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 Inflation Causes for Increase in Demand :- Increase in Money Supply Increase in Black Marketing Increase in Hoarding Repayment of Past Internal Debt Increase in Exports Deficit Financing

Cont………. g)Increase in Income h)Demonstration Effect i)Increase in Black money j) Increase in Credit facilities

Cont…. 2) Cost Push Inflation Causes for Increase in Cost :- Increase in cost of raw materials Shortage of Supplies Natural calamities Industrial Disputes Increase in Exports Increase in Wages Increase in Transportation Cost 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 Fedalso 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 with 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 Fixing an Economy: Monetary Policy & Federal Reserve Fed’s Tools of Monetary Control The Fed has 3 “tools” in its monetary toolbox: Changing the Reserve Requirement Open-Market Operations (buying & selling government securities performed by the Federal Open-Market Committee) Changing the Discount Rate R.O.D.

CONTROLLING THE MONEY SUPPLY THROUGH BANKS THE RESERVE REQUIREMENT Fixing an Economy: Monetary Policy & Federal Reserve Monetary Policy Tools CONTROLLING THE MONEY SUPPLY THROUGH BANKS THE 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.

Fixing an Economy: Monetary Policy & Federal Reserve Monetary Policy Tools CONTROLLING THE MONEY SUPPLY THROUGH BANKS THE RESERVE REQUIREMENT 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.

Open Market Operations: the buying and selling of U. S 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.

The Federal Reserve Controls the Money MS* MS1 The Federal Reserve Controls the Money Supply, which determines the Nominal Interest Rate in the Short-Term Money Markets Nominal Interest Rate I* I1 DM* Qm* Qm1 Note: Qm* represents M1 Money Supply Money Supply Buying bonds (securities), lowering the Reserve Requirement or lowering the Discount Rate, will put more money into the banking system. Supply of funds available in the banking system will INCREASE!!

Supply, which determines The Interest Rate The Federal Reserve Controls the Money Supply, which determines The Interest Rate MS1 MS* Nominal Interest Rate I1 I* DM* Qm1 Qm* Money Supply Selling bonds (securities), Raising the Reserve Requirement or Raising the Discount Rate, will take money out of the banking system. Supply of funds available in the banking system will DECREASE!!

Fixing an Economy: Monetary Policy & Federal Reserve Monetary Policy Tools CONTROLLING MONEY SUPPLY THROUGH THE INTEREST RATE THE DISCOUNT RATE (Federal Funds Rate) The Discount Rate is the interest rate the Fed charges banks for loans. 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.

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 rate lowers 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 declines of the increase in investment The 3 Tools the Fed Uses to Control the Money Supply

Monetary Policy Tools REVIEW: TOOLS OF MONETARY POLICY Open-Market Operations The Reserve Ratio The Discount Rate What will happen to the money supply in the following situations? Examples: Buy securities Increase Reserve Ratio Raise Discount Rate Sell Securities Decrease Reserve Ratio Lower Discount Rate MONEY DECREASES MONEY INCREASES MONEY DECREASES MONEY INCREASES MONEY DECREASES MONEY INCREASES

How Banks Create Money by Extending Loans

Fractional Reserve Banking 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).

Creating Money from New Reserves New cash deposits: Actual Reserves Potential demand deposits created by extending new loans New Required Reserves Bank Initial deposit (bank A) $1,000.00 $200.00 $800.00 Second stage (bank B) 800.00 160.00 640.00 Third stage (bank C) 640.00 128.00 512.00 Fourth stage (bank D) 512.00 102.40 409.60 Fifth stage (bank E) 409.60 81.92 327.68 Sixth stage (bank F) 327.68 65.54 262.14 Seventh stage (bank G) 262.14 52.43 209.71 All others (other banks) 1,048.58 209.71 838.87 Total $5,000.00 $1,000.00 $4,000.00 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-Supply Multiplier From this example, we see that there is a new kind of multiplier operating on bank reserves – a money-supply multiplier very different from the Keynesian expenditure multiplier.

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. Page down to advance the presentation

The Money Multiplier: III Now suppose the RR is instead 50%, what’s the money multiplier? Page down to advance the presentation

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. Page down to advance the presentation

The Money Multiplier Point The bigger the RR, the smaller the MM and the less money created by a new dollar of demand deposits. Page down to advance the presentation

How Banks Create Money by 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

Wage levels, which affect firms’ unit labour costs. Supply side shocks The 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: Wage levels, which affect firms’ unit labour costs. Other costs of production, such as commodity prices, or which changes in oil prices are significant. Indirect taxes, such as VAT. Subsidies. Productivity of factors, especially labour. Changes in the use of technology and production methods. Direct taxes, such as income tax, via an incentive or disincentive effect. Length of the working week. 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 tax Tobacco, 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

