Macroeconomics 1202

Fiscal policy refers to changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives.

(State taxes and spending are not generally aimed at affecting national-level objectives.)

The bank must keep some cash available for its depositors; it does this through a combination of vault cash and deposits with the Federal Reserve. Banks in the U.S. are required to hold required reserves: reserves that a bank is legally required to hold, based on its checking account deposits. At least 10 percent of checking account deposits above some threshold level ($103.6 million in 2015). 10 percent is the required reserve ratio (RR): the minimum fraction of deposits banks are required by law to keep as reserves. Banks might choose to hold excess reserves: reserves over the legal requirement.

A T-account is a stripped-down version of a bank balance sheet, showing only how a transaction changes a bank's balance sheet. When you deposit $1,000 in currency at Bank of America, its reserves increase by $1,000 and so do its deposits. The currency component of the money supply decreases by the $1,000, since that $1,000 is no longer in circulation; but the checking deposits component increases by $1,000. So there is no net change in the money supply—yet.

For several reasons, fiscal policy may be even less effective than monetary policy at countercyclical stabilization: -Timing fiscal policy is harder, due to: Legislative delay: Congress needs to agree on the actions Implementation delay: Large spending projects may take months or even years to begin, even once approved. Government spending might crowd out private spending Crowding out: A decline in private expenditures as a result of an increase in government purchases

A temporary increase in government purchases will cause the demand for money, and hence the interest rate, to rise. But with the higher interest rate, consumption, investment, and net exports all fall.

Fiat money has the advantage that governments do not have to be willing to exchange it for gold or some other commodity on demand. This makes central banks more flexible in creating money. However it also creates a potential problem: fiat money is only acceptable as long as households and firms have confidence that if they accept paper dollars in exchange for goods and services, the dollars will not lose much value during the time they hold them. If people stop "believing" in the fiat money, it will cease to be useful.

A woman in California went to an Apple store and tried to buy an iPad using $600 in currency. Apple refused the sale. It wanted to keep track of people buying multiple iPads to resell, so it was only accepting credit or debit cards.

The first goal for the Fed is price stability. The figure shows CPI inflation in the United States. Since rising prices erode the value of money as a medium of exchange and a store of value, policymakers in most countries pursue price stability as a primary goal.

After the high inflation of the 1970s, then Fed chairman Paul Volcker made fighting inflation his top policy goal. To this day, price stability remains a key policy goal of the Fed.

E. Cary Brown: "Fiscal policy... seems to have been... unsuccessful ...not because it did not work, but because it was not tried."

Although many economists believe the federal budget should be balanced when the economy is at potential GDP, few believe it should be balanced during a recession. During a recession, tax revenues fall; to balance the budget, spending would have to fall also—making the recession worse. In fact, some economists argue that the federal budget should normally be in deficit. Just as households and firms borrow money to implement long-term investments, they argue that the federal government should do the same. Especially since the government can borrow so cheaply.

An increase in aggregate demand will not only result in real GDP rising; it will also result in a price level increase, because the short-run aggregate supply curve is upward-sloping. Suppose that between the autonomous and induced effects, fiscal policy causes aggregate demand to increase by $1.2 trillion. The resulting real GDP increase is smaller—only $1.0 trillion. The price level also rises.

An increase in government purchases and a cut in taxes have a positive multiplier effect. A decrease in government purchases and an increase in taxes have a negative multiplier effect. Example: a reduction in government spending on defense initially affects defense contractors; but then it would spread to suppliers to and employees of those contractors, and then to other firms and workers.

Suppose a recession beginsin August 2018. The Fed finds out aboutthe recession with a lag. In June 2019, the Fedstarts expansionarymonetary policy; butthe recession hasalready ended. By keeping interest rates low for too long, the Fed encourages real GDP to go far beyond potential GDP. The result: High inflation The next recession will be more severe

As if the Fed's job wasn't hard enough, it also has to deal with changing estimates of important economic variables. GDP from the first quarter of 2008 was initially estimated to have increased by 0.6 percent. But the estimate changed over time. Not only was it revised later in 2008, it was revised in 2009, 2011, and even again in 2013.

Bitcoins are a new form of e-money, owned not by a government or firm, but a product of a decentralized system of linked computers. Bitcoins can be traded for other currencies on web sites. Some web sites accept Bitcoins as a form of payment. Should Bitcoins be included in a measure of the money supply? For now, they are not; if they grow popular, maybe they should be.

Banks play a critical role in the money supply. Recall that there is more money held in checking accounts than there is actual currency in the economy. So somehow money is being created by banks. Further, banks are generally profit-making private firms: some small, but some among the largest corporations in the country. Their activities are designed to allow themselves to make a profit. In order to understand the role that banks play, we will first try to understand how banks operate as a business.

Discretionary fiscal policy, on the other hand, refers to intentional actions the government takes to change spending or taxes.

Before the Great Depression of the 1930s, most government spending was at the state or local level; now the federal government's share is two-thirds to three-quarters.

