Final notes on Fiscal Policy

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Final notes on Fiscal Policy

• Which tax and government spending policies
  achieve desired equilibrium levels of national
  income?
• Given a desired level of Y, be able to find the
  needed G or Tx to achieve it.
• When is an increase in government spending, or a
  decrease in taxes, not inflationary?
• Not inflationary when increased output is
  produced using unemployed resources.
• Increased spending is inflationary if economy is
  at full employment.

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Fiscal Policy v Monetary Policy

• Fiscal Policy
• Conducted by legislative and executive branches
  of government
• Government spending and taxes to stimulate or
  slow down the economy
• Monetary Policy
• Conducted by the Central Bank or Federal Reserve
• Aimed at influencing the amount of investment,
  often through influence over interest rates

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Topic 4 Monetary Policy

• Interest rates and investment
• Banking system
• Federal Reserve

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Interest Rates

• Monetary policy is aimed at influencing
  investment, often through interest rates.
• Interest rates --
• The price of borrowing (or the payment for
  lending) money
• For this class, we will assume a single interest
  rate. E.g., the rate associated with US Treasury
  Bonds
• If you buy US Treasury Bonds from the government,
  you lend the government money. Used to finance
  spending and debt.
• A relatively stable investment with low
  volatility

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Interest Rates

• Suppose interest rate i 5. Buy a 1-year 1000
  bond.
• At the end of the year, the bond pays out 1000 x
  1.05 1050
• Interest rates in the economy help determine the
  amount of Investment or I.
• Remember investment or I includes plant
  equipment, housing, and inventories (NOT stocks
  and bonds)
• A higher interest rate i makes buying bonds
  more attractive relative to investing in I. So,
  as i goes up, I goes down.

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How i influences I -- Example
Firm Project Cost Expected Return
Gomers Filling Station Tow truck 190 10
Gomers Filling Station Pay at the pump 150 8
Gomers Filling Station Hydraulic Lift 50 4
Gomers Filling Station Inventory speculation 35 2
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How i influences I

• See In Class Exercise 1

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How does the Fed influence i?

• So, i helps determine the level of investment in
  an economy. How does monetary policy work (e.g.,
  how does the government influence i?)
• Through the banking system.
• Federal Reserve or Central Bank controls money
  supply.
• Money supply determines the price of money, or i.

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Banking System

• Central Bank, aka Federal Reserve
• Controls the central money supply
• Fractional Reserve Banking System
• Where we keep our money
• Banks are allowed to lend out some fraction of
  our deposits as investments to others
  (fractional reserve is the fraction that they
  cannot lend out and must keep as reserves)

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What is money?

• Money is what money does
• Medium of exchange
• Store of value
• Unit of account
• Not the same as currency. Although currency is
  usually a form of money.

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Evolution of Money

• Stage 1 No Money
• Q Without money how do people engage in trade?
• A Barter
• Problem High transaction costs
• Stage 2 Goods become treated as money
• E.g., tobacco in colonies, gold, silver, jewels
• Problems
• Hard to carry
• Can be perishable
• Quality isnt constant

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Evolution of Money

• Stage 3 Set up a central treasury for valued
  goods
• E.g., tobacco warehouse, where people can deposit
  their tobacco. The tobacco is rated, and the
  depositor is given a bank note stating rights to
  claim the tobacco.
• Now, bank note may be used as money.
• On gold standard, can take 1 bill to treasury
  and exchange for 1 worth of gold (case in US
  prior to 1971)
• Stage 4 Fiat money
• The government says that money can be used (e.g.,
  for all debts public and private)
• If go to treasury, can trade in your 1 bill for
  another 1 bill

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Philadelphia Goldsmith

• Goldsmith in 1740 Philly
• Has a good safe to keep his gold
• Offers neighbors the chance to keep there gold in
  the safe
• On any given day some people take gold out, other
  people put gold in
• Observation daily balance might go up and down
  slightly, but never falls below some level
• Good Idea Lend out some of the money from the
  vault

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Philadelphia Goldsmith Balance Sheet
Assets Liabilities
Reserves ( in vault) 2000 Demand Deposits 10,000
Loans 8,000
Total 10,000 Total 10,000
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Bank Balance Sheet same idea
Assets Liabilities
Reserves ( in vault) 1000 Demand Deposits 10,000
Loans 7000
Securities 2000
Total 10,000 Total 10,000
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Reserve Ratio

• Reserve Ratio Reserves / Deposits
• Required Reserve Ratio (i.e., RRR) The minimum
  reserve ratio as mandated by the Federal Reserve.
• If the RRR 0.2, then a bank with 10,000 in
  deposits can lend out 8000.
• Required Reserves RRR x Deposits
• Excess Reserves Reserves Required Reserves

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Money Supply

• Money Supply Cash On Hand Total Deposits
• The Fed influences money supply by buying or
  selling government securities (i.e., government
  bonds).
• Buy securities gt put new money into the economy
  gt increases the money supply
• Sell securities gt take money out of the economy
  gt decreases the money supply

