Fiscal Policy

Fiscal policy: the use of government revenue collection and expenditure to influence the economy.

• Revenue collection = taxation
• expenditures = gov. spending. 
• Legislative

Designed to promote

• full employment
• price stability (control inflation)
• economic growth 

Modes or Stances of Fiscal Policy

• Neutral (usually when an economy is in equilibrium) 
• Government spending is fully funded by tax revenue 
• budget outcome has a neutral effect on the level of economic activity. 

Countercyclical Policies

• Expansionary (usually during recessions)
• fight unemployment 
• shift AD to the right, increasing real output 
• involves increasing gov spending, lowering taxes, or combination

• Contractionary (dealing with inflation)
• used to control demand-pull inflation
• meant to shift AD to the left
• involves reduction in gov spending, increasing taxes, or combination
• revenue should exceed gov. spending (run a budget surplus)

The above policies are discretionary - at the option of congress

Automatic Fiscal Policy 

• nondiscretionary, they happen automatically 
• uses automatic stabilizers

Income Tax (Progressive)

• During an expansion
• as incomes rise (during an expansion) taxes increase
• slows spending (useful when economy approaching inflation)
• contributes to surplus (maybe) (will help in the next recession)

• During a recession   
• as incomes fall so do tax rates
• encourages more spending (good when you want to encourage growth) 
• decreasing taxes cushion the contraction  

 
Transfer Payments (welfare / unemployment)

• increase during recession
• decrease during expansion

The Tax Multiplier (discretionary fiscal policy)

When government injects spending into the economy 

• the spending multiplier will be affected by MPC/MPS
• but only after the private citizens begin to spend.

If government uses tax cuts to spur economic activity, 

• the multiplier effect is assumed to be LESS effective than the government transfer. 
• because people will save part of the amount of the tax cut immediately when they are given new disposable income.  
• Remember, disposable income can only be used for either spending or savings.

IN addition, tax rates will also reduce the effectiveness of growth when people discover that they owe more taxes as their income levels improve.

Evaluations of Monetary Policy

Recall:
Expansionary Policy

1. increase money supply
2. reduce interest rates
3. increase investment spending
4. boost GDP

Restrictive Policy

1. reduces money supply
2. increase interest rates
3. decrease investment spending
4. decreases inflation

Strengths / Weaknesses of Fed Policy

Strengths 

• speed and flexibility
• low lag
• political acceptability

•  board members serve 14 year terms (less lobbying)
• can make politically hard choices
• (avoids political problems with Fiscal policy) 

weaknesses

• time lags
• recognition, operational
• ineffectiveness in severe recession
• firms are reluctant to borrow and invest, even if interest rates are low

"Pushing vs. Pulling on thread"

Restrictive 

• MP can "pull" AD to the left
• have very high interest rates  
• no limit on restricting money supply
• "pulling on thread"

Expansive

• MP may not push AD to the right
• pessimistic firms may sit and wait
• expand excess reserves, but nobody wants to acquire debt
• "pushing on thread"

Loanable Funds / Private Savings (Graph)

Loanable Funds Market  

• The private component of the money market
• brings private lenders and borrowers together
• matches money of private savers with borrowers for investment or consumption

Savers = Supply line

• willingness of society to save
• savers supply loanable funds
• buying bonds
• savings accounts

Borrowers = demand line

• firms that sell bonds are demanding money
• can also borrow from savings accounts (bank loans)
• firms
• households

Interest Rates and Monetary Policy

The Fed has many “tools” to help run the US banking and money supply systems.
 
The main tools:

• The buying and selling of Bonds
• The Discount Rate 
• The Reserve Requirement

The Fed's PRIMARY influence is on the money supply and interest rates. 

interest: the price paid for the use of money


Demand for Money

• people demand money for   
• transactions  
• assets 

inverses relationship between b/t interest rate and the quantity of money demanded
 
Supply of Money 

• inelastic (set by the Fed)
• manipulated by the Fed

Supply and demand for money gives 
us the nominal interest rate.

A Selection of Different Interest Rates
Fed Funds Rate

• Background on the FFR  
• Cash in the vault earns no interest  
• banks don't like to let excess reserves sit idle 
• loan money to each other overnight  
• (in order to balance deposit accounts each day) 

• FFR is the interest rate they use to loan each other this money
• The Federal Reserve "targets" this rate by suggesting its raising or lowering and uses bonds to accomplish the targets.
• The FFR influences other interest rates, so if you can adjust it, you can adjust interest rates overall.

Prime Rate

• the interest rate banks charge their most "credit worthy" borrowers.
• Historically, the prime rate, in the US, has been set about 3% above the Fed Fund Rate.

Private Rates

• These loan rates are set by supply and demand
• Examples: 
• car companies "selling" "zero interest" loans, 
• special student rate loans, etc.
• Payday lenders 
• Any rate below the Fed Fund Rate probably has some kind of financial trick attached to the contract.