Commodity money has a value independent of its use as money. Some important historical and modern commodity moneys: Cowrie shells in Asia (the Classical Chinese character for money/currency, 貝, originated as a pictograph of a cowrie shell) Precious metals, such as gold or silver Beaver pelts in colonial North America Cigarettes in prisons and prisoner-of-war camps

Beginning in China in the tenth century and spreading throughout the world, paper money was issued by banks and governments. The paper money was exchangeable for some commodity, typically gold, on demand. In modern economies, paper money is generally issued by a central bank run by the government. The Federal Reserve is the central bank of the United States. However, money issued by the Federal Reserve is no longer exchangeable for gold; nor is any current world currency. Instead, the Fed issues currency known as fiat money. Fiat money refers to any money, such as paper currency, that is authorized by a central bank or governmental body, and that does not have to be exchanged by the central bank for gold or some other commodity money.

Adjusting the federal funds rate had been an effective way for the Fed to stimulate the economy, but it began to fail in 2008. Banks did not believe there were good loans to be made, so they refused to lend out reserves, despite the federal funds rate being maintained at zero. This is known as a liquidity trap: the Fed was unable to push rates any lower to encourage investment.

But the Fed was certain the economy was below potential GDP, so it wanted to stimulate demand. It performed quantitative easing (A new tool) buying securities beyond the normal short-term Treasury securities, including 10-year Treasury notes and mortgage-backed securities. This pushed real interest rates into the negatives.

A bubble in a market refers to a situation in which prices are too high relative to the underlying value of the asset. Bubbles can form due to: Herding behavior: failing to correctly evaluate the value of the asset, and instead relying on other people's apparent evaluations; and/or Speculation: believing that prices will rise even higher, and buying the asset intending to sell it before prices fall. Example: Stock prices of internet-related companies were "optimistically" high in the late 2000s, before the "dot-com bubble" burst, starting in March 2000. 2007-2009 recession

By 2005, many economists argued that a bubble had formed in the U.S. housing market. Comparing housing prices and rents makes it clear now that this was true. The high prices resulted in high levels of investment in new home construction, along with optimistic sub-prime loans.

Each expected inflation rate generates a different short-run Phillips curve. In each case, when the inflation rate is actually at the expected level, the unemployment level is at its natural rate—i.e. the long-run Phillips curve.

By the 1970s, most economists agreed that the long-run Phillips curve was vertical; it was not possible to "buy" a permanently lower unemployment rate at the cost of permanently higher inflation. In order to keep unemployment lower than the natural rate, the Fed would need to continually increase inflation.

The ability of the Fed to affect economic variables such as real GDP depends on its ability to affect long-term real interest rates. It uses the federal funds rate (a short-term nominal interest rate) for this—an imperfect tool. HOWEVER-We will assume in this section that the Fed can affect long-term real interest rates using the federal funds rate.

Consumption Lower interest rates encourage buying on credit, which typically affects the sale of durables. Lower rates also discourage saving. Investment Lower interest rates encourage capital investment by firms: By making it cheaper to borrow (sell corporate bonds). By making stocks more attractive for households to purchase, allowing firms to raise funds by selling additional stock. Lower rates also encourage new residential investment. Net exports Lower U.S. interest rates turn away foreign funds, lowering the $US exchange rate, causing net exports to increase.

the AD-AS model, a small aggregate demand increase leads to low inflation and high unemployment. A stronger AD increase results in lower unemployment but more inflation—the short run Phillips curve relationship.

During the 1960s, some economists argued that the Phillips curve was a structural relationship: a relationship that depends on the basic behavior of consumers and firms, and that remains unchanged over long periods. In the 1960s, this relationship had appeared to be quite stable. If this were true, policy-makers could choose a point on the curve: trading permanently higher inflation for lower unemployment, or vice versa. But this turned out not to be true: allowing more inflation doesn't lead to permanently lower

After becoming Fed chair in 2014, Janet Yellen quickly learned how sensitive investors were to her statements.

During the financial crisis, the Fed adopted a too-big-to-fail policy, taking actions to save Bear Stearns and AIG from bankruptcy. Too-big-to-fail policy: A policy under which the federal government does not allow large financial firms to fail, for fear of damaging the financial system. The Wall Street Reform and Consumer Protection Act (2010) (aka the Dodd-Frank Act) prohibited the Fed from making loans "for the purpose of assisting a single and specific company avoid bankruptcy". This has uncertain consequences for the future stability of the financial system.

The Congressional Budget Office (CBO) is a non-partisan organization that estimates the effects of government policies. The table shows CBO estimates of the effect of the stimulus package on economic variables, relative to what would have happened without the stimulus package: The CBO's conclusion: the stimulus package reduced the severity of the recession, but did not come close to bringing the economy back to full employment.

Even after the stimulus package, the economy had not returned to potential GDP. Recently, monetary policy has been expansionary, but fiscal policy has been much less so. Do you think more expansionary fiscal policy is needed?

Some forms of government spending and taxes automatically increase or decrease along with the business cycle; these are automatic stabilizers.

Example: Unemployment insurance payments are larger during a recession.

Congress and the President carry out fiscal policy through: Changes in government purchases Changes in taxes A change in government purchases directly affects aggregate demand. A change in taxes changes income; this in turn affects consumption, and so it has an indirect effect on aggregate demand.

Expansionary fiscal policy involves increasing government purchases or decreasing taxes. If the government believes real GDP will be below potential GDP, it can enact expansionary fiscal policy in an attempt to restore long-run equilibrium—decreasing unemployment.

