CFA lvl 1 - Reading18 PDF

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Economics Reading 18: Monetary and Fiscal Policy  Fiscal Policy Refers to a government’s use of spending and taxation to influence economic activity - Budget surplus: government tax revenues exceed expenditures - Budget deficit: government expenditures exceed tax revenues Could be a tool for redistribution of income and wealth  Monetary Policy Refers to the central bank’s actions that affect the quantity of money and credit in an economy in order to influence economic activity - Expansionary: increase the money supply, decrease interest rates, increase aggregate demand - Contractionary: decrease the money supply, increase interest rates, slow economic growth and inflation  Both monetary and fiscal policies are used with the goals of maintaining stable prices and producing positive economic growth  Functions of Money Medium of exchange: accepted as payment for goods and services Unit of account: prices of all goods and services are expressed in units of money Store of value: money received for work or goods now can be saved to purchase goods later  Definitions of Money Narrow Money (M1 in US and Eurozone) => most liquid forms of money - Currency in circulation - Checkable deposits - Travelers checks Broad Money (M2 in US and M3 in Eurozone) - Savings deposits - Time deposits < $100,000 - Money market mutual funds  How banks create money Promissory note: a promise by the banker to return on demand from the depositor Fractional reserve banking system: a bank is required to hold a fraction of its deposits in reserve; this fraction is the required reserve ratio new deposit Money created= reserve requirement Money multiplier=

1 reserve requirement

 Relationship between money and price level

Quantity theory of money: quantity of money is some proportion of the total spending in an economy and implies the quantity equation of exchange money supply × velocity= price × real output (MV =PY ) Velocity: average number of times per year each unit of money is used to buy goods or services Money neutrality: the belief that real variables (real GDP and velocity) are not affected by monetary variables (money supply and prices)  Demand for Money The amount of wealth that households and firms in an economy choose to hold in the form of money - Transactions demand: money held to meet the need for undertaking transactions  increases with GDP - Precautionary demand: Money held for unforeseen future needs  increases with GDP - Speculative demand: Money held to take advantage of future investment opportunities, smaller when current returns are high, greater when risk is perceived to be high Supply of money is set by the central bank and is independent of interest rate  Fisher Effect Riskless nominal interest rate = real riskless rate + expected inflation + risk premium for uncertainty  Central banks Roles: - Issue currency - Banker to banks and government - Regulate banking and payments system - Lender of last resort - Hold gold and foreign currency reserves - Conduct monetary policy Objectives - Control inflation o High inflation leads to menu costs (cost to businesses of constantly having to change their prices) and shoe leather costs (costs to individuals of making frequent trips to the bank so as to minimize their holdings of cash that are depreciating in value due to inflation) - Maintain full employment - Promote economic growth - Keep exchange rates stable - Keep long-term interest rates moderate A 0-inflation target is not used because that increases the risk of deflation

 Monetary Policy Tools

Policy rate: interest rate central banks charge banks for borrowed reserves - Increasing the policy rate discourages banks from borrowing reserves; bank reduce their lending - Decreasing the policy rate tends to increase the amount of lending and the money supply - The US Fed sets a target for the fed funds rate, the rate at which banks lend shortterm to each other Open market operations: - Central banks buy government securities for cash, reserves increase, money supply increases - Selling securities decreases the money supply Required reserve ratio: - Reducing required reserve percentage increases excess reserves and increases the money supply - Increasing required reserve ratio decreases the money supply  1. 2. 3.

Expansionary monetary policy affects 4 things Market interest rates fall, less incentive to save Asset prices increase, wealth effect, consumption increases Expectations for economic growth increase, may expect further decreases in interest rates 4. Domestic currency depreciates, import prices increase, export prices decrease

 Central bank characteristics 1. Independent: free from political interference Operational independence: free to set policy rate Target independence (ECB): sets inflation target, measures inflation, determines horizon to meet target 2. Credible: bank follows through on stated intentions and policies 3. Transparent: bank discloses inflation reports, indicators they use, and how they use them  -

When a central bank buys security: Bank reserves increase Interbank lending rates decrease Short-term and long-term lending rates decrease Businesses increase investment Consumers increase durable goods purchases Domestic currency depreciates, exports increase

 Central bank targets Interest rate targeting: increase (decrease) money supply growth when interest rates are above (below) targets Inflation targeting: target band for inflation rate (1%-3%) Exchange rate targeting: target band for currency exchange rate with developed country

 The neutral interest rate = trend growth rate of real GDP + target inflation rate Policy rate > neutral rate: contractionary Policy rate < neutral rate: expansionary  Limitations of monetary policy 1. Long-term rates may move oppositely to SR rates because inflation expectations change 2. If monetary tightening is extreme, expectations of recession may take long-term bonds more attractive, decreasing long-term rates 3. If demand for money is very elastic, people will hold currency even as money supply increases, referred to as a liquidity trap 4. Banks may desire to increase capital and not increase lending in response to expansionary monetary policy 5. Short-term rates cannot be below zero – limits a central bank’s ability to act against deflation  Fiscal Policy Keynesian economists: believe discretionary fiscal policy can stabilize the economy, increasing aggregate demand to combat recessions and decreasing aggregate demand to combat inflation Monetarists: believe that such effects are temporary and appropriate monetary policy will dampen economic cycles Automatic stabilizers (taxes and transfer payments): tend to increase deficits during recessions and decrease deficits during expansions  1. 2. 3.

Governments use fiscal policy to: Influence aggregate demand and economic growth Redistribute wealth Affect the allocation of resources to different sectors of the economy

 1. 2. 3.

Fiscal tools: spending Transfer payments: cash payments by government to redistribute wealth Current spending: purchases of goods and services Capital spending: to increase future productivity; on infrastructure, or to support R&D of new technologies

 Fiscal tools: revenue Direct taxes: levied on income or wealth => take time to implement Indirect taxes: levied on goods and services  Quick to implement to raise revenue or promote social goals (ex: tobacco tax)  Fiscal multiplier 1 FM = 1−MPC(1−t)  Ricardian equivalence

Ricardian equivalence: If the increase in saving (decrease in consumption) just offsets the tax decrease  Government debt government debt debt ratio= GDP  -

Reasons to be concerned about budget deficits Higher future taxes will decrease GDP growth Government borrowing can drive up interest rates and reduce private investment At some point, debt can become risky, interest rate rises, country may default or expand money supply and cause inflation

 -

Arguments that budget deficits are not concerning If deficit is to finance capital investment, future GDP will be higher Deficits don’t matter if Ricardian equivalence holds If the economy is operating below capacity, government borrowing will not displace capital investment

 Fiscal policy lags Recognition lag: to identify the need for fiscal policy change Action lag: to enact legislation Impact lag: for the policy change to have the intended effect  Policy interaction Monetary up and fiscal up: strong expansionary effect, public and private sectors grow Monetary down and fiscal down: decreased GDP growth, higher interest rates, public and private sectors decline Monetary up and fiscal down: interest rate fall, consumption, output and private sector expand Monetary down and fiscal up: interest rates rise, aggregate demand likely higher, public sector portion of spending grows...