Part 5. Monetary & Fiscal Policy

Question 1

Fiscal policy

Answer 1

The governments use of spending and taxation to influence economic activity.

Balanced budget - G = T
Budget surplus - G < T
Budget deficit - G > T

Question 2

Monetary policy

Answer 2

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

Expansionary - CB increases money and credit in an economy.
Contractionary - CB reduces quantity of money and credit in an economy.

Question 3

Money primary functions:

Answer 3

1. Medium of exchange/means of payment
2. Unit of account - determines how much of any good we are foregoing when consuming another.
3. Store of value

Question 4

Narrow money

Answer 4

The amount of notes (currency) and coins in circulation in an economy plus balances in checkable bank deposits.

Question 5

Broad money

Answer 5

This includes narrow money plus any amount available in liquid assets, which can be used to make purchases.

Question 6

Money supply

Answer 6

These measures reflect the different degrees of liquidity or spending ability that different types of money have.

M1 - the narrowest measure is restricted to the most liquid forms of money, consists of currency in the hands of the public, traveler’s checks, demand deposits, and other deposits against which checks can be written.

M2 - includes M1, plus savings accounts, time deposits of under $100,000, and balances in retail money market mutual funds.

Question 7

Fractional reserve banking

Answer 7

A bank holds a proportion of deposits in reserve.

This formed when:

• promissory notes were developed when customers deposited gold with early bankers, a promise by the banker to return gold on demand from the depositor.
• The notes became a medium of exchange, but bankers recognized all deposits would never be withdrawn at the same time and started lending a portion of deposits to earn interest.

Question 8

Money neutrality

Answer 8

The belief real variables (real GDP and velocity) are not affected by monetary variables (money supply and prices).

Question 9

The key role of central banks:

Answer 9

1. Sole supplier of currency - legal tender by law providing fiat money (money not backed by any tangible value).
2. Bank to the government and other banks
3. Regulator and supervisor of payments system - imposing standards of risk-taking allowed and reserve requirements of bank under its jurisdiction.
4. Lender of last resort - the CB ability to supply money to banks with shortages, to prevent bank runs (i.e. large scale withdrawals) by assuring fund security.
5. Holder of gold and foreign exchange reserves
6. Conductor of monetary policy

Question 10

High inflation leads to:

Answer 10

Menu costs = costs to businesses of constantly having to change their prices.

Shoe leather costs = costs to individuals making frequent trips to the bank to minimise their holdings of cash depreciating in value due to inflation.

Question 11

Objectives of central bank:

Answer 11

• price stability
• stability in exchange rates with foreign currencies
• full employment
• sustainable positive economic growth
• moderate long-term interest rates

Question 12

Pegging exchange rate to dollar:

Answer 12

• if currency appreciates, they can sell their domestic currency reserves for dollars to reduce exchange rate.
• Actions may be effective in the short run to stabilise the exchange rate over time, but interest rates and economic activity must be managed, as leads to increased volatility of MS and IR.
• This commits to a policy intended to make inflation rate equal to inflation rate of country to which they peg their currency.

Question 13

Perfectly anticipated inflation

Answer 13

• the price of all goods and wages should be indexed to this rate increasing/decreasing approx. each month by 1/2% dependent on demand.
• the cost of holding money than interest-bearing securities is higher as its purchasing power decreases steadily, decreasing money supply.
• a decrease in the quantity of money people are willing to hold and impose some to more frequent movement from interest-bearing securities to cash or non-interest bearing deposit accounts to facilitate transactions.

Question 14

Unanticipated inflation

Answer 14

• Inflation that is higher or lower than expected rate of inflation.
• Inflation higher = borrowers gain at expense of lender as loan payments in future are made with currency less value in real terms.
• Inflation lower = benefit lender at expense of borrowers.
• Volatile inflation rates require higher IR to compensate for additional risk they face due to unexpected changes in inflation; higher borrowing rate slows business investment and reduce level of economic activity.
• This can cause excess capacity/inventory, with firms decreasing production, lay off workers, reduce/eliminate expenditure, thus increasing magnitude or frequency of business cycle.

Question 15

Qualities for succeeding inflation targeting policies:

Answer 15

1. Independence

• Free from political interference, who have an incentive to boost economic activity and reduce unemployment prior to elections.
• Operational independence = the CB is allowed to independently determine policy rate.
• Target independence = the CB defines how inflation is computed and sets to a level determining the horizon over which target is to be achieved.

2. Credibility

• gov with large debts instead of CB set inflation target, its not credible as gov incentive for inflation to exceed the target level.
• If market believes CB serious about achieving target inflation of 3%, then actual will be close to that level.