Does this prove people werenot forming their expectationsabout inflation rationally? Not necessarily. The Fed hada credibility problem: it hadpreviously announcedcontractionary policies, butallowed inflation to occuranyway. Eventually, several years of tight money convinced people that inflation would be lower. Prices fell, and so did expectations about inflation: a new, lower short-run Phillips curve.

Fed policies in the 1970s resulted in high inflation. This forced the "Volcker disinflation" of the early 1980s; subsequent Fed chairs have been equally determined to keep inflation low. Disinflation: A significant reduction in the inflation rate.

When the federal government runs a budget deficit, it finances its activities by selling Treasury securities. The total value of those securities outstanding is known as the federal government debt, or the national debt. The national debt increased dramatically as a percentage of GDP during the two world wars, and the two worst recessions. It is now at its highest level since 1947.

For now, the federal government is at no serious risk of defaulting on its obligations, because: The interest rate it can borrow money at is very low The size of the interest payments on the debt is low relative to the size of the federal budget—around 11 percent In the long run, a debt that increases in size relative to GDP can pose a problem—potentially crowding out investment, which is a key component of long term growth. This problem is reduced if the government uses debt was incurred to finance infrastructure, education, or research and development; these serve as a long term investment for the economy.

We saw in the previous chapter that the Fed alters the money supply by buying and selling U.S. Treasury securities—open market operations. To increase the money supply, the Fed buys those securities; the sellers deposit the sale proceeds in a checking account, and the money gets loaned out—increasing the money supply. Decreasing the money supply would require selling securities.

For simplicity, we assume theFed can completely control the money supply. Then the money supplycurve is a vertical line—it does not depend onthe interest rate. Equilibrium occurs in the money market where the two curves cross. When the Fed increases the money supply, the short-term interest rate must fall until it reaches a level at which households and firms are willing to hold the additional money.

Budget deficits also occur during recessions, as tax receipts fall, and automatic stabilizers like increases in transfer payments (unemployment insurance, food stamps, etc.) take effect. These automatic stabilizers are important for limiting the severity of a recession; many economists believe that the Great Depression of the 1930s was more severe because most of these automatic stabilizers did not exist then.

Government expenditures increased after the Great Depression of the 1930s as part of the "New Deal", enacted by Franklin D. Roosevelt. Similarly, there was a budget deficit each year in the 1930s (except 1937). However recovery from the Great Depression was painfully slow. Does this show that expansionary fiscal policy didn't work during the 1930s?

Social Security and Medicare have helped to reduce poverty among the elderly, while Medicaid helps improve the health of poor people. But the aging population and rising health care costs are combining to put those programs in jeopardy. Through 2090, the budget shortfall for these programs is estimated to be enormous: almost $50 trillion.

How can these programs continue to exist? It is likely that a combination of these measures will eventually need to be adopted: 1) Increasing taxes 2) Decreasing benefits (including slower benefit growth, perhaps differently for different income groups) 3) Decreasing eligibility (SSI age already increasing from 65 to 67) 4) But perhaps the most important element will be finding a way to reduce medical costs

Can Apple do this legally? Yes! Firms are not obliged to accept currency as payment. (Debts are a different story.) Similarly, many convenience stores and gas stations refuse to take large-denomination bills ($50 or more). Nor can you force a store to accept a bucket of pennies as payment. Due to bad publicity, Apple ended up giving the woman (who was in a wheelchair!) an iPad for free.

How much money is there in America? This is harder to answer than it first appears, because you have to decide what to count as "money". M1 is the narrowest definition of the money supply: the sum of currency in circulation, checking account deposits in banks, and holdings of traveler's checks. M2 is a broader definition of the money supply: it includes M1, plus savings account deposits, small-denomination time deposits, balances in money market deposit accounts, and noninstitutional money market fund shares.

How long the economy remains off the long-run Phillips curve depends on how fast workers and firms adjust their expectations about future inflation. This in turn depends on inflation itself: Low inflation: slow adjustment, since workers and firms seem to ignore inflation Moderate but stable inflation: quick adjustment; stable but noticeable inflation is easily incorporated into expectations High and unstable inflation: quick adjustment again, but for a different reason: forming rational expectations about inflation becomes very important, so workers and firms pay a lot of attention to forecasting inflation. Rational expectations: Expectations formed by using all available information about an economic variable.

If workers and firms have adaptive expectations, expecting inflation to be the same as it was last period, then expansionary monetary policy can increase employment. But if they have rational expectations, workers and firms will anticipate the Fed's policies, and adjust their expectations about inflation accordingly. Then the policy would have no effect on employment: the short-run Phillips curve would be vertical also.

In early 2008, believing a recession was imminent, Congress authorized a tax cut: a one-time rebate of taxes already paid, totaling $95 billion. This resulted in a boost to consumers' current incomes. Changes to current incomes result in smaller increases in spending than changes to permanent incomes, because people seek to "smooth" their consumption over time. Economists estimate that consumers spent about 33-40 percent of the rebates they received; so the tax cut resulted in about $35 billion in increased spending.

In 2009, Congress passed the "stimulus package", a combination of increased government spending (about two-thirds)...... and decreased taxes (about one-third). At $840 billion, the stimulus package was by far the largest fiscal policy action in U.S. history.

In 2005, the Fed believed the economy was in long-run equilibrium. In 2006, the Fed believed aggregate demand growthwas going to be "too high", resulting in excessive inflation. So the Fed raised the federal funds rate—a contractionary monetary policy, designed to decrease inflation. The result: lower real GDP and less inflation in 2006, than would otherwise have occurred.

