1. 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.

2. Fiscal Policy v Monetary 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

3. Topic 4: Monetary Policy
Interest rates and investment
Banking system
Federal Reserve

4. 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

5. 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.

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

7. How i influences I
See In Class Exercise #1

8. 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.

9. 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)

10. 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.

11. 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 isn’t constant

12. 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

13. 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

14. Philadelphia Goldsmith Balance Sheet
Assets
Liabilities
Reserves ($ in vault) $2000
Demand Deposits $10,000
Loans $8,000
Total: $10,000

15. Bank Balance Sheet – same idea
Assets
Liabilities
Reserves ($ in vault) $1000
Demand Deposits $10,000
Loans $7000
Securities $2000
Total: $10,000

16. 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

17. 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 => put new money into the economy => increases the money supply
Sell securities => take money out of the economy => decreases the money supply

18. 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
Sam’s bank keeps $160 in reserves and loans out $640 …
In total, the money supply increases up to $5000

19. 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

20. In Class Exercise #2
See handout.

21. 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.

22. 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

23. 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 => total demand (downward sloping)

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

25. 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

26. 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

27. 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

28. 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

29. 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

30. Causal Arrows Buy Bonds  +ΔMS  −Δi  +ΔI  +ΔY
Sell Bonds  −ΔMS  +Δi  −ΔI  −ΔY
−RRR  +ΔMS  −Δi  +ΔI  +ΔY
+RRR  −ΔMS  +Δi  −ΔI  −ΔY

31. Causal Arrows – Second Order Effects
+ΔMS  −Δi  +ΔI  +ΔY 
“Second order” effects: +ΔMD +Δi …
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 don’t need to know.

32. Buy Bonds  +ΔMS  −Δi  +ΔI  +ΔY
Can you answer this…
Buy Bonds  +ΔMS  −Δi  +ΔI  +ΔY
(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?

33. Types of Policy “Expansionary” Policy “Contractionary” 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