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Buying Securities

• If the Fed buys 1000 in securities, it increases
  total money supply by MORE than 1000.
• Example How the 1000 flows through the economy,
  with a RRR 0.2
• Fed buys 1000 in securities from Sally, who puts
  the in bank
• Bank holds on to 200 and loans 800 to Fred to
  buy a car
• Fred buys the car from Sam who puts the 800 in
  her bank
• Sams bank keeps 160 in reserves and loans out
  640
• In total, the money supply increases up to 5000

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Changes to Money Supply

• Initial injection of Z into the money supply
  (i.e., purchase of Z worth of bonds) changes the
  total money supply by up to Z 1 / RRR
• Initial decrease of Z in the money supply (i.e.,
  sell Z worth of bonds) changes the total money
  supply by up to - Z 1 / RRR

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In Class Exercise 2

• See handout.

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3 Primary Tools of Fed

• Open Market Operations Buying and selling
  government securities (or other assets)
• Changing the Required Reserve Ratio
• Setting the Federal Funds Rate interest rate at
  which banks can borrow at the Fed
• The Fed does not directly set the US treasury
  bond rate. They announce a target, and achieve it
  through Open Market Operations.

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Market for Money

• Vertical axis is the price of money, represented
  by the interest rate, i
• Horizontal axis is the quantity of money
• Firms, Individuals, etc. determine money demand
• The Federal Reserve (Fed) determines money supply

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Money Demand

• Made up of three pieces
• Transaction Demand money on hand for
  transactions (money needed for purchases)
• Precautionary Demand rainy day funds (money
  that might be needed for purchases)
• Speculative Demand e.g., hold cash to buy bonds
  later if you expect bond rate will rise soon
  (money you are waiting until the right time to
  invest)
• Taken together gt total demand (downward sloping)

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Money Supply

• Typically, if banks have excess reserves, then
  they lend it out
• Money supply is vertical

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Market for Money

• Supply and Demand together
• Shifts in Supply when the Fed engages in open
  market operations or changes the required reserve
  ratio (RRR)
• Immediate shift
• Long-run shift

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Changing Investment through open market operations

• Fed buys bonds, causing the money supply to
  increase
• Through the market for money, an increase in
  money supply causes the price of money (i.e., the
  interest rate, i) to decrease
• A decrease in the interest rate increases
  investment I, as investors become less likely to
  put their money in bonds and more likely to
  invest in capital improvement projects, etc.
• An increase in investment increases the
  equilibrium level of national income and output

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Changing Investment through open market operations

• Fed sells bonds, causing the money supply to
  increase
• Through the market for money, a decrease in money
  supply causes the price of money (i.e., the
  interest rate, i) to increase
• An increase in the interest rate decreases
  investment I, as investors become more likely to
  put their money in bonds and less likely to
  invest in capital improvement projects, etc.
• A decrease in investment decreases the
  equilibrium level of national income and output

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Changing Investment through changing the required
reserve ratio

• Fed decreases RRR
• Banks can loan out more of their deposits, which
  increases the money supply
• As money supply increases, the price of money
  (i.e., the interest rate i) decreases
• A decrease in the interest rate results in more
  investment
• Higher investment increases national income

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Changing Investment through changing the required
reserve ratio

• Fed increases RRR
• Banks can loan out less of their deposits, which
  decreases the money supply
• As money supply decreases, the price of money
  (i.e., the interest rate i) increases
• An increase in the interest rate results in less
  investment
• Lower investment decreases national income

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Causal Arrows

• Buy Bonds ? ?MS ? -?i ? ?I ? ?Y
• Sell Bonds ? -?MS ? ?i ? -?I ? -?Y
• -RRR ? ?MS ? -?i ? ?I ? ?Y
• RRR ? -?MS ? ?i ? -?I ? -?Y

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Causal Arrows Second Order Effects

• ?MS ? -?i ? ?I ? ?Y
• 
  ?
• Second order effects ?MD ??i ?
• When income increases, money demand increases.
  This causes a second order effect
• Although the second order effect tends to
  decrease income (in this case), second order
  effects are less significant than the initial
  effect on income. Therefore, the overall change
  to income will still be positive.
• This slide is a technical point that you dont
  need to know.

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Can you answer this

• Buy Bonds ? ?MS ? -?i ? ?I ?
  ?Y
• (A) (B)
  (C) (D)
• How does buying bonds increase the money supply?
• How does an increase to the money supply decrease
  the interest rate?
• How does a decrease to the interest rate increase
  investment?
• How does increasing investment increase national
  income?

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Types of Policy

• Expansionary Policy
• Any policy that expands the economy
• Monetary Policy Reducing the RRR, buying bonds
• Fiscal Policy Increasing G, decreasing Tx
• Contractionary Policy
• Any policy that slows down or contracts the
  economy
• Monetary Policy Increasing the RRR, selling
  bonds
• Fiscal Policy Decreasing G, increasing Tx