View
215
Download
0
Category
Tags:
Preview:
Citation preview
Final notes on Fiscal Policy
1
Which tax and government spending policies achieve desired equilibrium levels of national income?Given a desired level of Y, be able to find the
needed G or Tx to achieve it.
When is an increase in government spending, or a decrease in taxes, not inflationary?Not inflationary when increased output is
produced using unemployed resources. Increased spending is inflationary if economy is
at full employment.
Fiscal Policy v Monetary Policy
2
Fiscal Policy– Conducted by legislative and executive
branches of governmentGovernment spending and taxes to stimulate
or slow down the economy
Monetary Policy—Conducted by the Central Bank or Federal
ReserveAimed at influencing the amount of
investment, often through influence over interest rates
Interest Rates
4
Monetary policy is aimed at influencing investment, often through interest rates.
Interest rates -- The price of borrowing (or the payment for lending)
money
For this class, we will assume a single interest rate. E.g., the rate associated with US Treasury BondsIf you buy US Treasury Bonds from the government, you lend
the government money. Used to finance spending and debt.A relatively stable investment with low volatility
Interest Rates
5
Suppose interest rate i = 5%. Buy a 1-year $1000 bond. At the end of the year, the bond pays out $1000 x
1.05 = $1050
Interest rates in the economy help determine the amount of “Investment” or “I”.Remember “investment” or “I” includes plant &
equipment, housing, and inventories (NOT stocks and bonds)
A higher interest rate “i” makes buying bonds more attractive relative to investing in I. So, as i goes up, I goes down.
How i influences I -- Example
6
Firm Project Cost Expected Return
Gomer’s Filling Station
Tow truck 190 10%
Pay at the pump 150 8%
Hydraulic Lift 50 4%
Inventory speculation
35 2%
How does the Fed influence i?
8
So, i helps determine the level of investment in an economy. How does monetary policy work (e.g., how does the government influence i?)
Through the banking system.Federal Reserve or Central Bank controls
money supply.Money supply determines the price of
money, or i.
Banking System
9
Central Bank, aka Federal ReserveControls the central money supply
Fractional Reserve Banking SystemWhere we keep our moneyBanks are allowed to lend out some fraction
of our deposits as investments to others (“fractional reserve” is the fraction that they cannot lend out and must keep as reserves)
What is money?
10
Money is what money does:1. Medium of exchange2. Store of value3. Unit of account
Not the same as currency. Although currency is usually a form of money.
Evolution of Money
11
1. Stage 1: No Money Q: Without money how do people engage in
trade? A: Barter Problem: High transaction costs
2. Stage 2: Goods become treated as money E.g., tobacco in colonies, gold, silver, jewels Problems:
Hard to carry Can be perishable Quality isn’t constant
Evolution of Money
12
Stage 3: Set up a central treasury for valued goodsE.g., tobacco warehouse, where people can deposit
their tobacco. The tobacco is rated, and the depositor is given a bank note stating rights to claim the tobacco.
Now, bank note may be used as money. On gold standard, can take $1 bill to treasury and
exchange for $1 worth of gold (case in US prior to 1971)
Stage 4: Fiat moneyThe government says that money can be used (e.g.,
“for all debts public and private”) If go to treasury, can trade in your $1 bill for another
$1 bill
Philadelphia Goldsmith
13
Goldsmith in 1740 PhillyHas a good safe to keep his goldOffers neighbors the chance to keep there
gold in the safeOn any given day some people take gold
out, other people put gold inObservation: daily balance might go up and
down slightly, but never falls below some level
Good Idea: Lend out some of the money from the vault
Philadelphia Goldsmith Balance Sheet
14
Assets Liabilities
Reserves ($ in vault) $2000 Demand Deposits $10,000
Loans $8,000
Total: $10,000 Total: $10,000
Bank Balance Sheet – same idea
15
Assets Liabilities
Reserves ($ in vault) $1000 Demand Deposits $10,000
Loans $7000
Securities $2000
Total: $10,000 Total: $10,000
Reserve Ratio
16
Reserve Ratio = Reserves / Deposits
Required Reserve Ratio (i.e., RRR) = The minimum reserve ratio as mandated by the Federal Reserve.If the RRR = 0.2, then a bank with $10,000 in
deposits can lend out $8000.
Required Reserves = RRR x DepositsExcess Reserves = Reserves – Required
Reserves
Money Supply
17
Money Supply = Cash On Hand + Total Deposits
The Fed influences money supply by buying or selling government securities (i.e., government bonds).Buy securities => put new money into the
economy => increases the money supplySell securities => take money out of the
economy => decreases the money supply
Buying Securities
18
If the Fed buys $1000 in securities, it increases total money supply by MORE than $1000.
