Transcript Chapter 13

Macroeconomic
Policy
Fundamentals
Chapter 13
Discussion Topics
Characteristics of money
Federal Reserve System
Changing the money supply
Money market equilibrium
Effects of monetary policy on economy
The federal budget deficit
The national debt
Fiscal policy options
Functions of Money
Medium of exchange – facilitates payment to
others for goods and services
Unit of accounting – assessing profitability of
businesses, household budgets and aggregate
variables like GDP
Store of value – money is a liquid asset which
has value in investment portfolios and cash
flow decisions of businesses and households
Page 299
Functions of the Fed
1.
2.
3.
4.
Supply the economy with paper currency
Supervise member banks
Provide check collection and clearing services
Maintain the reserve balances of depository
institutions
5. Lend to depository institutions
6. Act at the federal government’s banker and
fiscal agent
7. Regulate the money supply
Page 302-303
Location of the 12 District
Federal Reserve Banks
Page 301
Changing of the Guard
Alan Greenspan
Ben Bernanke
The Fed’s Policy Tools
 Reserve requirements – depository institutions
are required to maintain a specific fraction of
their customers’ deposits as reserves.
 Discount rate – rate depository institutions pay
when they borrow from the Fed
 Open market operations – Fed can buy or sell
government securities to alter the money
supply
Page 304 – 305
Role of the Board of
Governors of the
Federal Reserve System
Page 303
Role of the Board of
Governors of the
Federal Reserve System
Page 303
Role of the Board of
Governors of the
Federal Reserve System
Page 303
Key role played by the
Federal Open Market
Committee or FOMC
Page 303
Recent Fed Rate Actions
Role of the 12 District
Federal Reserve Banks
located throughout
the country
Page 303
Determinants
of the
Money Supply
Existing money supply
curve. Note it is
perpendicular to the
quantity axis, implying
it is unaffected by the
interest rate.
Page 309
Expansionary monetary policy
actions will shift the MS
curve to the right over a
period of 12 months or so.
Page 309
Contractionary monetary
policy actions, on the
other hand, will shift the
money supply curve to
left over a similar time
period.
Page 309
Suppose a depositor in Bank Ag sells $1 million in government securities
to the Fed. He then deposits the proceeds from the sale in his bank. If
the fractional reserve requirement ratio is 20 percent, Bank Ag can
increase the volume of its loans by $800,000. Suppose the proceeds of
these loans are deposited in Bank B. Follow the trail to the Total line.
Page 307
Change in the Money Supply
We can skip tracing deposits through the economy by
using the following money supply (MS) equation:
MS = (1.0 ÷ RR) × TR = MM × TR
where TR represents total reserves and RR is the
reserve requirement ratio. The expression with the
brackets is known as the money multiplier.
We can restate this equation in terms of the change in
the money supply as follows:
MS = (1.0 ÷ RR) ×  TR = MM × TR
Page 307 – 308
Change in the Money Supply
Using the example in Table 13.3 of the $1 million
deposit on page 307 and 20% reserve requirements
ratio, we see that the change in the money supply is:
MS = (1.0 ÷ .20) x TR
= 5.0 x $1 million
= $5 million
This results in a change in loans of
loans = MS - TR
= $5 million - $1 million
= $4 million
See bottom line
in Table 13.3
Page 307 – 308
Change in
money supply
Change in
= loan volume
Initial
+ infusion
Page 307
Impacts of Policy Tools
Expansionary actions:
Fed buys securities
Fed lowers the discount rate
Fed lowers required reserve ratio
Effects of action:
Total reserves increase
Total reserves increase
Money multiplier increases
Greenspan
Page 308 - 309
Impacts of Policy Tools
Expansionary actions:
Fed buys securities
Fed lowers the discount rate
Fed lowers required reserve ratio
Effects of action:
Total reserves increase
Total reserves increase
Money multiplier increases
Contractionary actions:
Fed sells securities
Fed raises the discount rate
Fed raises required reserve ratio
Effects of action:
Total reserves decrease
Total reserves decrease
Money multiplier decreases
Greenspan
Page 308 - 309
Determinants
of the
Money Demand
Demand for Money
Transactions demand for money – carry
cash to pay for normal expenditures
Precautionary demand for money – carry
cash to cover unexpected expenditures
Speculative demand for money – hold
cash as an asset in investment portfolios
since the value of cash does not decline
during periods of falling asset prices.
Page 310 - 311
The money demand curve
is given by equation (16.5):
MD = c –d(R) + e(NI)
where R is the rate of
interest and NI is national
income. The coefficient d
is the slope of the curve and
e represents MD÷ NI.
Page 311
Increase in income
increases demand
for money
MD = c –d(R) + e(NI)
Page 311
Money market interest
rate given by intersection
of demand and supply
Page 311
M S*
0.06
Expansionary
monetary policy
lowers interest
rates
Page 311
M S*
0.14
Contractionary
monetary policy
raises interest
rates
Page 311
The full effects of this change
could take 12 months or more
to register in bank deposits
Page 312
A change in the money
supply will alter the
equilibrium interest rate
in the money market
Page 312
We know from Chapter 12
that a change in interest
rates will lead to movement
along the planned investment
function….increasing or
decreasing new investment
Page 312
We also know from Chapter
12 that increased investment
expenditures, a component
of GDP, increases the demand
for labor, lowers unemployment
and thus fuels further growth
in national income…
Page 312
Eliminating
Recessionary and
Inflationary Gaps
What is the
magnitude of the
recessionary gap?