In normal times, the Fed targets the federal funds rate. One alternative to this is to target the money supply instead. Should it use the money supply as its monetary policy target instead?

Medium of exchange Money is acceptable to a wide variety of parties as a form of payment for goods and services. Unit of account Money allows a way of measuring value in a standard manner. Store of value Money allows people to defer consumption till a later date by storing value. Other assets can do this too, but money does it particularly well because it is liquid, easily exchanged for goods. Standard of deferred payment Money facilitates exchanges across time when we anticipate that its value in the future will be predictable.

In order to serve as an acceptable medium of exchange (and hence a potential "money"), a good should have the following characteristics: The good must be acceptable to most people. It should be of standardized quality so any two units are alike. It should be durable so that value is not lost by storage. It should be valuable relative to its weight, so that it can easily be transported even in large quantities. It should be divisible because different goods are valued differently.

The German government went a step further in 2015: it sold bonds with negative nominal interest rate. Investors believed the guarantee of repayment was worth avoiding the risk of default from alternative bonds and deposits.

In our demonstration of monetary policy, the Fed Knew how far to shift aggregate demand, and Was able to shift aggregate demand exactly this far. In practice, monetary policy is much harder to get right than the graphs make it appear. Completely offsetting a recession is not realistic; the best the Fed can hope for is to make recessions milder and shorter. Another complicating factor is that current economic variables are rarely known; we usually can only know them for the past—i.e. with a lag. In November 2001, NBER announced that the economy was in a recession that had begun in March 2001; several months later, it announced the recession ended... in November 2001.

So the initial increase in spending... ... is partially offset by the crowding out.

In the long run, the increase in government purchases will have no effect on real GDP: the reduction in consumption, investment, and net exports will exactly offset the increase in government purchases. Why? Because in the long run, the economy returns to potential GDP, even without the government's intervention. The long run effect is simply to increase the size of the government sector within the economy. Bear in mind that the long run may be many years away, however; so the intermediate increase in real GDP may be worth the cost.

Our model of fiscal policy so far is static: it assumes long-run potential GDP does not change, and that the price level is constant. While the lessons from this model are still appropriate—Congress and the President can use fiscal policy to affect real GDP and the price level—our understanding of fiscal policy can be improved by seeing it in the dynamic aggregate demand and aggregate supply model.

Initially, the economy isin long-run equilibrium. The federal government projects that aggregate demand will not rise by enough to maintain full employment. It enacts an expansionary fiscal policy to increase aggregate demand, hopefully to the full employment level. The price level is higher than it would have been without the expansionary fiscal policy

Monetarists, led by Nobel Laureate Milton Friedman, said "yes". Friedman advocated a monetary growth rule, increasing the money supply at about the long-run rate of real GDP growth. He argued that an active countercyclical monetary policy would serve to destabilize the economy; the monetary growth rule would provide stability instead. Monetarism was popular in the 1970s; but since the 1980s, the link between the money supply and real GDP seems to have broken down: M1 seems to change "wildly", but real GDP and inflation do not react in the same way.

It might seem that the Fed could "get the best of both worlds" by targeting both interest rates and the money supply. But this is impossible: the two are linked through the money demand curve. So a decrease in the money supply will increase interest rates; an increase in the money supply will increase interest rates. Taylor rule 3 screenshots

This idea of rational expectations and a vertical short-run Phillips curve was proposed by Nobel Laureates Robert Lucas and Thomas Sargent. Their critics argued that the 1950s and 1960s showed an obvious short-run tradeoff between unemployment and inflation. Lucas and Sargent: This happened because the Fed was secretive, not announcing changes in policy. If the Fed announces its policies, people will correctly anticipate inflation. Critics: Workers and firms still cannot correctly anticipate inflation; their expectations are not rational. Besides, wages and prices don't adjust fast enough anyway; so even if people anticipated the inflation, they couldn't do enough about it to make the short-run Phillips curve vertical.

Lucas and Sargent concluded the Fed could affect output and employ-ment; but only through unexpected changes to the money supply. During the 1980s, a different mechanism for explaining changes in real GDP: technology shocks—increases or decreases in productive ability—might push real GDP above or below its (previous) potential level. Since this was based on real (not monetary) factors, models based on this became known as real business cycle models. Real business cycle models: Models that focus on real rather than monetary explanations of the fluctuations in real GDP. These models assume rational expectations and quickly-adjusting prices, as did Lucas and Sargent; collectively, these two approaches are known as the new classical macroeconomics.

When the housing bubble burst, more of these lower-quality loans were defaulted on than investors were expecting. The market for securities based on these loans became very illiquid—few people or firms were willing to buy them, and their prices fell quickly. Many commercial and investment banks were invested heavily in these mortgage-backed securities, and so suffered heavy losses. These problems were so profound that the Fed and the U.S. Treasury decided to take unprecedented actions.

Many economists were critical of the Fed underwriting Bear Stearns, as managers would now have less incentive to avoid risk: a moral hazard problem. So in September 2008, the Fed did not step in to save Lehman Brothers, another investment bank experiencing heavy losses. This was supposed to signal to firms not to expect the Fed to save them from their own mistakes. Lehman Brothers declared bankruptcy on September 15. Financial markets reacted adversely—more strongly than expected. When AIG began to fail a few days later, the Fed reversed course, providing them with a $87 billion loan.

