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 Page 299 Functions of the Fed 1. Supply the economy with paper currency 2. Supervise member banks 3. Provide check collection and clearing services 4. Maintain the reserve balances of depository institutions 5. Lend to depository institutions 6. Act at the federal government’s banker and fiscal agent 7. Regulate the money supply Page 302-303 Location of the 12 District Federal Reserve Banks Page 301 Changing of the Guard Alan Greenspan Ben Bernanke The Fed’s Policy Tools Reserve 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 Page 304 – 305 Role of the Board of Governors of the Federal Reserve System Page 303 Role of the Board of Governors of the Federal Reserve System Page 303 Role of the Board of Governors of the Federal Reserve System Page 303 Key role played by the Federal Open Market Committee or FOMC Page 303 Recent Fed Rate Actions Role of the 12 District Federal Reserve Banks located throughout the country Page 303 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 309 Expansionary monetary policy actions will shift the MS curve to the right over a period of 12 months or so. Page 309 Contractionary monetary policy actions, on the other hand, will shift the money supply curve to left over a similar time period. Page 309 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 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. 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. We can restate this equation in terms of the change in the money supply as follows: MS = (1.0 ÷ RR) × TR = MM × TR Page 307 – 308 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 See bottom line in Table 13.3 This results in a change in loans of loans = MS - TR = $5 million - $1 million = $4 million Page 307 – 308 Change in Change in Initial money supply = loan volume + infusion Page 307 Impacts of Policy Tools Expansionary actions: Effects of action: Fed buys securities Total reserves increase Fed lowers the discount rate Total reserves increase Fed lowers required reserve ratio Money multiplier increases Greenspan Page 308 - 309 Impacts of Policy Tools Expansionary actions: Effects of action: Fed buys securities Total reserves increase Fed lowers the discount rate Total reserves increase Fed lowers required reserve ratio Money multiplier increases Contractionary actions: Effects of action: Fed sells securities Total reserves decrease Fed raises the discount rate Total reserves decrease Fed raises required reserve ratio Money multiplier decreases Greenspan Page 308 - 309 Determinants of the Money Demand Demand for Money 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. Page 310 - 311 The money demand curve is given by equation (16.5): 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 311 Increase in income increases demand for money MD = c –d(R) + e(NI) Page 311 Money market interest rate given by intersection of demand and supply Page 311 M S* Expansionary monetary policy lowers interest rates 0.06 Page 311 M S* 0.14 Contractionary monetary policy raises interest rates Page 311 The full effects of this change could take 12 months or more to register in bank deposits Page 312 A change in the money supply will alter the equilibrium interest rate in the money market Page 312 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 312 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… Page 312 Eliminating Recessionary and Inflationary Gaps What is the magnitude of the recessionary gap? Page 313 What is the magnitude of the recessionary gap? It is YFE – Y1 Page 313 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. Page 313 Recessionary gap of YFE – Y1 is partially closed to Inflation rate YFE – Y3 (P3 – P0) ÷P0 Page 313 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. Page 313 Inflation rate (P4 – P3) ÷P3 Recessionary gap fully closed Page 313 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 Inflationary gap created….. Page 313 Microeconomic Interest Rate Implications Interest Rate Impacts on a 10- Year $150K Business Loan Annual Annual Total Interest total PI interest interest rate payment payment 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 Page 315 Interest Rate Impacts on a 20- Year $100K Home Mortgage Monthly Monthly Total Interest total PI interest interest rate payment payment payment 8 percent $848.78 $432.08 $103,707.46 12 percent 1,115.73 699.06 167,773.46 Page 315 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 Page 316 States Without Income Tax Eight states do not have a state income tax State and Local Taxes Alaska, thanks to oil reserves, has the lowest tax burden Maine registering the highest has the highest tax burden Major sources are sales taxes and property taxes Our focus is on fiscal policy at the federal level…. Rising spending and tax cuts to spur the economy brought back budget deficits Page 318 Individuals and not businesses pay the Bulk of federal taxes. Page 318 The effects of 9/11 and increased spending plus tax cuts to stimulate the economy led to record high deficits… A strong economy and controlled spending led to the first budget surplus in more than 20 years… Page 320 Recent Trends in Deficit • Typically the economy runs a budget deficit at the federal level • 1998-2001 were the exceptions in recent years • Fueled by growing economy and falling interest rates Debt and the Deficit National debtT = National debtT-1 + DeficitT The growth in federal spending has grown rapidly over the last 20 years… Page 321 While the national debt grew as deficit spending dominated the 1980s and 1990s, debt as a percent of GDP stayed within post-WW II experience… Page 322 Federal government spending on Agriculture programs is the fourth highest on this list of total federal spending. Fiscal Policy Options Automatic fiscal policy instruments: take effect without explicit action by policymakers (e.g., progressive tax rates) Discretionary fiscal policy instruments: require explicit actions by the president or Congress (e.g., passing a law) Page 324 Impacts of Policy Tools Expansionary actions: Effects of action: Cut taxes Increase disposable income Increase government spending Increase aggregate demand Congress & Bush Page 327 Impacts of Policy Tools Expansionary actions: Effects of action: Cut taxes Increase disposable income Increase government spending Increase aggregate demand Contractionary actions: Effects of action: Increase taxes Decrease disposable income Cut government spending Decrease aggregate demand Congress & Bush Page 327 A federal budget deficit requires the U.S. Treasury to issue more government securities to balance sources and uses of funds… Page 324 An increase in the sale of government securities reduces the pool of private capital available to finance investment expenditures, raising interest rates… Page 324 We know from Chapter 12 that higher interest rates depresses investment expenditures… Page 324 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 Page 328 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…. Page 328 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…. Page 328 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” Chapter 14 focuses on the key consequences of business fluctuations….