reading 16 - Monetary and Fiscal Policy

many central banks in developed economies target an inflation rate of X percent based on a consumer price index

2

If the government is concerned with both unemployment and inflation in an economy, then raising aggregate demand toward the full X level may also lead to a tightening labour market and rising wages and prices

employment

inflation uncertainty can X the economic cycle. Inflation uncertainty is the degree to which economic agents view future rates of inflation as hard to forecast

exacerbate

A medium of X is any asset that can be used to purchase goods and services or to repay debts

exchange

Other currencies operate under a "managed X rate policy," where they are allowed to fluctuate within a range that is maintained by a monetary authority via market intervention

exchanged

a reduction in government spending could be accompanied by an even bigger fall in taxation, making it be X

expansionary

as interest rates rise, the speculative demand for money X

falls

But the risks involved in purchasing assets with credit risk should be clear. In the end, the central bank is just a special bank. If it accumulates bad assets that then turn out to create losses, it could face a fatal loss of confidence in its main product: X money.

fiat

X policy involves the use of government spending and taxation to influence economy activity.

fiscal

The Bank of England chose to buy X (bonds issued by the UK government), where the focus was on gilts with three to five years maturity

gilts

the result of these actions on the economy will take additional time to become evident; this is the X lag

impact

Ricardian equivalence involves individuals X anticipating future taxes

correctly

There is an X relationship between the money multiplier and the reserve requirement. The money multiplier is equal to 1 divided by the reserve requirement.

inverse

Investment is expected to move X with the official policy rate.

inversely

A fall in interest rates is likely to lead to a rise in X

investment

As a result, the costs of borrowing will be higher than would otherwise have been the case. Higher borrowing costs could in turn reduce economic activity, for example, by discouraging X

investment

In very extreme instances, there may be occasions where the demand for money becomes infinitely elastic—that is, where the demand curve is horizontal and individuals are willing to hold additional money balances without any change in the interest rate—so that further injections of money into the economy will not serve to further lower interest rates or affect real activity. This is known as a X trap. In this extreme circumstance, monetary policy can become completely ineffective

liquidity

conventional monetary policy—the adjustment of short- term interest rates

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Clearly, the possibility that fiscal policy can influence output means that it may be an important tool for economic X

stabilization

The real trend rate of growth of an economy is also difficult to discern, but it corresponds to that rate of economic growth that is achievable in the long run that gives rise to X inflation

stable

Although the practice of inflation targeting is widespread, there are two prominent central banks that have not adopted a formal inflation target along the lines of the New Zealand model: the Bank of X and the US Federal Reserve System

Japan

Central banks are also often charged by the government to supervise the banking system, or at least to supervise those banks that they license to accept deposits. However, in some countries, this role is undertaken by a separate X

authority

I0 is the rate of interest at which no excess money X exist

balances

An economy where such economic agents as households, corporations, and even governments pay for goods and services in this way is known as a X economy.

barter

Suppose that a central bank announces an increase in its official interest rate. Commercial banks would normally increase their X rates at the same time. A commercial bank's base rate is the reference rate on which it bases lending rates to all other customers

base

Open market operations involve the purchase and sale of government X from and to commercial banks and/or designated market makers

bonds

Many developing economies choose to operate monetary policy by targeting their currency's X rate, rather than an explicit level of domestic inflation

exchange

By setting its official interest rate, a central bank could expect to have a direct influence on inflation X

expectations

Because the increase in the supply of money makes it more plentiful and hence less valuable, its price (the interest rate) X as the price level rises.

falls

Money that is not convertible into any other commodity is known as X money. Fiat money derives its value via government decree and because people accept it for payment of goods and services and for debt repayment

fiat

X policy refers to the government's decisions about taxation and spending

fiscal

The supply curve (MS) is vertical because we assume that there is a X nominal amount of money circulating at any one time

fixed

This practice of lending customers' money to others on the assumption that not all customers will want all of their money back at any one time is known as X reserve banking.

fractional

in some economies, the central bank sets the reserve requirement, which is a potential means of affecting money X

growth

X- targeting regimes vary a little from economy to economy, their success is thought to depend on three key concepts: central bank independence, credibility, and transparency

inflation

X policy refers to central bank activities that are directed toward influencing the quantity of money and credit in an economy

monetary

Developing economies often face significant impediments to the successful operation of any monetary policy the absence of a sufficiently liquid government bond market and developed interbank market through which monetary policy can be conducted; ■ a rapidly changing economy, making it difficult to understand what the neutral rate might be and what the equilibrium relationship between monetary aggregates and the real economy might be; ■ rapid financial innovation that frequently changes the definition of the money supply; ■ a poor track record in controlling inflation in the past, making monetary policy intentions less credible; and ■ an unwillingness of governments to grant genuine independence to the central bank.

