Unit 3: Chapters 13, 14, 15 Flashcards
Fiscal policy
changing the levels of government spending and taxes to stabilize the economy, i.e., achieve potential real GDP, the natural rate of unemployment, and price stability.
Should be counter-cyclical
Objective of Expansionary fiscal policy
to close a recessionary gap (recession) by increasing aggregate demand
Objective of Contractionary fiscal policy’s
to close an inflationary gap (boom) by decreasing aggregate demand
Fiscal policy can be either….
Discretionary or non discretionary
Discretionary or active fiscal policy
means that Congress actually meets to implement changes in government expenditures and/or taxes to close an output gap
Negative GDP gap or recession characteristics & solution
1.High unemployment (cyclical) inflation
- Actual GDP < potential real GDP
- Unemployment rate > natural rate
Solution: increase aggregate demand
Positive GDP gap or economic boom characteristics and solution
- Demand-pull inflation
- Actual GDP > potential real GDP
- Unemployment rate < natural rate
Solution:
Decrease aggregate demand
Expansionary fiscal policy—
Policy options/anticipated effect/final result
Policy options for Congress:
- Increase government spending
- Increase investment tax credit
- Reduce corporate income tax rate
- Reduce personal income taxes
- Increase transfer payments
- Incur a budget deficit
Anticipated effect:
Aggregate demand increases
Final result: 1.Unemployment falls 2.Negative GDP gap closed 3.Actual GDP = potential real GDP 4.Unemployment rate = natural rate
Contractionary fiscal policy–
Policy options/anticipated effect/final result
Policy options for Congress:
- Reduce government spending
- Reduce investment tax credit
- Increase corporate income tax rate
- Increase personal income taxes
- Decrease transfer payments
- Incur a budget surplus
Anticipated impact on the economy:
Aggregate demand decreases
Final result:
- Demand-pull inflationary pressures fall
- Positive GDP gap closed
- Actual GDP = potential real GDP
- Unemployment rate = natural rate
Level of taxes increase
1.TX ↑ Income ↓ C ↓ (S ↓) GDP ↓
2.If taxes increase by $x,then disposable income decreases by $x
3.If disposable income decreases by $x,then C decreases (and S decreases)
4.If C decreases,then real GDP decreases
Level of taxes decrease
1.TX ↓ Income ↑ C ↑ (S ↑) GDP ↑
2.If taxes decrease by $x,then disposable income increases by $x
3.If disposable income increases by $x,then C increases (and S increases)
4.If C increases, then real GDP increases
Non-discretionary fiscal policy
(automatic stabilizers, built-in stability) passively manipulates aggregate demand
built-in stabilizer
1.Increases the government’s budget deficit (or reduces its budget surplus) during a recession
both of which are expansionary
2.Increases the government’s budget surplus (or reduces its budget deficit) during an expansion both of which are contractionary
automatic stabilizer examples
1.Personal income tax, corporate income tax, sales tax, payroll tax revenues
2.Unemployment compensation
3.Welfare payments
Advantages of the automatic stabilizers
1.The automatic stabilizers are “built-in” to federal government programs, therefore the dollar amounts change with no explicit action taken by Congress
2.The automatic stabilizers do not suffer from some of the timing problems of discretionary fiscal policy. No recognition lag and no administrative lag
Problems with state and local government fiscal policies offsetting federal fiscal policy
State fiscal policy is pro-cyclical or destabilizing because state governments have legal requirements to annually balance their budgets
Problem of the crowding-out effect
An expansionary fiscal policy designed to increase aggregate demand will increase the budget deficit. If the deficit is financed by an increase in government borrowing, interest rates will increase causing private-sector investment spending (IG) to fall. The “crowding out” of investment reduces aggregate demand and, thus, weakens the impact of an expansionary fiscal policy.
Problems with implementing fiscal policy in an open economy (foreign sector)
Net export effect arises because international flows of financial capital are seeking the best interest rate. Net export effect weakens the impact of fiscal policy
Budget deficit (G > Tx)
Amount by which government expenditures exceed tax collections in a given year.
Budget surplus (G < Tx)
Amount by which tax collections exceed government expenditures in a given year
Public (national) debt
Accumulation of federal budget deficits and surpluses over time
Public debt consists of
Treasury bills, Treasury notes, Treasury bonds, and U.S. savings bonds.
