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CFA Level 1 - Quantitative Methods > Monetary and Fiscal Policy > Flashcards

Monetary and Fiscal Policy Flashcards

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1
Q

Refers to a governments use of spending and taxation to influence economic activity

A

Fiscal Policy

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2
Q

Refers to the central banks actions that affect the quantity of money and credit in an economy in order to influence economic activity

A

Monetary Policy

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3
Q

When a central bank increases the quantity of money and credit in an economy.

A

Expansionary Monetary Policy

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4
Q

3 Primary Functions of Money

A
  1. Medium of Exchange
  2. Unit of Account
  3. Store of Value
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5
Q

Amount of currency in circulation + balances in checkable bank deposits

A

Narrow Money

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6
Q

Narrow Money + Any available liquid assets to make purchases

A

Broad Money

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7
Q

= Currency in public hands + travelers checks + demand deposits + and others deposits against which checks can be written

A

M1

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8
Q

= M1 + savings accounts + time deposits + retail money market funds

A

M2

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9
Q

A bank that holds a proportion of deposits in reserve

A

Fractional reserve banking

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10
Q

Money not need for reserves

A

Excess Reserves

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11
Q

Money Created Calculation

A

New Deposits / Reserve Requirement

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12
Q

Money Multiplier

A

1 / Reserve Requirement

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13
Q

The quantity of money is some proportion of the total spending in an economy and implies the quantity equation of exchange

A

Quantity Theory of Money

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14
Q

Quantity Equation of Exchange

A

Money Supply * Velocity = Price * Real Output

M*V = P * Y

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15
Q

The amount of wealth that households and firms in an economy chose to hold in money form

A

Demand for Money

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16
Q

3 Reasons to Hold Money

A
  1. Transaction Demand
  2. Precautionary Demand
  3. Speculative Demand: Take Advantage of investment opportunities when available.
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17
Q

Supply of money is determined by …

A

the Federal Reserve and is independent of interest rate

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18
Q

ST interest rates are determined by equilibrium between money supply and money demand.

A

if I > eq. rate, excess supply of real money

if I < eq. rate, excess demand of real money

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19
Q

An increase in money supply will put downward pressure on interest rates.

A

Nominal Interest Rate vs. Quantity of Money

Y axis v. X axis

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20
Q

States the nominal interest rate is the sum of the real interest rate plus the expected inflation

A

Rnom = Rreal + E[I] + Risk Premium

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21
Q

Key Roles of Central Banks

A
  1. Sole supplier of currency
  2. Banker to the government and other banks
  3. Regulator and Supervisor of payments systems; reserve requirements, risk, etc.
  4. Lender of Last Resort
  5. Holder of gold and FX reserves
  6. Conductor of Monetary Policy
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22
Q

Primary Objective of a central bank is to control inflation to promote price stability.

A

…

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23
Q

Costs to businesses for having to constantly change prices

A

Menu Costs

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24
Q

Costs to individuals of making frequent trips to the bank

A

Shoe Leather Costs

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25
Q

Other Objectives of Central Banks:

A
  1. Stability in Exchange Rates
  2. Full employment
  3. Sustainable, positive economic growth
  4. Moderate LT interest rates
26
Q

Cost of holding money rather than interest bearing securities is higher because purchasing power decreases.

A

Costs of Expected Inflation

27
Q

When information about supply and demand become les reliable, creating over biased earnings leading to overproduction in private sector

A

Costs of Unexpected Inflation

28
Q

3 Monetary Policy Rules:

A
  1. Policy Rate – “Federal Funds Rate”
  2. Reserve Requirements – % of deposits banks are required to retain as reserves.
  3. Open Market Operations – Buying and Selling Securities. When the central bank buys -> Cash replaces securities in investors accounts –> banks have excess reserves –> Money Supply increases –> interest rate decreases.
29
Q

When Central Banks succeed, it has 3 qualities:

A
  1. Independence from political interference
  2. Credibility: follows through on stated intentions regarding target inflation rates.
  3. Transparency: Central Banks periodically disclose the state of the economy by issuing inflation reports–> gains credibility and makes policy changes easier to anticipate.
30
Q

Steps in the Transmission Mechanism (How ST interest rates affect variables):

A
  • The CB buys securities, which ^ bank reserves
  • The interbank lending rate decreases as bank do not want to lend to each other
  • Other ST rates decrease as the increase in the supply of loanable funds decreases the equilibrium rate for loans.
  • LT interest rates decrease
  • Decrease in Interest Rate causes the currency to depreciate in the FX market
  • Decrease in LT interest rate increase business investment in plants and equipment
  • Lower interest rates cause consumers to increase purchases of homes, autos and durable goods.
  • Depreciation of the currency increases foreign demand for the domestic goods.
  • Increase in consumption, investment and exports: ^ Aggregate Demand
  • An increase in aggregate demand causes inflation ^, employment ^, and ^ GDP.
31
Q

Transmission mechanism for a decrease in interbank lending rates affects 4 things simultaneously:

A
  1. Market rates decrease due to banks adjusting their lending rates for the ST and LT
  2. Asset Prices ^ because lower discount rates are used for computing present values
  3. Firms and individuals raise their expectations for economic growth and profitability
  4. Domestic currency depreciates due to an outflow of foreign money as real interest rates decrease.

