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 :- • Increase in Money Supply • Increase in Black Marketing • Increase in Hoarding • Repayment of Past Internal Debt • Increase in Exports • Deficit Financing
Cont………. g)Increase in Income h)Demonstration Effect i)Increase in Black money j) Increase in Credit facilities
Cont…. • 2) Cost Push Inflation Causes for Increase in Cost :- • Increase in cost of raw materials • Shortage of Supplies • Natural calamities • Industrial Disputes • Increase in Exports • Increase in Wages • Increase in Transportation Cost • 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 Fedalso 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 with 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: • Changing the Reserve Requirement • Open-Market Operations(buying & selling government securities performed by the Federal Open-Market Committee) • Changing the Discount Rate R.O.D.
Monetary Policy Tools CONTROLLING THE MONEY SUPPLY THROUGH BANKSTHE 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 BANKSTHE 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.
Buying bonds (securities), lowering the Reserve Requirement or lowering the Discount Rate, will put more money into the banking system. Supply of funds available in the banking system will INCREASE!! The Federal Reserve Controls the Money Supply, which determines the Nominal Interest Rate in the Short-Term Money Markets MS* MS1 Nominal Interest Rate I* I1 DM* Qm* Qm1 Note: Qm* represents M1 Money Supply Money Supply
Selling bonds (securities), Raising the Reserve Requirement or Raising the Discount Rate, will take money out of the banking system. Supply of funds available in the banking system will DECREASE!! The Federal Reserve Controls the Money Supply, which determines The Interest Rate MS1 MS* Nominal Interest Rate I1 I* DM* Qm1 Qm* Money Supply
Monetary Policy Tools CONTROLLING MONEY SUPPLY THROUGH THE INTEREST RATETHE DISCOUNT RATE (Federal Funds Rate) • TheDiscount Rateis the interest rate the Fed charges banks for loans. • Increasingthe discount ratedecreasesthe money supply. • Decreasingthe discount rateincreasesthe money supply. “The Discount Window”
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.
(1) (2) Easy money policy (Expansionary) Tight money policy (Contractionary) Problem: unemployment and recession Problem: inflation Federal Reserve buys Federal Reserve sells bonds, increases bonds, lowers reserve ration, or reserve ratio, or increases the discount rate lowers 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 Inflation declines of the increase in investment The 3 Tools the Fed Uses to Control the Money Supply
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 • Increase Reserve Ratio • Raise Discount Rate • Sell Securities • Decrease Reserve Ratio • Lower Discount Rate MONEY DECREASES MONEY INCREASES MONEY DECREASES MONEY INCREASES MONEY DECREASES MONEY INCREASES
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 Potential demand deposits created byextending new loans NewRequired Reserves Bank Initial deposit (bank A) $1,000.00 $200.00 $800.00 Second stage (bank B) 800.00 160.00 640.00 Third stage (bank C) 640.00 128.00 512.00 Fourth stage (bank D) 512.00 102.40 409.60 Fifth stage (bank E) 409.60 81.92 327.68 Sixth stage (bank F) 327.68 65.54 262.14 Seventh stage (bank G) 262.14 52.43 209.71 All others (other banks) 1,048.58 209.71 838.87 Total $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-Supply Multiplier • From this example, we see that there is a new kind of multiplier operating on bank reserves – a money-supply multiplier very different from the Keynesian expenditure multiplier.
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. Page down to advance the presentation
The Money Multiplier: III • Now suppose the RR is instead 50%, what’s the money multiplier? Page down to advance the presentation
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. Page down to advance the presentation
The Money Multiplier Point • The bigger the RR, the smaller the MM and the lessmoney created by a new dollar of demand deposits. Page down to advance the presentation
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.
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: • Wage levels, which affect firms’ unit labour costs. • Other costs of production, such as commodity prices, or which changes in oil prices are significant. • Indirect taxes, such as VAT. • Subsidies. • Productivity of factors, especially labour. • Changes in the use of technology and production methods. • Direct taxes, such as income tax, via an incentive or disincentive effect. • Length of the working week. • 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
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 (-).