The fiscal policy we have concentrated on so far was intended to address short-run goals of stabilizing the economy. But other fiscal policy actions are intended to have long-run impacts on potential GDP—i.e. on aggregate supply, rather than aggregate demand. Hence these actions are often referred to as supply-side economics. Expand Most such policies are based on changing taxes in order to increase incentives to work, save, invest, and start a business.

Marginal tax rates matter because the larger they are, the larger will be the behavioral response to the tax.... Individual income tax Affects labor supply decisions, and the returns to entrepreneurship Corporate income tax Affects the incentives of firms to engage in investment Tax on dividends and capital gains Affects the supply of loanable funds from households to firms, and hence the real interest rate Also affects the way firms disburse profits—2003 reduction in dividend tax led some firms like Microsoft to pay dividends for the first time

If the expectations about inflation are correct, the real wage will be $30 as expected; Ford will hire its planned number of workers. However if inflation is lower (higher) than expected, the real wage becomes higher (lower) than expected, and Ford will adjust its hiring decisions.

Milton Friedman: "There is always a temporary trade-off between inflation and unemployment; there is no permanent trade-off. The temporary trade-off comes not from inflation per se, but from unanticipated inflation."

More consequences of the Lehman brothers

Reserve Primary Fund was a money market mutual fund that was heavily invested in Lehman Brothers. Many investors withdrew money from Reserve and other money market funds, fearing losing their investments. This prompted the Treasury to offer insurance for money market mutual funds, similar to FDIC insurance. Finally, in October 2008, Congress passed the Troubled Asset Relief Program (TARP), providing funds to banks in exchange for stock—another unprecedented action. Although these interventions took new forms, they were all designed to achieve traditional macroeconomic goals: high employment, price stability, and financial market stability.

On a balance sheet, a firm's assets are listed on the left, and its liabilities (and stockholders' equity, or net worth) are listed on the right. The left and right sides must add to the same amount. Banks use money deposited with them to make loans and buy securities (investments). Their largest liabilities are their deposit accounts: money they owe to their depositors.

Reserves are deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve. Notice that the bank does not keep enough deposits on hand to cover all of its deposits. This is how the bank makes a profit: lending out or investing money deposited with it.

Keeping the federal funds rate at 1 percent from June 2003 to June 2004 In 2001, the economy experienced a mild recession. By 2003, the recession was long over; but the Fed kept interest rates low anyway. This encouraged borrowing, and may have exacerbated the housing bubble.

Since 2008, the Fed has used "forward guidance" as a monetary policy tool: telling the public what future monetary policy will be. This guidance has convinced investors that interest rates will continue to be low for extended periods, bringing long-term interest rates to very low levels.

By the late 1960s, most economists agreed that the long-run aggregate supply curve was vertical. Is a vertical long-run AS curve compatible with a downward-sloping long-run Phillips curve? Economists Milton Friedman and Edmund Phelps argued that this implied the long-run Phillips curve was also vertical: in the long run, employment is determined by output, which in the long run does not depend on the price level.

Since employment was determined by potential GDP, so must be unemployment. Unemployment, in the long run, goes to its natural rate, when the output returns to potential GDP. At this output level, there is no cyclical unemployment; but there does remain structural and frictional unemployment. These latter two are not predictably affected by inflation.

The Fed conducts expansionary monetary policy when it takes actions to decrease interest rates to increase real GDP. Correcting a recession. This works because decreases in interest rates raise consumption, investment, and net exports. Moving from point A to B. The Fed would take this action when short-run equilibrium real GDP was below potential real GDP. The increase in aggregate demand encourages increased employment, one of the Fed's primary goals.

Sometimes the economy may be producing above potential GDP. In that case, the Fed may perform contractionary monetary policy: increasing interest rates to reduce inflation. Why would the Fed intentionally reduce real GDP? The Fed is mostly concerned with long-run growth. If it determines that inflation is a danger to long-run growth, it can contract the money supply in order to discourage inflation, i.e. encouraging price stability.

At the end of World War II, Congress passed the Employment Act of 1946, which stated that it was the: "responsibility of the Federal government... to foster and promote... conditions under which there will be afforded useful employment, for those able, willing, and seeking to work, and to promote maximum employment, production, and purchasing power." Price stability and high employment are often referred to as the dual mandate of the Fed.

Stable and efficient financial markets are essential to a growing economy. The Fed makes funds available to banks in times of crisis, ensuring confidence in those banks. In 2008, the Fed temporarily made these discount loans available to investment banks also, in order to ease their liquidity problems.

Money is one of mankind's most important inventions. Economists consider money to be any asset that people are generally willing to accept in exchange for goods and services, or for payment of debts. Asset: Anything of value owned by a person or a firm. We will begin by considering what role money serves, and what can be used as money. Then we will consider modern forms of money, and the roles of banks and the government in creating and managing money. Finally, we will create a model relating prices to the amount of money.

Suppose you were living before the invention of money. If you wanted to trade, you would have to barter, trading goods and services directly for other goods and services. Trades would require a double coincidence of wants. Eventually, societies started using commodity money—goods used as money that also have value independent of their use as money—like animal skins or precious metals. The existence of money makes trading much easier, and allows specialization, an important step for developing an economy.

