Fiscal and Monetary Policy Overview

Fiscal policy

How the government influences the economy using spending and taxation.

Multiplier Effect

A small increase in government spending leads to a larger increase in overall economic output (GDP).

Expansionary Fiscal Policy

Boost the economy during a recession by increasing government spending and/or cut taxes.

Contractionary Fiscal Policy

Cool down an overheated economy by cutting government spending and/or raise taxes.

Information Lag

The time it takes to realize a problem (e.g., gathering unemployment data).

Formulation Lag

The time to decide what policy to use (debates, approvals).

Implementation Lag

The time for the policy to show effects after it's applied.

Financial market

Where people trade money or promises of future money.

Loans

You get money now, repay later (plus interest).

Stocks

You buy a share now and get a piece of future profits.

Insurance

Pay now, get money later if something bad happens.

Bonds

Form of debt where the bond issuer promises to repay the principal plus interest payments.

Closed economy w/ no gov

Income = Consumption + Savings OR Investment (S=I).

Closed economy w/ gov

Public savings + Private savings = National savings.

Disposable Income

Income − Taxes (Paid).

MPC

Consumption/Disposable Income.

Interest

Principal × Rate × Time.

Information Asymmetry

One person knows more than the other in a financial deal.

Adverse Selection

Happens before the deal and one side doesn't know the full risk or quality of what they're buying/selling.

Moral Hazard

Happens after the deal and people take more risks because they won't suffer the full consequences.

Banks & The Market for Loanable Funds

Savers have extra money now, Borrowers need money now, Banks are middlemen who connect savers and borrowers.

Loanable Funds Market

Savers (supply) lend money and borrowers (demand) use money to invest.

Interest rate (r)

The 'price' of borrowing money.

Supply of loanable funds

More saving → Supply of loanable funds ↑ = interest rate ↓ & quantity of investment ↑; Less saving → Supply of loanable funds ↓ = interest rate ↑ & quantity of investment ↓

Demand for loanable funds

More investment demand → demand for loanable funds ↑= interest rate ↑ & quantity of investment ↑; Less investment demand → demand for loanable funds ↓ = interest rate ↓ & quantity of investment ↓

Lower interest rate

Lower interest rate → borrowing is cheap → higher quantity of money demanded.

Higher interest rate

Higher interest rate → borrowing is expensive → lower quantity of money demanded.

Medium of Exchange

Money must be accepted by sellers and used by buyers.

Unit of Account

Money is used to measure and compare the value of things.

Store of Value

Money saves purchasing power over time.

Money Supply

M1 is the most liquid form of money M1 = currency + checkable deposits + other liquid deposits.

M2

M2 includes everything in M1, plus near-monies: assets that are almost like money because they can easily become cash, but they aren't used directly to buy things. M2 = M1 + small denominated time deposits + MMMFS.

Small-denominated Time Deposits

These pay interest but can't be easily accessed without a penalty until a certain date.

Retail Money Market Mutual Funds (MMMFs)

Funds that invest in short-term financial assets. People can access their money by writing large checks but not instantly.

Acceptability

People trust that others will accept it.

Legal Tender

It's legally required to be accepted for debts.

Relative Scarcity

Money is valuable because there is a limited supply.

Purchasing Power of the Dollar

How much stuff a dollar can buy. prices ↑ = purchasing power of the dollar ↓; prices ↓ = purchasing power of the dollar ↑.

Value of Dollar Formula

$V = 1/p (p=price level, $v=value of dollar).

Money Multiplier Formula

= 1 / required reserve ratio.

Demand Deposits

Customer funds available on demand (like checking accounts).

Reserves

Money banks keep on hand.

Required Reserves

Amount banks must keep (set by the Fed).

Excess Reserves

Money banks can loan out after keeping required reserves.

Reserve Ratio

Reserves / total amt of demanded deposits.

Required reserves formula

Required reserves = total amt of demanded deposits x required reserve ratio.

Transaction Demand

To buy things (normal spending), depends on GDP (more economic activity → more need for money), not affected by interest rates.

Asset Demand

To store wealth; if interest rates go up, people would rather invest money (and hold less cash).

Total Demand for Money (Dm)

Total Demand for Money (Dm) = Transaction Demand (Dt) + Asset Demand (Da).

Bond Prices and Interest Rates

As interest rates rise, bond prices fall. As interest rates fall, bond prices rise.

Perpetual Bond

A bond that pays a fixed coupon forever with no maturity date.

Plain Vanilla Bond

Pays periodic coupon payments and returns face value at maturity.

Money Demand Shifts

Factors that cause the demand for money to change.

Inflation (Price Level Changes)

Higher inflation leads to a rightward shift of the money demand curve.

Real GDP Increases

More goods and services produced leads to more transactions and a rightward shift of the money demand curve.

Real GDP Decreases

Fewer goods and services produced leads to fewer transactions and a leftward shift of the money demand curve.

Technological Advancements

Reduces the need to hold physical cash, leading to a leftward shift in money demand.

Money Supply Shifts

Changes in money supply occur only when the FED acts, not because of interest rates.

Expansionary Monetary Policy

The Fed increases money supply by buying bonds and lowering reserve requirements, shifting the money supply curve right.

Contractionary Monetary Policy

The Fed decreases money supply by selling bonds and raising reserve requirements, shifting the money supply curve left.

Monetary Policy

Actions taken by a central bank to influence the amount of money in the economy and the cost of borrowing money.

Reserve Requirement

The percentage of deposits banks must keep in the bank and not lend out.

Discount Window

When banks borrow money directly from the Fed if they don't have enough reserves.

Discount Rate

The interest rate the Fed charges banks for borrowing money.

Open Market Operations (OMO)

Buying and selling U.S. government securities by the Fed to affect short-term interest rates.

Buying Bonds

Fed gives money to banks, increasing their lending capacity and lowering interest rates.

Selling Bonds

Fed takes money out of banks, decreasing their lending capacity and raising interest rates.

Administered Rates

Interest rates that the Fed directly sets to guide market rates.

IORB (Interest on Reserve Balances)

Fed pays banks interest for the money they leave at the Fed.

ON RRP (Overnight Reverse Repurchase Agreements)

Fed sells a Treasury security to a bank/money market fund with a promise to buy it back tomorrow at a higher price.

Forward Guidance

The Fed communicates its future intentions publicly.

Quantitative Easing (QE)

When the Fed buys large amounts of long-term government bonds and private securities to inject money into the economy.

Quantitative Tightening (QT)

Fed sells bonds to pull money out of the economy to help with high inflation.

The Taylor Rule

A formula suggesting how the Fed should set interest rates based on current inflation and the economy's distance from full employment.