Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 1 Econ 210D Intermediate Macroeconomics Spring...

Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 1

Econ 210D Intermediate Macroeconomics

Spring 2015

Professor Kevin D. Hoover

Topic 8Monetary and Fiscal Policy


The Government’s Budget Constraint G – (T – TR) = BG + MB

deficit change in government’s financial portfolio

Fiscal Policy Monetary Policy


Pure Policy

G – (T – TR) = BG + MB

Pure Fiscal Policy: changes in taxes or spending, holding government liabilities constant (BG = 0 and MB = 0) o E.g., balanced budget stimulus

Pure Monetary Policy: changes in liability mix BG = – MB), holding deficit constant (G – (T – TR) = 0)o E.g., open-market operation


Mixed Policies

G – (T – TR) = BG + MB

Deficit finance:o G – (T – TR) = BG > 0

Monetizing the deficit:o G – (T – TR) = MB > 0


The Federal Reserve System

Figure 17.1 The Federal Reserve System

Notes: Numbers represent the Federal Reserve Districts and cities indicate the location of the Federal Reserve Bank for each district. The Board of Governors is located in Washington, D.C.


The Board of Governors of the Federal Reserve System 7 Governors with 14-year terms Chairman – governor with a 4-year term

as chairmano Current Chairman: Ben Bernankeo Replaced Alan Greenspan, who replaced

Paul Volcker Duties

o Bank regulationo Monetary policyo Lender of last resort


Federal Open-Market Committee (FOMC) Main policy making body Composition

o 7 Fed Governorso President of Federal Reserve Bank of New

Yorko 4 other district bank presidents on a rotating

basiso Remaining 7 presidents present as non-

voting members Meets about every 5 weeks


Fed and Commercial Bank Balance Sheets

Table 17.1 The Balance Sheets of the Federal Reserve and the Commercial Banks Federal Reserve Commercial Banks

Assets Liabilities Assets Liabilities Government Bonds Banknotes held by non-bank

public Reserves

[Sources: owned outright borrowed at discount window Federal funds borrowed]

Transactions Accounts

Discount Loans Reserves (reserve balances

and eligible vault cash) Loans Savings and large and small time

deposits Coins held by Federal Reserve Government and commercial

bonds and other assets Discount Loans

Foreign Exchange (Federal funds lent) (Federal funds borrowed) Gold Net worth Net worth


Open-market Operations

Open-market operations = the Fed buys or sells assets on the open market, paying with reserves.

Open-market sale:o Public holdings of government bonds riseso Banks’ holdings of reserves falls

Open-market purchase:o Public holdings of government bonds fallo Banks’ holdings of reserves rises


The Discount Window

Discount borrowing (borrowing at the “discount window”) = banks’ borrowing reserves from the Fed using their assets (typically short term bonds) as collateral.

Common in the early days of the Fed. Rare later On large scale in recent financial crisis.


Reserve Demand

Reserve requirements: banks must hold reserves = 10% of the value of checking accounts.

Check Clearing Prudential Needs – costs of falling short

o discount borrowing o interbank borrowing = Federal funds

market


Holding Reserves: Banks’ Profit Maximization Problem Benefit of lending to another bank: rFF

Cost of not having reserves on hand to cover withdrawals: probability of reserve loss × rFF

Opportunity Cost: Benefit – Cost: rFF – prl × rFF = (1 – prl) rFF

The higher the opportunity cost, the lower the demand to hold reserves.


Open-market Purchase

Public’s holdings of government bonds falls

Banks’ holdings of reserves rise Interest rates fall


“Open-mouth” Operation

Fed announces Federal funds rate target

Market moves to target without an actual open-market operation

Interest rates in other markets move in same direction as the Federal funds rate: substitution and arbitrage


Brief History of Monetary Policy Monetization of debt at fixed short and

long rates during and after World War II Fed-Treasury Accord of 1951 ends

compulsory monetization Early 1960s: “bills only” doctrine Recent Fed purchase of long-term and

nongovernmental assets.


