MONETARY AND FISCAL POLICIES

Barbulean

STAGES OF INFLATION

• 1. CREEPING INFLATION (0%-3%)

• 2. WALKING INFLATION ( 3% - 7%)

• 3. RUNNING INFLATION (10% - 20 %)

• 4. HYPER INFLATION ( 20% and abv)

TYPES OF INFLATION

1. Demand Pull Inflation

2. Cost Push Inflation

Causes of Inflation

• 1. Demand pull InflationCauses for Increase in Demand :-a) Increase in Money Supplyb) Increase in Black Marketingc) Increase in Hoardingd) Repayment of Past Internal Debte) Increase in Exportsf) Increase in Income

• 2) Cost Push InflationCauses for Increase in Cost :-a) Increase in cost of raw materialsb) Shortage of Suppliesc) Natural calamitiesd) Industrial Disputese) Increase in Exportsf) Increase in Wagesg) Increase in Transportation Costh) Huge Expenditure on Advertisement

Effects of Inflation

• Inflation can have positive and negative effects on an economy. Negative effects of inflation include loss in stability in the real value of money and other monetary items over time; uncertainty about future inflation may discourage investment and saving, and high inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future. Positive effects include a mitigation of economic recessions, and debt relief by reducing the real level of debt.

What is the Monetary Policy?• The Monetary and Credit Policy is the policy

statement, traditionally announced twice a year, through which the Federal Reserve Bank seeks to ensure price stability for the economy.

• These factors include - money supply, interest rates and the inflation. In banking and economic terms money supply is referred to as M3 - which indicates the level (stock) of legal currency in the economy.

• Besides, the Fed also announces norms for the banking and financial sector and the institutions which are governed by it.

How is the Monetary Policy different from the Fiscal Policy?

• The Monetary Policy regulates the supply of money and the cost and availability of credit in the economy. It deals with both the lending and borrowing rates of interest for commercial banks.

• The Monetary Policy aims to maintain price stability, full employment and economic growth.

• The Monetary Policy is different from Fiscal Policy as the former brings about a change in the economy by changing money supply and interest rate, whereas fiscal policy is a broader tool within the government.

• The Fiscal Policy can be used to overcome recession and control inflation. It may be defined as a deliberate change in government revenue and expenditure to influence the level of national output and prices.

What are the objectives of the Monetary Policy?

• The objectives are to maintain price stability and ensure adequate flow of credit to the productive sectors of the economy.

• Stability for the national currency (after looking at prevailing economic conditions), growth in employment and income are also looked into. The monetary policy affects the real sector through long and variable periods while the financial markets are also impacted through short-term implications.

Fed’s Tools of Monetary Control

The Fed has 3 “tools” in its monetary toolbox:1) Changing the Reserve Requirement2) Open-Market Operations (buying & selling

government securities performed by the Federal Open-Market Committee)

3) Changing the Discount Rate

R.O.D.

CONTROLLING THE MONEY SUPPLY THROUGH BANKSTHE RESERVE REQUIREMENT

• Reserves are deposits that banks have received but have not loaned out.

• In the U.S. we have a fractional reserve banking system:– banks hold a fraction of the money

deposited as reserves and lend out the rest.

Monetary Policy Tools

The money supply in America is affected by the amount deposited in banks and the amount that banks loan out. The fraction of total deposits that a bank has to

keep as reserves is called the reserve requirement ratio.

Put another way, the reserve requirement is the amount (10%) of a bank’s total reserves that may not be loaned out.

Monetary Policy ToolsCONTROLLING THE MONEY SUPPLY THROUGH BANKS

THE RESERVE REQUIREMENT

• Open Market Operations:the buying and selling of U.S. securities (national debt in the form of bonds) by the Fed.– This is the primary tool used by the Fed. – Fed buys bonds – the money supply expands:

• bond buyers acquire money• bank reserves increase, placing banks

in a position to expand the money supply through the extension of additional loans.

– Fed sells bonds – the money supply contracts:• bond buyers give up money for securities• bank reserves decline, causing them to extend fewer

loans.

CONTROLLING MONEY SUPPLY THROUGH THE INTEREST RATETHE DISCOUNT RATE (Federal Funds Rate)

• The Discount Rate is the interest rate the Fed charges banks for loans.

Monetary Policy Tools

Increasing the discount rate decreases the money supply.

Decreasing the discount rate increases the money supply.

“The Discount Window”

• Discount Rate:the interest rate the Fed charges banking institutions for borrowed funds.– An increase in the discount rate decreases the

money supply (restrictive) because it discourages banks from borrowing from the Federal Reserve to extend new loans.

