Monetary and Fiscal Policy Flashcards
Monetary policy is what and controlled by who?
- controlled by central banks (the FED)
- they influence the level of interest rates and money supply in the economy
Fiscal policy is what and controlled by who?
- controlled by the government
- they decide about taxation and govt spending levels
*only fiscal policy can be used as a tool for redistribution of income and wealth
Money creation formula:
money creation = (new deposit / reserve requirement)
$100 deposit, 10% reserve requirement = $1000 new
Money multiplier formula
money multiplier = (1 / reserve requirement)
(1 / 10% reserve requirement) = 10x multiplier; $100 new deposit * 10x = $1000 new
**the smaller the reserve requirement, the greater the money multiplier
M1 in the US is what
- M1 is “Narrow Money”
- money in circulation and highly liquid deposits
- notes and coins, traveler’s checks, demand deposits
M2 money in the US is what
- M2 is “Broad Money”
- includes M1
plus less liquid moneys - savings
- money market deposits
- time deposits of less than $100k
- other balances in retail money market and mutual funds
Credit card balances are
- are not considered part of money
The Quantity Theory of Money
definition and formula
- QTM states that total spending is proportional to the quantity of money
Quantity of money (M) * velocity of circulation of money (V) = average price level (P) * real output (Y)
M * V = P * Y
Money neutrality
- if it “holds”, an increase in M (money supply) will increase price levels (P), but output (Y) and employment will not change in the long run
- output will not increase by increasing the money supply
Demand for Money and
Motives for holding money
- w/ regard for demand for money: as GDP increases, both transaction and precautionary demand increase
- transaction-related
- precautionary
- speculative
What does the Money Demand Curve look like and what is the SR impact of increasing money supply?
Money demand curve:
- x-axis: nominal interest rates
- y-axis: quantity of money
- MD money demand: a curved, downward sloping line - as interest rates go up, the speculative demand for money goes down (ie the returns on stocks and bonds)
- MS money supply: a vertical line fixed at the current quantity of money
In the SR if MS increases
- the MS curve will move to the right
- interest rates fall
- price levels increase
- AD increases in SR, and so may Y
- but in LR AD and Y will not be affected (ie the money neutrality theory)
Fischer Effect
what it states and the formula
- states that the real rate of interest in an economy is relatively stable and changes in nominal interest rates are due to changes in expected inflation
- which is directly related to the concept of money neutrality
Fisher Effect:
Rnom = Rreal + πe
nominal interest rate = real interest rate + expected rate of inflation over a given time horizon
Nominal interest rates are comprised of
3 components
- required real return
- expected inflation
- risk premium
Roles of Central Banks:
MONETARY POLICY
- monopoly supplier of the currency
- banker to the govt and the banker’s bank
- lender of last resort
- regulator and supervisor of the payments system
- conductor of monetary policy: influence quantity of money and credit in an economy
- supervisor of the banking system
- manage foreign currency reserves and gold reserves: the Reserve Bank of India sold dollars to boost the Indian rupee
If the nominal GDP is $10T, and money supply is $2T, according to the quantity theory of money, the velocity of money supply is:
M * V = P * Y
$2M * V = $10PY
V = $10PY/$2M
V = 5
Monetary policy objectives
- maintain full employment and output
- maintain confidence in the financial system
- **price stability and keeping inflation in check
Who benefits if inflation is higher than expected?
- borrowers benefit at the expense of lenders
-
Monetary policy tools:
- open market operations
- refinancing rates (the Central Bank’s policy rate)
- reserve requirements
Central Bank: Open market operations
The objective is to increase or decrease the amount of money in circulation
Increase MS
- buy govt bonds from commercial banks
- this increases the reserves at private banks, they then lend money to firms and households
Decrease MS
- selling govt bonds to commercial banks
- this decreases private bank reserves to lend
Central Bank: refinancing rates and policy rate
In general, if the policy rate is high, the amount of lending will decrease and the quantity of money will decrease
- rate high = low lending = MS decrease
- official rate: objective to influence short and long-term interest rates
- repo rates
- base rate: rate that commercial banks lend to each other
- Federal funds rate: on in the US; interbank lending rate on overnight borrowings of reserves
What are the impacts of an increase to the Offical Rate?