Sources or causes of budget deficits and thus a large public debt
1.Wars
2.Recessions
3.Lack of fiscal discipline by Congress
Federal government can meet its financial obligations by:
1.Refinancing maturing Treasury securities
2.Increasing taxes
3.Creating money (through the Federal Reserve in a national emergency)
Externally-held debt
is an economic burden to Americans
Interest payments and repayment of principal transfers funds to foreign lenders
Crowding-out of private investment
is an economic burden to future generations
Barter
refers to the exchanging of one good for another good
Problems associated with barter
- Trade requires a double coincidence of wants
- No common unit of account to measure relative value
- Opportunity cost of making a transaction is high
The only requirement for anything to serve as money is that it must be
Socially acceptable
Money promotes economic efficiency because it…
1.Overcomes the problems associated with barter
2.Promotes specialization and trade
3.Increases real output and standard of living
Three functions of money
1.Medium of exchange
2.Unit of account: Allows people to measure relative value; the “price” of something.
3.Store of value: Allows people to transfer purchasing power from the present to the future.
Commodity money
Intrinsic value: the value of the physical material
If intrinsic value exceeds the face value, then
It takes out of circulation; ceases to function as money
Fiat money
1.No intrinsic value
2.Token money: Government makes sure that the face value exceeds its intrinsic value
3.Not backed by any commodity
4.Social acceptability of what is no more than a fiction or belief
5.Legal tender means that Federal Reserve Notes and coins must be accepted as payment for all debts, public and private
Paper money in the United States is in the form of
Federal Reserve Notes
Issued by the 12 Federal Reserve banks
The backing for the money in the United States comes from
Legal tender
Value of money is determined by:
- Social acceptability
- Legal tender
- Scarcity
The purchasing power of money ($V)is _______ related to the price level (P)
Inversely
12 Federal Reserve abanks
Quasi-public banks: owned by the commercial banks, not the federal government
FOMC
Twelve people including the 7 members of the board of governors
FOMC meets eight times a year (about every six weeks) to assess economic conditions and make decisions regarding monetary policy and open-market operations
Federal Reserve Act in 1913
Federal Reserve became the central bank of the United States
Board of Governors
Seven people appointed by the president, with the confirmation of the Senate, who serve fourteen year terms
Responsibilities of the Board include:
a.Supervise the activities of the Federal Reserve banks
b.Regulate commercial banks
c.Formulate and implement monetary policy
Functions of the Federal Reserve
A.Issue currency (Federal Reserve Notes)
B.Reserves
1.Set the reserve requirement (a tool of monetary policy)
2.Hold the deposits of commercial banks, called reserves
C.Lend money to commercial banks
1.Set the discount rate (a tool of monetary policy)
2.“Lender of last resort” to commercial banks
D.Provide for check clearing
E.Act as fiscal agent for the United States government, in other words, the United States Treasury has its “checking account” at the 12 Federal Reserve Banks
F.Supervise and regulate commercial banks
G.Control the money supply
The M1 money supply consists primarily of:
c.currency in circulation and checkable deposits.
Currently, U.S. paper currency is issued by the
12 Federal Reserve Banks
If you write a check on your commercial bank account to purchase anything, say common stocks, this is an example of money functioning as a
Medium of exchange
When people hold some of their wealth as money because it enables them to transfer purchasing power from the present to the future money functions as a
Store of value
Assume the economy is at its full-employment real GDP. Which of the following would most
likely result if the federal government increased spending without increasing tax revenues?
c.an increase in the price level
During the past twelve months unemployment has been under 5 percent and the GDP price index has increased by 2%. Total production of goods and services is projected to be 5% higher in the next twelve months. Which of the following policies would be most appropriate for short-run stabilization purposes?
D. Relying on the automatic stabilizers
100% reserve banking system
ASingle bank holds all deposits “in reserve” or in its vault
B.Only one function of a bank, they are just a safe place to keep money
Accept deposits (from savers) Þ Bank Þ Keep all the money in a secure vault
Banks do not make loans with depositor’s funds
Fractional-reserve banking system
ASingle bank holds only a fraction of deposits “in reserve”
B.Two functions of a commercial bank in a fractional-reserve banking system
Accept deposits (from savers) Þ Bank Þ Make loans (to borrowers)
Banks create money by using your deposits (their reserves) to make a loan
Other characteristics of fractional reserve banking
1.Legal reserve requirement is less than 100% (currently 10%), thus commercial banks hold less in reserves than the amounts they owe their depositors.