– A reduction in the discount rate increases the money supply (expansionary) because it makes borrowing from the Federal Reserve less costly.

The 3 Tools the Fed Uses to Control the Money Supply

(1) (2)Easy money policy (Expansionary) Tight money policy (Contractionary)

Problem: unemployment and recession Problem: inflation

Federal Reserve buys Federal Reserve sells bonds, increases bonds, lowers reserve ration, or reserve ratio, or increases the discount ratelowers the discount rate

Excess reserves increase Excess reserves decrease

Money supply rises Money supply falls

Interest rates fall Interest rate rises

Investment spending increases Investment spending decreases

Aggregate demand increases Aggregate demand decreases

Real GDP rises by a multiple Inflation declinesof the increase in investment

REVIEW: TOOLS OF MONETARY POLICYOpen-Market Operations

The Reserve RatioThe Discount Rate

Examples:•Buy securities

•Increase Reserve Ratio

•Raise Discount Rate

•Sell Securities

•Decrease Reserve Ratio

•Lower Discount Rate

What will happen to the money supply in the following situations?

MONEY DECREASES

MONEY DECREASES

MONEY INCREASES

MONEY INCREASES

MONEY DECREASES

MONEY INCREASES

Monetary Policy Tools

Banks are any institution holding deposits. People deposit money in a bank. Banks must hold a specific percentage of the deposit as reserves; this percentage is called the required reserve ratio. The deposit that is not part of required reserves is called excess reserves.

The bank may loan excess reserves or buy government securities. A bank makes a loan by creating a checkable deposit for the borrower; this results in an increase in the money supply. The money supply equals currency, checkable deposits and traveler’s checks.

The total increase in the money supply may be less than predicted by the money expansion multiplier if - borrowers do not spend all of the money they borrow,- banks do not lend out all their excess reserves and- people hold part of their money as cash.

Activity 37

The Multiple Expansion of Checkable Deposits

Assume thatthe required reserve ratio is 10% of checkable deposits and banks lend out the other 90% (banks wish to hold no excess reserves) andall money lent out by one bank is re-deposited in another bank

• 1. Under these assumptions, if a new checkable deposit of $1,000 is made in Bank 1

• (A) how much will Bank 1 keep as required reserves? • (B) how much will Bank 1 lend out?• (C) how much will be re-deposited in Bank 2?• (D) how much will Bank 2 keep as required reserves?• (E) how much will Bank 2 lend out?• (F) how much will be re-deposited in Bank 3?

Assume thatthe required reserve ratio is 10% of checkable deposits and banks lend out the other 90% (banks wish to hold no excess reserves) andall money lent out by one bank is re-deposited in another bank

• 1. Under these assumptions, if a new checkable deposit of $1,000 is made in Bank 1

• (A) how much will Bank 1 keep as required reserves?

• (B) how much will Bank 1 lend out?• (C) how much will be re-deposited in Bank 2?• (D) how much will Bank 2 keep as required

reserves?• (E) how much will Bank 2 lend out?• (F) how much will be re-deposited in Bank 3?

$900.00

$100.00

$90.00

$810.00

$810.00

$900.00

Checkable deposits, Reserves and Loans in seven banks

Bank # New checkable deposits

10% fractional reserves Loans

1 $1,000 $100.00 $900.002 900.00 810.003 81.004 656.1056 59.057 531.44 478.30

All other banks combined

Total for all banks $10,000.00 $9,000.00

Figure 37.1Checkable deposits, Reserves and Loans in seven banksBank # New checkable

deposits10% fractional reserves Loans

1 $1,000 $100.00 $900.002 900.00 90.00 810.003 810 81.00 729.004 729.00 72.90 656.105 656.10 65.61 590.496 590.49 59.05 531.447 531.44 53.14 478.30

All other banks combined 4782.98 478.30 4304.67

Total for all banks $10,000.00 1,000.00 $9,000.00

In the example from figure 37.1:1. The original deposit of $1,000 increased total bank reserves by ________ .

Eventually this led to a total $10,000 expansion of bank deposits, ________ of which was because of the original deposit, while ________ was because of repeated bank lending activity.

2. Therefore, if the fractional reserve had been 15% instead of 10%, the amount of deposit expansion would have been (more / less) than in this example.

3. Therefore, if the fractional reserve had been 5% instead of 10%, the amount of deposit expansion would have been (more / less) than in this example.

4. If banks had not loaned out all of their excess reserves, the amount of deposit expansion would have been (more / less) than in this example.