Example: How the $1000 flows through the economy, with a RRR = 0.2 …Fed buys $1000 in securities from Sally, who puts the $
in bankBank holds on to $200 and loans $800 to Fred to buy a
carFred buys the car from Sam who puts the $800 in her
bankSam’s bank keeps $160 in reserves and loans out $640
…In total, the money supply increases up to $5000
Changes to Money Supply
19
Initial injection of $Z into the money supply (i.e., purchase of $Z worth of bonds) changes the total money supply by up to
Z * 1 / RRR
Initial decrease of $Z in the money supply (i.e., sell $Z worth of bonds) changes the total money supply by up to
- Z * 1 / RRR
3 Primary Tools of Fed
21
1. Open Market Operations – Buying and selling government securities (or other assets)
1. Changing the Required Reserve Ratio
1. Setting the Federal Funds Rate – interest rate at which banks can borrow at the Fed
The Fed does not directly set the US treasury bond rate. They announce a target, and achieve it through Open Market Operations.
Market for Money
22
Vertical axis is the price of money, represented by the interest rate, i
Horizontal axis is the quantity of money
Firms, Individuals, etc. determine money demand
The Federal Reserve (Fed) determines money supply
Money Demand
23
Made up of three pieces:Transaction Demand – money on hand for
transactions (money needed for purchases)Precautionary Demand – rainy day funds (money
that might be needed for purchases)Speculative Demand – e.g., hold cash to buy
bonds later if you expect bond rate will rise soon (money you are waiting until the right time to invest)
Taken together => total demand (downward sloping)
Money Supply
24
Typically, if banks have excess reserves, then they lend it out
Money supply is vertical
Market for Money
25
Supply and Demand together
Shifts in Supply when the Fed engages in open market operations or changes the required reserve ratio (RRR)Immediate shiftLong-run shift
Changing Investment through open market operations
26
Fed buys bonds, causing the money supply to increase
Through the market for money, an increase in money supply causes the price of money (i.e., the interest rate, i) to decrease
A decrease in the interest rate increases investment I, as investors become less likely to put their money in bonds and more likely to invest in capital improvement projects, etc.
An increase in investment increases the equilibrium level of national income and output
Changing Investment through open market operations
27
Fed sells bonds, causing the money supply to increase
Through the market for money, a decrease in money supply causes the price of money (i.e., the interest rate, i) to increase
An increase in the interest rate decreases investment I, as investors become more likely to put their money in bonds and less likely to invest in capital improvement projects, etc.
A decrease in investment decreases the equilibrium level of national income and output
Changing Investment through changing the required reserve ratio
28
Fed decreases RRRBanks can loan out more of their deposits,
which increases the money supplyAs money supply increases, the price of
money (i.e., the interest rate i) decreasesA decrease in the interest rate results in
more investmentHigher investment increases national
income
Changing Investment through changing the required reserve ratio
29
Fed increases RRRBanks can loan out less of their deposits,
which decreases the money supplyAs money supply decreases, the price of
money (i.e., the interest rate i) increasesAn increase in the interest rate results in
less investmentLower investment decreases national
income
Causal Arrows
30
Buy Bonds +ΔMS −Δi +ΔI +ΔYSell Bonds −ΔMS +Δi −ΔI −ΔY
−RRR +ΔMS −Δi +ΔI +ΔY+RRR −ΔMS +Δi −ΔI −ΔY
Causal Arrows – Second Order Effects
31
+ΔMS −Δi +ΔI +ΔY
“Second order” effects: +ΔMD +Δi …
When income increases, money demand increases. This causes a “second order effect”
Although the second order effect tends to decrease income (in this case), second order effects are less significant than the initial effect on income. Therefore, the overall change to income will still be positive.
This slide is a technical point that you don’t need to know.
Can you answer this…
32
Buy Bonds +ΔMS −Δi +ΔI +ΔY (A) (B) (C)
(D)
(A)How does buying bonds increase the money supply?
(B)How does an increase to the money supply decrease the interest rate?
(C)How does a decrease to the interest rate increase investment?
(D)How does increasing investment increase national income?
Types of Policy
33
“Expansionary” PolicyAny policy that expands the economyMonetary Policy – Reducing the RRR, buying
bondsFiscal Policy – Increasing G, decreasing Tx
“Contractionary” PolicyAny policy that slows down or contracts the
economyMonetary Policy – Increasing the RRR, selling
bondsFiscal Policy – Decreasing G, increasing Tx
Recommended