Eventually, firms and workers adjusted their expectations to the inflation rate of 4.5 percent. Workers demanded higher wages to compensate for the increased inflation, and the economy returned to potential GDP, with unemployment at its natural rate of 5 percent.

The "new normal" inflation rate of 4.5 percent became embedded in the economy, in the form of the short-run Phillips curve shifting to the right. 3.5 percent unemployment would require another unexpected increase in the rate of inflation.

But Bank of America needs to make a profit; so it keeps 10 percent of the deposit as reserves, and lends out the rest, creating a $900 checking account deposit.

The $900 initially appears in a BoA checking account, but will soon be spent; and Bank of America will transfer $900 in currency to the bank at which the $900 check is deposited. And the cycle will continue, with PNC now making a loan. p 25 CH 14 = end

Although it does not directly set the federal funds rate, through open market operations the Fed can control it quite well. From December 2008, the target federal funds rate was 0-0.25 percent. The low federal funds rate was designed to encourage banks to make loans instead of holding excess reserves, which banks were holding at unusually high levels.

The FOMC has since 2015..December 2015- The Fed increased the FFR to between .25% and .5% In 2016 increased to between .5% and .75% March 2017- increased to between .75% and 1%.......will continue to rise

The Fed can choose to target a particular level of the money supply, or a particular short-term nominal interest rate. TODAY..... It concentrates on the interest rate, in part because the relationship between the money supply (M1 or M2) and real GDP growth broke down in the early 1980s (M1) and 1990s (M2). There are many different interest rates in the economy; the Fed targets the federal funds rate: the interest rate banks charge each other for overnight loans. The Fed does not set the federal funds rate; but rather affects the supply of bank reserves through open market operations, hoping to change FFR.

The Fed can change the supply of reserves in the system, thus is able to change the Federal Funds Rate.......

Stable economic growth encourages long-run investment, which is itself necessary for growth. It is not clear to what extent the Fed can really encourage long-run investment, beyond meeting the previous three goals; Congress and the President may be in a better position to address this goal.

The Fed has three monetary policy tools at its disposal: Open market operations Discount policy Reserve requirements It uses these tools to try to influence the unemployment and inflation rates. It does this (at least, in "normal" times) by directly influencing its monetary policy targets: The money supply **The interest rate (primary monetary policy target of the Fed)

When the Federal Reserve was created in the 1913, its main responsibility was to 1) prevent bank runs. After the Great Depression of the 1930s, Congress gave the Fed broader responsibilities: 2) to act "so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." Since World War II, the Fed has carried out an active monetary policy. Monetary policy: The actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy goals.

The Fed pursues four main monetary policy goals: Price stability High employment Stability of financial markets and institutions Economic growth We will consider each goal in turn.

A budget deficit occurs when the government's expenditures are greater than its tax revenue. A budget surplus occurs when the government's expenditures are less than its tax revenue. Do you know whether the federal government is running a budget deficit or a budget surplus currently?

The U.S. federal government does not generally balance its budget. Sometimes its revenues are higher than its expenditure, but usually the reverse is true—especially so during wartime.

Contractionary fiscal policy involves decreasing government purchases or increasing taxes. This works just like expansionary fiscal policy, only in reverse. If the government believes real GDP will be above potential GDP, it can enact contractionary fiscal policy in an attempt to restore long-run equilibrium—decreasing inflation.

The federal government's actions described on the previous slides constitute a countercyclical fiscal policy. Bear in mind that: The effects described assume ceteris paribus: everything else is staying the same, including monetary policy. Contractionary fiscal policy is not really causing prices to fall; it's causing inflation to be lower than it otherwise would have been.

Through the late 1960s and early 1970s, Federal Reserve policy had led to high inflation rates. Actions by the Organization of Petroleum Exporting Countries (OPEC) in the mid-1970s made the situation worse.

The graphs show the U.S. economy in 1973: moderate but anticipated inflation, hence unemployment at its natural rate. In 1974, OPEC caused oil prices to rise dramatically. This was a supply shock, decreasing short-run aggregate supply. Unemployment rose, but so did people's expectations of inflation—a higher short-run Phillips curve.

Federal purchases consist of defense spending and "everything else", like salaries of FBI agents, operating national parks, and funding scientific research. Around half of federal expenditures are spent on transfer payments, like Social Security, Medicare, and unemployment insurance. The rest is spent on grants to state and local governments to support their activities, like crime prevention and education; and on paying interest on the federal debt.

The majority of federal revenues come from taxes on individual employment: individual income taxes, and "payroll taxes" earmarked to fund Social Security and Medicare. Taxes on corporate profits constitute about one-seventh of federal receipts. The remainder of federal revenue comes from excise taxes (on cigarettes, gasoline, etc.), tariffs on imports, and other fees from firms and individuals.

Or it could decrease inflation, at the cost of a temporarily higher unemployment rate. Since any rate of unemployment other than the natural rate results in the rate of inflation increasing or decreasing, the natural rate of unemployment is sometimes referred to as the non-accelerating inflation rate of unemployment, or NAIRU.

The natural rate of unemployment might change if the amount of frictional or structural unemployment changed. Possible reasons for this include: Demographic changes: younger and less skilled workers have higher unemployment rates. Changes in labor market institutions: a change in the availability of unemployment insurance, the prevalence of unions, or legal barriers to firing workers. Past high rates of unemployment: during long periods of unemployment, workers' skills may deteriorate, or they may become dependent on the government for support.

