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Reading 16: Monetary and Fiscal Policy (Fiscal policy (Balance Budget…
Reading 16: Monetary and Fiscal Policy
Money
Definition
: the widely accepted medium of exchanges.
Function
Medium of exchange
A store of value
An account unit
Money Multiplier
Formula:
\( M=\frac{1}{Reserve Ratio}\)
Fractional reserve banking system
: Bank is required to hold a fraction of its deposit in reserve
Money Multiplier
:
show the potential increase of money supply.
If original money amount = $1,000 and M=4 --> potential increase = $4,000
Factors influencing Money demand and supply
Money demand
Transaction demand (to buy G&S), increase with GDP
Precautionary demand (to meet unforeseen future need), increase with GDP
Speculative demand (to take advantages of investment opportunity); smaller when current returns are high, greater when risk perceived is high
Money Supply
Central bank's goals (regarding inflation & other objectives)
Fisher effect
:
Riskless Nominal rate = Real rickless rate + expected inflation rate
If there is any uncertainty about inflation rate, it must have an extra premium to compensate such uncertainty
Money neutrality
changes in the money supply affect the prices of goods, services, and wages but not overall economic productivity, thus aggregate supply should remain constant.
Narrow vs. Broad Money
Narrow money
M1 in US and Eurozone
Currency in circulation
Checkable deposits
Travelers checks
Broad money
M2 in US, M3 in Eurozone
Savings deposits
Time deposits < $100,000
Money market mutual funds
Equilibrium in Money Market
Money supply is inelastic (vertical
Money demand is downward-sloping
\(i^{*}\) is the equilibrium interest rate.
\(S^{*}\) is the equilibrium amount of real money
\(i_{1}>i^{*}\)
\(S_{1} < S^{*}\)
excess supply of money, leading to purchases of securities --> securities prices increase --> interest rate decreases
\(i_{2} < i^{*}\)
\(S_{2} > S^{*}\)
excess demand for money, leading to sales of securities --> securities prices decrease --> interest rate increases
Central Bank
Role
Supplying currency
Acting as banker of government and other banks
Regulating/ supervising the payment system
Acting as lender of last resort
Holding the nation's gold and foreign currency reserves
Conducting monetary policy
Objectives
Managing price stability
Costs of inflation
Expected costs
Cash balance is reduced (due to high opportunity cost of holding cash)
Unexpected costs
Information value of price change is reduced
make economic cycles worse
Shift wealth from lender to borrowers
Decrease business investment.
Less reliable supply/ demand information in price changes
Maintaining currency stability, full employment, positive and sustainable economic growth
Moderating long-term interest rate.
Qualities of Central Bank
Independence
Free from political interference.
Operational independence
: free to set policy rate
Target independence
: Sets inflation target, measures inflation, determines horizon to meet target.
No absolute; viewed as degree of independence
Credibility
Follow through on its stated policy intentions.
Transparency
Report clearly on economic indicators being used.
Monetary Policy
Monetary policy transmission mechanism
Via asset prices
Via expectations for economic activity and future policy rate changes
Via exchange rate with foreign currencies
Via short-term bank lending rates
Effect on economy
Contractionary policy
Decrease economic growth
Increase market interest rate.
Decrease money supply
Appreciate domestic currency
Decrease inflation
Expansionary policy
Increase aggregate demand
Decrease interest rate
Increase the money supply
Depreciate domestic currency
Identifying contractionary and expansionary policy
Real trend rate
: long-term sustainable real growth rate of economy
Neutral rate
= real trend rate + targeted inflation rate
Neutral rate > Policy rate
Expansionary
Neutral rate < policy rate
Contractionary
Limitations
Inflation expectations change, causing long-term interest rates to move opposite to short-term interest rate.
Liquidity trap
: if demand for money is very elastic, people will hold currency even as money supply increases.
If monetary tightening is extreme, expectations of recession may make long-term bonds more attractive, decreasing long-term rates.
Banks may wants to increase capital and not increase lending in response to expansionary monetary policy
Short-term rates cannot be < 0, limits a central bank's ability to act against deflation
Definition
：management of the supply of money and credit
Monetary Policy Tools
Policy Rate
:
Interest rate that central banks charge banks for borrowed reserves
Increasing the rate
discourages banks from borrowing reserves --> banks reduce their lending
Decreasing the rate
tends to increase the amount of lending and the money supply
The US Fed sets a target for
fed funds rate
, the rate at which banks lend short-term to each other
Open-market operations
Most often used
Central banks buy government securities for cash, reserve increase, money supply increases.
