Agri 2312 chapter 13 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

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

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 at the federal government’s banker and fiscal agent Regulate the money supply Page 246-247

Location of the 12 District Federal Reserve Banks

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 Page 248-249

Role of the Board of Governors of the Federal Reserve System

Key role played by the Federal Open Market Committee or FOMC

Role of the 12 District Federal Reserve Banks located throughout the country

Determinants of the Money Supply

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

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

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

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 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.

Change in the Money Supply We can skip tracing deposits through the economy by using the following money supply (M S ) equation: M S = (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 . We can restate this equation in terms of the change in the money supply as follows:  M S = (1.0 ÷ RR) ×  TR = MM ×  TR 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 the change in the money supply is:  M S = (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 251-253

Change in money supply Change in loan volume Initial infusion + =

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 Page 253 Bernanke

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 Total reserves decrease Fed raises the discount rate Total reserves decrease Fed raises required reserve ratio Money multiplier decreases Page 253 Bernanke

Determinants of the Money Demand

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. Page 254

The money demand curve is given by equation (16.5): M D = 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  M D ÷  NI.

M D = c –d(R) + e(NI) Increase in income increases demand for money

Money market interest rate given by intersection of demand and supply

M S * 0.06 Expansionary monetary policy lowers interest rates

M S * 0.14 Contractionary monetary policy raises interest rates

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

A change in the money supply will alter the equilibrium interest rate in the money market

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

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…

Eliminating Recessionary and Inflationary Gaps

What is the magnitude of the recessionary gap?

What is the magnitude of the recessionary gap? It is Y FE – Y 1

The use of expansionary monetary policy actions to push aggregate demand from AD 1 to AD 3 increases real GDP from Y 1 to Y 3 while only increasing the general price level to P 3 .

Inflation rate (P 3 – P 0 ) ÷ P 0 Recessionary gap of Y FE – Y 1 is partially closed to Y FE – Y 3

The further use of expansionary monetary policy to push aggregate demand from AD 3 to AD 4 increases real GDP from Y 3 to Y FE (full employment GDP), but increases the general price level to P 4 .

Inflation rate (P 4 – P 3 ) ÷ P 3 Recessionary gap fully closed

The use of expansionary monetary policy to attain Y POT by shifting aggregate demand to AD 5 will increase the general price level to P 5 . Inflation rate (P 5 – P 4 ) ÷ P 4 Inflationary gap created…..

Microeconomic Interest Rate Implications

Interest Rate Impacts on a 10-Year $150K Business Loan Page 259 Interest rate Annual total PI payment Annual interest payment Total interest payment 8 percent $22,354.69 $7,354.69 $73,546.90 14 percent 28,757.67 13,757.67 137,576.88 20 percent 35,782.44 20,782.44 207,824.40

Interest Rate Impacts on a 20- Year $100K Home Mortgage Page 259 Interest rate Monthly total PI payment Monthly interest payment Total interest payment 8 percent $848.78 $432.08 $103,707.46 12 percent 1,115.73 699.06 167,773.46

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

States Without Income Tax Eight states do not have a state income tax

State and Local Taxes Alaska, thanks to oil reserves, has the lowest tax burden Maine registered the highest the highest state tax burden Major sources are sales taxes and property taxes

Our focus is on fiscal policy at the federal level….

Rising spending and tax cuts to spur the economy brought back budget deficits

Individuals and not businesses pay the Bulk of federal taxes.

A strong economy and controlled spending led to the first budget surplus in more than 20 years… The effects of the sub-prime lending defaults and subsequent financial crisis and deficit spending have led to record high deficits…

Recent Trends in Deficit Typically the economy runs a budget deficit at the federal level 1998-2001 were the exceptions in recent years Fueled by 2008-09 financial crisis and huge deficit spending in bailouts, etc.

Debt and the Deficit National debt T = National debt T-1 + Deficit T

The growth in federal debt has grown rapidly over the last 25 years…

While the national debt grew as deficit spending dominated the Last 30 years, debt as a percent of GDP stayed within post-WW II experience…

Federal government spending on Agriculture programs is the fourth highest on this list of total federal spending.

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) Page 266

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

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

A federal budget deficit requires the U.S. Treasury to issue more government securities to balance sources and uses of funds…

An increase in the sale of government securities reduces the pool of private capital available to finance investment expenditures, raising interest rates…

We know from Chapter 12 that higher interest rates depresses investment expenditures…

The use of expansionary fiscal policy actions to push aggregate demand from AD 1 to AD 3 increases real GDP from Y 1 to Y 3 while only increasing the general price level to P 3 . Inflation rate (P 3 – P 0 ) ÷ P 0 Recessionary gap partially closed

The use of expansionary fiscal policy to push demand from AD 3 to AD 4 increases real GDP from Y 3 to Y FE (full employment GDP), But increases the general price level to P 4 . Inflation rate (P 4 – P 3 ) ÷ P 3 Recessionary gap closed….

The use of expansionary fiscal policy to attain Y POT by shifting aggregate demand to AD 5 will Increase the general price level to P 5 . Inflation rate (P 5 – P 4 ) ÷ P 4 Inflationary gap created….

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 ”

Chapter 14 focuses on the key consequences of business fluctuations ….

Agri 2312 chapter 13 macroeconomic policy fundamentals

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Agri 2312 chapter 13 macroeconomic policy fundamentals