Monetary and fiscal policy (Demand side policies)

What is Monetary Policy?

Use of interest rates & money supply to influence level of AD and economic activities

What is the central bank?

• Independent authority responsible for monetary policy in a country 

• Controls money supply and setting interest rate

  • Money supply = refers to the total amount of money in circulation (notes, coins, bank)

What are the 5 functions of central bank

• 1. Determines money supply and interest rate

  • Supply of money is always fixed (perfectly inelastic)

  • Example of demand and supply for money graph

• For example, if CB intervenes to increase money supply from S_m1 to S_m2 → results in increase of Qmoney, driving down interest rate

• Example

  • Y1 is lower than full employment level (Y_fe) → central banks can choose to lower interest rates

• By lowering interest rates → increase I + C → increases AD (and PL and GDP)

• 2. Prints physical money and mints coins

  • Function: increase money supply to align with increases in GDP, replace old/torn bank notes

  • Also use security features to reduce counterfeit money

• 3. Lender of last resort for commercial banks

  • In financial crisis → consumers withdraw money (run on the bank)

    • Banks will not have the funds 

• 4. Issues bonds and other financial instruments

  • To raise funds to finance projects (ex. War, infrastructure)

  • Citizens buy a bond to lend money to the government → repay with interest

• 5. Regulates the banking system

  • Ensure commercial banks don’t take too much risk

  • Function: set reserve requirements (= proportion of deposits that a commercial bank must keep in its vaults in reserve)

4 goals of monetary policy (demand side)

1. Low and stable rate of inflation

• Operates monetary policy to influence AD

• Rising prices reduce purchasing power of individuals – uncertainty for firms

• a)Inflation targeting

  • CB maintains it to 2%

  • Creates greater certainty 

  • Preferable to waiting until inflation is out of control

• b) low unemployment

  • Keeps unemployment low

  • Unemployment leads to slower economic growth (makes up ⅔ AD)

• c) reducing business cycle fluctuations

2. Long term growth (stable economic environment)

• Through managing money supply and interest rates:

  • Can control inflation and real GDP

3. External balance

• Achieved when imports = exports

• How to do this

  • By raising interest rates, CB discourages spending

  • If this includes imports, it moves economy to balance

How is money created by commercial banks

• Can create money through credit (Credit creation)

• Individuals put money into a bank account → bank only keeps a small amount as cash (reserve requirement)

  • They lend the other amount

• This process creates credit

• Central bank requires commercial banks to hold some deposits in reserve → ensure banks don’t take too much risk

What are the 4 ways monetary policy is made/tools

1. Open market operations

• Definition: the central bank buying and selling bonds to regulate money supply

• Bonds = used by governments to finance infrastructure projects

• The central bank buys and sells bonds on the OM to regulate money supply

  • Ex. when selling a bond for $500, the money supply is reduced by $500

• Example: graph shows the supply moving left (when selling a bond)

• Interest rate is driven up

• Therefore, it can influence interest rate

2. Minimum reserve requirements

• The proportion of bank deposits that a bank must hold in cash

• A fall in reserve requirements is expansionary → increased supply  (more money can be lent)

• An increase in reserve requirements is contractionary → decreases money supply

• Example: CB can stimulate economy by lowering reserve requirement

3. Changes in central bank minimum lending rate

• CB can determine interest rates offered by commercial banks

• Minimum lending rate = rate which central bank charges commercial banks to borrow money

• Example: if CB cutting minimum lending rate, decreases cost of borrowing for commercial banks

• Commercial banks also compete to cut mortgage/lending rates

4. Quantitative easing

• Definition: A way for the CB to inject money directly into economy

• Definition: where the central bank creates more digital money

  • CB uses new money to buy bonds

  • Boosts spending and investment

• Example: CB buys assets from banks → banks get more money therefore lending increases → results in lower interest rate for borrowers → boosts investment

• *quantitative tightening is the opposite = CB roll back expansion in money supply