Transmission Mechanism

Transmission Mechanism = means by which monetary policy effects the real economy

Two types:o Interest-rate or Opportunity-cost Channelo Credit Channel


Interest-rate or Opportunity-cost Channel Interest Rate or Opportunity-Cost Channel

= monetary policy changes interest rates which effects the opportunity cost of investing.

Mechanism:A. Fed controls short rates in order to

manipulate long rates through the term structure.

B. Real long rates affect investment; investment affects aggregate demand through the multiplier.


Credit Channel

Credit Channel = monetary policy effects economy through reduction in funds available to borrowers with or without changing interest rates.

Two types:o Narrow credit channelo Broad credit channel


Narrow Credit Channel

Narrow Credit Channel = change in reserves owing to monetary policy action reduces volume of bank lending.


Broad Credit Channel

Broad Credit Channel = changes in interest rates change credit-worthiness of borrowers, changing the availability of bank and nonbank credit.


Transmission Mechanism and the Real Economy Interest-rate or Opportunity-cost

channel movement along IS curve Credit channel (narrow or broad) shift

of IS curve


Monetary Policy and the Recent Financial Crisis Lender of last resort “Quantitative Easing” = purchases of

long-term (government and private) bondso Interest-rate channel: similar to other open-

market operations except at long end of term structure.

o Direct relief of credit rationing. Challenge: How to unwind without

squelching recovery.


Fiscal Policy

Fiscal policy =

Tax Policy

Expenditure Policy


Types of Fiscal Policy

Automatic stabilizers

Discretionary Policyo Inadvertento Intentional


Shocks Shift IS Curve

Demand shocks = Y holding Ypot

constant

Supply shocks = Ypot holding Y constant

Mixed shocks = both Y and Ypot

PotY

YY ~


Limits to Fiscal Policy

Lagso Inside Lag

• Recognition Lag• Implementation Lag

o Outside Lag• Recognition Lag• Implementation Lag

State and Local Governments as Automatic Destabilizers


Fiscal Policy in the Long Run – 1 G – (T – TR) = BG + MB

deficit change in government’s financial portfolio

Fiscal Policy Monetary Policy


Figure 18.5 U.S. Federal Taxes and Spending, 1790-1990

1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990

Sh

are

of P

oten

tial

GD

P

(per

cen

t)

logarithmic scale

Spending

Taxes

40.0

20.0

15.0

10.0

5.0

1.0

0.5

War of 1812Mexican-American War

Civil War

Spanish-American

War

World War I

World War II

Korean War

Vietnam War


Federal Government Expeditures and Revenues

15

16

17

18

19

20

21

22

23

24

25

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Per

cen

t of

GD

P

Expenditures

Revenues


Dynamics of the Debt

G – (T – TR) = interest payments + primary deficit

tGtt

Gt

Gt PDBrBB 111

Gt

ttG

t

GtG

t B

PDr

B

BB

11

1

1ˆ


Functional Finance – 1

Deficits and debt not bad in and of themselves.

Balanced budgets not good in and of themselves.

Must be judged by their effects on the real economy.


Functional Finance – 2: types of effect Aggregate demand Interactions between public and private

sectors Redistribution Incentives


Crowding Out

Crowding Out = increases in government expenditure reduce private expenditure or, more particularly, private investment


Types of Crowding Out

Zero-sum crowding out = at full employment any increase in G or TR must reduce private expenditure

Displacement of private expenditure – e.g., public schools replace private schools

Monetary snubbing of aggregate demand = deficits in face of fixed monetary policy raise interest rates, lowering investment

Crowding In = government expenditure promotes private investment – e.g., R&D


Burden of the Debt

Debt to GDP Ratio: B/pY

In Growth Rates:tt

Gt

tt

Gt YpBYp

B ˆˆˆ^


The Federal Debt

0.0

2,000.0

4,000.0

6,000.0

8,000.0

10,000.0

12,000.0

1938 1942 1946 1950 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006

Dol

lars

(b

illio

ns)

0

20

40

60

80

100

120

140

Per

cen

t of

GD

P

Debt as a Percentage of GDP (right axis)

Debt (left axis)


END of Topic 8

END OF COURSE

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Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 1 Econ 210D Intermediate Macroeconomics Spring...

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