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Expected inflation can give rise to: ■ menu costs and ■ shoe leather costs. Unanticipated (unexpected) inflation can in addition: ■ lead to inequitable transfers of wealth between borrowers and lenders (including losses to savings); ■ give rise to risk premia in borrowing rates and the prices of other assets; and ■ reduce the information content of market prices

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Expected inflation is clearly the level of inflation that economic agents expect in the future. Unexpected inflation can be defined as the level of inflation that we experience that is either below or above that which we expected; it is the component of inflation that is a surprise

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Generally speaking, the higher the policy rate, the higher the potential penalty that banks will have to pay to the central bank if they run short of liquidity, the greater will be their willingness to reduce lending, and the more likely that broad money growth will shrink.

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Generally, a central bank is the monopoly supplier of the currency, the banker to the government and the bankers' bank, the lender of last resort, the regulator and supervisor of the payments system, the conductor of monetary policy, and the supervisor of the banking system

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In this regard, economists often speak of the rate of growth of narrow money and/or broad money. By narrow money, they generally mean the notes and coins in circulation in an economy, plus other very highly liquid deposits. Broad money encompasses narrow money but also includes the entire range of liquid assets that can be used to make purchases

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Monetary policy seeks to influence the macro economy by influencing the quantity of money and credit in the economy.

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Money Measures in Japan The Bank of Japan calculates three measures of money. M1 is the narrowest measure and consists of cash currency in circulation. M2 incorporates M1 but also includes certificates of deposit (CDs). The broadest measure, M3, incorporates M2, plus deposits held at post offices, plus other savings and deposits with financial institutions. There is also a "broad measure of liquidity" that encompasses M3 as well as a range of other liquid assets, such as government bonds and commercial paper.

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Money Measures in the United Kingdom The United Kingdom produces a set of four measures of the money stock. M0 is the narrowest measure and comprises notes and coins held outside the Bank of England, plus Bankers' deposits at the Bank of England. M2 includes M0, plus (effectively) all retail bank deposits. M4 includes M2, plus wholesale bank and building society deposits and also certificates of deposit. Finally, the Bank of England produces another measure called M3H, which is a measure created to be comparable with money definitions in the EU (see above). M3H includes M4, plus UK residents' and corporations' foreign currency deposits in banks and building societies

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Money balances that are held to finance transactions are referred to as transactions money balances

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Most central banks will also be responsible for managing their country's foreign currency reserves and also its gold reserves

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Similarly, the central bank can sell government bonds to commercial banks. By doing this, the reserves of commercial banks decline, reducing their capacity to make loans (i.e., create credit) to households and corporations and thus causing broad money growth to decline through the money multiplier mechanism

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The European Central Bank (ECB) produces three measures of euro area money supply. The narrowest is M1. M1 comprises notes and coins in circulation, plus all overnight deposits. M2 is a broader definition of euro area money that includes M1, plus deposits redeemable with notice up to three months and deposits with maturity up to two years. Finally, the euro area's broadest definition of money is M3, which includes M2, plus repurchase agreements, money market fund units, and debt securities with up to two years maturity

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The Federal Open Market Committee (FOMC) seeks to move this rate to a target level by reducing or adding reserves to the banking system by means of open market operations. The level of the rate is reviewed by the FOMC at its meetings held every six weeks

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The US Federal Reserve produces two measures of money. The first is M1, which comprises notes and coins in circulation, travelers' cheques of non- bank issuers, demand deposits at commercial banks, plus other deposits on which cheques can be written. M2 is the broadest measure of money currently produced by the Federal Reserve and includes M1, plus savings and money market deposits, time deposit accounts of less than $100,000, plus other balances in retail money market and mutual funds.

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The name of the official interest rate (or official policy rate or just policy rate) varies from central bank to central bank, but its purpose is to influence short- and long- term interest rates and ultimately real economic activity

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The theory can be explained in terms of Equation 2, known as the quantity equation of exchange: M × V = P × Y where M is the quantity of money, V is the velocity of circulation of money (the average number of times in a given period that a unit of currency changes hands), P is the average price level, and Y is real output

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There are three basic motives for holding money: ■ transactions- related; ■ precautionary; and ■ speculative.