 Monetary Policy: The central bank's attempts to influence the economy through manipulating the money supply.  
most common tool: buying and selling bonds 

A brief word about bonds

• Bond: contract promising to repay borrowed money on a designated date and to pay interest on the way. (An IOU) 
• bonds are a type of security; a tradable financial asset 
• (Bonds can be bought and sold on the bond market)
• high liquid assets 

Two "modes" of Monetary Policy
1. Expansionary policy

• increases the total supply of money in the economy more rapidly than usual 

used to try to combat unemployment in a recession 

• lowering interest rates to encourage borrowing and spending
• increase in AD, expand real output
• "easy money"

Lower the FFR, open market operations

• buy bonds = big bucks
• increase reserves in the banking system 
• increase the money supply

2. Restrictive policy

• expands the money supply more slowly than usual or even shrinks it. 

Used to fight inflation (avoid the resulting distortions and deterioration of asset values)

• "tight money"
• increase the interest rate to reduce borrowing and spending
• slow the expansion of AD, hold down PL increases 

Raise the FFR, Open Market Operations (normally)

• Sell bonds  = small bucks
• absorb reserves in the banking system 
• decrease the money supply

Recall our other tools. How might these be used?

• The Discount Rate 
• The Reserve Requirement

The Discount Rate

• FDIC member banks, and other eligible institutions, may borrow short term loans directly from the Federal Reserve.  
• This is the "discount window", and is set above the Fed Fund Rate.
• Banks do not like to use the window, since it appears to be a move of "last resort"
• Set by the Fed 

Fractional Reserve Banking

Banks “create” money

• By lending out deposits that are used multiple times

Where do the loans come from?

• From depositors who take cash and place it in accounts at banks
• Fractional Reserve Banking 

Bank Liabilities (the right side of the T Account Sheet):
1 ) Demand Deposits (also known as “Checkable Deposits”)(DD)

• cash deposits from the public.
• liability because they belong to the depositors and can be withdrawn by the depositors.

2 ) Owners Equity (also known as “Stock  Shares”)

• values of stocks held by the public ownership of bank shares.

Bank Assets (the left side of the T Account Sheet):
 
1) Required Reserves (RR)

• percentages of demand deposits that must be held in the vault so that some depositors have access to their money. 

2) Excess Reserves (ER)

• These are the source of new loans.

DD = RR plus ER

3) Bank Property Holdings (Buildings and Fixtures)
These are usually stated as a money value of the bank’s property…

4) Securities (Federal Bonds)
    
5) Customer Loans

• This can be amounts held by banks from previous transactions, owed to the bank by prior customers.

Money Creation (Using Excess Reserves)

• Banks want to create profit.  
• They can generate profit by lending the excess reserves and collecting interest payments.  
• each loan will go out into customer’s and business’ accounts, more loans are created in decreasing amounts. 
• Each successive bank must pull some of the money out for required reserves.  
• A rough estimate of the number of loan amounts created by any first loan is the “monetary multiplier”.

The Monetary Multiplier (also known as):

• Checkable Deposits Multiplier
• Reserve Multiplier
• Loan Multiplier

Formula:  1 divided by the reserve requirement (ratio)
An example = RR = 10% = 1/.1 = Monetary Multiplier of 10.

• Excess Reserves are multiplied by the Multiplier to create new loans for the entire banking system and this creates new Money Supply.

The Federal Reserve System

Federal Reserve

• Government agency that regulates banks and sets monetary policy
• Formed in 1913 in response to huge number of bank failures
• help provide a safety net for banks and make financial transactions between banks easier

Three Parts
1. Board of Governors

• 7 members
• Runs the system, headed by a chairman  
• chairman appointed by the President, approved by the Senate
• currently Janet Yellen
• prior Chairmen: Ben Bernanke, Paul Volcker, Alan Greenspan  

• predict economic trends, 
• oversee reserve system, 
• serve on Federal Open Market Committee (FOMC)

 2. FOMC (Federal Open Market Committee)

• 12 members (7 governors, head of New York Fed, four other reserve heads that rotate in and out); 
• make decisions about how to use monetary policy

3. Reserve Banks- 12 of them around the U.S.

A = Boston
B = New York City
C = Philadelphia
D = Cleveland
E = Richmond
F = Atlanta
G = Chicago
H = St. Louis
I  = Minneapolis
J  = Kansas City
K = Dallas
L = San Francisco

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• Provide financial services for banks (check cashing/transfer, holding extra money, etc.)
• Contribute to monetary policy (have economists that inform reserve heads about state of economy in the region)
• Supervise and regulate banks in area (oversee operations, make sure banks are financially sound)
• If banks have problems, Fed will give short term loans to the banks through the discount window.  
• idea is to keep banks from collapsing 

Money

The Functions of Money
1. Medium of exchange 

• buying and selling of goods and services
• allows society to escape the complications of a barter economy 
• advantages of geographic and human specialization

2. Unit of Account 

• yardstick for measuring the relative worth of a variety of goods
• aids rational decision making 
• defines debt obligations, taxes, nations GDP

3. Store of Value

• enables people to transfer purchasing power from the present to the future

Other ways to store value:

• like: real-estate, stocks, bonds, mineral assets, art.
• liquidity: the ability to convert an asset into cash. 
• the more liquid an asset is, the easier it is to covert to cash without a loss of value.

examples of liquidity?