5. If all loans had not been re-deposited in the banking system, the amount of deposit expansion would have been (more / less) than in this example.

In the example from figure 37.1:1. The original deposit of $1,000 increased total bank reserves by $1,000 .

Eventually this led to a total $10,000 expansion of bank deposits, $1,000 of which was because of the original deposit, while $9,000 was because of repeated bank lending activity.

2. Therefore, if the fractional reserve had been 15% instead of 10%, the amount of deposit expansion would have been LESS than in this example.

3. Therefore, if the fractional reserve had been 5% instead of 10%, the amount of deposit expansion would have been MORE than in this example.

4. If banks had not loaned out all of their excess reserves, the amount of deposit expansion would have been LESS than in this example.

5. If all loans had not been re-deposited in the banking system, the amount of deposit expansion would have been LESS than in this example.

Double Entry Bookkeeping

Arguably, the greatest innovation in practical mathematics since the

decimal system

The T-account• A T-account is an accounting relationship that looks at changes in balance sheet

items.• Since balance sheets must balance, so must T-accounts• T-account entries on the asset side must be balanced by an offsetting asset or

liability• For a bank

– Assets include • vault cash, • accounts at the Federal Reserve district bank,• Treasury securities • loans.

– Liabilities are • deposits.

• Net worth is – Assets minus Liabilities

Deposits $1000

Assets

Reserves $100Loans $900

Liabilities

Assume that $1000 is deposited in a bank, that each bank lends out all excess reserves (banks wish to hold no excess reserves)

all money lent out by one bank is re-deposited in another bank

1% 5% 10% 12.5% 15% 25%Required reserves $100

Excess reserves $900

Deposit expansion multiplier

10

Maximum increase in the money supply

10,000-1,000=9,000

Required Reserve Ratio

Assume that $1000 is deposited in a bank, that each bank lends out all excess reserves

(banks wish to hold no excess reserves) all money lent out by one bank is re-deposited in another bank

1% 5% 10% 12.5% 15% 25%Required reserves $10 $50 $100 $125 $150 $250

Excess reserves $990 $950 $900 $875 $850 $750

Deposit expansion multiplier

100 20 10 8 6.67 4

Maximum increase in the money supply

100,000-1,000

=$99,000

20,000-1,000

=$19,000

10,000-1,000

=$9,000

8,000-1,000

=$7,000

6,667-1,000

=$5,667

4,000-1000

=$3,000

Required Reserve Ratio

6. If the required reserve requirement were 0%, then the money supply expansion would be infinite.

• Why don’t we want an infinite growth of the money supply? (remember the equation of exchange)

6. If the required reserve requirement were 0%, then the money supply expansion would be infinite.

• Why don’t we want an infinite growth of the money supply? (remember the equation of exchange)

• We know that with – a given population and– A given quantity of capital– At a given level of technology for the natural resources available

• Real Output (Q) cannot increase beyond full employment• The result would be hyper-inflation

7. If the Federal Reserve wants to increase the money supply,

• Should it raise or lower the reserve requirement?

• Why?

7. If the Federal Reserve (FRB) wants to increase the money supply,

• Should it raise or lower the reserve requirement?

• Why?

• The FRB should lower the reserve requirement.

• Lowering the percentage of required reserves, increases the excess reserves available in the banking system

• Increasing the deposit expansion multiplier

8. If the Federal Reserve increases the reserve requirement and velocity remains stable,

• What will happen to nominal GDP?• Why?

8. If the Federal Reserve increases the reserve requirement and velocity remains stable,

• What will happen to nominal GDP?• Why?• Nominal GDP would decrease.• Because the equation of exchange is an accounting identity, both products

MV and PQ must balance –• If the money supply (M) decreases,

– because of the increase in required reserves reduces excess reserves for loans; • and velocity (V) remains constant• Then (PQ) nominal GDP must also decrease

9. What economic goal might the Federal Reserve try to meet by reducing the money supply?

(A) Maximum employment

(B) Maintain price stability

(C) Moderate long term interest rates

9. What economic goal might the Federal Reserve try to meet by reducing the money supply?

(A) Maximum employment

(B) Maintain price stability

(C) Moderate long term interest rates

• (B) Price stability

10. Why might the money supply not expand by the amount predicted by the

deposit expansion multiplier?

10. Why might the money supply not expand by the amount predicted by the

deposit expansion multiplier?

• Banks may not choose to lend out all excess reserves

• Banks may be unable to lend out all excess reserves because households or firms may not want to borrow

• All loans may not be re-deposited into the banking system

How Banks Create Moneyby Extending Loans

• The U.S. banking system is a fractional reserve system where banks maintain only a fraction of their assets as reserves to meet the requirements of depositors.

