5 1 reading 18 monetary and fiscal policy pdf

LOS Economics • Topics in Demand and Supply Analysis • The Firm and Market Structures • Aggregate Output, Prices, And Economic Growth • Understanding Business Cycles • Monetary and Fiscal Policy • International Trade and Capital Flows • Currency Exchange Rates LOS LOS Compare monetary and fiscal policy Monetary Policy • Central bank actions impact availability and price of money and credit Setting interest rates, open market operations, bank reserve ratio requirements Fiscal Policy • Actions by governments Government spending, taxation  Both are macro tools geared towards economic stability and growth, and are government policies  Monetary policy are implemented by central banks, while fiscal policy is implemented through laws LOS LOS Describe functions and definitions of money Three functions of money: Store of Value • Transfers the purchasing power from the present into the future • Non-perishable Unit of Account • Used for price quotations and debt recording • “Yardstick” by which we measure economic transactions Medium of Exchange • Tools used to buy goods and services • Liquid asset for making purchases or settling debts LOS LOS Explain the money creation process Money is created through lending: i Made possible because of Fractional Reserve Lending ii Banks allowed to lend more than they hold in reserves • If the reserve requirement is 20%, banks can lend out 80% of money they receive in deposits i Banks keep lending out 80% of reserves they receive, which creates new money each time • Total amount of money that can be created is equal to: 𝟏 𝐑𝐞𝐬𝐞𝐫𝐯𝐞 𝐑𝐞𝐪𝐮𝐢𝐫𝐞𝐦𝐞𝐧𝐭 = 0.2 =5 LOS LOS Describe theories of the demand for and supply of money Quantity Theory of Money: • Is the hypothesis that changes in prices correspond to changes in the monetary supply • The formula is: 𝑴𝒙𝑽 = 𝑷𝒙𝒀 Where M = Quantity of money V = Velocity of money P = Price level Y = Real output • Three primary drivers of demand for money: Transaction motive: wanting money to make purchases Precautionary motive: wanting to hold money to have in case of emergencies Speculative motive: wanting to hold money for speculation in the future LOS LOS Describe the Fisher effect • The Fisher Effect (named after Irvin Fisher) states that real interest rates are stable, so changes in nominal rates must be due to changes in expected inflation • Therefore, the sum of the required real rate of interest and the anticipated rate of inflation over a given time period gives us the nominal interest rate in the same economy 𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑹𝒂𝒕𝒆 = 𝑹𝒆𝒂𝒍 𝑹𝒂𝒕𝒆 + 𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝑰𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏 • However, investors can never be certain of future values of economic variables such as real growth and inflation This is compensated by a risk premium LOS LOS Describe roles and objectives of central banks What are the roles of central banks? • Currency Regulation: Monopoly issuer of currency notes • Control of Commercial Banks: Regulates and oversees banks • Banker, Fiscal Agent and Adviser to the Govt: Receives deposits and makes payments on behalf of the government • Controller of Credit: Use of Monetary Policy to manage credit availability • Custodian of Cash Reserves of Commercial Banks: Holds reserves and transfers between banks as needed • Lender of Last Resort: Provides funding to banks in times of financial crisis  Primary Objective: ensuring financial stability LOS LOS Contrast the costs of expected and unexpected inflation Expected Inflation • Economic agents price in the effects of inflation they expect to occur in the future • Internet has reduced the effects on transactions because fewer are made in cash  Menu costs and Shoe leather costs are byproducts of expected inflation vs Unexpected Inflation • Reduces the information economic agents can get from market prices • Lenders require higher rates to deal with higher uncertainty • Inequality, information asymmetry, and risk premiums are byproducts of unexpected information LOS LOS Describe tools used to implement monetary policy Banks use the following tools to implement monetary policy: Interest Rate Policy • Central bank influences rates at which banks lend money Open Market Operations • Central banks buys or sells securities to commercial banks • Actions add or remove money from the economy Reserve Requirements • Changes how much of banks’ reserves they are able to lend LOS LOS Describe the monetary transmission mechanism How monetary policy decisions impact economic growth and asset prices? • Traditional Interest Rate Channels Decreasing interest rates leads to more borrowing and investment • Balance Sheet Channel Easing monetary policy increases stock and asset prices, which leads to increased investment • Household Liquidity Effects Increased wealth from rising asset prices leads to more consumption purchases • Bank Lending Channel Increased deposits resulting from loose monetary policy lead to more lending activity LOS LOS Describe the monetary transmission mechanism Other Asset Price Effects on Monetary Policy: • Wealth Effect: Effects on stock prices caused by monetary policy consequently influence financial wealth and consumer spending on non-durable goods and services • Exchange Rate Effects on Net Exports: The real interest rates and exchange rates lead to changes in the net exports LOS LOS Describe qualities of effective central banks • Transparency i Central banks should produce regular reports outlining economic conditions ii The decision-making process should be well known and consistent • Independence i Central banks must be free from political influence ii Central banks must be willing to reduce money supply and slow growth when needed to control inflation • Credibility