2.Banks are vulnerable to bank panics or runs
In the U.S., a major deterrent to bank panics is the FDIC
Balance sheet
summarizes the financial position of the bank at a given point in time
Assets
Items that the bank owns
Liabilities
Claims of the non-owners against the banks assets
Owners equity
Claims of the owners of the bank against the banks assets
Reserves are:
Deposits received by a bank but have not been loaned out
Reserves are physically held as:
A) vault cash at the commercial bank
B) deposits at the regional Federal Reserve bank
Banks assets are its:
Uses of funds (for loans, buying securities, equipment etc)
Bank liabilities (from deposit accounts) and owners equity serve as
Sources of funds
Required reserves
Legal reserve requirement or reserve ratio is set by the Fed’s Board of Governors
The primary function of reserves and the reserve ratio is
to give the Fed control over the lending or money-creating ability of commercial banks
Required reserves are
Minimum reserve balance that a commercial bank must keep in its reserve account
To calculate required reserves
Required reserves = Checkable-deposit liabilities x Reserve ratio
To calculate excess reserves
Actual reserves = Required reserves + Excess reserves
Excess reserves = Actual reserves − Required reserves
Single bank can only lend up to its pre-loan excess reserves because
it faces the possibility that it will lose those excess reserves to other banks when the entire amount of the loan is drawn and cleared against it.
Check clearing
- Bank against which a check is drawn and cleared loses both reserves and deposits
- Bank in which a check is deposited gains both reserves and deposits
A single commercial bank creates money when it uses its excess reserves to:
- Make a Loan
Monetizing an IOU or create checkable deposits in exchange for IOUs.
A promissory note (which is not money) is exchanged for a check (which is money); - Buy gov bonds from public
A government bond (which is not money) is exchanged for a check (which is money)
A single commercial bank destroys money (reduces M1) when:
1.Bank loans are repaid
2.Banks sell government bonds (Treasury securities) to the public
Managing a profit-maximizing commercial bank
A.Liability management seeks to attract funds (deposits) at low cost
B.Asset management seeks to profit with the funds the bank acquires from depositors by making loans and purchasing government securities
C.Liquidity management
1.Have sufficient funds in the reserve account to meet deposit outflows and the minimum reserve requirement
If a bank has insufficient funds to meet its reserve requirements the options available to avoid being penalized by the Fed are:
a.Borrow reserves overnight in the federal funds market,
paying the other commercial bank the federal funds rate
b.Call in loans and/or sell Treasury securities
c. Tender of last resort
Four steps needed to calculate the maximum money-creating ability of the banking system
1.Calculate required reserves
2.Calculate excess reserves
3.Calculate the deposit or money multiplier (m) = __________1___________
Legal reserve requirement
The finite number representing the money multiplier is the sum of the infinite geometric series involved in the deposit – loan chain reaction
4.Maximum money-creating ability of the banking system = Money multiplier (m) x Excess reserves in the banking system
The banking system can create money up to a multiple of its excess reserves because
the banking system cannot lose reserves.
The simple money multiplier (m) assumes:
1.The public does not hold any cash
2.Banks are fully loaned up or hold no excess reserves
The money-creating ability of the banking system is reduced when:
1.The public decides to hold currency
2.Commercial banks decide to hold excess reserves.
In a 100% reserve banking system:
d.banks serve only as a place for the safe-keeping of money and are prevented from making loans.
In a 100% reserve banking system the money multiplier is
1
In a 10% reserve banking system the money multiplier is
10
A commercial bank creates money when:
c.the bank creates checkable deposits in exchange for IOUs or lends its excess reserves.
The legal reserve requirement is 10%. A check for $1,000 drawn on 1st National Bank anddeposited in 2nd National Bank will increase the excess reserves of 2nd National Bank by
$900
A commercial bank temporarily short of required reserves may replenish reserves by:
b.borrowing reserves in the federal funds market.
In a ——- commercial banks create money through lending and therefore hold less in reserves than the amounts they owe their depositors.
fractional reserve banking
To find by how much C decreases when taxes increase use:
MPC x D Disposable income = D C
To find by how much GDP decreases when taxes increase and consumer spending decreases use:
D Real GDP = multiplier x D C
D(Change)
To find by how much C increases when taxes decrease use:
MPC x D Disposable income = D C
To find by how much GDP increases when level of taxes decrease use:
D Real GDP = multiplier x D C