3. Transparency

• The CB periodically discloses the state of economic environment by issuing inflation reports.
• Gain in credibility of est. MP, making it easier to anticipate and implement.

Question 16

Effects of change to more expansionary monetary policy:

Answer 16

1. CB buys securities which increases bank reserves.
2. Interbank lending rate falls as banks are more willing to lend each other reserves.
3. ST rates decrease as rising in the supply of loanable funds decreases the equilibrium rate for loans.
4. LT IR decrease.
5. Fall in real IR causes the currency to depreciate in the foreign exchange market.
6. Fall in LT IR increases business investment in plant and equipment.
7. Fall in IR causes consumers to increase purchases of houses, autos, and durable goods.
8. Fall in currency increases foreign demands for domestic goods.
9. Rise in C, I, and X-M all increase AD.
10. Rise in AD increases inflation, employment, and real GDP.

Question 17

The transmission mechanism for decrease in interbank lending rates:

Answer 17

1. Market rate decrease since banks adjust lending rates for ST and LT.
2. Asset prices rise as lower discount rates are used for computing PV.
3. Firms and individuals raise expectations for economic growth and profitability; CB may follow up with a further fall in IR.
4. Dom currency depreciates due to the outflow of foreign money as IR falls.

Overall:

• rise in domestic demand (less incentive to save)
• increase in net external demand (X-M)
• rise in AD and domestic inflation

Question 18

Inflation targeting

Answer 18

Increasing the money supply when specific interest rates rose above the target band and decreasing money supply when rates fall below the target band.

currently: +-2%, so target band is 1% to 3%

Question 19

Exchange rate targeting

Answer 19

They target a foreign exchange rate between their currency and other currencies (US dollar).

i. e. if domestic currency value falls relative to the US dollar, the use of foreign reserves to purchase domestic currency (reduce MS, increase IR) to reach the target exchange rate.
- The net effect is targeting a country will have the same inflation rate as the targeted currency, and targeting the country will follow MP and accept IR consistent with this goal.

Question 20

Real trend rate

Answer 20

An economy long-term sustainable real growth rate; this changes over time as structural conditions of the economy change.

Question 21

Neutral interest rate

Answer 21

The growth rate of the money supply that neither increases or decreases the economic growth rate.

neutral IR = real trend rate of economic growth + inflation target

• the policy above the neutral rate, the MP is contractionary.

Question 22

Limitations of monetary policy:

Answer 22

• This can be viewed as too extreme increasing the probability of a recession by making long-term bonds more attractive and reducing long-term IR. WIth MS growth seen as inflationary, higher expected future asset prices will make long-term bonds relatively less attractive, increasing LT IR —- bond market vigilantes.
• If demand for money becomes very elastic, individuals are willing to hold more without a decrease in ST rates causing a liquidity trap.
• The CB is limited to reducing nominal policy rate to zero, as there is limited ability to further stimulate the economy.

Question 23

Quantitative Easing

Answer 23

The large purchase of British government bonds in the maturity range of 3-5 years to reduce IR to encourage borrowing and generate excess reserves in banking system to encourage lending.

Question 24

Fiscal policy beliefs

Answer 24

Keynesian = its effect on AD can have a strong effect on GDP when the economy is operating in less than full employment.

Monetarists = the effect of fiscal stimulus is only temporary, and monetary policy should be used to increase or decrease inflationary pressures over time. To influence AS to counter cyclical movements in the economy.

Question 25

Discretionary fiscal policy

Answer 25

The spending and taxing decisions of the national government are intended to stabilize the economy.

Automatic stabilisers = built-in fiscal devices triggered by the state of the economy, whereby during a recession tax receipts will fall, and government expenditure on unemployment insurance payments will increase.

• These tend to increase budget deficits and are expansionary; higher tax revenues coupled with lower outflows for social programs tend to decrease budget deficits and are contractionary.

Question 26

Objectives of fiscal policy:

Answer 26

• Influencing the level of economic activity and AD.
• Redistributing wealth and income among segments of the population.
• Allocating resources among economic agents and sectors in the economy.

Question 27

Transfer payments

Answer 27

Entitlement programs, redistribute wealth, taxing some and making payments to others.

e. g. Social Security, unemployment insurance benefits
- not included in GDP computations

Question 28

Direct tax

Answer 28

Levied on income and wealth; progressive taxes generate revenue for wealth and income redistributing.

i.e. income tax, tax on income for national insurance, wealth taxes, estate taxes, corporate taxes, capital gains taxes, Social Security taxes.

