Monetary and Fiscal Policy Flashcards
Refers to a governments use of spending and taxation to influence economic activity
Fiscal Policy
Refers to the central banks actions that affect the quantity of money and credit in an economy in order to influence economic activity
Monetary Policy
When a central bank increases the quantity of money and credit in an economy.
Expansionary Monetary Policy
3 Primary Functions of Money
- Medium of Exchange
- Unit of Account
- Store of Value
Amount of currency in circulation + balances in checkable bank deposits
Narrow Money
Narrow Money + Any available liquid assets to make purchases
Broad Money
= Currency in public hands + travelers checks + demand deposits + and others deposits against which checks can be written
M1
= M1 + savings accounts + time deposits + retail money market funds
M2
A bank that holds a proportion of deposits in reserve
Fractional reserve banking
Money not need for reserves
Excess Reserves
Money Created Calculation
New Deposits / Reserve Requirement
Money Multiplier
1 / Reserve Requirement
The quantity of money is some proportion of the total spending in an economy and implies the quantity equation of exchange
Quantity Theory of Money
Quantity Equation of Exchange
Money Supply * Velocity = Price * Real Output
M*V = P * Y
The amount of wealth that households and firms in an economy chose to hold in money form
Demand for Money
3 Reasons to Hold Money
- Transaction Demand
- Precautionary Demand
- Speculative Demand: Take Advantage of investment opportunities when available.
Supply of money is determined by …
the Federal Reserve and is independent of interest rate
ST interest rates are determined by equilibrium between money supply and money demand.
if I > eq. rate, excess supply of real money
if I < eq. rate, excess demand of real money
An increase in money supply will put downward pressure on interest rates.
Nominal Interest Rate vs. Quantity of Money
Y axis v. X axis
States the nominal interest rate is the sum of the real interest rate plus the expected inflation
Rnom = Rreal + E[I] + Risk Premium
Key Roles of Central Banks
- Sole supplier of currency
- Banker to the government and other banks
- Regulator and Supervisor of payments systems; reserve requirements, risk, etc.
- Lender of Last Resort
- Holder of gold and FX reserves
- Conductor of Monetary Policy
Primary Objective of a central bank is to control inflation to promote price stability.
…
Costs to businesses for having to constantly change prices
Menu Costs
Costs to individuals of making frequent trips to the bank
Shoe Leather Costs
Other Objectives of Central Banks:
- Stability in Exchange Rates
- Full employment
- Sustainable, positive economic growth
- Moderate LT interest rates
Cost of holding money rather than interest bearing securities is higher because purchasing power decreases.
Costs of Expected Inflation
When information about supply and demand become les reliable, creating over biased earnings leading to overproduction in private sector
Costs of Unexpected Inflation
3 Monetary Policy Rules:
- Policy Rate – “Federal Funds Rate”
- Reserve Requirements – % of deposits banks are required to retain as reserves.
- 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.
When Central Banks succeed, it has 3 qualities:
- Independence from political interference
- Credibility: follows through on stated intentions regarding target inflation rates.
- Transparency: Central Banks periodically disclose the state of the economy by issuing inflation reports–> gains credibility and makes policy changes easier to anticipate.
Steps in the Transmission Mechanism (How ST interest rates affect variables):
- 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.
Transmission mechanism for a decrease in interbank lending rates affects 4 things simultaneously:
- Market rates decrease due to banks adjusting their lending rates for the ST and LT
- Asset Prices ^ because lower discount rates are used for computing present values
- Firms and individuals raise their expectations for economic growth and profitability
- 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 ^
increasing the money supply when specific interest rates rose above the target band, and vice versa
interest rate targeting
*Goal is to keep it within +/- 2% of goal
Instead of targeting inflations, countries target a FX rate between their currency and another.
Exchange Rate Targeting
When the policy rate is above (below) the neutral interest rate, the monetary policy is said to be contractionary (expansionary)
…
real trend rate of economic growth + inflation target
neutral interest rate
LT rates may not rise and fall with ST rates because of effects of monetary policy changes on expected inflation
Expectations of ^ inflations or interests.
Money may become more elastic and individuals become more likely to hold money even without a decrease in ST rates
Liquidity Trap
Even if interest rates decrease and excess reserves increase, banks still may not be willing to lend money.
Credit Bubble
When a government buys its own bonds to increase excess reserves to encourage lending.
Quantitative Easing
Monetary Policy Difficulties in Developing Economies.
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
Refers to a governments use of spending and taxation to meet macroeconomic goals.
Fiscal Policy
Believes fiscal policy can greatly affect Aggregate Demand
Keynesian School
Objectives of Fiscal Policy
- Influencing the level of economic activity
- Redistributing Wealth and Income among segments of the population
- Allocating resources among economic agents and sectors in the economy
Fiscal policy is split into spending tools and revenue tools
…
Spending Tools in Fiscal Policy Include
- 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.
Revenue Tools in Fiscal Policy Include
- Direct Taxes – taxes on income and wealth
* Indirect Taxes – levied on goods and services. Reducing consumption.
Advantages of Fiscal Policy
- Social Policies – such that discouraging tobacco use can be implemented quickly.
- Quick implementation via indirect taxes mean government revenue can increase quickly
Disadvantages of Fiscal Policy
- 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
Fiscal Multiplier
= 1 / [1-MPC*(1-t)]
*MPC = Marginal Propensity to Consume
t = tax rate
*Inversely related to the tax rate
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.
Ricardian Equivalence
Debt Ratio Calculation
= aggregate debt / GDP
Arguments for concern about debt/deficit:
- 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
Arguments against debt/deficit:
- Overstated if debt is most domestically held
* debt could finance infrastructure for future productivity
Fiscal policy that is implemented through changes in taxes and spending
Discretionary Fiscal Policy
Difficulties of Implementation of Fiscal Policy
- 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.
Macroeconomic Issues that hinder the usefulness of fiscal policy include
- 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)
An increase (decrease) in surplus is indicative of a contractionary (expansionary) fiscal policy
An increase (decrease) in deficit is indicative of an expansionary (contractionary) fiscal policy.
- Expansionary Fiscal and Monetary Policy, highly expansionary
interest rates decrease, and public and private sector likely to expand.
- Contraction Fiscal and Monetary Policy
Aggregate Demand decreases, GDP decreases, interest rates ^. Public and Private sector contract.
- Expansionary Fiscal and Contractionary Monetary Policy
Aggregate Demand ^ (because of fiscal policy), interest rates increase (because of monetary policy).
*Government Spending as proportion of GDP ^^.
- Contractionary Fiscal and Expansionary Monetary Policy
interest rate decreases (because of monetary) and private sector ^.
* Government Spending as % of GDP decreases.
