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Macroeconomic Policy Fundamentals Chapter 13
MacroeconomicPolicy
Fundamentals
Chapter 13
Discussion TopicsCharacteristics of moneyFederal Reserve SystemChanging the money supplyMoney market equilibriumEffects of monetary policy on economyThe federal budget deficitThe national debtFiscal policy options
2
Functions of MoneyMedium 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 Federal Reserve System
Supply the economy with paper currencySupervise member banksProvide check collection and clearing servicesMaintain the reserve balances of depository
institutionsLend to depository institutionsAct at the federal government’s banker and
fiscal agentRegulate the money supply
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Location of the 12 DistrictFederal Reserve Banks
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The Fed’s Policy ToolsReserve 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
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Role of the Board ofGovernors of theFederal Reserve System
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Key role played by theFederal Open MarketCommittee (FOMC)
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Recent Fed Rate Actions
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Role of the 12 DistrictFederal Reserve Bankslocated throughoutthe country
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Determinantsof the
Money Supply
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Existing money supply curve Perpendicular to
the quantity axis → it is unaffected
by the interest rate
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Change in the Money Supply
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Expansionary monetary policy action will shift MS curve to the right over a period of 12 mo. or so.
Change in the Money Supply
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Contractionary monetary policy actions will shift themoney supply curve left
Change in the Money Supply
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Ag Bank depositor sells $1 million in gov’t securities to the Fed Sale proceeds are deposited in his bank. W/ fractional reserve requirement ratio is 20% → Bank Ag
can ↑ the volume of its loans by $800,000. Suppose loan proceeds are deposited in Bank B. Etc……..15
Change in the Money SupplyWe can skip tracing deposits through the
economy via 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 within the parentheses is known as
the money multiplier → In terms of the money supply change (ΔMS):
MS = (1.0 ÷ RR) × TR = MM × TRPage 252-253 16
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 ΔMS is
MS = (1.0 ÷ .20) x TR = 5.0 x $1 million = $5 million
This results in Loans of
loans = MS - TR = $5 million - $1 million = $4 million
Table 13.3 bottom line
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Change inmoney supply
Change inloan volume +=
Initialinfusion
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Impacts of Policy ToolsExpansionary actions: Effects of action:Fed buys securities Total reserves increaseFed lowers the discount rate Total reserves increaseFed lowers required reserve ratio Money multiplier increases
Contractionary actions: Effects of action:Fed sells securities Total reserves decreaseFed raises the discount rate Total reserves decreaseFed raises required reserve ratio Money multiplier decreases
Page 253Bernanke
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Determinantsof the
Money Demand
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Demand for MoneyTransactions demand for money – carry
cash to pay for normal expendituresPrecautionary 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 (16.5):
MD = α – β x IR + γ x NI R is the interest rate NI is national income – β is the MD slope (i.e.,
MD÷IR) γ represents MD÷ NI
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Page 255MD = α – β x IR + γ x NI
↑ in income→ ↑ demand for money
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Money market interestrate given by intersectionof demand and supply
Determination of Interest Rate
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MS*
0.06
Expansionarymonetary policylowers interestrates
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MS*
0.14
Contractionarymonetary policyraises interestrates
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The full effects of this changecould take 12 months or moreto register in bank deposits
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A change in MS will alter theequilibrium money market interest rate
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From Chapter 12 ΔIR → movement along the
planned investment function ↑ or ↓new investment
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From Chapter 12 ↑ investment expenditures, a
component of GDP ↑ demand for labor → ↓
unemployment further ↑ in NI
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EliminatingRecessionary andInflationary Gaps
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What is the magnitude of the recessionary gap? YFE – Y1
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Use expansionary monetary policy Push aggregate demand
from AD1 to AD3 ↑ real GDP from Y1 to
Y3
→ only ↑ general price level to P3
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Inflation rate =% Δ in price =(P3 – P0) ÷P0
