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 2

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 244 3

Functions of the Federal Reserve System Supply the economy with paper currency Supervise member banks Provide check collection and clearing services Maintain the reserve balances of depository institutions Lend to depository institutions Act at the federal governments banker and fiscal agent Regulate the money supply Page

Page 246 Location of the 12 District Federal Reserve Banks Location of the 12 District Federal Reserve Banks 5

The Feds 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

Page 247 Role of the Board of Governors of the Federal Reserve System Role of the Board of Governors of the Federal Reserve System 7

Page 247 Key role played by the Federal Open Market Committee (FOMC) Key role played by the Federal Open Market Committee (FOMC) 8

Recent Fed Rate Actions 9

Page 247 Role of the 12 District Federal Reserve Banks located throughout the country Role of the 12 District Federal Reserve Banks located throughout the country 10

Determinants of the Money Supply 11

Page 253 Existing money supply curve Perpendicular to the quantity axis it is unaffected by the interest rate Existing money supply curve Perpendicular to the quantity axis it is unaffected by the interest rate 12 Change in the Money Supply

Page 253 Expansionary monetary policy action will shift MS curve to the right over a period of 12 mo. or so. Change in the Money Supply 13

Page 253 Contractionary monetary policy actions will shift the money supply curve left Contractionary monetary policy actions will shift the money supply curve left Change in the Money Supply 14

Page 251 Ag Bank depositor sells $1 million in govt securities to the Fed Sale proceeds are deposited in his bank. W/ fractional reserve requirement ratio is 20% Bank Ag can the volume of its loans by $800,000. Suppose loan proceeds are deposited in Bank B. Etc…….. 15

Change in the Money Supply We can skip tracing deposits through the economy via the following money supply (M S ) equation: M S = (1.0 ÷ RR) × TR = MM × TR where TR represents total reserves and RR is the reserve requirement ratio. The expression within the parentheses is known as the money multiplier In terms of the money supply change (ΔM S ): M S = (1.0 ÷ RR) × TR = MM × TR Page

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 ΔM S is M S = (1.0 ÷.20) x TR = 5.0 x $1 million = $5 million This results in Loans of loans = MS - TR = $5 million - $1 million = $4 million Table 13.3 bottom line Page

Page 251 Change in money supply Change in money supply Change in loan volume Change in loan volume + = Initial infusion Initial infusion 18

Impacts of Policy Tools Expansionary actions:Effects of action: Fed buys securities Total reserves increase Fed lowers the discount rateTotal reserves increase Fed lowers required reserve ratioMoney multiplier increases Contractionary actions:Effects of action: Fed sells securities Total reserves decrease Fed raises the discount rateTotal reserves decrease Fed raises required reserve ratioMoney multiplier decreases Page 253 Bernanke 19

Determinants of the Money Demand 20

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

Page 255 The money demand curve is given by equation (16.5): M D = α – β x IR + γ x NI R is the interest rate NI is national income – β is the M D slope (i.e., M D ÷ IR) γ represents M D ÷ NI The money demand curve is given by equation (16.5): M D = α – β x IR + γ x NI R is the interest rate NI is national income – β is the M D slope (i.e., M D ÷ IR) γ represents M D ÷ NI 22

Page 255 M D = α – β x IR + γ x NI in income demand for money in income demand for money 23

Page 255 Money market interest rate given by intersection of demand and supply Money market interest rate given by intersection of demand and supply Determination of Interest Rate 24

Page 255 MS*MS* 0.06 Expansionary monetary policy lowers interest rates Expansionary monetary policy lowers interest rates 25

Page 255 MS*MS* 0.14 Contractionary monetary policy raises interest rates Contractionary monetary policy raises interest rates 26

Page 256 The full effects of this change could take 12 months or more to register in bank deposits The full effects of this change could take 12 months or more to register in bank deposits 27

Page 256 A change in M S will alter the equilibrium money market interest rate A change in M S will alter the equilibrium money market interest rate 28

Page 256 From Chapter 12 ΔIR movement along the planned investment function or new investment From Chapter 12 ΔIR movement along the planned investment function or new investment 29

Page 256 From Chapter 12 investment expenditures, a component of GDP demand for labor unemployment further in NI From Chapter 12 investment expenditures, a component of GDP demand for labor unemployment further in NI 30

Eliminating Recessionary and Inflationary Gaps 31

Page 257 What is the magnitude of the recessionary gap? Y FE – Y 1 What is the magnitude of the recessionary gap? Y FE – Y 1 32

Page 257 Use expansionary monetary policy Push aggregate demand from AD 1 to AD 3 real GDP from Y 1 to Y 3 only general price level to P 3 Use expansionary monetary policy Push aggregate demand from AD 1 to AD 3 real GDP from Y 1 to Y 3 only general price level to P 3 33

Page 257 Inflation rate = % Δ in price = (P 3 – P 0 ) ÷P 0 Inflation rate = % Δ in price = (P 3 – P 0 ) ÷P 0 Recessionary gap of Y FE – Y 1 is partially closed to Y FE – Y 3 Recessionary gap of Y FE – Y 1 is partially closed to Y FE – Y 3 34