What could the Fed do? It wanted to fight both inflation and unemployment, but the short-run Phillips curve makes clear that improving one worsens the other. The Fed chose expansionary monetary policy: reducing unemployment, at the cost of even more inflation.

The newly high inflationwas incorporated intopeople's expectations,and became self-reinforcing. The Fed's new chairman,Paul Volcker, wantedinflation lower, believinghigh inflation was hurtingthe economy. So Volcker announced and enacted a contractionary monetary policy. If people believed the announcement, they would adjust down to a lower Phillips curve. But for several years, the Phillips curve appeared not to move.

Suppose each increase in spending induces half again as much consumption spending. Over time, a $100 billion increase in government purchases will result in an additional $100 billion in induced consumption spending.

The tax multiplier applies to changes in the amount of taxes, without changes in tax rates. Example: In 2009 and 2010, the federal government enacted the Making Work Pay Tax Credit: a $400 reduction in taxes for working individuals ($800 for households). Decreases in tax rates have a slightly different effect: Increasing the disposable income of households, leading them to increase their consumption spending Increasing the size of the multiplier effect, since more of any increase in income becomes disposable income.

Most economists believe an increase in inflation will quickly lead to an increase in wages. However workers tend not to believe this, expecting that inflation will decrease their purchasing power for years, or even permanently. This has an important consequence: since workers do not expect their wages to increase with inflation, firms can increase wages by less than inflation (i.e. decrease real wages) without worrying about workers quitting or their morale falling. This gives a further reason why higher inflation will lead to lower (short-run) unemployment.

Throughout the early 1960s, inflation was low—about 1.5 percent. Firms and workers expected this rate to continue; but inflation was higher in the late 1960s, about 4.5 percent, due to expansionary monetary and fiscal policies. Because this was unexpected, the economy moved along the short-run Phillips curve, resulting in low unemployment of 3.5 percent.

During 2006 and 2007, house prices started to fall, in part because of mortgage defaults, and new home construction fell considerably. Banks became less willing to lend, and the resulting credit crunch further depressed the housing market.

Until the 1970s, when a commercial bank granted a mortgage, it would "keep" the loan until it was paid off. This limited the number of mortgages banks were willing to provide. A secondary market in mortgages was made possible by the formation of the Federal National Mortgage Association ("Fannie Mae") and the Federal Home Loan Mortgage Corporation ("Freddie Mac"). These government-sponsored enterprises (GSEs) sell bonds to investors and use the funds to purchase mortgages from banks. This allowed more funds to flow into mortgage markets.

Alternatively, the Fed may decide to lower the money supply, by selling Treasury securities. Now firms and households (who bought the securities with money) hold less money than they want, relative to other financial assets. In order to retain depositors, banks are forced to offer a higher interest rate on interest-bearing accounts.

We now have two models of the interest rate: The loanable funds model (chapter 10) Concerned with long-term real rate of interest Relevant for long-term investors (firms making capital investments, households building new homes, etc.) The money market model (this chapter) Concerned with short-term nominal rate of interest Most relevant for the Fed: changes in money supply directly affect this interest rate Usually, the two interest rates are closely related; an increase in one results in the other increasing also.

The Fed's two monetary policy targets are related in an important way: Higher interest rates result in a lower quantity of money demanded. Why? When the interest rate is high, alternatives to holding money begin to look attractive—like U.S. Treasury bills. So the opportunity cost of holding money is higher when the interest rate is high.

What could cause themoney demand curveto shift? A change in the need to hold money, to engage in transactions. For example, if more transactions are taking place (higher real GDP) or more money is needed for each transaction (higher price level), the demand for money will be higher. Decreases in real GDP or the price level decrease money demand.

The effect of the stimulus package on federal expenditures and revenue was not immediate; but it mostly occurred over the following two years.

When the stimulus was passed, Obama administration economists believed that by the end of 2010, it would: Increase real GDP by 3.5 percent Increase employment by 3.5 million By the end of 2010, real GDP actually rose by 4.4 percent but employment fell by 3.3 million. Did the stimulus fail? To judge the effect of the stimulus package, we have to measure its effects holding constant all other factors affecting real GDP and employment. Isolating the effects of the stimulus package is very difficult; economists still differ in their views about how effective the stimulus package was.

Debit cards directly access checking accounts; but the card is not money; the checking account balance is. Credit cards are a convenient way to obtain a short-term loan from the bank issuing the card. But transactions are not really complete until you pay the loan off—transferring money to pay off the credit card loan. So credit cards do not represent money.

When we think of money, we typically think of currency issued by a government. But currency is only a small part of the money supply. Over the last decade or so, consumers have come to trust forms of e-money such as PayPal.

By the 2000s, investment banks had started buying mortgages also, packaging them as mortgage-backed securities, and reselling them to investors. These securities were appealing to investors because they paid high interest rates with apparently low default risk. But with more money flowing into mortgage markets, "worse" loans started to be made, to people With worse credit histories (sub-prime loans) Without evidence of income ("Alt-A" loans) With lower down-payments Who couldn't initially afford traditional mortgages (adjustable-rate mortgages start with low interest rates)

Why does the size of the down-payment matter? By owning a house, you become exposed to increases or decreases in the price of that large asset. With a smaller down-payment, you are said to be highly leveraged, exposed to large potential changes in the value of your investment.

