Reading 16: Monetary and Fiscal Policy

Question 1

Define unexpected inflation and explain what it leads to.

Answer 1

Unexpected inflation is the level of inflation that comes as a surprise to economic agents.

Unexpected inflation leads to:
Inequitable transfers of wealth between borrowers and lenders.
Higher risk premium in borrowing rates.
A reduction in the information content of market prices.

Question 2

Describe money neutrality.

Answer 2

It says that an increase in money supply will not result in an increase in real output (Y). Therefore, an increase in money supply will cause the aggregate price level (P) to rise.

Question 3

Explain the required reserve ratio.

Answer 3

Banks must hold a proportion of deposits in the form of “vault cash plus deposits at the Fed.” If a bank has deposits of $100, and if the reserve requirement is 20%, it must hold a total of $20 in its account at the Fed and currency in its vaults.

Question 4

Describe the banking system cycle that increases the quantity of money.

Answer 4

Excess reserves → lending → deposits increase → quantity of money increases → deposits further increase → excess reserves further increase

Question 5

Identify the objectives of fiscal policy.

Answer 5

Increasing personal income by social expenditures and infrastructure spending.

Increasing disposable income by reducing personal income taxes and tax on saving and investment returns and increasing transfer payments.

Encouraging business investment via lower corporate taxes.

Question 6

Identify the objectives of U.S. monetary policy.

Answer 6

Maximum employment consistent with stable prices.

Moderate long-term interest rates.

Question 7

Describe the central bank’s policy rate. What happens if the central bank increases this rate?

Answer 7

Influences short- and long-term interest rates
Has an impact on the broader economy
This is the discount rate in the U.S.
It is the rate at which the Fed is ready to lend reserves to depository institutions if reserves fall below required levels

When the rate increases:
Banks increase base lending rate
Asset prices fall as present values of expected future cash flows decline
Economic agents expect slower growth, reduce purchases and investments
Domestic currency appreciates as foreign reserves seek higher interest rates

Question 8

How are open market operations conducted?

Answer 8

The monetary authority purchases treasury securities to increase money reserves and stimulate the economy, or sells treasury securities to decrease money reserves and slow economic activity.

Question 9

Differentiate between contractionary and expansionary monetary policies.

Answer 9

Contractionary measures: Decreasing economic activity by slowing the growth of or decreasing the money supply through Treasury sales, higher discount rates, or increased reserve requirements.

Expansionary measures: Increasing economic activity by the opposite of the above.

Question 10

Explain the advantages and disadvantages of fiscal policy tools.

Answer 10

Indirect taxes – Adjusted quickly at little cost to the government, fast results. Social objectives can easily be met by raising indirect taxes.

Direct taxes/welfare and other social transfers – Difficult to change without significant notice but rapid impact.

Capital spending decisions are slow to plan, implement, and execute.

Question 11

Explain the Fischer effect.

Answer 11

It states that the nominal interest rate (RN) reflects the real interest rate (RR) and the expected rate of inflation (Πe).

Note: The factors that influence the nominal interest rate are (1) uncertainty and (2) inflation.

Question 12

Describe forms of government spending.

Answer 12

Transfer payments – Unemployment benefits or job search allowances, and low-income support.

Current spending – Ongoing payments for health, education, defense, and so on.

Capital expenditures – Infrastructure that contributes to the economy’s capital stock and theoretically adds to its productive capacity.

Question 13

Identify fiscal policy targets.

Answer 13

Aggregate demand and, therefore, economic activity.

The distribution of wealth.

The allocation of resources between different subsectors and economic agents.

Question 14

List the roles of the central bank regarding the money supply.

Answer 14

Monopoly supplier of currency and responsibility for monetary policy.

Most central banks also manage the country’s foreign currency and gold reserves.

Central banks are usually responsible for conducting monetary policy.

Question 15

Describe qualities of effective central banks.

Answer 15

Independent and free from political pressure.

Public confidence in the central bank.

Transparent decision making.

Question 16

Give the equation described by the quantity theory of money.

Answer 16

M×V=P×Y

M = Quantity of money
V = Velocity of circulation
P = Price level
Y = Real output
Note: The velocity of money is the number of times a unit of currency changes hands annually to purchase goods and services. Under the quantity theory, velocity is assumed constant.

Question 17

Identify the challenges to the effectiveness of monetary policy in developing countries.

Answer 17

Less liquid bond and interbank market for conducting monetary policy.

Rapid innovation and economic changes make it difficult to identify the neutral rate or define the money supply.

The central bank lacks independence to conduct policy or credibility due to its poor historical record in controlling inflation.

Question 18

Explain the factors that influence the mix of fiscal and monetary policy.

Answer 18

To expand potential output, government should aim to keep interest rates low and fiscal policy tight to avoid crowding out.

To build infrastructure and develop human capital, government should focus on spending in those areas; however, loose monetary policy could cause inflation.

Question 19

Describe what happens when there is easy fiscal policy but tight monetary policy. Then, describe when the opposite occurs with tight fiscal policy and easy monetary policy.

Answer 19

Higher interest rates from tight monetary policy offset potential expansionary effects of easy fiscal policy. The economic outcome is uncertain, but government will expand.

Lower interest rates from easy monetary policy offset potential contractionary effects of tight fiscal policy. The economic outcome is uncertain, but the private sector will expand.

Question 20

Name the reasons why governments do not use discretionary fiscal policy to stabilize aggregate demand.

Answer 20

Recognition lag: Time it takes the government to figure out that the economy is not functioning at potential output. Need time to analyze and understand data.

Action lag: Fiscal actions must be approved by Congress, and before approval there are numerous committee meetings and debates because members have different ideas regarding the most appropriate course of action.

Impact lag: Refers to the time it takes for a fiscal stimulus to flow through the economy and generate the changes in spending patterns that are desired.

Question 21

Identify the most important interest rate in the conduct of U.S. monetary policy.

Answer 21

Fed funds rate (FFR). This is the rate at which banks loan each other funds in the overnight market.

Question 22

Differentiate between monetary and fiscal policy.

Answer 22

Monetary policy refers to the government’s or central bank’s manipulation of the quantity of money and cost of credit in the economy.

Fiscal policy refers to the government’s use of spending and tax policies to influence the economy.

Question 23

Explain why fiscal policy is an important tool for economic stabilization through its impact on output.

Answer 23

In a recession, governments can increase spending and/or reduce taxes (expansionary fiscal policy) to try to raise employment and output.

In an expansion, governments can reduce spending and/or increase taxes (contractionary fiscal policy) to try to control inflation.

Question 24

Name the two automatic stabilizers embedded in fiscal policy.

Answer 24

1. Tax rates increase as income rises (induced taxes).
2. Need-tested spending (government programs that pay benefits to qualified individuals and businesses) increases during recession and decreases during expansion.

Note: Discretionary fiscal actions are those related to tax rates or the level of government spending. Basically, these actions are up to the government’s discretion, as opposed to automatic stabilizers, which act on their own to bring the economy toward full employment.