Monetary and Fiscal Policy Flashcards
A Compare monetary and fiscal policy (stable prices and economic growth)
MonP=CB=Qms, Credit = stable P, +Y *easy expansion, restrictive contraction
Fiscal-G spending and taxation (income, wealth redistribution)
Balanced budget; G=T
Budget surplus; T>G
Budget deficit; G>T
B Describe functions and definitions of money
Money - Medium of exchange, unit of account, store of value
Narrow Money = (Currency+Checkable bank deposits)
Broad Money; Narrow + liquid assets
MS: Reflects different degrees of liquidity -
M1;most liquid- currency in the hands of the public;Trav. checks, demand deposits, checks.
M2; M1 + savings accts, CD’s under 10k, retail money market mutual funds
C Explain the money creation process (NEw deposits / reserve requirment, where excess reserves are loaned out)
Promissory notes led to fractional reserve banking:bank golds a proportion of deposits in reserve
Cash not in reserve;excess reserves: Loaned out, and the cycle repeats
Money Creation = New Deposit / Reserve Requirement
Money Multiplier: Measures magnitude of money creation = 1/ reserve req.
Relationship of Money and the Price Level
Quantity theory of Money;quantity equation of exchange; MV=PY: States that Qm is some prop. of Y; total spending in an econ
V; Velocity:Avg #(year) money is used to buy goods or services - any +MS leads to =+Plevel;monetarists: Monetary policy can be used to control and reg. inflation
Money Neutrality: Real variables;real Y and V are not affected by MS and Prices;MS and Prices
D Describe theories of demand(Qwealth households and firms hold in money form) and supply for money(CB determined: perfectly inelastic;No effect by R)
Reasons (why ppl demand) to hold money: Transaction demand, Precautionary demand, Speculative demand
R and Dm: low%, high Dm, vice versa
+% -> +Qs money (money used to purchase equities and such, which drive interest rates further to depress excess Qsm)
Shortage Qsm; excess Qdm, % rates bid back up leading to sales of securities
CB SR R;MS manipulation: +MS>Downward pressure on R; firms and people buy securities. +MS>Upward pressure on R;Firms and people sell securities.
E Describe the fisher effect (real rates are stable, changes in int. rates are driven by changes in expected inflation;consistent w/ money neutrality)
Nominal interest rate is sum of real + expected
A third component of nominal interest rate: A risk premium; Nom = Real + Exp. Inf +Risk Prem.
F Describe roles and objectives of CB’s
Roles: Sole Supplier of a Currency, Banker to gov and other banks, Regulator and supervisor of payments system, lender of last resort, holder of gold and foreign exchange reserves, conductor of monetary policy
Primary objective: Control inflation (to reduce menu costs, shoe leather costs;constant bank runs). Other: Exchange rate stability, fullY, +econ growth, moderate LT r-rates
*Pegging: A target level for a currency exchange rate with that of US. Foregin currency appreciates; reduce exchange rate; sell their currency for $$ reserves
G Contrast the costs of expected and unexpected inflation
Costs of expected inflation; perfectly anticipated: Cost of holding money is higher than holding interest bearing assets
Costs of unexpected inflation: Higher than expected;Borrowers gain at lenders expense as future currency has less value than present currency; high borrow rates slow business investment and reduce the level of economic activity.
Second cost of unexpected inf. Info about SnD becomes less reliable. Price increases may not be the result of demand, suppliers may produce too much; increases magnitude or frequency of business cycles
H Describe tools used to implement monetary policy, open market policies
Open Market Activities: Fed Sells bonds>-investors accounts>-reserves>-funds available for lending>-MS = +r=contractionary
Fed Buys bonds:>+Investors accounts>+reserves>+funds for lending>+MS=-r=expansionary
I Describe qualities of effective central banks (independence, credibility)
Independence (operational;CB determines policy rate, target;CB determines inflation calculation,level, and time horizon)
Credibility
Transparency;inflation reports
J Explain the relationships between monetary policy and economic growth, inflation, interest, and exchange rates
Monetary policy only affects short-term rates (policy rates) but in SR affects Real Variables (economic growth and the inflation rate);(transmission mechanism)
Trans. Mechanism (for a decrease in interbank lending rates affects four things simultaneously
- Marker R’s decrease due to banks adjusting their lending rates for SR and LR
- Asset prices increase because lower discount rates are used for computing present values
- Firms and individuals raise their expectations for economic growth and profitability. They may also expect the central bank to follow up with further interest rate decreases.
