Transcript Ch. 13: Macroeconomics Policy Fundamentals

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
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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 as the federal government’s banker and
fiscal agent
7. Regulate the money supply
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Location of the 12 District
Federal Reserve Banks
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The Fed’s Policy Tools
 Reserve requirements – depository institutions
are required to maintain a specific fraction of
their customers’ deposits as reserves.
 banks must hold as vault cash or on deposit at a
Federal Reserve Bank.
 As of June 2004, the reserve requirement was 10%
on transaction deposits, and there were zero
reserves required for time/savings deposits
 Currently play limited role in money creation in US
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The Fed’s Policy Tools
 Discount rate – rate depository institutions pay
when they borrow from the Fed
 They borrow from Fed if they want to increase loans
but does not have any excess reserves at the moment
 Also to meet reserve requirements
 Federal Funds Market - interbank market trafficking
in reserves; banks with excess reserves can lend to
banks that are short on 24 hour basis.
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The Fed’s Policy Tools
 Open market operations – Fed can buy or sell
government securities to alter the money
supply (used most frequently)
 Federal Open Market Committee (FOMC) directs
the operations
 Directive to sell results in decrease in reserves at
depository institutions because deposits are
withdrawn to pay for the securities
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Role of the Board of
Governors of the
Federal Reserve System
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Role of the Board of
Governors of the
Federal Reserve System
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Role of the Board of
Governors of the
Federal Reserve System
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Key role played by the
Federal Open Market
Committee or FOMC
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Role of the 12 District
Federal Reserve Banks
located throughout
the country
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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.
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Expansionary monetary policy
actions will shift the MS
curve to the right over a
period of 12 months or so.
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Contractionary monetary
policy actions, on the
other hand, will shift the
money supply curve to
left over a similar time
period.
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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 will have
excess reserves of $800,000. It 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. From this example, we can make generalizations
About the extent to which the money supply will increase when reserves are
Increased.
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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 (MM).
We can restate this equation in terms of the change in
the money supply as follows:
MS = (1.0 ÷ RR) ×  TR = MM × TR
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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
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Change in
money supply
Change in
= loan volume
Initial
+ infusion
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Impacts of Policy Tools
Expansionary actions:
Fed buys securities
Fed lowers the discount rate
Fed lowers required reserve ratio
Bernanke
Effects of action:
Total reserves increase
Total reserves increase
Money multiplier increases
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Impacts of Policy Tools
Expansionary actions:
Fed buys securities
Fed lowers the discount rate
Fed lowers required reserve ratio
Effects of action: Inc Ms
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: Dec Ms
Total reserves decrease
Total reserves decrease
Money multiplier decreases
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Determinants
of the
Money Demand
Demand for Money: Why we hold
cash?
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.
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The money demand curve
is given by equation (13.5):
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.
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Increase in income
increases demand
for money
MD = c –d(R) + e(NI)
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Money market interest
rate given by intersection
of demand and supply
Reflects the opp cost of
holding money rather than
income-earning asset.
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M S*
0.06
Expansionary
monetary policy
lowers interest
rates
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M S*
0.14
Contractionary
monetary policy
raises interest
rates
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The full effects of this change
could take 12 months or more
to register in bank deposits
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A change in the money
supply will alter the
equilibrium interest rate
in the money market
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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
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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 (increases AD)
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Eliminating
Recessionary and
Inflationary Gaps
What is the
magnitude of the
recessionary gap?
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What is the
magnitude of the
recessionary gap?
It is YFE – Y1
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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.
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Inflation rate
(P3 – P0) ÷P0
Recessionary gap
of YFE – Y1 is
partially closed to
YFE – Y3
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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.
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Inflation rate
(P4 – P3) ÷P3
Somewhat inflationary
But does not swamp
growth
Recessionary gap
fully closed
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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
Would cause
inflation
Inflationary gap
created…..use contractionary
monetary policy Page 313
Microeconomic
Interest Rate
Implications
• Contractionary monetary policies that drive
up interest rates will depress investment
expenditures by businesses and households
• Expansionary monetary policies that lower
interest rates will stimulate investment
expenditures in the economy
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
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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
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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
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Fiscal Policy Options
 Automatic fiscal policy instruments: take effect without
explicit action by policymakers (e.g., progressive tax
rates; unemployment compensation –built in
stabilizers)
 Discretionary fiscal policy instruments: require explicit
actions by the president or Congress (e.g., passing a tax
cut law; increase government spending authorized by
Congress)
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Impacts of Policy Tools
Expansionary actions:
Cut taxes
Increase government spending
Effects of action:
Increase disposable income
Increase aggregate demand
Congress & Obama
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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 & Obama
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A federal budget deficit requires
the U.S. Treasury to issue more
government securities to balance
sources and uses of funds…
An increase in the sale of
government securities
reduces the pool of private
capital available to finance
investment expenditures,
raising interest rates…
We know from Chapter
12 that higher interest
rates depresses investment
expenditures…
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
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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….
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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….
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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”