i The public must believe in bank’s actions and reasons for acting LOS LOS Explain the relationships between monetary policy and economic growth, inflation, interest, and exchange rates • Economic Growth Expansionary policy spurs economic growth by increasing money supply and lowering rates • Inflation A contractionary policy slows inflation by contracting money supply • Interest The monetary policy influences interest rates for lending • Exchange Rates An expansionary policy increases a country’s exchange rates relative to other countries LOS LOS Contrast the use of inflation, interest rate, and exchange rate targeting by central banks • Interest Rates The central bank has a policy rate at which it lends to commercial banks • Inflation Target Independence represents the degree of freedom that central banks have to set and work towards a target level of inflation Central banks try to increase (decrease) the money supply to increase (decrease) the rate of inflation • Exchange Rates Higher interest rates lead to higher exchange rates for a country’s currency LOS LOS Determine whether a monetary policy is expansionary or contractionary • Expansionary Policy Intended to increase the supply of money and the lending activity i Buy securities in the open market ii Reduce the discount rate iii Decrease the reserve requirements • Contractionary Policy Intended to decrease the money supply and the lending activity, and to slow inflation i Sell securities on the open market ii Increase the discount rate iii Increase the reserve requirements LOS LOS Describe limitations of monetary policy • Deflation Central banks may reduce rates to without being able to reverse deflationary forces • Severe Decrease in Lending Activity The Fed can influence lending, but cannot force banks to increase the lending activity • Liquidity Trap Short-term interest rates can be stuck at Trying to increase money supply only keeps interest rates low • Bond Market Vigilantes Bond market participants who can reduce demand for long-term bonds, which causes yields to rise Attempts to increase economic growth through money supply won’t work if participants don’t invest extra money LOS LOS Describe roles and objectives of fiscal policy Fiscal policy has similar objectives to monetary policy in that it can: • Promote stable economic growth • Manage inflation • Encourage investment activity • Encourage consumption and spending increases • Ensure equal distribution of resources LOS LOS Describe tools of fiscal policy, including their advantages and disadvantages • Spending Tools i Capital expenditures (long-term spending) ii Current spending (recurring goods and services) iii Transfer payments (social security and welfare systems) ⁺ ⁺ ⁻ ⁻ Increases aggregate demand Reduces unemployment rate Capital spending takes time to implement Too much recurrent spending depletes reserves • Revenue Tools i Taxation policies (direct or indirect taxes) ⁺ Taxing certain behaviors discourages those activities (“sin taxes”) ⁺ Tax subsidies encourage investment ⁻ Taxes are unpopular and can be politically challenging to implement LOS LOS Describe the arguments about whether the size of a national debt relative to GDP matters National Debt is the total amount of money owed by a government • Large debt balance can cause instability: Investors lose confidence The government must reduce spending to cover interest payments Increased currency printing can increase inflation • Historically, these concerns not usually cause significant problems • Situations when debt levels are a problem: When debt is denominated in other countries’ currencies When economic growth is low for extended periods When government spending is in deficit during periods of growth LOS LOS Explain the implementation of fiscal policy and difficulties of implementation Fiscal policy are enacted through passage of laws Common difficulties: • Time Lag Delay between observed economic pattern and enacting of policy change • Inaccurate Information Policy changes based on predictions of future, which may not play out • Recognition and Impact Lag It takes time to recognize economic patterns, new policies enacted also take time before impact is felt • Uncertainty in the Economic Future Crowding-out and Public Spending Side Effects LOS LOS Determine whether a fiscal policy is expansionary or contractionary • Expansionary Policy Intended to spur economic activity and growth i Deficit spending ii Tax cuts/subsidies • Contractionary Policy Policies intended to decrease the level of government debt and slow inflation growth i Budget surplus ii Increase tax rates LOS LOS Explain the interaction of monetary and fiscal policy • Monetary and Fiscal policy both have either contractionary or expansionary effects When in conflict, they may cancel each other out • Increased government spending (fiscal) and increased money supply (monetary) may cause excess growth and inflation  They should ideally be coordinated to achieve optimal economic outcomes LOS Economics • Topics in Demand and Supply Analysis • The Firm and Market Structures • Aggregate Output, Prices, And Economic Growth • Understanding Business Cycles • Monetary and Fiscal Policy  International Trade and Capital Flows • Currency Exchange Rates ...LOS LOS Compare monetary and fiscal policy Monetary Policy • Central bank actions impact availability and price of money and credit Setting interest rates, open market... of fiscal policy and difficulties of implementation Fiscal policy are enacted through passage of laws Common difficulties: • Time Lag Delay between observed economic pattern and enacting of policy. .. Market Structures • Aggregate Output, Prices, And Economic Growth • Understanding Business Cycles • Monetary and Fiscal Policy  International Trade and Capital Flows • Currency Exchange Rates