations for future economic growth decrease.
68
MTM: Currency Exchange Rates
The increase in interest rates may attract foreign investment in debt securities, leading to an appreciation of the domestic currency relative to foreign currencies. An appreciation of the domestic currency increases the foreign currency prices of exports and can reduce demand for the country’s export goods.
69
Q: What happens when the central bank buys securities in an expansionary monetary policy?
A: The central bank's purchase of securities increases bank reserves.
70
Q: How does an increase in bank reserves affect the interbank lending rate?
A: The interbank lending rate decreases as banks become more willing to lend reserves to each other.
71
Q: What is the effect of increased reserves on short-term interest rates?
A: Short-term interest rates decrease because the increased supply of loanable funds lowers the equilibrium rate for loans.
72
Q: How do long-term interest rates respond to expansionary monetary policy?
A: Long-term interest rates decrease as a result of the overall reduction in interest rates.
73
Q: What effect does a decrease in real interest rates have on the currency?
A: A decrease in real interest rates leads to a depreciation of the currency in the foreign exchange market.
74
Q: How does a decrease in long-term interest rates impact business investment?
A: Lower long-term interest rates increase business investments in plant and equipment.
75
Q: What is the effect of lower interest rates on consumer purchases?
A: Lower interest rates lead consumers to increase their purchases of houses, autos, and durable goods.
76
Q: How does currency depreciation affect foreign demand for domestic goods?
A: Depreciation of the currency increases foreign demand for domestic goods.
77
Q: What are the overall effects of increased consumption, investment, and net exports on aggregate demand?
A: These increases in consumption, investment, and net exports raise aggregate demand
78
Q: How does an increase in aggregate demand affect inflation, employment, and real GDP?
A: An increase in aggregate demand leads to higher inflation, increased employment, and higher real GDP.
79
What are the two types of independence crucial for a central bank's effectiveness?
Operational independence (ability to set policy rates) and target independence (defining inflation computation, target level, and horizon).
80
How does credibility impact a central bank’s inflation targeting?
A credible central bank's targets can become self-fulfilling prophecies, as market expectations align with the central bank's stated goals, influencing actual inflation to meet the target.
80
What does operational independence entail for a central bank?
It means the central bank can independently determine the policy rate without external pressures.
80
Why is transparency important for a central bank?
Transparency helps build credibility by disclosing economic conditions and policy decisions, making it easier for the public and markets to anticipate and understand policy changes.
80
What is the importance of independence for a central bank in inflation targeting?
Independence ensures the central bank can manage inflation effectively without political interference, which might compromise its ability to control inflation and impact economic growth.
81
What does target independence involve for a central bank?
It involves setting the inflation target, defining how inflation is measured, and deciding the timeline for achieving the target.
82
How can a central bank’s credibility become undermined if inflation targeting is set by the government?
The government may have incentives to allow inflation to exceed the target, reducing the credibility of the inflation target.
83
Describe qualities of effective central banks
1. Independence
2. Credibility
3. Transparency
84
What was a historical monetary policy tool used by central banks before inflation targeting became common?
Interest rate targeting, where the central bank adjusted the money supply to keep interest rates within a target band.
84
What happens if the value of the domestic currency appreciates beyond the target exchange rate?
The central bank sells its own currency to increase the money supply and lower interest rates, which helps to reduce the currency's value back toward the target.
85
What is the most common inflation rate target for central banks, and why is it not set at 0%?
The most common inflation rate target is 2%, with a ±1% deviation. It is not set at 0% to avoid the risk of deflation, which can be disruptive to the economy.
86
What is exchange rate targeting, and which type of countries often use it?
Exchange rate targeting involves setting a target for the value of a country’s currency relative to another currency, often the U.S. dollar. It is commonly used by developing countries.
86
How do central banks that use inflation targeting forecast inflation?
They target inflation not just based on current inflation but on expected inflation within a range of two years into the future.