Page 313
What is the
magnitude of the
recessionary gap?
It is YFE – Y1
Page 313
The use of expansionary
monetary policy actions
to push aggregate demand
from AD1 to AD3 increases
real GDP from Y1 to Y3
while only increasing the
general price level to P3.
Page 313
Inflation rate
(P3 – P0) ÷P0
Recessionary gap
of YFE – Y1 is
partially closed to
YFE – Y3
Page 313
The further use of
expansionary monetary
policy to push aggregate
demand from AD3 to AD4
increases real GDP from
Y3 to YFE (full employment
GDP), but increases the
general price level to P4.
Page 313
Inflation rate
(P4 – P3) ÷P3
Recessionary gap
fully closed
Page 313
The use of expansionary
monetary policy to attain
YPOT by shifting aggregate
demand to AD5 will increase
the general price level to P5.
Inflation rate
(P5 – P4) ÷P4
Inflationary gap
created…..
Page 313
Microeconomic
Interest Rate
Implications
Interest Rate Impacts on a 10Year $150K Business Loan
Interest
rate
Annual
total PI
payment
Annual
interest
payment
Total
interest
payment
8 percent
$22,354.69
$7,354.69
$73,546.90
14 percent
28,757.67
13,757.67
137,576.88
20 percent
35,782.44
20,782.44
207,824.40
Page 315
Interest Rate Impacts on a 20Year $100K Home Mortgage
Interest
rate
Monthly
total PI
payment
Monthly
interest
payment
Total
interest
payment
8 percent
$848.78
$432.08
$103,707.46
12 percent
1,115.73
699.06
167,773.46
Page 315
What is Fiscal Policy?
Taxation by federal,
state and local
governments
Government
spending by federal
state and local
governments
Budget deficit and
the national debt
Page 316
States Without Income Tax
Eight states do
not have a state
income tax
State and Local Taxes
Alaska, thanks to oil
reserves, has the
lowest tax burden
Maine registering the
highest has the
highest tax burden
Major sources are
sales taxes and
property taxes
Our focus is on fiscal policy at
the federal level….
Rising spending and
tax cuts to spur the
economy brought back
budget deficits
Page 318
Individuals and not businesses pay the
Bulk of federal taxes.
Page 318
The effects of 9/11 and
increased spending
plus tax cuts to
stimulate the economy
led to record high
deficits…
A strong economy and
controlled spending led
to the first budget surplus
in more than 20 years…
Page 320
Recent Trends in Deficit
• Typically the economy
runs a budget deficit at
the federal level
• 1998-2001 were the
exceptions in recent
years
• Fueled by growing
economy and falling
interest rates
Debt and the Deficit
National debtT = National debtT-1 + DeficitT
The growth in federal
spending has grown
rapidly over the last 20
years…
Page 321
While the national debt grew as
deficit spending dominated the
1980s and 1990s, debt as a percent
of GDP stayed within post-WW II
experience…
Page 322
Federal government
spending on Agriculture
programs is the fourth
highest on this list of
total federal spending.
Fiscal Policy Options
Automatic fiscal policy instruments: take
effect without explicit action by
policymakers (e.g., progressive tax rates)
Discretionary fiscal policy instruments:
require explicit actions by the president
or Congress (e.g., passing a law)
Page 324
Impacts of Policy Tools
Expansionary actions:
Cut taxes
Increase government spending
Effects of action:
Increase disposable income
Increase aggregate demand
Congress & Bush
Page 327
Impacts of Policy Tools
Expansionary actions:
Cut taxes
Increase government spending
Effects of action:
Increase disposable income
Increase aggregate demand
Contractionary actions:
Increase taxes
Cut government spending
Effects of action:
Decrease disposable income
Decrease aggregate demand
Congress & Bush
Page 327
A federal budget deficit requires
the U.S. Treasury to issue more
government securities to balance
sources and uses of funds…
Page 324
An increase in the sale of
government securities
reduces the pool of private
capital available to finance
investment expenditures,
raising interest rates…
Page 324
We know from Chapter
12 that higher interest
rates depresses investment
expenditures…
Page 324
The use of expansionary
fiscal policy actions
to push aggregate demand
from AD1 to AD3 increases
real GDP from Y1 to Y3
while only increasing the
general price level to P3.
Inflation rate
(P3 – P0) ÷P0
Recessionary gap
partially closed
Page 328
The use of expansionary
fiscal policy to push demand
from AD3 to AD4 increases
real GDP from Y3 to YFE
(full employment GDP),
But increases the general
price level to P4.
Inflation rate
(P4 – P3) ÷P3
Recessionary gap
closed….
Page 328
The use of expansionary
fiscal policy to attain
YPOT by shifting aggregate
demand to AD5 will
Increase the general price
level to P5.
Inflation rate
(P5 – P4) ÷P4
Inflationary gap
created….
Page 328
Monetary Policy Summary
Functions of money and the
role of the Federal Reserve
System in the economy
The money multiplier and the
growth of the money supply
Tools of monetary policy
Demand for money and money
market equilibrium
Policy linkages and timing of
full effects
Elimination of recessionary
and inflationary gaps.
Fiscal Policy Summary
Difference between discretionary
and automatic fiscal policy tools
Expansionary and
contractionary fiscal policy
actions
Application to eliminating
recessionary and inflationary
gaps
Budget deficits, national debt
and concept of “crowding out”
Chapter 14 focuses on the key
consequences of business
fluctuations….