Selling securities decreases the money supply
Quantitative easing
Required reserved ratio
Seldom changed
Reducing required reserve percentage increases excess reserves and increases the money supply
Increasing required reserve ratio decreases the money supply
Monetary Policy Transmission
Effects of expansionary monetary policy
Market interest rates fall, less incentive to save
Asset prices increase, wealth effect, consumption increases
Expectations for economic growth increase, may expect further decreases in interest rate
Domestic currency depreciates, import prices increase, export prices decrease
Overall. aggregate demand increases, increasing real GDP, employment and inflation
Targets
Interest rate targeting
Increase (decrease) money supply growth when interest rates are above (below) targets
Inflation targeting
Target band for inflation rate (1%-3%)
Increase money supply growth when inflation is below target band.
Decrease money supply growth when inflation is above target band
Target inflation band > 0 to prevent deflation
Exchange rate targeting
Target band for currency exchange rate with developed country
Sell (buy) domestic currency when above (below) target
Central bank won't react to domestic economic conditions
Results: Same inflation rate in domestic economy as in targeted developed country
Fiscal policy
Introduction
Definition
:
Government use of taxation and spending to influence the economy.
Objectives
Influence level of economic activity
Redistribute wealth and incomes.
Allocate resources among industries
Fiscal policy tools
Spending tools
Transfer payment
Government current spending (buy stuffs)
Government capital spending (project, investment)
Revenue tools
Taxation
Direct
: levied on income or wealth
Take time to implement
Indirect
: levied on goods and services
Quick to implement to raise revenue or promote social goals
Pros and Cons
Pro
quickly implement social policies
quickly raise revenues at low cost
Cons
take time lag in order to have impact
Implementation delay
Recognition lag
:
Policymaker may not immediately recognize when fiscal policy changes are needed
Action lag
:
Government take time to enact needed fiscal policy changes
Impact lag
: fiscal policy changes take time to affect economic activities.
Lags can cause fiscal policy to destabilize, instead of stabilize
If economy is at full employment, fiscal stimulus will result in higher inflation
If economy is below full employment due to supply shortage, fiscal stimulus will lead to inflation rather than GDP growth
fiscal policy cannot address stagflation (high unemployment and high inflation)
Arguments toward fiscal debts
Should concern because
Higher future taxes cause disincentive to work --> decrease GDP growth
Debt can become risky --> interest rate rise --> country may default or expand money supply, causing inflation
Crowding-out effect as government borrowing increase interest rates and decreases private sector investment.
Should not concern because
If deficits is to finance capital investment, future GDP will be higher
Deficits don't matter if Ricardian equivalence holds
When economy is operating below full employment, deficits do not crowd out private investment.
Identifying contractionary and expansionary policy
budget surplus (deficit)
: when tax revenues > (<) government spending.
budget surplus increase (deficit decrease) --> contractionary policy
budget surplus decrease (deficit increase) --> expansionary policy
Effects on economy
Expansionary
Increase spending
Decrease taxes
Increase budget deficit
Increase aggregate demand
Contractionary
Decrease spending
Increase taxes
Decrease budget deficit
Reduce aggregate demand
Arguments
Keynesian
Discretionary fiscal policy
can stabilize the economy
increasing aggregate demand to combat recessions
decreasing aggregate demand to combat inflation
Monetarists
Effects are temporary (so don't do it) and appropriate monetary policy will dampen economic cycles
Automatic stabilizers
(tax and transfer payments) tend to increase deficits during recession and decrease deficits during expansions
Balance Budget Multiplier
Spending increase to raise consumption
Fiscal Multiplier
\(=\frac{1}{1-MPC(1-t)}\)
MPC: Marginal propensity to consume
t: tax rate
Initial government spending has a multiplied effect as it creates more spending
Increase in consumption = Government spending x Fiscal mutiplier
Tax increase to reduce consumption
Tax Multiplier
Consumption reduced (initial) = MPC x (amount of tax revenue increased)
(Total) reduced consumption = Reduced consumption (initial) x Fiscal mutiplier
Government spending is financed by tax income
Usually the balance budget multiplier is
positive
(consumption increased > consumption decreased)
A balance government budget will overtime increase aggregate demand
Ricardian Equivalence
If a tax decrease causes taxpayers to anticipate higher future taxes, they will save more --> decrease in spending --> reduce the expansionary impact of a tax cut
Ricardian equivalence
: the increase in saving (decrease in consumption) just offsets the tax decrease
An increase in spending funded by issuing debt will have no impact on aggregate demand
Government Debt Ratio
\(=\frac{Debt}{GDP}\)
If real interest rate on Government Debt < Real growth rate, debt ratio will decrease overtime (opposite also true)
Interaction between Monetary and Fiscal Policy
Both MP and FP are Contractionary
strong contractionary effect
Higher interest rate
Lower GDP output
Lower both public and private spendings
Both MP and FP are Expansionary
Strong expansionary effect
Lower interest rate
Higher GDP output
Higher both public and private spendings
Contractionary MP and Expansionary FP
Higher interest rate
Public sector spending grows
GDP output grows
Expansionary MP and Contractionary FP
Lower interest rate
Consumption, GDP output, and private sector spending expand
Public sector spending shrinks