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
3
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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 government’s banker and
fiscal agent
Regulate the money supply
4
Page 246-247
Location of the 12 District
Federal Reserve Banks
5
Page 246
The Fed’s 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
6
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Role of the Board of
Governors of the
Federal Reserve System
7
Page 247
Key role played by the
Federal Open Market
Committee (FOMC)
8
Page 247
Recent Fed Rate Actions
9
Role of the 12 District
Federal Reserve Banks
located throughout
the country
10
Page 247
Determinants
of the
Money Supply
11
Change in the Money Supply
Existing money
supply curve
 Perpendicular to
the quantity axis
 → it is unaffected
by the interest rate
12
Page 253
Change in the Money Supply
Expansionary monetary
policy action will shift MS
curve to the right over a
period of 12 mo. or so.
13
Page 253
Change in the Money Supply
Contractionary monetary
policy actions will shift the
money supply curve left
14
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 Ag Bank depositor sells $1 million in gov’t securities to the Fed
15
 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……..
Page 251
Change in the Money Supply
We can skip tracing deposits through the
economy via the following money supply (MS)
equation:
MS = (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 (ΔMS):
MS = (1.0 ÷ RR) ×  TR = MM × TR
16
Page 252-253
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 ΔMS is
MS = (1.0 ÷ .20) x TR
= 5.0 x $1 million
= $5 million
Table 13.3
bottom line
 This results in Loans of
loans = MS - TR
= $5 million - $1 million
= $4 million
17
Page 251-253
Change in
money supply
18
Change in
= loan volume
Initial
+ infusion
Page 251
Impacts of Policy Tools
Expansionary actions:
Effects of action:
Fed buys securities
Total reserves increase
Fed lowers the discount rate
Total reserves increase
Fed lowers required reserve ratio Money multiplier increases
Contractionary actions:
Effects of action:
Fed sells securities
Fed raises the discount rate
Fed raises required reserve ratio
Total reserves decrease
Total reserves decrease
Money multiplier decreases
Bernanke
19
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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
21
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The money demand curve
is given by equation (16.5):
MD = α – β x IR + γ x NI
 R is the interest rate
 NI is national income
 – β is the MD slope (i.e.,
MD÷IR)
 γ represents MD÷ NI
22
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↑ in income
→ ↑ demand
for money
MD = α – β x IR + γ x NI
23
Page 255
Determination of Interest Rate
Money market interest
rate given by intersection
of demand and supply
24
Page 255
MS*
0.06
25
Expansionary
monetary policy
lowers interest
rates
Page 255
M S*
0.14
26
Contractionary
monetary policy
raises interest
rates
Page 255
The full effects of this change
could take 12 months or more
to register in bank deposits
27
Page 256
A change in MS will alter the
equilibrium money market
interest rate
28
Page 256
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
30
Page 256
Eliminating
Recessionary and
Inflationary Gaps
31
What is the magnitude
of the recessionary
gap?
 YFE – Y1
32
Page 257
Use expansionary
monetary policy
 Push aggregate demand
from AD1 to AD3
 ↑ real GDP from Y1 to
Y3
 → only ↑ general price
level to P3
33
Page 257
Recessionary gap
of YFE – Y1 is
partially closed to
YFE – Y3
Inflation rate =
% Δ in price =
(P3 – P0) ÷P0
34
Page 257
Use of expansionary
monetary policy to
push AD from AD3 to
AD4
 ↑real GDP from Y3 to
YFE (full employment
GDP)
 ↑general price level to
P4
Recessionary gap
fully closed
35
Page 257
 Use of expansionary
monetary policy to
attain YPOT
 Shift aggregate
demand to AD5
 Will ↑ general price
level to P5
Inflation rate
(P5 – P4) ÷ P4
36
Inflationary
gap created
Page 257
Microeconomic
Interest Rate
Implications
37
Interest Rate Impacts on a 10Year $150K Business Loan
Annual
Annual
Total
Interest Total P & I Interest Interest
Rate
Payment Payment Payment
38
8%
$22,354.69
$7,354.69
$73,546.90
14%
28,757.67
13,757.67
137,576.88
20%
35,782.44
20,782.44
207,824.40
Page 259
Interest Rate Impacts on a 20Year $100K Home Mortgage
Monthly
Interest Total P & I
Rate
Payment
39
Monthly
Interest
Payment
Total
interest
payment
8%
$848.78
$432.08
$103,707.46
12%
1,115.73
699.06
167,773.46
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
40
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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
↑ spending and tax cuts
recently used to stimulate
the economy resulted in
new budget deficits
Budget deficit = Gov’t
expenditures > receipts
44
Page 262
% of Total Federal Taxes
Individuals vs. Business
Individuals and not businesses pay the
Bulk of federal taxes.
45
Page 262
A strong economy and
controlled spending led
to 1st 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
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Recent Trends in Deficit
47
Debt and the Deficit
General formula for the National Debt
National DebtT = National debt(T-1) + DeficitT
A negative deficit is a surplus
The growth in federal
debt has grown rapidly
over the last 25 years
48
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National debt grew as deficit spending
dominated the last 30 years
Debt as a % of GDP stayed within postWW II levels
49
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Federal government
spending on Agriculture
programs is the 4th
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)
51
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Impacts of Policy Tools
Expansionary actions:
Effects of action:
Cut taxes
Increase government spending
Increase disposable income
Increase aggregate demand
Contractionary actions:
Effects of action:
Increase taxes
Cut government spending
Decrease disposable income
Decrease aggregate demand
Congress & President
52
Page 269
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
54
Page 266
From Chapter 12
higher interest rates ↓
investment expend.
Page 266
The use of expansionary
fiscal policy actions
to push aggregate demand
from AD1 to AD3 increases
real GDP from Y1 to Y3
while only increasing the
general price level to P3.
Inflation rate
(P3 – P0) ÷P0
Recessionary gap
partially closed
Page 270
The use of expansionary
fiscal policy to push demand
from AD3 to AD4 increases
real GDP from Y3 to YFE
(full employment GDP),
But increases the general
price level to P4.
Inflation rate
(P4 – P3) ÷P3
Recessionary gap
closed….
Page 270
The use of expansionary
fiscal policy to attain
YPOT by shifting aggregate
demand to AD5 will
Increase the general price
level to P5.
Inflation rate
(P5 – P4) ÷P4
Inflationary gap
created….
Page 270
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”