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 244

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 as the federal government’s banker and fiscal agent 7.Regulate the money supply Page 247

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

The Fed’s Policy Tools Reserve requirements – depository institutions are required to maintain a specific fraction of their customers’ deposits as reserves. banks must hold as vault cash or on deposit at a Federal Reserve Bank. As of June 2004, the reserve requirement was 10% on transaction deposits, and there were zero reserves required for time/savings deposits Currently play limited role in money creation in US Page 248

The Fed’s Policy Tools Discount rate – rate depository institutions pay when they borrow from the Fed They borrow from Fed if they want to increase loans but does not have any excess reserves at the moment Also to meet reserve requirements Federal Funds Market - interbank market trafficking in reserves; banks with excess reserves can lend to banks that are short on 24 hour basis. Page 249

The Fed’s Policy Tools Open market operations – Fed can buy or sell government securities to alter the money supply (used most frequently) Federal Open Market Committee (FOMC) directs the operations Directive to sell results in decrease in reserves at depository institutions because deposits are withdrawn to pay for the securities Page 249

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

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

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

Page 247 Key role played by the Federal Open Market Committee or FOMC Key role played by the Federal Open Market Committee or FOMC

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

Determinants of the Money Supply

Page 253 Existing money supply curve. Note it is perpendicular to the quantity axis, implying it is unaffected by the interest rate. Existing money supply curve. Note it is perpendicular to the quantity axis, implying it is unaffected by the interest rate.

Page 253 Expansionary monetary policy actions will shift the MS curve to the right over a period of 12 months or so. Expansionary monetary policy actions will shift the MS curve to the right over a period of 12 months or so.

Page 253 Contractionary monetary policy actions, on the other hand, will shift the money supply curve to left over a similar time period. Contractionary monetary policy actions, on the other hand, will shift the money supply curve to left over a similar time period.

Page 307 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 will have excess reserves of $800,000. It 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. From this example, we can make generalizations About the extent to which the money supply will increase when reserves are Increased. 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 will have excess reserves of $800,000. It 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. From this example, we can make generalizations About the extent to which the money supply will increase when reserves are Increased.

Change in the Money Supply We can skip tracing deposits through the economy by using 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 with the brackets is known as the money multiplier (MM). We can restate this equation in terms of the change in the money supply as follows:  M S = (1.0 ÷ RR) ×  TR = MM ×  TR Page 252

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:  M S = (1.0 ÷.20) x  TR = 5.0 x $1 million = $5 million This results in a change in loans of  loans =  MS -  TR = $5 million - $1 million = $4 million See bottom line in Table 13.3 See bottom line in Table 13.3 Page 252

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

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 Page 253 Bernanke

Impacts of Policy Tools Expansionary actions:Effects of action: Inc Ms 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: Dec Ms Fed sells securities Total reserves decrease Fed raises the discount rateTotal reserves decrease Fed raises required reserve ratioMoney multiplier decreases Page 253

Determinants of the Money Demand

Demand for Money: Why we hold cash? 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 254

Page 255 The money demand curve is given by equation (13.5): M D = 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  M D ÷  NI. The money demand curve is given by equation (13.5): M D = 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  M D ÷  NI.

Page 255 M D = c –d(R) + e(NI) Increase in income increases demand for money Increase in income increases demand for money

Page 255 Money market interest rate given by intersection of demand and supply Reflects the opp cost of holding money rather than income-earning asset. Money market interest rate given by intersection of demand and supply Reflects the opp cost of holding money rather than income-earning asset.

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

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

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

Page 256 A change in the money supply will alter the equilibrium interest rate in the money market A change in the money supply will alter the equilibrium interest rate in the money market

Page 256 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 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 256 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 (increases AD) 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 (increases AD)

Eliminating Recessionary and Inflationary Gaps

Page 257 What is the magnitude of the recessionary gap? What is the magnitude of the recessionary gap?

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

Page 257 The use of expansionary monetary 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 monetary 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.

Page 257 Inflation rate (P 3 – P 0 ) ÷P 0 Inflation rate (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

Page 257 The further use of expansionary monetary policy to push aggregate 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 further use of expansionary monetary policy to push aggregate 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.

Page 257 Inflation rate (P 4 – P 3 ) ÷P 3 Somewhat inflationary But does not swamp growth Inflation rate (P 4 – P 3 ) ÷P 3 Somewhat inflationary But does not swamp growth Recessionary gap fully closed Recessionary gap fully closed

Page 313 The use of expansionary monetary 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 monetary 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 Would cause inflation Inflation rate (P 5 – P 4 ) ÷P 4 Would cause inflation Inflationary gap created…..use contractionary monetary policy Inflationary gap created…..use contractionary monetary policy

Microeconomic Interest Rate Implications

Contractionary monetary policies that drive up interest rates will depress investment expenditures by businesses and households Expansionary monetary policies that lower interest rates will stimulate investment expenditures in the economy

Interest Rate Impacts on a 10- Year $150K Business Loan Interest rate Annual total PI payment Annual interest payment Total interest payment 8 percent$22,354.69$7,354.69$73, percent28, , , percent35, , , Page 259

Interest Rate Impacts on a 20- Year $100K Home Mortgage Interest rate Monthly total PI payment Monthly interest payment Total interest payment 8 percent$848.78$432.08$103, percent1, , Page 259

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 259

Fiscal Policy Options  Automatic fiscal policy instruments: take effect without explicit action by policymakers (e.g., progressive tax rates; unemployment compensation –built in stabilizers)  Discretionary fiscal policy instruments: require explicit actions by the president or Congress (e.g., passing a tax cut law; increase government spending authorized by Congress) Page 266

Impacts of Policy Tools Expansionary actions:Effects of action: Cut taxes Increase disposable income Increase government spendingIncrease aggregate demand Congress & Obama Page 269

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 & Obama Page 269

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…

An increase in the sale of government securities reduces the pool of private capital available to finance investment expenditures, raising interest rates… An increase in the sale of government securities reduces the pool of private capital available to finance investment expenditures, raising interest rates…

We know from Chapter 12 that higher interest rates depresses investment expenditures… We know from Chapter 12 that higher interest rates depresses investment expenditures…

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”