Macroeconomic Policy Fundamentals Chapter 13 Discussion Topics Characteristics

Macroeconomic Policy Fundamentals Chapter 13

Discussion Topics üCharacteristics of money üFederal Reserve System üChanging the money supply üMoney market equilibrium üEffects of monetary policy on economy üThe federal budget deficit üThe national debt üFiscal policy options

Functions of Money üMedium of exchange – facilitates payment to others for goods and services üUnit of accounting – assessing profitability of businesses, household budgets and aggregate variables like GDP üStore of value – money is a liquid asset which has value in investment portfolios and cash flow decisions of businesses and households Page 244

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 Page 247

Location of the 12 District Federal Reserve Banks Page 246

The Fed’s Policy Tools ü Reserve requirements – depository institutions are required to maintain a specific fraction of their customers’ deposits as reserves. ü banks must hold as vault cash or on deposit at a Federal Reserve Bank. ü As of June 2004, the reserve requirement was 10% on transaction deposits, and there were zero reserves required for time/savings deposits ü Currently play limited role in money creation in US Page 248

The Fed’s Policy Tools ü Discount rate – rate depository institutions pay when they borrow from the Fed ü They borrow from Fed if they want to increase loans but does not have any excess reserves at the moment ü Also to meet reserve requirements ü Federal Funds Market - interbank market trafficking in reserves; banks with excess reserves can lend to banks that are short on 24 hour basis. Page 249

The Fed’s Policy Tools ü Open market operations – Fed can buy or sell government securities to alter the money supply (used most frequently) ü Federal Open Market Committee (FOMC) directs the operations ü Directive to sell results in decrease in reserves at depository institutions because deposits are withdrawn to pay for the securities Page 249

Role of the Board of Governors of the Federal Reserve System Page 247

Role of the Board of Governors of the Federal Reserve System Page 247

Role of the Board of Governors of the Federal Reserve System Page 247

Key role played by the Federal Open Market Committee or FOMC Page 247

Role of the 12 District Federal Reserve Banks located throughout the country Page 247

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 253

Expansionary monetary policy actions will shift the MS curve to the right over a period of 12 months or so. Page 253

Contractionary monetary policy actions, on the other hand, will shift the money supply curve to left over a similar time period. Page 253

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. 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 (MM). We can restate this equation in terms of the change in the money supply as follows: MS = (1. 0 ÷ RR) × TR = MM × TR Page 252

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 252

Change in money supply Change in = loan volume Initial + infusion Page 251

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 Money multiplier increases Page 253

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 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 Money multiplier decreases Page 253

Determinants of the Money Demand

Demand for Money: Why we hold cash? üTransactions demand for money – carry cash to pay for normal expenditures üPrecautionary demand for money – carry cash to cover unexpected expenditures üSpeculative 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 254

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. Page 255

Increase in income increases demand for money MD = c –d(R) + e(NI) Page 255

Money market interest rate given by intersection of demand supply Reflects the opp cost of holding money rather than income-earning asset. Page 255

MS * 0. 06 Expansionary monetary policy lowers interest rates Page 255

MS * 0. 14 Contractionary monetary policy raises interest rates Page 255

The full effects of this change could take 12 months or more to register in bank deposits Page 256

A change in the money supply will alter the equilibrium interest rate in the money market Page 256

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 256

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) Page 256

Eliminating Recessionary and Inflationary Gaps

What is the magnitude of the recessionary gap? Page 257

What is the magnitude of the recessionary gap? It is YFE – Y 1 Page 257

The use of expansionary monetary policy actions to push aggregate demand from AD 1 to AD 3 increases real GDP from Y 1 to Y 3 while only increasing the general price level to P 3. Page 257

Inflation rate (P 3 – P 0) ÷P 0 Recessionary gap of YFE – Y 1 is partially closed to YFE – Y 3 Page 257

The further use of expansionary monetary policy to push aggregate demand from AD 3 to AD 4 increases real GDP from Y 3 to YFE (full employment GDP), but increases the general price level to P 4. Page 257

Inflation rate (P 4 – P 3) ÷P 3 Somewhat inflationary But does not swamp growth Recessionary gap fully closed Page 257

The use of expansionary monetary policy to attain YPOT by shifting aggregate demand to AD 5 will increase the general price level to P 5. Inflation rate (P 5 – P 4) ÷P 4 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 10 Year $150 K Business Loan Inter Annual est total PI rate payment Annual interest payment Total interest payment 8 percent $22, 354. 69 $73, 546. 90 14 percent 28, 757. 67 137, 576. 88 20 percent 35, 782. 44 207, 824. 40 Page 259

Interest Rate Impacts on a 20 Year $100 K Home Mortgage Inter Monthly est rate 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 259

What is Fiscal Policy? üTaxation by federal, state and local governments üGovernment spending by federal state and local governments üBudget deficit and the national debt Page 259

Fiscal Policy Options Ø Automatic fiscal policy instruments: take effect without explicit action by policymakers (e. g. , progressive tax rates; unemployment compensation –built in stabilizers) Ø 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) Page 266

Impacts of Policy Tools Expansionary actions: Cut taxes Increase government spending Effects of action: Increase disposable income Increase aggregate demand Congress & Obama Page 269

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 Page 269

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 AD 1 to AD 3 increases real GDP from Y 1 to Y 3 while only increasing the general price level to P 3. Inflation rate (P 3 – P 0) ÷P 0 Recessionary gap partially closed Page 270

The use of expansionary fiscal policy to push demand from AD 3 to AD 4 increases real GDP from Y 3 to YFE (full employment GDP), But increases the general price level to P 4. Inflation rate (P 4 – P 3) ÷P 3 Recessionary gap closed…. Page 270

The use of expansionary fiscal policy to attain YPOT by shifting aggregate demand to AD 5 will Increase the general price level to P 5. Inflation rate (P 5 – P 4) ÷P 4 Inflationary gap created…. Page 270

Monetary Policy Summary üFunctions of money and the role of the Federal Reserve System in the economy üThe money multiplier and the growth of the money supply üTools of monetary policy üDemand for money and money market equilibrium üPolicy linkages and timing of full effects üElimination of recessionary and inflationary gaps.

Fiscal Policy Summary üDifference between discretionary and automatic fiscal policy tools üExpansionary and contractionary fiscal policy actions üApplication to eliminating recessionary and inflationary gaps üBudget deficits, national debt and concept of “crowding out”