- market rates
- asset prices
- expectations/confidence
- exchange rate
- domestic demand
- total demand
- inflation
- market rates will INCREASE
- asset prices will DECREASE
- expectations/confidence will DECREASE
- exchange rate: uncertain outcome, but the domestic will appreciate, making exports unattractive
- domestic demand will DECREASE, savings will increase, less borrowing, reduced profitability, deferred projects, investments, and hiring
- inflation will decrease
The factors that affect the effectiveness of a central bank:
- independence from political interference
- operationally v target-independent
- if govt determines the appropriate level of inflation, the central bank is only operationally independent
- credibility
- transparency
Exchange rate targeting:
some economies target an exchange rate vs targeting inflation
- set a fixed level for the exchange rate against a major currency
- they import inflation
- may result in domestic interest rate and MS volatility
Pegged exchange rt: Brz Real to USD
- if inflation is higher in US, Brz would sell dollar reserves and buy reals
- this restricts MS and increase SR interest rates
Dollarization
- a country uses USD as its functional currency
If the policy rate is > the neutral rate, then
- then the monetary policy is contractionary
If the policy rate is < the neutral rate, then
- then the monetary policy is expansionary
Increasing interest rates to fight inflation is not appropriate during
- during a supply shock
Monetary policy will most likely fail to stimulate growth when the economy is experiencing:
A. rapid economic growth
B. disinflation
C. deflation
C. deflation
- central banks can’t cut the nominal interest rate below 0
Quantitive easing
- used when traditional policy becomes ineffective
- used to increase MS buy assets
- to avoid deflation
Fiscal policy: what it is and its objective
- the taxing and spending policies of the government
Objective - Primary:
- influence the overall level of AD and real GDP - Secondary: tied to political motive
- distribution of income and wealth
- allocation of resources - influence output through changes in govt spending and/or taxes
- if G increases, what is the impact on Y?
Keynesian view on fiscal policy
- govt intervention is necessary to get an economy out of recession
- believe that AD, employment, and output increase with fiscal policy
Monetarist view on fiscal policy
- believe fiscal policy offers only a temporary effect
An increase in the budget surplus is
- indicates a contractionary fiscal policy
An increase in the budget deficit is
- indicates an expansionary fiscal policy
Automatic stabilizers
- fiscal policy tool to stabilize the economy
- help reduce the impact of a recession
- ie social insurance and unemployment benefits
Discretional fiscal policies
- fiscal policy tool to stabilize the economy
- changes in govt spending
- changes in tax rates
The desirable attributes of tax policy
- simplicity
- efficiency
- fairness (subjective)
- revenue sufficiency
Fiscal multiplier
what it is and formula
- explains the changes in output when there are changes in spending and taxes
- it is inversely related to the tax rate
- it is directly related to the marginal propensity to consume
= 1 / ( 1 - (c*(1 - t)))
c: marginal propensity to consume
In an economy, the tax rt is 30%, marginal propensity to consume is 75%, govt spending will increase by $3B. What is the increase in AD?
fiscal multiplier = 1 / (1 - (c * (1 -t)))
1 / (1 - (.75 * .70) = 2.10 fiscal multiplier
$3B G * 2.10 = $6.3B increase in AD
If G and T increase by the same amounts, then
- the effect of increased G is greater than the impact of higher taxes
Fiscal policy can be difficult to execute because of:
- recognition lag
- action lag
- impact lag
Easy fiscal policy Tight fiscal policy
Easy monetary policy:
Tight monetary policy:
- the first line denotes the effect of fiscal policy
- *the second line denotes the effect of monetary policy
- **the third line denotes the overall effect on the economy
Easy fiscal policy Tight fiscal policy
Easy monetary policy: AD up AD down
**low rates, private sector demand up ** low rates, private sector stimulated
**growing private and public sector **the private sector becomes a larger % of Y
Tight monetary policy: *AD up *AD down
* *high rates, private sector down **higher rates, private sector demand decreases
* **public spending % of Y grows ***shrinking private and public sectors
- the first line denotes the effect of fiscal policy
- *the second line denotes the effect of monetary policy
- **the third line denotes the overall effect on the economy