** As a result of all these, AD ^ and domestic inflation ^

32
Q

increasing the money supply when specific interest rates rose above the target band, and vice versa

A

interest rate targeting

*Goal is to keep it within +/- 2% of goal

33
Q

Instead of targeting inflations, countries target a FX rate between their currency and another.

A

Exchange Rate Targeting

34
Q

When the policy rate is above (below) the neutral interest rate, the monetary policy is said to be contractionary (expansionary)

A

…

35
Q

real trend rate of economic growth + inflation target

A

neutral interest rate

36
Q

LT rates may not rise and fall with ST rates because of effects of monetary policy changes on expected inflation

A

Expectations of ^ inflations or interests.

37
Q

Money may become more elastic and individuals become more likely to hold money even without a decrease in ST rates

A

Liquidity Trap

38
Q

Even if interest rates decrease and excess reserves increase, banks still may not be willing to lend money.

A

Credit Bubble

39
Q

When a government buys its own bonds to increase excess reserves to encourage lending.

A

Quantitative Easing

40
Q

Monetary Policy Difficulties in Developing Economies.

A

Monetary policy in developing economies may not get independence from government, may not have reliable information or rapid financial innovations may be hard to account for

41
Q

Refers to a governments use of spending and taxation to meet macroeconomic goals.

A

Fiscal Policy

42
Q

Believes fiscal policy can greatly affect Aggregate Demand

A

Keynesian School

43
Q

Objectives of Fiscal Policy

A
  1. Influencing the level of economic activity
  2. Redistributing Wealth and Income among segments of the population
  3. Allocating resources among economic agents and sectors in the economy
44
Q

Fiscal policy is split into spending tools and revenue tools

A

…

45
Q

Spending Tools in Fiscal Policy Include

A
  • Transfer Payments (AKA entitlement programs) – redistribute wealth taxing some and making payments to other.
  • Current Spending – Government purchases of good and services on an ongoing and routine basis.
  • Capital Spending – Government spending on infrastructure. Expected to boost future productivity of the economy.
46
Q

Revenue Tools in Fiscal Policy Include

A
  • Direct Taxes – taxes on income and wealth

* Indirect Taxes – levied on goods and services. Reducing consumption.

47
Q

Advantages of Fiscal Policy

A
  • Social Policies – such that discouraging tobacco use can be implemented quickly.
  • Quick implementation via indirect taxes mean government revenue can increase quickly
48
Q

Disadvantages of Fiscal Policy

A
  • Direct Taxes and transfer payments are hard to implement and take a long time to become effective.
  • Capital Spending takes a long time to implement
49
Q

Fiscal Multiplier

A

= 1 / [1-MPC*(1-t)]

*MPC = Marginal Propensity to Consume
t = tax rate
*Inversely related to the tax rate

50
Q

If taxpayers reduce current consumption and increase current saving by just enough to repay the principal and interest on debt the government issued to fund the increased deficit, there is not change in aggregate demand.

A

Ricardian Equivalence

51
Q

Debt Ratio Calculation

A

= aggregate debt / GDP

52
Q

Arguments for concern about debt/deficit:

A
  • High deficits leads to higher taxes
  • If markets lose confidence in the government investors may no be willing to refinance
  • Government crowds out private sector borrowing
53
Q

Arguments against debt/deficit:

A
  • Overstated if debt is most domestically held

* debt could finance infrastructure for future productivity

54
Q

Fiscal policy that is implemented through changes in taxes and spending

A

Discretionary Fiscal Policy

55
Q

Difficulties of Implementation of Fiscal Policy

A
  • Economic forecasts might be wrong, to lead to incorrect policy decisions.
  • Recognition lag – takes policymakers time to recognize the nature and extent of problems
  • Action lag – the time government takes to actually enact policy.
  • Impact lag – time between enactment and the impact of the changes crystallize.
56
Q

Macroeconomic Issues that hinder the usefulness of fiscal policy include

A
  • Misreading economic statistics
  • Crowding out effect: expansionary fiscal policy may crowd out private investment
  • Supply shortages
  • Multiple targets to target with different prescriptions for each (inflation and unemployment)
57
Q

An increase (decrease) in surplus is indicative of a contractionary (expansionary) fiscal policy

A

An increase (decrease) in deficit is indicative of an expansionary (contractionary) fiscal policy.

58
Q
  1. Expansionary Fiscal and Monetary Policy, highly expansionary
A

interest rates decrease, and public and private sector likely to expand.

59
Q
  1. Contraction Fiscal and Monetary Policy
A

Aggregate Demand decreases, GDP decreases, interest rates ^. Public and Private sector contract.

60
Q
  1. Expansionary Fiscal and Contractionary Monetary Policy
A

Aggregate Demand ^ (because of fiscal policy), interest rates increase (because of monetary policy).
*Government Spending as proportion of GDP ^^.

61
Q
  1. Contractionary Fiscal and Expansionary Monetary Policy
A

interest rate decreases (because of monetary) and private sector ^.
* Government Spending as % of GDP decreases.

CFA Level 1 - Quantitative Methods (29 decks)

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