Key Concepts in Monetary and Fiscal Policy

Central Bank

The institution designed to control the quantity of money in the economy and also to oversee the safety and stability of the banking system.

The Federal Reserve

The institution that oversees the safety and stability of the U.S. banking system.

Discount rate

The interest rate charged by the central bank when it makes loans to commercial banks.

Altering the discount rate

Considered to be a relatively weak tool of monetary policy.

Open market operations

A traditional tool used by the Fed during recessions.

Reserve requirements

The proportion of deposits that banks are legally required to deposit with the central bank.

Buying bonds in open market operations

Action taken by a central bank that wants to increase the quantity of money in the economy.

Raising the reserve requirement

Action taken by a central bank that desires to reduce the quantity of money in the economy.

Quantitative easing

An innovative and nontraditional method used by the Federal Reserve to expand the quantity of money and credit during the recent U.S. recession.

Money supply

Decreases if the central bank sells $25 million in bonds to Southern Bank.

Borrowing for the short term

Likely action of Southern Bank if it is not holding enough in reserves to meet higher requirements.

Interest rates

Increase when the central bank decides to increase the discount rate.

Selling bonds using open market operations

Results in the money supply decreasing.

Lowering the reserve requirement on deposits

Results in the money supply increasing and interest rates decreasing.

Higher discount rate

Event that would cause interest rates to increase.

Federal funds rate

Affected when the Federal Reserve announces that it is implementing a new interest rate policy.

Specific interest rates

Determined by the forces of supply and demand in the lending and borrowing markets.

Expansionary monetary policy

Followed when the Central Bank acts in a way that causes the money supply to increase while aggregate demand remains unchanged.

Tight monetary policy

Followed if a Central Bank decides it needs to decrease both the aggregate demand and the money supply.

Contractionary monetary policy

Followed when a Central Bank takes action to decrease the money supply and increase the interest rate.

Loose monetary policy

Followed when a Central Bank makes a decision that will cause an increase in both the money supply and aggregate demand.

Long and variable time lags

Will often cause monetary policy to be considered counterproductive because it makes it hard for the central bank to know when the policy will take effect.

Excess reserves

Held by banks when they don't see good lending opportunities, negatively affecting expansionary monetary policy.

Countercyclical monetary policy

Used by the central bank to offset business-related economic contractions and expansions.

Basic quantity equation of money

The macroeconomic equation MV = PQ.

Unpredictable rises and falls in nominal GDP

Result of constant growth in the money supply combined with fluctuating velocity according to the quantity theory.

Quantity of money

Will fall if price and output fall while velocity increases according to the basic quantity equation of money.

Velocity

Calculated as 4 if nominal GDP is 1800 and the money supply is 450.

Aggregate Demand

The total demand for goods and services within an economy at a given overall price level and in a given time period.

Expansionary Monetary Policy

A policy that shifts aggregate demand to increase the price level.

Contractionary Monetary Policy

A policy that increases unemployment but has little effect on inflation.

Budget Surplus

When a government receives more in taxes than it spends in a given year.

Budget Deficit

Created each time the federal government spends more than it collects in taxes in a given year.

Balanced Budget

Means that government spending and taxes are equal.

Progressive Tax

A tax policy that causes a greater share of income to be collected from those with high incomes than from those with lower incomes.

Proportional Tax

A tax calculated as a flat percentage of income earned, regardless of level of income.

Regressive Tax

When the share of individual income tax collected from people with higher incomes is smaller than the share of tax collected from people with lower incomes.

Corporate Profits

The basis on which corporate income tax is calculated.

Accumulated Government Debt

The total amount of money that the government owes, which has remained unpaid over time.

Expansionary Fiscal Policy

A government policy that reduces taxes in order to increase the level of aggregate demand.

Contractionary Fiscal Policy

A typical fiscal policy that allows government to decrease the level of aggregate demand through increases in taxes.

Fiscal Policies

The set of policies that relate to government spending, taxation, and borrowing.

Discretionary Fiscal Policy

When the government passes a new law that explicitly changes overall tax or spending levels.

Automatic Stabilizers

A form of tax and spending rules that can affect aggregate demand in the economy without any additional change in legislation.

Total Debt

The total amount of money that a government owes at a given time.

Aggregate Demand Curve

A curve that shows the relationship between the overall price level and the quantity of goods and services demanded.

Potential GDP

The maximum output an economy can produce without triggering inflation.

Time Lag for Monetary Policy

Typically shorter than the time lag for fiscal policy.

Time Lag for Fiscal Policy

The delay between the implementation of a policy and its effects on the economy.

Percentage of Total Annual Tax Revenue

The portion of tax revenue allocated to specific categories of government spending.

Percentage of Annual Tax Revenue Allocated

The proportion of total tax revenue that is distributed to certain government spending categories.