The Presidential Role in the Budget Process Early in this century, the president had very little involvement in the development of the federal budget By the mid-1970s the president had been given the resources to translate policy into a budget proposal to be presented to Congress Office of Management and Budget (1921) Employment Act of 1946 (Council of Economic Advisers)

The Presidential Role in the Budget Process (continued) The development of the president’s budget begins a year before it is submitted to Congress The presidents proposed budget (The Budget of the United States Government) is supported by the Economic Report of the President The budget is submitted in January for the upcoming fiscal year October 1-September 30

The Congressional Role in the Budget Process House and Senate budget committees review the president’s budget proposal An overall budget outline is approved by Congress (budget resolution) and given to the various congressional committees and subcommittees which authorize federal spending

Budget Deficits and Surpluses When budgeted expenditures exceed projected tax revenues, the budget is projected to be in deficit When projected tax revenues exceed budgeted expenditures, the budget is projected to be in surplus

Suggestions for Budget Reform Biennial budget The elimination of line item details before Congress Congress would consider only the overall budget for a given agency, rather that detailed line items

Rationale for Budget Deficits Large capital projects (highways, etc.) The benefits from these project will benefit more than current taxpayers, so deficit financing is appropriate Major Wars Keynesian economics points to the use of deficits to stimulate the economy during periods of economic slowdown Automatic stabilizers tend to increase deficits, since during times of recession, taxes are reduced while unemployment insurance and welfare payments are increased

Budget Philosophies Annually balanced budget—Budget philosophy prior to the Great Depression; aimed at equating revenues with expenditures, except during times of war Cyclically balanced budget—Budget philosophy calling for budget deficits during recessions to be financed by budget surpluses during expansions Functional Finance—A budget philosophy aiming fiscal policy at achieving potential GDP rather than balancing budgets either annually or over the business cycle

Crowding Out and Crowding In Crowding out--When the government undertakes expansionary fiscal policy, interest rates increase due to competition for borrowed funds and increased transactions demand for money As a result, private investment is “crowded out” due to increases in public investment Crowding in—If expansionary fiscal policy raises the general level of prosperity in the economy, private investors may expect greater investment-related profits, causing private investment to increase

The Federal Deficit Versus the National Debt The federal deficit is a flow variable measuring the amount by which expenditures exceed revenues in a particular year The national debt is a stock variable measuring the accumulation of past deficits In the U.S., it took 200 years for the national debt to reach $1 trillion After the debt reached this level, it took only 15 years for the debt to reach the $5 trillion level

The Debt and Problems http://www.brillig.com/debt_clock/ Arguments about the Debt We have to pay it back We owe it to ourselves (much less so than years ago).

Size of Government

Reducing the Deficit Line-item veto (signed into law in April 1996 struck by the Supreme Court in 1998) A provision to allow the president to reject particular portions of the budget rather than simply accept or reject the entire budget Balanced budget amendment Proposed amendment to the U.S. Constitution requiring a balanced federal budget

Five Debates over Macroeconomic Policy Chapter 34

Five Debates over Macroeconomic Policy 1. Should monetary and fiscal policymakers try to stabilize the economy? 2. Should monetary policy be made by rule rather than by discretion? 3. Should the central bank aim for zero inflation?

Five Debates over Macroeconomic Policy 4. Should the government balance its budget? 5. Should the tax laws be reformed to encourage saving?

1. Should Monetary and Fiscal Policymakers Try to Stabilize the Economy?

Pro: Policymakers should try to stabilize the economy The economy is inherently unstable, and left on its own will fluctuate. Policy can manage aggregate demand in order to offset this inherent instability and reduce the severity of economic fluctuations.

Pro: Policymakers should try to stabilize the economy There is no reason for society to suffer through the booms and busts of the business cycle. Monetary and fiscal policy can stabilize aggregate demand and, thereby, production and employment.

Con: Policymakers should not try to stabilize the economy Monetary policy affects the economy with long and unpredictable lags between the need to act and the time that it takes for these policies to work. Many studies indicate that changes in monetary policy have little effect on aggregate demand until about six months after the change is made.

Con: Policymakers should not try to stabilize the economy Fiscal policy works with a lag because of the long political process that governs changes in spending and taxes. It can take years to propose, pass, and implement a major change in fiscal policy.

Con: Policymakers should not try to stabilize the economy All too often policymakers can inadvertently exacerbate rather than mitigate the magnitude of economic fluctuations. It might be desirable if policy makers could eliminate all economic fluctuations, but this is not a realistic goal.

2. Should Monetary Policy Be Made by Rule Rather Than by Discretion?

Pro: Monetary policy should be made by rule Discretionary monetary policy can suffer from incompetence and abuse of power. To the extent that central bankers ally themselves with politicians, discretionary policy can lead to economic fluctuations that reflect the electoral calendar – the political business cycle.