- Domestic currency depreciates due to an outflow of foreign money as real R declines
All four lead to +domestic demand as people consume more (less incentive to save given lower interest rates) and +net external demand (exports - imports) because depr. of domestic currency makes X less expensive to foreigners and Imp more expensive to domestic. Inc. overall D and import prices tends to +Add.D and domestic inflation.
K Contrast the use of inflation, interest rate, and exchange rate targeting by central banks
Super important! Current inflation targeting is the result of prior policy and event.
Interest Rate Targeting: +MS when specific R rose > target band, etc
Inflation targeting: 2-2.5% in the range of two years in the future
Exchange Rate Targeting: Target a foreign exchange rate between their currency and another. Greater volatility of MS because domestic Mon. policy must adapt to the necessity of maintaining a stable foreign exchange rate.
L Determine whether a monetary policy is expansionary or contractionary
- Real trend Rate: Econs LT sustainable Y growth rate
- Neutral R - Growth rate of MS that doesnt change econ growth rate = Real trend rate + Inflation target
If policy R>Neutral R;contractionary; -MS
If Neutral>policy; Expansionary; +MS
*remember Fed focus’ on core inflation, to eliminate volatile food and energy prices.
M Describe limitations of monetary policy (why standard tools for +MS may not +econ activity)
Bond Market Vigilantiasm: MS seems inflationary, higher expected future asset prices will make long-term bonds relatively less attractive and will inc. long-term interest rates
Liquidity Trap: Dm becomes elastic and indivs. willingly hold more money even w/o a decrease in ST r’s.
^^ +MS growth won’t -ST rates because indivs. hold money in cash balances instead of investment in interest bearing securities.
Deflation: CB has limited ability to stimulate R beyond 0 when deflation -R persists.
Credit Bubble: Even w/ +reserves, banks may not be willing to lend, because they had previously lost equity capital and wished instead to rebuild it.
Quantitative Easing: Should encourage borrowing and reduce R to egen. excess reserves in the banking system to encourage lending….but it didn’t.
N Describe roles and objectives of fiscal policy(G and T to meet macro goals)
Fiscal Policy
Balanced G=T
Surplus T>G
Deficit G>T
-T and +G BOTH increase a budget deficit(Budget deficit = response to recession, or - to slow growth when inflation is too high), Agg.D, econ growth, and employment
+T and -G BOTH decrease a budget deficit, Agg.D, econ growth, employment
Monetarists don’t believe monetary policy to use on Agg.D to counter cyclical movements in the economy.
Discretionary fiscal policy: Spending and tax decisions of a national government to stabilize econ; auto-stabilizers:Built in fiscal devices triggered by the state of the econ.
Auto-stabs: Recession; -T, +G on unemp = + budget deficit, expansionary
Booms: +T, -Transfer Payments = -Budget deficit, contractionary
O Describe tools of fiscal policy, including their advantages and disadvantages
Fiscal policy tools (spending and revenue tools)
Spending: Transfer payments(not inc. in GDP), Current Spending (G; goods and services), Capital Spending (Expected to boost future prod. of the economy)
Revenue Tools: Direct Taxes; T on inc or wealth. Indirect T’s; Sales;VAT;Excise(used to reduce consumption of some goods and services)
Desirable Attribs of T policy: Simple, efficient, fair
Adv Fisc. P tools: Social policies via indirect T’s, which also +G revs w/o significant costs
Disadv: Direct T’s and Transfer payments take time, delaying the impact of fiscal policy. Capital spending takes long and econ may have recovered by time impact is felt.