Recessionary gapof YFE – Y1 ispartially closed toYFE – Y3
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Use of expansionary monetary policy to push AD from AD3 to AD4 ↑real GDP from Y3 to
YFE (full employment GDP)
↑general price level to P4
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Recessionary gapfully closed
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Use of expansionary monetary policy to attain YPOT Shift aggregate
demand to AD5 Will ↑ general price
level to P5
Inflationarygap created
Inflation rate(P5 – P4) ÷ P4
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MicroeconomicInterest RateImplications
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Interest Rate Impacts on a 10-Year $150K Business Loan
InterestRate
Annual Total P & I Payment
Annual Interest Payment
Total Interest Payment
8% $22,354.69 $7,354.69 $73,546.90
14% 28,757.67 13,757.67 137,576.88
20% 35,782.44 20,782.44 207,824.40
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Interest Rate Impacts on a 20- Year $100K Home Mortgage
Interest
Rate
MonthlyTotal P & IPayment
MonthlyInterest Payment
Totalinterest payment
8% $848.78 $432.08 $103,707.46
12% 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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States Without Income Tax
Eight states do not have a state income tax
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State and Local Taxes
Alaska, thanks to oil reserves, has the lowest tax burden
Maine registered the highest state tax burden
Major sources are of government revenue are sales and property taxes
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Our focus is on fiscal policy at the federal level….
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Budget deficit = Gov’t expenditures > receipts
↑ spending and tax cuts recently used to stimulate the economy resulted in new budget deficits
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Individuals and not businesses pay the Bulk of federal taxes.
% of Total Federal TaxesIndividuals vs. Business
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A strong economy andcontrolled spending ledto 1st budget surplusin more than 20 years
The sub-prime lending defaults and resulting financial crisis and deficit spending have led to record high deficits…
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Recent Trends in Deficit
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Debt and the Deficit
National DebtT = National debt(T-1) + DeficitT General formula for the National Debt
A negative deficit is a surplus
The growth in federal debt has grown rapidly over the last 25 years
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National debt grew as deficit spending dominated the last 30 years
Debt as a % of GDP stayed within post-WW II levels
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Federal government spending on Agriculture programs is the 4th highest on this list of total federal spending
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Fiscal Policy OptionsAutomatic fiscal policy instruments
Take effect without explicit action by policymakers (e.g., progressive tax rates)
Discretionary fiscal policy instrumentsRequire explicit actions by the President
or Congress (e.g., passing a law)
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Impacts of Policy ToolsExpansionary actions: Effects of action:Cut taxes Increase disposable incomeIncrease government spending Increase aggregate demand
Contractionary actions: Effects of action:Increase taxes Decrease disposable incomeCut government spending Decrease aggregate demand
Congress & PresidentPage 26952
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A federal budget deficit requiresthe U.S. Treasury to issue moregovernment securities to balancesources and uses of funds
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An ↑ in the sale of government securities ↓ the pool of private
capital available to finance investment expenditures
↑ interest rates
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From Chapter 12 higher interest rates ↓ investment expend.
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The use of expansionaryfiscal policy actionsto push aggregate demandfrom AD1 to AD3 increasesreal GDP from Y1 to Y3
while only increasing thegeneral price level to P3.
Inflation rate(P3 – P0) ÷P0 Recessionary gap
partially closed
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The use of expansionaryfiscal policy to push demandfrom AD3 to AD4 increasesreal 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 expansionaryfiscal policy to attainYPOT by shifting aggregatedemand to AD5 will Increase the general price level to P5.
Inflation rate(P5 – P4) ÷P4 Inflationary gap
created….
Monetary Policy SummaryFunctions of money and the role of the
Federal Reserve System in the economyThe money multiplier and the growth of the
money supplyTools of monetary policyDemand for money and money market
equilibriumPolicy linkages and timing of full effectsElimination of recessionary and inflationary
gaps.
Fiscal Policy SummaryDifference between discretionary and
automatic fiscal policy toolsExpansionary and contractionary fiscal
policy actionsApplication to eliminating recessionary
and inflationary gapsBudget deficits, national debt and
concept of “crowding out”
