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Macroeconomic Policy Fundamentals

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.

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Macroeconomic Policy Fundamentals

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  1. MacroeconomicPolicyFundamentals Chapter 13

  2. 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

  3. 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 Page 244

  4. Functions of the Fed • 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 as the federal government’s banker and fiscal agent • Regulate the money supply Page 247

  5. Location of the 12 District Federal Reserve Banks Page 246

  6. The Fed’s Policy Tools • Reserve requirements – depository institutions are required to maintain a specific fraction of their customers’ deposits as reserves. • banks must hold as vault cash or on deposit at a Federal Reserve Bank. • As of June 2004, the reserve requirement was 10% on transaction deposits, and there were zero reserves required for time/savings deposits • Currently play limited role in money creation in US Page 248

  7. The Fed’s Policy Tools • Discount rate – rate depository institutions pay when they borrow from the Fed • They borrow from Fed if they want to increase loans but does not have any excess reserves at the moment • Also to meet reserve requirements • Federal Funds Market - interbank market trafficking in reserves; banks with excess reserves can lend to banks that are short on 24 hour basis. Page 249

  8. The Fed’s Policy Tools • Open market operations – Fed can buy or sell government securities to alter the money supply (used most frequently) • Federal Open Market Committee (FOMC) directs the operations • Directive to sell results in decrease in reserves at depository institutions because deposits are withdrawn to pay for the securities Page 249

  9. Role of the Board of Governors of the Federal Reserve System Page 247

  10. Role of the Board of Governors of the Federal Reserve System Page 247

  11. Role of the Board of Governors of the Federal Reserve System Page 247

  12. Key role played by the Federal Open Market Committee or FOMC Page 247

  13. Role of the 12 District Federal Reserve Banks located throughout the country Page 247

  14. Determinantsof theMoney Supply

  15. Existing money supply curve. Note it is perpendicular to the quantity axis, implying it is unaffected by the interest rate. Page 253

  16. Expansionary monetary policy actions will shift the MS curve to the right over a period of 12 months or so. Page 253

  17. Contractionary monetary policy actions, on the other hand, will shift the money supply curve to left over a similar time period. Page 253

  18. Suppose a depositor in Bank Ag sells $1 million in government securities to the Fed. He then deposits the proceeds from the sale in his bank. If the fractional reserve requirement ratio is 20 percent, Bank Ag will have excess reserves of $800,000. It can increase the volume of its loans by $800,000. Suppose the proceeds of these loans are deposited in Bank B. Follow the trail to the Total line. From this example, we can make generalizations About the extent to which the money supply will increase when reserves are Increased. Page 307

  19. Change in the Money Supply We can skip tracing deposits through the economy by using 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 with the brackets is known as the money multiplier (MM). We can restate this equation in terms of the change in the money supply as follows: MS = (1.0 ÷ RR) ×  TR = MM × TR Page 252

  20. 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 the change in the money supply is: MS = (1.0 ÷ .20) x TR = 5.0 x $1 million = $5 million This results in a change in loans of loans = MS - TR = $5 million - $1 million = $4 million See bottom line in Table 13.3 Page 252

  21. Change in money supply Change in loan volume Initial infusion + = Page 251

  22. 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 Bernanke Page 253

  23. Impacts of Policy Tools Expansionary actions:Effects of action: Inc Ms 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: Dec Ms Fed sells securities Total reserves decrease Fed raises the discount rate Total reserves decrease Fed raises required reserve ratio Money multiplier decreases Page 253

  24. Determinantsof theMoney Demand

  25. Demand for Money: Why we hold cash? • 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. Page 254

  26. The money demand curve is given by equation (13.5): MD = c –d(R) + e(NI) where R is the rate of interest and NI is national income. The coefficient d is the slope of the curve and e represents MD÷NI. Page 255

  27. Increase in income increases demand for money MD = c –d(R) + e(NI) Page 255

  28. Money market interest rate given by intersection of demand and supply Reflects the opp cost of holding money rather than income-earning asset. Page 255

  29. MS* Expansionary monetary policy lowers interest rates 0.06 Page 255

  30. MS* Contractionary monetary policy raises interest rates 0.14 Page 255

  31. The full effects of this change could take 12 months or more to register in bank deposits Page 256

  32. A change in the money supply will alter the equilibrium interest rate in the money market Page 256

  33. We know from Chapter 12 that a change in interest rates will lead to movement along the planned investment function….increasing or decreasing new investment Page 256

  34. We also know from Chapter 12 that increased investment expenditures, a component of GDP, increases the demand for labor, lowers unemployment and thus fuels further growth in national income (increases AD) Page 256

  35. EliminatingRecessionary andInflationary Gaps

  36. What is the magnitude of the recessionary gap? Page 257

  37. What is the magnitude of the recessionary gap? It is YFE – Y1 Page 257

  38. The use of expansionary monetary 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. Page 257

  39. Recessionary gap of YFE – Y1 is partially closed to YFE – Y3 Inflation rate (P3 – P0) ÷P0 Page 257

  40. The further use of expansionary monetary policy to push aggregate demand from AD3 to AD4 increases real GDP from Y3 to YFE (full employment GDP), but increases the general price level to P4. Page 257

  41. Inflation rate (P4 – P3) ÷P3 Somewhat inflationary But does not swamp growth Recessionary gap fully closed Page 257

  42. The use of expansionary monetary policy to attain YPOT by shifting aggregate demand to AD5 will increase the general price level to P5. Inflation rate (P5 – P4) ÷P4 Would cause inflation Inflationary gap created…..use contractionary monetary policy Page 313

  43. MicroeconomicInterest RateImplications

  44. Contractionary monetary policies that drive up interest rates will depress investment expenditures by businesses and households • Expansionary monetary policies that lower interest rates will stimulate investment expenditures in the economy

  45. Interest Rate Impacts on a 10-Year $150K Business Loan Page 259

  46. Interest Rate Impacts on a 20- Year $100K Home Mortgage Page 259

  47. 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 Page 259

  48. Fiscal Policy Options • Automatic fiscal policy instruments: take effect without explicit action by policymakers (e.g., progressive tax rates; unemployment compensation –built in stabilizers) • Discretionary fiscal policy instruments: require explicit actions by the president or Congress (e.g., passing a tax cut law; increase government spending authorized by Congress) Page 266

  49. Impacts of Policy Tools Expansionary actions:Effects of action: Cut taxes Increase disposable income Increase government spending Increase aggregate demand Congress & Obama Page 269

  50. Impacts of Policy Tools Expansionary actions:Effects of action: Cut taxes Increase disposable income Increase government spending Increase aggregate demand Contractionary actions:Effects of action: Increase taxes Decrease disposable income Cut government spending Decrease aggregate demand Congress & Obama Page 269

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