• Under a fractional reserve system, an increase in reserves (excess reserves) will permit banks to extend additional loans and thereby expand the money supply (by creating additional checking deposits).

Fractional Reserve Banking

Bank

New cash deposits:

Actual Reserves New

Required Reserves

Potential demand deposits created by

extending new loansInitial deposit (bank A) Second stage (bank B) Third stage (bank C) Fourth stage (bank D) Fifth stage (bank E) Sixth stage (bank F) Seventh stage (bank G)

$1,000.00 $200.00 160.00

102.40 81.92 65.54 52.43

800.00 $800.00

512.00 128.00 640.00

640.00 512.00

409.60 409.60

327.68 327.68

262.14 262.14 209.71

Total $5,000.00 $1,000.00 $4,000.00All others (other banks) 1,048.58 209.71 838.87

Creating Money from New Reserves

• When banks are required to maintain 20% reserves against demand deposits, the creation of $1,000 of new reserves will potentially increase the supply of money by $5,000.

What is the Purpose of changing the Money Supply?

• The assumption is that the increased excess reserves from an expansionary monetary policy are going to be loaned out and going to be used to purchase Goods/Services – INCREASING GDP (Recession, less than full-employment)

• The assumption is that the decrease in excess reserves from a contractionary monetary policy are going to decrease loans and is going to discourage the purchases of Goods/Services – DECREASING GDP (Inflation, greater than full-employment)

The Money Multiplier: II

• MoneyMultiplier = 1/ ReserveRatio• So in the example above, if RR is .10, Money

Multiplier is ten.– And ten times the original $1,000 increase in

demand deposits is $10,000.

The Money Multiplier: III

• Now suppose the RR is instead 50%, what’s the money multiplier?

The Money Multiplier: III

• That’s right, it’s two – one divided by .50.• So if Bank 1 receives a new demand deposit

of $1,000, it can lend out $500, Bank 2 can lend out $250, and so on until a total of $2,000 of new money is in circulation.

The Money Multiplier Point

• The bigger the RR, the smaller the MM and the less money created by a new dollar of demand deposits.

How Banks Create Moneyby Extending Loans• The lower the percentage of the reserve requirement, the

greater the potential expansion in the money supply resulting from the creation of new reserves.

• The fractional reserve requirement places a ceiling on potential money creation from new reserves.

• The actual deposit multiplier will be less than the potential because: – Some persons will hold currency rather than bank

deposits. – Some banks may not use all their excess reserves to

extend loans.

Government in the Economy

• Nothing arouses as much controversy as the role of government in the economy.

• Government can affect the macroeconomy in two ways:– Fiscal policy is the manipulation of

government spending and taxation.– Monetary policy refers to the behavior of

the Federal Reserve regarding the nation’s money supply.

What is Fiscal Policy?

• Fiscal policy is the deliberate manipulation of government purchases, transfer payments, taxes, and borrowing in order to influence macroeconomic variables such as employment, the price level, and the level of GDP

Government in the Economy• Discretionary fiscal policy refers to deliberate

changes in taxes or spending.

• The government can not control certain aspects of the economy related to fiscal policy. For example:

– The government can control tax rates but not tax revenue. Tax revenue depends on household income and the size of corporate profits.

– Government spending depends on government decisions and the state of the economy.

Fiscal Policy in Practice

Introduction• Before the 1930s, fiscal policy was not explicitly used to influence the

macroeconomy– The classical approach implied that natural market forces, by way of

flexible prices, wages, and interest rates, would move the economy toward its potential GDP

– Thus there appeared to be no need for government intervention in the economy

• Before the onset of the Great Depression, most economists believed that active fiscal policy would do more harm than good

The Great Depression and World War II

• Three developments bolstered the use of fiscal policy– The publication of Keynes’ General Theory– War-time demand on production helped pull the U.S. out of the

Great Depression– The Full Employment Act of 1946, which gave the federal

government responsibility for promoting full employment and price stability

Automatic Stabilizers• Structural features of government

spending and taxation that smooth fluctuations in disposable income over the business cycle

• Examples include,– Our progressive income system with its

increasing marginal income tax rates– Unemployment insurance– Welfare spending

Supply side shocksThe level of national income can change in short term if there is a supply-side shock. Many factors can bring about a changes in supply, including changes in following:1.Wage levels, which affect firms’ unit labour costs.2.Other costs of production, such as commodity prices, or which changes in oil prices are significant.3.Indirect taxes, such as VAT.4.Subsidies.5.Productivity of factors, especially labour.6.Changes in the use of technology and production methods.7.Direct taxes, such as income tax, via an incentive or disincentive effect.8.Length of the working week. 9.Labor migration.