Describe/draw the demand and supply of money graph

Describe the curve for demand of money and why. What are the 3 reasons to use money

• Definition = the willingness and ability for economic agents to use money at a given interest rate and point in time

• 3 reasons to use money:

  • 1. Transactions motive (buy goods)

  • 2. Precautionary motive (precaution against unexpected events like medical bill)

  • 3. Speculative motive (individuals hold money receive no rate of return and lose purchasing power due to inflation)

    • Opportunity cost = interest rate lost

    • Beneficial in stock market crash

• Downward sloping (higher interest rate, less likely people hold money)

Define the supply of money

• Definition: total amount of money in circulation (coins, banks, notes)

What determines the interest rate

• Refers to the price and cost of borrowing money

• Determined by forces of supply and demand

How can economy be stabilized by changing money supply

If central bank can increase supply of money at same rate as increase in D_m, can maintain interest rates at i* to maintain stability

What is nominal vs real interest rate, how to calculate

Nominal = the interest rate quoted by commercial bank

• Not adjusted for inflation

Real = interest rate with inflation taken into account

• True cost of borrowing

• When negative = savers lose, borrowers benefit

How to calculate real interest rate

• (1+nominal interest rate)/(1+inflation rate) = 1 + real interest rate

When is expansionary monetary policy used? how does it work?

• to close recessionary gap

• CB can intervene and increase money supply (S_m1 → S_m2)

  • Increases money in circulation from Q1 to Q2 → drive down interest rate from i1 to i2

  • Lowering interest rates = more investment = increase AD = closing recessionary gap

Keynesian vs monetarist view of monetary policy in solving deflationary gap

Keynesian

• 1. Assume economy at Y1 → economy produces at a level of output lower than full capacity

  • Any stimulus to increase AD will increase real GDP without pressure on PL

  • Possible to operate this policy without driving up PL

• 2. Assume economy at Y2 → at upward sloping section

  • Supply side bottlenecks

  • Firms compete with other firms for FOP

  • This case, the policy will drive up price level

How is contractionary monetary policy used? describe

• closing inflationary gap

• Definition: an inflationary gap is where the economy overheats and creates upward pressure on PL

  • Difficult to plan for future

• CB will decrease money supply

  • Reduce money in circulation

  • Drive up interest rates

  • Discourage investment, lower AD

what are 2 cons of monetary policy effectivity

Factor	Explanation
Limited scope for reducing interest rates when close to zero	Expansionary monetary policy depending on lower interest rates to stimulate I If interest rates already close to 0, cannot be lowered, not effective
Low consumer and business confidence	Expansionary monetary policy may not be effective in these times During recessions, firms not responsive to changes in interest rate

What are 2 pros of monetary policy effectiveness

Factor	Explanation
Incremental, flexible, easily reversible	Interest rates easy to adjust
Short time lag	Usually meet monthly to decide

How is conflict amongst macroeconomic objectives created using monetary policy

• Example: government wants growth = CB uses expansionary monetary policy by lowering interest rates = puts upward pressure on PL = does not meet goals

  • However, this is possible in LR → if its used to encourage firms to improve LRAS, it will work

What is fiscal policy

Government adjusts government expenditure or taxation to stimulate the economy

What are 4 sources of revenue

• Direct taxation

  • On income

  • Can be used to redistribute income → progressive taxation

• Indirect tax

  • On expenditure

  • To discourage consumption of undesirable goods

• Sale of goods and services from state-owned entreprises

  • State owned enterprise = a firm where the government has a significant financial stake and control (ex. Post office)

  • Resource curse = government difficult to benefit from selling natural resources

• Sale of government assets

  • Selling state-owned entreprises

  • Privatization = transferring ownership from public to private sector → revenue is 1 time payment

    • Why: private firms improve efficiency, decrease costs, etc  → creates greater revenue for government

What are 3 types of government expenditure

1. Current expenditure

• Involves financing daily expenditure (ex. salaries)