Money Definition M1

• currency in the hands of the public
• all checkable deposits

currency: coins & paper money
checkable deposits: just what it sounds like

M1 = currency + checkable deposites

amount of money available to the private sector
we exclude 

• checkable deposits of the government
• money held by US treasury, commercial banks, federal reserve banks and thrift institutions

Money Definition M2

• (broader definition of money)
• Includes M1 and also "near monies"

near-monies: high liquid assets that are not directly mediums of exchange but that can be easily converted into currency or checkable deposits

Three categories of near-monies

• savings deposits, including MMDAs,
• Small time deposits (less than 100,000)
• MMMFs held by individuals

M2 = M1 + Near monies (three above)

What backs the money supply?

• good intentions

US currency is not backed by anything of intrinsic value.

Why?

• allows gov. to expand and contract the money supply as it sees fit.
• -cough-
• in the interest of the economy 

Value of money

• Money is valued by the resources that it will purchase
• acceptability (because people use it as money)
• legal tender (government decree that money is money) 
• relative scarcity (recall exchange markets?)

The purchasing power of the dollar

• inverse relationship b/t PL and $ purchasing power
• PI increases, value of $ goes down
• more dollars needed to purchase existing goods and services
• PI decreases, value of $ goes up
• fewer dollars needed to purchase goods and services 

V$ = 1/P

V$ = Purchasing power of a dollar 
P = price index

Unit 2-3 Exam Review (from syllabus)

Unit Two: Measurement of Economic Performance

McConnell and Brue Ch. 7 and 9 (2 weeks)

Unit 2 and 3 Test:__________________

AP Outline:

Measurement of Economic Performance (12-16% of exam)

• National Income Accounts- Circular Flow, Gross Domestic Product, Components of Gross Domestic Product, Real versus Nominal Gross Domestic Product
• Inflation Measurement and Adjustment- Price Indices, Nominal and Real Values, Costs of Inflation
• Unemployment- Definition and Measurement, Types of Unemployment, Natural Rate of Unemployment

Key Concepts: measuring gross domestic product, relationships between GDP, domestic product,

national income, personal income, and disposable income, nature and function of a GDP price index, difference between nominal and real GDP, limitations of measuring GDP, business cycle and its primary phases, how unemployment and inflation are measured, types of unemployment and inflation and their impacts

Graphs: circular flow model, business cycle

Vocabulary: national income accounting, gross domestic product, intermediate goods, final goods, multiple counting, value added, expenditures approach, income approach, personal consumption expenditures, gross private domestic investment, net private domestic investment, government purchases, net exports, national income, consumption of fixed capital, net domestic product, personal income, disposable income, nominal GDP, real GDP, price index, business cycle, peak, recession, trough, expansion, labor force, unemployment rate, discouraged workers, frictional unemployment, structural unemployment, cyclical unemployment, full-employment rate of unemployment, natural rate of unemployment, potential output, GDP gap, Okun’s law, inflation, consumer price index, demand-pull inflation, cost-push inflation, nominal income, real income, deflation, hyperinflation

Unit Three: National Income and Price Determination

McConnell and Brue Ch. 10 and 12 (2 weeks)

Unit Two and Three Test:__________________

AP Outline:

National Income and Price Determination (10-15% of exam)

• Aggregate Demand (Determinants, Multiplier, and Crowding-Out Effects)
• Aggregate Supply (Short-Run vs. Long-Run Analysis, Sticky vs. Flexible Wages and Prices, Determinants)
• Macroeconomic Equilibrium (Real Output and Price Level, Short and Long Run, Actual vs. Full-Employment Output, Economic Fluctuations)

Key Concepts: how changes in income affect consumption, how changes in interest rates affect investment, why changes in investment increase or decrease real GDP by a multiple amount, aggregate demand and its determinants, aggregate supply and its determinants, how AD and AS determine an economy’s equilibrium price level and level of real GDP, how AD-AS model explains periods of demand-pull inflation, cost-push inflation, and recession

Graphs: consumption and savings schedules, investment demand curve, AD-AS model

Vocabulary: marginal propensity to consume, marginal propensity to save, expected rate of return, investment demand curve, multiplier, aggregate demand, real-balances effect, interest-rate effect, foreign purchases effect, aggregate supply, short-run aggregate supply curve, long-run aggregate supply curve, equilibrium price level, equilibrium real output