http://www.economicsonline.co.uk/Managing_the_economy/Supply_side_shocks.html

The Golden Age of Keynesian Fiscal Policy to Stagflation

• The Early 1960s provided support for Keynesian theories– In particular, President Kennedy’s 1964 income tax cut did much to

boost the economy and reduce unemployment• However, the 1970s were marked by significant supply-side

shocks (increases in oil prices in addition to crop failures)– The economic ills brought about by these supply-side shocks to the

economy could not be remedied by demand-side Keynesian economic theories

Supply side shocks cause cyclical instability by shifting short-run aggregate supply (SRAS) although they are unlikely to have any major impact on the long-run productive potential of the economy. A negative supply-side shock might be caused by a rise in world oil prices - over the last thirty years there have been several occasions when the international price of crude oil has moved sharply higher causing major effects on the economies of countries across the global economy. The rise in oil prices has causes an increase in the variable costs of firms for whom oil is an essential input into the production process. For this reason firms may seek to raise their prices to protect their profit margins

Lags in Fiscal Policy• The time required to approve and implement fiscal

legislation may hamper its effectiveness and weaken fiscal policy as a tool of economic stabilization

• In the case of an oncoming recession, it may take time to– Recognize the coming recession– Implement the policy– Let the policy have its impact

Discretionary Policy and Permanent Income

• Permanent income is income that individuals expect to receive on average over the long run

• To the extent that consumers base spending decisions on their permanent income, attempts to fine-tune the economy through discretionary fiscal policy will be less effective

Budgets, Deficits,and Public Policy

The Government Budget

• A plan for government expenditures and revenues for a specified period, usually a year

The Federal Budget

• The federal budget is the budget of the federal government.

• The difference between the federal government’s receipts and its expenditures is the federal surplus (+) or deficit (-).

The Federal Budget

There is one tax here that you probably do not know…. Be honest….

Excise taxTobacco, alcohol and gasoline These are the three main targets of excise taxation in most countries around the world. They are everyday items of mass usage (even, arguably, "necessity") which bring huge profits for governments. The first two are considered to be legal drugs, which are a cause of many illnesses, which are used by large swathes of the population, with tobacco being widely recognized as addictive. Gasoline (or petrol), as well as diesel and other fuels, meanwhile, despite being indispensable to modern life, have excise tax imposed on them mainly because they pollute the environment.Narcotics Many US states tax illegal drugs. Gambling Gambling licences are subject to excise in many countries; however, gambling itself was for a time also subject to taxation, in the form of stamp duty, whereby a revenue stamp had to be placed on the ace of spades in every pack of cards to demonstrate that the duty had been paid.

Taxes & Government Spending

• Entitlement Programs:– Entitlements – social welfare programs that

people are “entitled to” if they meet certain eligibility requirements. i.e. age or

income– Mandatory spending increases as more and more

people qualify for the money.– Some of the entitlement programs are “means-

tested”, that means people with higher incomes may receive lower benefits or no benefit at all.

Taxes & Government Spending

– Entitlements are a largely unchanging part of government spending.

– Once Congress has set the requirements, it cannot control how many people become

eligible for each king of benefit.– Congress can change the eligibility requirements

or reduce the amount of the benefits.

Taxes & Government Spending

• Social Security– This is the largest category of federal spending.– More than 50 million retired or disabled people

and their families and survivors receive monthly payments.

Taxes & Government Spending

• Medicare– Medicare serves about 40 million people, most of

them over the age of 65.– This program pays for hospital care and for the

costs of the physicians and medical services.

– Also pays for disabled people and those suffering from certain diseases.

– It is funded by taxes withheld from your paycheck

Taxes & Government Spending

• Medicaid– It benefits low-income families, some people with

disabilities, and elderly people in nursing homes.

– It is the largest source of funds for medical and health-related services for America’s

poorest people.

Taxes & Government Spending

• Other Mandatory Spending Programs– These include

• Food Stamps• Supplemental Security Income (SSI)• Child Nutrition

Taxes & Government Spending

• Future of Entitlement Spending– Spending for both Social Security and Medicare

have increased enormously.– It is expected to increase even more in the future

as the “baby-boomers” began to collect.

Entitlement spending

http://www.youtube.com/watch?v=JsTbkB9hOuw