When he left the Fed, Alan Greenspan's term appeared very successful: Low inflation Only two recessions—both short and mild (1990-1991, 2001) Increased Fed credibility (following through on announced actions) Increased Fed transparency (since 1994, federal funds rate target has been made public) Greenspan also oversaw the deemphasizing of the money supply as a Fed monetary policy target, and the increased interest rates—the federal funds rate, in particular.

With hindsight, two Fed actions during Greenspan's tenure appear to have worsened the 2007-2009 recession: Saving hedge fund Long-Term Capital Management (LTCM) LTCM suffered heavy investment losses in 1998. Owing money to other firms, it was going to have to sell off its investments quickly to repay debts. Rather than risking a series of failures of related firms, the Fed intervened and helped LTCM make arrangements with its creditors to unwind its investments slowly. This action set the precedent for helping over-leveraged financial firms, and may have encouraged financial firms to take too many risks, exacerbating the financial crisis.

As a percentage of GDP, federal expenditures are now higher than ever—almost 25 percent of GDP.

However a smaller proportion is now spent on government purchases of goods and services.

The economy startsonce more in long-run equilibrium. The federal government projects that aggregate demand will rise so much that employment is beyond the full-employment level, causing high inflation. It enacts a contractionary fiscal policy to decrease aggregate demand, again ideally to the full employment level.

If the government increases its spending on goods and services, then aggregate demand increases immediately. This is the autonomous increase in aggregate demand. But then people receive this increased spending as increased income, and increase their consumption spending accordingly.This is the induced increase in aggregate demand. The series of induced increases in consumption spending that results from the initial increase in autonomous expenditures is known as the multiplier effect.

Several proposals designed to alter the Fed's operations or structure have recently been proposed, including: 1) Requiring the Fed to adopt a formal policy rule (like the Taylor rule). 2) Making price stability the Fed's sole policy goal (i.e. removing its responsibility for employment under its dual mandate). 3) Changing the Fed's structure to alter the membership of the Federal Open Market Committee, or to add new Federal Reserve District Banks. 4) Auditing the Fed's monetary policy actions, adding more congressional oversight and decreasing Fed independence.

In 1993, economists Alberto Alesina and Larry Summers demonstrated an important link between the inflation rate in high-income countries and the degree of independence their central banks had from the rest of the government. They concluded that, in order to continue to fight inflation, the Fed would need to maintain its independence.

Simpler taxes would also lead to economic gains for society. The current tax code is extremely complicated—over 3,000 pages long.

The IRS estimates that taxpayers spend more than 6.4 billion hours each year filling out their tax returns—45 hours per tax return. A simplified tax code would increase economic efficiency by reducing the number of decisions households and firms make solely to reduce their tax payments.

Some economists argue that government spending simply shifts employment from one group to another—it does not increase total employment.

This debate was particularly important after the 2007-2009 recession: can the government use discretionary fiscal policy to increase employment?

Does Government Spending Create Jobs?

This makes it appear as though increases in government spending increase output—and hence other relevant economic variables like employment.

The two great macroeconomic problems that the Fed deals with (in the short run) are unemployment and inflation. But these two are related in an important way: higher levels of inflation are associated with lower levels of unemployment, and vice versa.

This relationship is known as the Phillips curve, after New Zealand economist A.W. Phillips, the first to identify this relationship. Phillips curve: A curve showing the short-run relationship between the unemployment rate and the inflation rate.

The charts show U.S. M1 and M2 as of July 2015. U.S. currency holdings are unusually high by world standards; people in other countries sometimes hold and use U.S. dollars.

When we want to talk about the money supply, which definition should we use? Either one might be valid; but we are mostly interested in money's role as the medium of exchange, so this suggests using M1. In our discussion of money, we will therefore: Treat both currency and checking account balances as "money", but nothing else. (Traveler's checks are insignificant.) Realize that banks play an important role in the money supply, since they control what happens to money when it is in a checking account.

real GDP formula

Y = C+ I + G + NX

We used the static AD-AS model initially for simplicity. But in reality, potential GDP increases every year (long-run growth); and the economy generally experiences inflation every year. We can account for these in the dynamic aggregate demand and aggregate supply model. Recall that this features: Annual increases in long-run aggregate supply (potential GDP) Typically, larger annual increases in aggregate demand Typically, smaller annual increases in short-run aggregate supply Typically, therefore, annual increases in the price level

long-run equilibrium at $17.0 trillion. The Fed forecasts thataggregate demand will notrise fast enough, so that inperiod 2, the short-runequilibrium will fall belowpotential GDP, at $17.3 trillion. So the Fed uses expansionary monetary policy to increase aggregate demand. The result: real GDP at its potential; and a higher level of inflation than would otherwise have occurred.

The Fed tries to set policy according to what it forecasts the state of the economy will be in the future. Good policy requires accurate forecasts. The forecasts of most economists in 2006/2007 did not anticipate the severity of the coming recession. So the Fed missed the opportunity to dampen the effects of the recession.

steps what would have happened without the monetary policy. Expansionary monetary policy is sometimes called "loose" or "easy" monetary policy. Contractionary monetary policy is "tight" monetary policy.