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 :a)
b)
c)
d)
e)
f)
Increase in Money Supply
Increase in Black Marketing
Increase in Hoarding
Repayment of Past Internal Debt
Increase in Exports
Increase in Income
• 2) Cost Push Inflation
Causes for Increase in Cost :a) Increase in cost of raw materials
b) Shortage of Supplies
c) Natural calamities
d) Industrial Disputes
e) Increase in Exports
f) Increase in Wages
g) Increase in Transportation Cost
h) 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 Fed also 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 within 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
The Fed has 3 “tools” in its monetary toolbox:
1) Changing the Reserve Requirement
2) Open-Market Operations (buying & selling
government securities performed by the Federal OpenMarket Committee)
3) Changing the Discount Rate
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.
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. 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.
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.
• 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.
The 3 Tools the Fed Uses
to Control the Money Supply
(1)
Easy money policy (Expansionary)
(2)
Tight money policy (Contractionary)
Problem: unemployment and recession
Problem: inflation
Federal Reserve buys
bonds, lowers reserve ration, or
lowers the discount rate
Federal Reserve sells bonds, increases
reserve ratio, or increases 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
of the increase in investment
Inflation declines
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
•Sell Securities
MONEY INCREASES
MONEY DECREASES
•Increase Reserve Ratio
•Decrease Reserve Ratio
MONEY DECREASES
•Raise Discount Rate
MONEY DECREASES
MONEY INCREASES
•Lower Discount Rate
MONEY INCREASES
Banks are any institution holding deposits. People deposit money in
a bank. Banks must hold a specific percentage of the deposit as
reserves; this percentage is called the required reserve ratio. The
deposit that is not part of required reserves is called excess
reserves.
The bank may loan excess reserves or buy government securities. A
bank makes a loan by creating a checkable deposit for the
borrower; this results in an increase in the money supply. The
money supply equals currency, checkable deposits and traveler’s
checks.
The total increase in the money supply may be less than
predicted by the money expansion multiplier if
- borrowers do not spend all of the money they borrow,
- banks do not lend out all their excess reserves and
- people hold part of their money as cash.
Activity 37
The Multiple Expansion of Checkable
Deposits
Assume that
the required reserve ratio is 10% of checkable deposits and banks lend out the other 90% (banks
wish to hold no excess reserves) and
all money lent out by one bank is re-deposited in another bank
• 1. Under these assumptions, if a new checkable
deposit of $1,000 is made in Bank 1
• (A) how much will Bank 1 keep as required reserves?
• (B) how much will Bank 1 lend out?
• (C) how much will be re-deposited in Bank 2?
• (D) how much will Bank 2 keep as required reserves?
• (E) how much will Bank 2 lend out?
• (F) how much will be re-deposited in Bank 3?
Assume that
the required reserve ratio is 10% of checkable deposits and banks lend out the other 90% (banks
wish to hold no excess reserves) and
all money lent out by one bank is re-deposited in another bank
• 1. Under these assumptions, if a new
checkable deposit of $1,000 is made in
Bank 1
• (A) how much will Bank 1 keep as
$100.00
required reserves?
• (B) how much will Bank 1 lend out? $900.00
• (C) how much will be re-deposited in
Bank 2?
$900.00
• (D) how much will Bank 2 keep as
$90.00
required reserves?
• (E) how much will Bank 2 lend out? $810.00
• (F) how much will be re-deposited in $810.00
Bank 3?
Checkable deposits, Reserves and Loans in seven banks
Bank #
New checkable
deposits
10% fractional reserves
Loans
1
2
3
4
5
6
7
$1,000
900.00
$100.00
$900.00
810.00
81.00
656.10
59.05
531.44
478.30
$10,000.00
$9,000.00
All other banks
combined
Total for all banks
Figure 37.1
Checkable deposits, Reserves and Loans in seven banks
Bank #
New checkable
deposits
10% fractional reserves
Loans
1
2
3
4
5
6
7
$1,000
900.00
810
729.00
656.10
590.49
531.44
4782.98
$100.00
90.00
81.00
72.90
65.61
59.05
53.14
478.30
$900.00
810.00
729.00
656.10
590.49
531.44
478.30
4304.67
$10,000.00
1,000.00
$9,000.00
All other banks
combined
Total for all banks
In the example from figure 37.1:
1.
2.
3.
4.
5.
The original deposit of $1,000 increased total bank reserves by ________ .
Eventually this led to a total $10,000 expansion of bank deposits, ________ of
which was because of the original deposit, while ________ was because of
repeated bank lending activity.
Therefore, if the fractional reserve had been 15% instead of 10%, the amount of
deposit expansion would have been (more / less) than in this example.
Therefore, if the fractional reserve had been 5% instead of 10%, the amount of
deposit expansion would have been (more / less) than in this example.
If banks had not loaned out all of their excess reserves, the amount of deposit
expansion would have been (more / less) than in this example.
If all loans had not been re-deposited in the banking system, the amount of
deposit expansion would have been (more / less) than in this example.
In the example from figure 37.1:
1.
2.
3.
4.
5.
The original deposit of $1,000 increased total bank reserves by $1,000 .
Eventually this led to a total $10,000 expansion of bank deposits, $1,000 of
which was because of the original deposit, while $9,000 was because of
repeated bank lending activity.
Therefore, if the fractional reserve had been 15% instead of 10%, the amount of
deposit expansion would have been LESS than in this example.
Therefore, if the fractional reserve had been 5% instead of 10%, the amount of
deposit expansion would have been MORE than in this example.