2. Capital expenditure

• Includes building infrastructure financed by government (roads, hospitals)

• Long term projects

3. Transfer payments

• Used to redistribute income (ex. Child support)

What are 5 goals of fiscal policy

1. Low and stable inflation

• Beneficial as it gives greater certainty for firms

2. Low unemployment

• Can use expansionary fiscal policy

• Can stimulate AD to the level of full employment

3. Promoting a stable economic environment for long term growth

• Through expansionary fiscal policy → build infrastructure like roads

  • Transport routes increase trade, hospitals for healthy workforce

4. Reducing business cycle fluctuations

• Can increase injections for boost

• Can slow economy in boom

5. Equitable distribution of income

• Indirect taxes: 

  • Can lower taxes on essential goods, increase on luxury

• Direct taxes:

  • Progressive system

• Transfer payments

• External balance:

  • Through contractionary fiscal policy, can discourage consumption of domestic and imported goods

    • Can move towards balance

What are 2 ways to do expansionary and contractionary fiscal policy

• tax revenue or government expenditure

How can expansionary fiscal policy be used

• close recessionary gap

• Government can intervene to help recover from recession

• Can either increase G or reduce taxation

  •  Both will increase AD → shifts towards full employment → increases price level → increases real GDP

  • Therefore, gap is closed

Monetarist vs. keynesian view of deflationary gap

Monetarist	Keynesian
Economy is self correcting, will move to full employment level of equilibrium If in recession → as workers compete for jobs, wages will fall This lowers COP to firms to rise profits Firms increase output	Economy not self correcting If in recession → unemployment will rise Due to sticky wages, it won’t adjust Need government
Deflationary gap is only in short run	Deflationary gap can be in short run and long run

How is contractionary fiscal policy used

• closing inflationary gap

• When economy overheats (when AD grows too fast, creating demand-pull inflation)

  • Causes reduction in confidence

• Contractionary policy → increase taxes (direct or indirect) OR reduce G

  • Reduce disposable income for households

  • G: unpopular

    • Wages to workers are cut (current), or hospital doesn’t get built (capital), or unemployment benefits decreased (Transfer)

  • Both will shift AD back to full employment level

Monetarist vs. keynesian for inflationary gap

Monetarist	Keynesian
Inflationary gap only in short run If AD rises too much, workers will be induced through higher wages to make more output This raises COP, so they cut back on output Naturally move back to equilibrium	Any attempt to move output beyond Yfe only results in inflation Need government

What is keynesian multiplier and formula

• The overall increase in GDP is larger than original stimulus due to multiplier effect

  • Size of effect depends on how much additional income was used for purchases

• 1/1-MPC OR 1/(MPS+MPT+MPM)

• Always greater or equal to 1

• When government spends $120M, the firms they hire for projects will notice lack in inventory → increase their output by $120M to hire workers

  • Households can spend (marginal propensity to consume) or save additional income

  • By spending $48M on g/s → firms, noticing stock is falling, expand output, which then increases household income by $48M

Give 3 constraints of fiscal policy

Factor	Explain
Political pressure	Depends on each party’s beliefs
Time lags	Once a new policy is made, it may take months
Sustainable debt	Government must operate a budget deficit (borrowing money by selling bonds) if it wants to stimulate the economy Governments respond to high debt by using austerity Definition: reduction in government spending A contractionary fiscal policy

What is crowding out? describe the 2 steps

• Definition: when public sector replaces private sector spending

• 1. Government spends on a road (shift AD right)

  • Can sell bonds and compete directly with private sector in loanable funds market

• 2. Competition will drive out interest rates to discourage private firms from investing → AD shifts left

• Depends on interest rate change

What are 2 strengths of fiscal policy

• ability to target sectors of economy

• effective in deep recession

What are automatic stabilizers? give 2

• Definition: ongoing government policies that automatically adjust tax rates and transfer payments

  • 2 examples: progressive taxes and unemployment benefits