Pro: Monetary policy should be made by rule There may be a discrepancy between what policymakers say they will do and what they actually do – called time inconsistency of policy. Because policymakers are so often time inconsistent, people are skeptical when central bankers announce their intentions to reduce the rate of inflation.

Pro: Monetary policy should be made by rule Committing the Fed to a moderate and steady growth of the money supply would limit incompetence, abuse of power, and time inconsistency.

Con: Monetary policy should not be made by rule An important advantage of discretionary monetary policy is its flexibility. Inflexible policies will limit the ability of policymakers to respond to changing economic circumstances.

Con: Monetary policy should not be made by rule The alleged problems with discretion and abuse of power are largely hypothetical. Also, the importance of the political business cycle is far from clear.

3. Should The Central Bank Aim for Zero Inflation?

Pro: The central bank should aim for zero inflation Inflation confers no benefit to society, but it imposes several real costs. Shoeleather costs Menu costs Increased variability of relative prices Unintended changes in tax liabilities Confusion and inconvenience Arbitrary redistribution of wealth

Pro: The central bank should aim for zero inflation Reducing inflation is a policy with temporary costs and permanent benefits. Once the disinflationary recession is over, the benefits of zero inflation would persist.

Con: The central bank should not aim for zero inflation Zero inflation is probably unattainable, and to get there involves output, unemployment, and social costs that are too high. Policymakers can reduce many of the costs of inflation without actually reducing inflation.

4. Should Fiscal Policymakers reduce the Government Debt?

Pro: The government should balance its budget Budget deficits impose an unjustifiable burden on future generations by raising their taxes and lowering their incomes. When the debts and accumulated interest come due, future taxpayers will face a difficult choice: They can pay higher taxes, enjoy less government spending, or both.

Pro: The government should balance its budget By shifting the cost of current government benefits to future generations, there is a bias against future taxpayers. Deficits reduce national saving, leading to a smaller stock of capital, which reduces productivity and growth.

Con: The government should not balance its budget The problem with the deficit is often exaggerated. The transfer of debt to the future may be justified because some government purchases produce benefits well into the future.

Con: The government should not balance its budget The government debt can continue to rise because population growth and technological progress increase the nation’s ability to pay the interest on the debt.

5. Should The Tax Laws Be Reformed to Encourage Saving?

Pro: Tax laws should be reformed to encourage saving A nation’s saving rate is a key determinant of its long-run economic prosperity. A nation’s productive capability is determined largely by how much it saves and invests for the future. When the saving rate is higher, more resources are available for investment in new plant and equipment.

Pro: Tax laws should be reformed to encourage saving The U.S. tax system discourages saving in many ways, such as by heavily taxing the income from capital and by reducing benefits for those who have accumulated wealth.

Pro: Tax laws should be reformed to encourage saving The consequences of high capital income tax policies are reduced saving, reduced capital accumulation, lower labor productivity, and reduced economic growth.

Pro: Tax laws should be reformed to encourage saving An alternative to current tax policies advocated by many economists is a consumption tax. With a consumption tax, a household pays taxes based on what it spends not on what it earns. Income that is saved is exempt from taxation until the saving is later withdrawn and spent on consumption goods.

Con: Tax laws should not be reformed to encourage saving Many of the changes in tax laws to stimulate saving would primarily benefit the wealthy. High-income households save a higher fraction of their income than low-income households. Any tax change that favors people who save will also tend to favor people with high incomes.

Con: Tax laws should not be reformed to encourage saving Reducing the tax burden on the wealthy would lead to a less egalitarian society. This would also force the government to raise the tax burden on the poor.

Con: Tax laws should not be reformed to encourage saving Raising public saving by eliminating the government’s budget deficit would provide a more direct and equitable way to increase national saving.

Summary Advocates of active monetary and fiscal policy view the economy as inherently unstable and believe policy can be used to offset this inherent instability. Critics of active policy emphasize that policy affects the economy with a lag and our ability to forecast future economic conditions is poor, both of which can lead to policy being destabilizing.

Summary Advocates of rules for monetary policy argue that discretionary policy can suffer from incompetence, abuse of power, and time inconsistency. Critics of rules for monetary policy argue that discretionary policy is more flexible in responding to economic circumstances.

Summary Advocates of a zero-inflation target emphasize that inflation has many costs and few if any benefits. Critics of a zero-inflation target claim that moderate inflation imposes only small costs on society, whereas the recession necessary to reduce inflation is quite costly.

Summary Advocates of reducing the government debt argue that the debt imposes a burden on future generations by raising their taxes and lowering their incomes. Critics of reducing the government debt argue that the debt is only one small piece of fiscal policy.

Summary Advocates of tax incentives for saving point out that our society discourages saving in many ways such as taxing income from capital and reducing benefits for those who have accumulated wealth. Critics of tax incentives argue that many proposed changes to stimulate saving would primarily benefit the wealthy and also might have only a small effect on private saving.