87
What is a limitation of using currency purchases or sales to influence exchange rates?
There are limits to how much influence these actions can have over time, especially if a country runs out of foreign reserves needed to buy its own currency.
88
What is a potential downside of exchange rate targeting in terms of monetary policy?
It can lead to greater volatility in the money supply because the central bank’s monetary policy must adapt to maintaining a stable exchange rate.
88
How does a country maintain its targeted exchange rate if its currency depreciates?
The central bank buys its own currency using foreign reserves, which decreases the domestic money supply and raises interest rates to support the currency's value.
89
What is a consequence of exchange rate targeting for a country’s inflation rate and monetary policy?
The targeting country will have an inflation rate similar to the country with the targeted currency and must follow monetary policy consistent with that inflation rate, regardless of its own domestic economic conditions.
90
What can cause long-term interest rates to behave differently from short-term rates despite monetary policy changes?
Changes in expected inflation can cause long-term rates to fall or rise independently of short-term rates.
91
What happens if individuals and businesses expect a successful decrease in inflation due to a reduction in the money supply?
They may expect lower future inflation rates, which can lead to falling long-term bond yields even if short-term rates are increased.
92
What is a liquidity trap, and how does it affect the effectiveness of monetary policy?
A liquidity trap occurs when individuals hold more money in cash balances rather than investing in interest-bearing securities, making it difficult for monetary policy to lower short-term rates.
93
Why is deflation more challenging for central banks to address compared to inflation?
Deflation is difficult to reverse because monetary policy can only lower nominal rates to zero, limiting further stimulation.
94
What is one limitation of increasing the money supply if banks are unwilling to lend?
Banks may not increase lending even with excess reserves, reducing the effectiveness of monetary policy.
95
What is quantitative easing (QE), and when was it used?
QE is a monetary policy where the central bank purchases assets, such as government bonds or mortgage securities, to increase money supply and lower interest rates. It was used during the 2008 financial crisis.
96
Bond Market Vigilantes
From a different perspective, monetary tightening may be viewed as too extreme— increasing the probability of a recession, making long-term bonds more attractive, and reducing long-term interest rates.
If money supply growth is seen as in flationary, higher expected future asset prices will make long-term bonds relatively less attractive and will increase long-term interest rates. Bond market participants that act in this way have been called bond market vigilantes. When the central bank’s policy is credible and investors believe that the inf lation target rate will be maintained over time, this effect on long-term rates will be small.
97
Monetary Policy in Developing Economies
Market Liquidity Issues: A lack of a liquid market for government debt can distort interest rate information and make open market operations difficult to execute.
Determining Neutral Interest Rates: Rapid economic development complicates the task of identifying the neutral interest rate, which is crucial for setting effective monetary policy.
Financial Innovation: Rapid financial innovation can alter the demand for monetary aggregates, complicating policy implementation.
Credibility and Independence: Central banks in developing countries may struggle with credibility due to past failures in maintaining inflation targets and may not have the independence needed for effective policy-making due to political interference.
98
Expansionary Fiscal & Monetary Policy
In this case, the impact will be highly expansionary, taken together. Interest rates will usually be lower (due to monetary policy), and the private and public sectors will both expand.
99
Contractionary f iscal and monetary policy.
In this case, aggregate demand and GDP would be lower, and interest rates would be higher due to tight monetary policy. Both the private and public sectors would contract.
100
Expansionary fiscal policy and contractionary monetary policy.
In this case, aggregate demand will likely be higher (due to fiscal policy), while interest rates will be higher (due to increased government borrowing and tight monetary policy). Government spending as a proportion of GDP will increase.
101
Contractionary f iscal policy and expansionary monetary policy.
In this case, interest rates will fall from decreased government borrowing and from the expansion of the money supply, increasing both private consumption and output. Government spending as a proportion of GDP will decrease due to contractionary fiscal policy. The private sector would grow as a result of lower interest rates.