Page 257 Use of expansionary monetary policy to push AD from AD 3 to AD 4 real GDP from Y 3 to Y FE (full employment GDP) general price level to P 4 Use of expansionary monetary policy to push AD from AD 3 to AD 4 real GDP from Y 3 to Y FE (full employment GDP) general price level to P 4 35 Recessionary gap fully closed Recessionary gap fully closed

Page 257 Use of expansionary monetary policy to attain Y POT Shift aggregate demand to AD 5 Will general price level to P 5 Use of expansionary monetary policy to attain Y POT Shift aggregate demand to AD 5 Will general price level to P 5 Inflationary gap created Inflationary gap created Inflation rate (P 5 – P 4 ) ÷ P 4 Inflation rate (P 5 – P 4 ) ÷ P 4 36

Microeconomic Interest Rate Implications 37

Interest Rate Impacts on a 10- Year $150K Business Loan Interest Rate Annual Total P & I Payment Annual Interest Payment Total Interest Payment 8%$22,354.69$7,354.69$73, %28, , , %35, , , Page

Interest Rate Impacts on a 20- Year $100K Home Mortgage Interest Rate Monthly Total P & I Payment Monthly Interest Payment Total interest payment 8%$848.78$432.08$103, %1, , Page

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

States Without Income Tax Eight states do not have a state income tax 41

State and Local Taxes Alaska, thanks to oil reserves, has the lowest tax burden Maine registered the highest state tax burden Major sources are of government revenue are sales and property taxes 42

Our focus is on fiscal policy at the federal level…. 43

Page 262 Budget deficit = Govt expenditures > receipts Budget deficit = Govt expenditures > receipts spending and tax cuts recently used to stimulate the economy resulted in new budget deficits 44

Page 262 Individuals and not businesses pay the Bulk of federal taxes. Individuals and not businesses pay the Bulk of federal taxes. % of Total Federal Taxes Individuals vs. Business % of Total Federal Taxes Individuals vs. Business 45

Page 263 A strong economy and controlled spending led to 1 st budget surplus in more than 20 years A strong economy and controlled spending led to 1 st budget surplus in more than 20 years The sub-prime lending defaults and resulting financial crisis and deficit spending have led to record high deficits… 46

Recent Trends in Deficit 47

Debt and the Deficit National Debt T = National debt (T-1) + Deficit T General formula for the National Debt A negative deficit is a surplus The growth in federal debt has grown rapidly over the last 25 years Page

Page 265 National debt grew as deficit spending dominated the last 30 years Debt as a % of GDP stayed within post- WW II levels National debt grew as deficit spending dominated the last 30 years Debt as a % of GDP stayed within post- WW II levels 49

Federal government spending on Agriculture programs is the 4 th highest on this list of total federal spending 50

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

Impacts of Policy Tools Expansionary actions:Effects of action: Cut taxes Increase disposable income Increase government spendingIncrease aggregate demand Contractionary actions:Effects of action: Increase taxes Decrease disposable income Cut government spendingDecrease aggregate demand Congress & President Page

Page 266 A federal budget deficit requires the U.S. Treasury to issue more government securities to balance sources and uses of funds A federal budget deficit requires the U.S. Treasury to issue more government securities to balance sources and uses of funds 53

Page 266 An in the sale of government securities the pool of private capital available to finance investment expenditures interest rates An in the sale of government securities the pool of private capital available to finance investment expenditures interest rates 54

Page 266 From Chapter 12 higher interest rates investment expend.

Page 270 The use of expansionary fiscal policy actions to push aggregate demand from AD 1 to AD 3 increases real GDP from Y 1 to Y 3 while only increasing the general price level to P 3. The use of expansionary fiscal policy actions to push aggregate demand from AD 1 to AD 3 increases real GDP from Y 1 to Y 3 while only increasing the general price level to P 3. Inflation rate (P 3 – P 0 ) ÷P 0 Inflation rate (P 3 – P 0 ) ÷P 0 Recessionary gap partially closed Recessionary gap partially closed

Page 270 The use of expansionary fiscal policy to push demand from AD 3 to AD 4 increases real GDP from Y 3 to Y FE (full employment GDP), But increases the general price level to P 4. The use of expansionary fiscal policy to push demand from AD 3 to AD 4 increases real GDP from Y 3 to Y FE (full employment GDP), But increases the general price level to P 4. Inflation rate (P 4 – P 3 ) ÷P 3 Inflation rate (P 4 – P 3 ) ÷P 3 Recessionary gap closed…. Recessionary gap closed….

Page 270 The use of expansionary fiscal policy to attain Y POT by shifting aggregate demand to AD 5 will Increase the general price level to P 5. The use of expansionary fiscal policy to attain Y POT by shifting aggregate demand to AD 5 will Increase the general price level to P 5. Inflation rate (P 5 – P 4 ) ÷P 4 Inflation rate (P 5 – P 4 ) ÷P 4 Inflationary gap created…. Inflationary gap created….

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