Macroeconomics: Monetary and Fiscal Policy Study Notes

Monetary Policy and Reserve Mechanisms

  • Interest on Reserve Balances (IORB): A decrease in the IORB decreases the FFR. This occurs because financial institutions are less willing to pay a higher FFR to borrow funds, shifting the demand for federal funds to the left.

  • Open Market Operations:   - Buying securities/government bonds shifts the supply curve for reserves to the right (expansionary).   - Selling securities shifts the supply curve for reserves to the left (contractionary).

  • Expansionary Monetary Policy: Designed to stimulate private expenditures (CC and II). If inflation expectations are constant, a sale of bonds results in both the FFR and long-run expected real interest rates rising.

  • Quantitative Easing: Classified as expansionary monetary policy.

The Quantity Theory of Money

  • Core Principle: Money supply growth is the primary driver of long-run inflation.

  • Inflation Formula: ̀π ≈ g_M - g_{realGDP}.

  • Money Neutrality: The supply of money is neutral in the long run.

  • Calculation Example: If the growth rate of money supply (gMg_M) is 10%10\% and inflation (̀π) is 5%5\%, the growth rate of real GDP is 5%5\%.

Fiscal Policy and the Multiplier Effect

  • Expansionary Fiscal Policy: Often funded through public debt; may lead to "crowding out" of private investment due to higher interest rates.

  • Government Expenditure Multiplier:   - Calculated as: Change in GDPChange in Expenditures\frac{\text{Change in GDP}}{\text{Change in Expenditures}}.   - Example: A $5\$5 increase in expenditures producing a $50\$50 change in GDP results in a multiplier of 1010.

  • Multiplier Size: Larger when the economy is well below its trend (high unemployment, negative output gap) or when spending is targeted at the unemployed.

  • Fiscal Theory of the Price Level: Predicts that expected future public deficits are inflationary.

Business Cycle Theories

  • Real Business Cycle (RBC) Theory: Emphasizes that fluctuations are primarily driven by changes in productivity and technology.

  • Keynesian Theory: Emphasizes shocks to business and consumer sentiment (animal spirits).

  • Common Sources of Fluctuations: Technology innovations, consumer confidence, and price fluctuations in key inputs like oil.

Current Macroeconomic Context (April 2026)

  • Labor Market: A persistently tight U.S. labor market (unemployment near 4.4%4.4\%, job openings-to-unemployed ratio above 11) has contributed to persistent inflation in core services via wage growth.

  • FOMC Strategy: The target range for the FFR is held at 3.50%–3.75%3.50\%–3.75\% as of early 2026.

  • Dual Mandate: Balancing maximum employment with a 2%2\% inflation target.

  • Risks to Outlook:   - Oil Prices: Influenced by conflict in the Middle East.   - AI (Artificial Intelligence): Impacts on productivity and the labor market.   - Tariffs: Pass-through effects to final prices.

Questions & Discussion

  • Question: How long do you expect the FFR to remain at its current level, why?

  • Response: Likely to remain near 3.50%–3.75%3.50\%–3.75\% through mid-2026. The Fed is in a "wait and see" stance because monetary policy has long lags (roughly 6–186–18 months) and inflation remains above 2%2\%. A deterioration in the labor market would accelerate cuts, while inflation surges from tariffs or energy would delay them.

  • Question: What are the risks of maintaining the FFR too high for too long?

  • Response: It is contractionary, potentially leading to lower economic growth, higher unemployment, and financial instability.