Question 29

Indirect tax

Answer 29

Levied on goods and services.

i.e. sales taxes, value-added taxes (VAT), excise taxes - to reduce consumption of external costs.

Question 30

Desires of tax policy:

Answer 30

1. Simple to use and enforce.
2. Efficiency has the least interference with market forces and does not act as a deterrent to working.
3. Fairness is subjective:

• Horizontal equality - people in similar situations should pay similar taxes.
• Vertical equality - richer people should pay more in taxes.

4. Sufficiency - taxes should generate sufficient revenues to meet spending needs of the governement.

Question 31

Advantages of fiscal policy tools:

Answer 31

• Social policies - discouraging tobacco use

- Quick implementation - gov rev increase without significant additional costs.

Question 32

Disadvantages of fiscal policy

Answer 32

• Direct taxes and transfer payments take time to implement, delaying their impact of fiscal policy.
• Capital spending takes a long time to implement; the economy may have recovered by the time impact is felt.

Question 33

Ricardian equivalence

Answer 33

• To maintain the preferred pattern of C overtime, taxpayers may increase current savings, to offset the expected cost of higher future taxes.
• If taxpayers reduce current C, and increase current savings by enough to repay principal and interest on debt the government issued to fund increased deficit, there is no effect on AD.
• taxpayers underestimate future liability for servicing and repaying debt, so AD increased by equal spending and tax increases, RE does not hold.

Question 34

Debt ratio

Answer 34

The ratio of aggregate debt to GDP, when the economy grows in real terms, taxes will also grow.

• if real IR on gov. debt is higher than the real growth rate, then the debt ratio will increase over time.
• if real IR on governments debt is lower than real growth in GDP, the debt ratio will decrease (i.e. improve) over time.

Question 35

Arguments for being concerned with size of fiscal deficit:

Answer 35

• higher deficits lead to higher future taxes, disincentivizing work, and entrepreneurship, lowering economic growth.
• Markets lose confidence in government, investors may not be willing to refinance debt, leading to gov. defaulting (debt in foreign currency) or print money (debt in local currency) - leading to higher inflation.
• Rise in government borrowing increase IR, and firms reduce borrowing and investment, resulting in decreasing impact on AD of deficit spending. – crowding-out effect; gov borrowing taking place of private-sector borrowing.

Question 36

Arguments against being concerned with size of fiscal deficit:

Answer 36

• If the debt is primarily being held by domestic citizens, the scale of the problem is overstated.
• If the debt is used to finance productive capital investment, future economic gains will be sufficient to repay debt.
• Deficits prompt the need for tax reform.
• Deficits do not matter if private sector savings in anticipation for future tax liabilities offset gov deficit (RE holds).
• The economy is operating at less than full capacity, deficits do not divert away from productive uses; contrary aid rise in GDP and employment.

Question 37

Disadvantages of discretionary fiscal policy:

Answer 37

1. Economic forecasts may be wrong, leading to incorrect policy decisions.
2. Complications arise in practice that delay implementation and impact of policy changes on the economy.
3. Lags:
   - Recognition lag - decisions made by the political process, take policymakers time to recognize the nature and extent of economic problems.
   - Action lag - the time gov takes to discuss, vote on and enact fiscal policy changes.
   - Impact lag - the time between the enactment of fiscal policy changes and on the economy actually take place, as takes time for individuals/corporations to act on changes and fiscal multiplier effect occurs over time.

Question 38

Add. macroeconomic issues hinder usefulness of fiscal policy:

Answer 38

1. Misreading economic statistics - i.e. full employment levels not precisely measurable, causing inflation higher.
2. Crowing out effect - expansionary fiscal policy crowd private investment.
3. Supply shortages - AD not affected by low demand, expansionary policy leads to higher inflation.
4. Limits to deficits - if the deficit is already too high as prop. of GDP, funding lead to higher IR and worsen the situation.
5. Multiple targets - an economy with high unemployment coupled with high inflation.

Question 39

Structural (cyclically adjusted) budget deficit:

Answer 39

• This deficit would occur based on current policies if the economy were at full employment; a natural outcome of recession without explicit gov. action.

Question 40

Interaction of MP and FP:

Answer 40

1. Expansionary MP&FP = IR lowers, and private and public sector expansion.
2. Contractionary FP&MP = AD and GDP lower, IR higher, and contraction of private and public sectors.
3. Expansionary FR and contractionary MP = AD likely higher, IR higher, G as prop. of GDP will increase.
4. Contractionary FP and expansionary MP = IR will fall from decreased gov. borrowing and expansion of MS, increasing private consumption and output.

Fall in G as prop. to GDP, and growth in private sector due to lower IR.