If banks had not loaned out all of their excess reserves, the amount of deposit
expansion would have been LESS than in this example.
If all loans had not been re-deposited in the banking system, the amount of
deposit expansion would have been LESS than in this example.
Double Entry Bookkeeping
Arguably, the greatest innovation in
practical mathematics since the
decimal system
The T-account
•
•
•
•
A T-account is an accounting
relationship that looks at changes in
balance sheet items.
Since balance sheets must balance,
so must T-accounts
T-account entries on the asset side
must be balanced by an offsetting
asset or liability
For a bank
– Assets include
• vault cash,
• accounts at the Federal Reserve
district bank,
• Treasury securities
• loans.
– Liabilities are
• deposits.
•
Net worth is
– Assets minus Liabilities
Assets
Loans
Reserves
Liabilities
$900
$100
Deposits
$1000
Assume that $1000 is deposited in a bank,
that each bank lends out all excess reserves (banks wish to hold no excess reserves)
all money lent out by one bank is re-deposited in another bank
Required Reserve Ratio
1%
5%
10%
Required reserves
$100
Excess reserves
$900
Deposit
expansion
multiplier
Maximum
increase in the
money supply
10
10,000
-1,000
=9,000
12.5%
15%
25%
Assume that $1000 is deposited in a bank,
that each bank lends out all excess reserves
(banks wish to hold no excess reserves)
all money lent out by one bank is re-deposited in another bank
Required Reserve Ratio
Required reserves
Excess reserves
Deposit
expansion
multiplier
Maximum
increase in the
money supply
1%
5%
10%
12.5%
15%
25%
$10
$50
$100
$125
$150
$250
$990
$950
$900
$875
$850
$750
100
20
10
8
6.67
4
100,000
-1,000
=$99,000
20,000
-1,000
=$19,000
10,000
-1,000
=$9,000
8,000
-1,000
=$7,000
6,667
-1,000
=$5,667
4,000
-1000
=$3,000
6. If the required reserve requirement were 0%, then
the money supply expansion would be infinite.
• Why don’t we want an
infinite growth of the
money supply?
(remember the
equation of exchange)
6. If the required reserve requirement were 0%, then
the money supply expansion would be infinite.
• Why don’t we want an
infinite growth of the
money supply? (remember
the equation of exchange)
• We know that with
– a given population and
– A given quantity of capital
– At a given level of technology
for the natural resources
available
• Real Output (Q) cannot
increase beyond full
employment
• The result would be hyperinflation
7. If the Federal Reserve wants to increase the money
supply,
• Should it raise or lower
the reserve
requirement?
• Why?
7. If the Federal Reserve (FRB) wants to increase the
money supply,
• Should it raise or lower
the reserve
requirement?
• Why?
• The FRB should lower
the reserve
requirement.
• Lowering the
percentage of required
reserves, increases the
excess reserves
available in the banking
system
• Increasing the deposit
expansion multiplier
8. If the Federal Reserve increases the reserve
requirement and velocity remains stable,
• What will happen to
nominal GDP?
• Why?
8. If the Federal Reserve increases the reserve
requirement and velocity remains stable,
• What will happen to nominal
GDP?
• Why?
• Nominal GDP would decrease.
• Because the equation of
exchange is an accounting
identity, both products MV and
PQ must balance –
• If the money supply (M)
decreases,
– because of the increase in
required reserves reduces excess
reserves for loans;
• and velocity (V) remains constant
• Then (PQ) nominal GDP must also
decrease
9. What economic goal might the Federal Reserve try to
meet by reducing the money supply?
(A) Maximum employment
(B) Maintain price stability
(C) Moderate long term
interest rates
9. What economic goal might the Federal Reserve try to
meet by reducing the money supply?
(A) Maximum employment
(B) Maintain price stability
(C) Moderate long term
interest rates
• (B) Price stability
10. Why might the money supply not expand by the amount
predicted by the
deposit expansion multiplier?
10. Why might the money supply not expand by the amount
predicted by the
deposit expansion multiplier?
• Banks may not choose to lend out all excess reserves
• Banks may be unable to lend out all excess reserves
because households or firms may not want to
borrow
• All loans may not be re-deposited into the banking
system
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
Bank
Initial deposit (bank A)
Second stage (bank B)
Third stage (bank C)
Fourth stage (bank D)
Fifth stage (bank E)
Sixth stage (bank F)
Seventh stage (bank G)
All others (other banks)
Total
New
Required Reserves
Potential demand
deposits created by
extending new loans
$1,000.00
800.00
640.00
512.00
409.60
327.68
262.14
1,048.58
$200.00
160.00
128.00
102.40
81.92
65.54
52.43
209.71
$800.00
640.00
512.00
409.60
327.68
262.14
209.71
838.87
$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 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.
The Money Multiplier: III
• Now suppose the RR is instead 50%, what’s
the money multiplier?
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.
The Money Multiplier Point
• The bigger the RR, the smaller the MM and
the less money created by a new dollar of
demand deposits.
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
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:
1.Wage levels, which affect firms’ unit labour costs.
2.Other costs of production, such as commodity prices, or which changes in oil
prices are significant.
3.Indirect taxes, such as VAT.
4.Subsidies.
5.Productivity of factors, especially labour.
6.Changes in the use of technology and production methods.
7.Direct taxes, such as income tax, via an incentive or disincentive effect.
8.Length of the working week.
9.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 “meanstested”, 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=JsTbkB9hO
uw