nhi 106 Lecture_4

Fiscal Policy, Money, Banking, and Money Supply

Overview

  • Presenter: Miguel H. Ferreira

  • Institution: Queen Mary University of London

  • Course: Macroeconomics

Financial Markets and Fiscal Policy

  • Relationship:

    • Fiscal policy significantly impacts financial markets.

    • Investment demand interacts with interest rates, influencing overall economic activity.

Key Aspects

  1. Fiscal Policy

    • Definition: Actions by the government to influence economic activity through spending and taxation.

    • Formula: Changes in government spending ($ riangle G$) affect saving and consumption.

    • Key Relationship:

      • Increased government spending leads to changes in national income ($ riangle Y$) and affects the overall economy.

  2. Investment Demand and Interest Rates

    • Effect of Increased Investment Demand:

      • When there is an increase in investment demand, the interest rate ($r$) rises on the loanable funds market.

      • This is illustrated through graphs showing shifts in supply and demand.

    • The equilibrium level of investment remains constant unless the supply of loanable funds increases.

  3. Defense Spending and Interest Rates

    • Historical analysis of World Wars and their impact on national interest rates and spending patterns.

      • Example: Interest rates and military spending over time show the direct correlation between defense expenditures and economic fluctuations.

    • Percentage of GDP allocated to military spending fluctuated significantly, impacting interest rates during various wars.

      • Notable Wars: World War I, American Revolutionary War, Seven Years War, etc.

Short-run Effects of Fiscal Policy

  1. Changes in Consumption:

    • Relationship explained where changes in tax ($T$) affect consumption ($C$):

      • $ riangle C = C(Y - T) = C + c imes (Y - T)$,

      • $ riangle C = -c imes riangle G$,

      • Where $c$ is the marginal propensity to consume.

    • Resulting changes impact savings: $ riangle S = - riangle C - riangle G$.

  2. Savings and Fiscal Policy:

    • The interaction between savings ($S$) and fiscal changes must be analyzed.

    • A decrease in savings results from increased governmental fiscal interventions.

Money Supply and Demand

  1. Concept of Money in Economics

    • Money is defined as any item or verifiable record that is generally accepted as payment for goods and services.

    • Important Equations:

      • Money Supply ($Ms$) is defined as:

      • Ms = C + D,

      • where $C$ represents currency and $D$ represents demand deposits.

Financial Markets' Response to Fiscal Policy

  • Key Point: An increase in interest rates leads to a subsequent increase in the quantity of saving.

  • As interest rates rise ($r$), the cost of borrowing increases, pushing down the quantity of investment unless there's a corresponding rise in the supply of loanable funds.

  • The equilibrium shifts necessitating a careful consideration of fiscal measures.

The Mechanics of Money Creation

  • Banks create money through lending processes, where the reserve requirement is essential.

    • RR = rac{C}{D} + ext{ reserves },

    • facilitating the money multiplier effect, where $m imes B = Ms$.

    • As reserves increase, money supply expands.

Reserves in Banking

  • Reserve Requirement (RR) is crucial for understanding how banks manage their reserves even as they extend loans.

  • A decrease in the reserve ratio increases the potential money supply, reflecting the critical leverage banks have in the broader economy.

Conclusion

  • The interrelation of fiscal policy, financial markets, and the banking sector underscores macroeconomic dynamics.

  • Policy implications must consider historical data and theoretical foundations to successfully navigate economic objectives and fiscal responsibilities.