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This phenomenon—whereby an increase in the money supply is thought in the long run simply to lead to an increase in the price level while leaving real variables like output and employment unaffected—is known as money neutrality

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Thus, the nominal interest rate (Rnom) in an economy is the sum of the required real rate of interest (Rreal) and the expected rate of inflation (πe) over any given time horizon: Rnom = Rreal + πe

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To calculate the increase in money from an additional deposit in the banking system, use the following expression: new deposit/reserve requirement

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To summarize, an inflation- targeting framework normally has the following set of features: ■ An independent and credible central bank; ■ A commitment to transparency; ■ A decision- making framework that considers a wide range of economic and financial market indicators; and ■ A clear, symmetric and forward- looking medium- term inflation target, sufficiently above 0 percent to avoid the risk of deflation but low enough to ensure a significant degree of price stability.

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Weaker total demand would tend to put downward pressure on the rate of domestic inflation—as would a stronger currency, which would reduce the prices of imports

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an increase in the money supply can lead to an increase in the aggregate price level as long as the velocity of circulation of money does not fall sufficiently to offset the increase in the money supply and real output is unchanged.

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money fulfills three important functions, it: ■ acts as a medium of exchange; ■ provides individuals with a way of storing wealth; and ■ provides society with a convenient measure of value and unit of account.

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money to act as this liberating medium of exchange, it must possess certain qualities. It must: i. be readily acceptable, ii. have a known value, iii. be easily divisible, iv. have a high value relative to its weight, and v. be difficult to counterfeit.

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speculative balances will tend to be inversely related to the expected return on other financial assets and directly related to the perceived risk of other financial assets

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the central bank's policy rate works through the economy via any one, and often all, of the following interconnected channels: ■ Short- term interest rates; ■ Changes in the values of key asset prices; ■ The exchange rate; and ■ The expectations of economic agents

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unexpected inflation that is most costly when inflation turns out to be higher than is anticipated, then borrowers benefit at the expense of lenders because the real value of their borrowing declines. Conversely, when inflation is lower than is anticipated, lenders benefit at the expense of borrowers because the real value of the payment on debts rises

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the most important interest rate used in US monetary policy is the federal funds rate. The federal funds rate (or fed funds rate) is the interbank lending rate on X borrowings of reserves

overnight

the speculative demand for money (sometimes called the X demand for money) relates to the demand to hold speculative money balances based on the potential opportunities or risks that are inherent in other financial instruments (e.g., bonds). Speculative money balances consist of monies held in anticipation that other assets will decline in value

portfolio

Furthermore, if inflation is very uncertain or very volatile, then lenders will ask for a X to compensate them for this uncertainty

premium

headline inflation rate that is announced in most economies every month, and which is the central bank's target, is a measure of how much a basket of goods and services has risen over the X twelve months

previous

central banks must maintain X stability

price

some economists believe that the long- run impact of an exogenous increase in the supply of money is an increase in the aggregate X level

price

A crucial development in the history of money was the X note. The process began when individuals began leaving their excess gold with goldsmiths, who would look after it for them. In turn the goldsmiths would give the depositors a receipt, stating how much gold they had deposite

promissory

the quantity theory of money, which asserts that total spending (in money terms) is proportional to the X of money

quantity

The ECB's official policy rate is known as the X rate and defines the rate at which it is willing to lend short- term money to the euro area banking sector

refinancing

Both monetary and fiscal policies are used to X economic activity over time. They can be used to accelerate growth when an economy starts to slow or to moderate growth and activity when an economy starts to overheat

regulate

This policy rate can be achieved by using short- term collateralized lending rates, known as X rates

repo

Many, if not all, independent inflation- targeting central banks produce a quarterly assessment of their economies. These Inflation X, as they are usually known, give central banks' views on the range of indicators that they watch when they come to their (usually) monthly interest rate decision. They will consider and outline their views on the following subjects, usually in this order: ■ Broad money aggregates and credit conditions; ■ Conditions in financial markets; ■ Developments in the real economy (e.g., the labour market); and ■ Evolution of prices

reports

if the central bank wishes to increase the supply of money, it might buy bonds (usually government bonds) from the banks, with an agreement to sell them back at some time in the future. This transaction is known as a X agreement

repurchase

The third primary way in which central banks can limit or increase the supply of money in an economy is via their X requirements

reserve

when the central bank buys government bonds from commercial banks, this increases the X of private sector banks on the asset side of their balance sheets. If banks then use these surplus reserves by increasing lending to corporations and households, then via the money multiplier process explained in Section 2.1.2, broad money growth expands

reserves

An increase in short- term interest rates could also cause the price of such assets as bonds or the value of capital projects to fall as the discount rate for future cash flows X

rises

The greater the uncertainty, the greater the required X premium. So, all nominal interest rates are comprised of three components: ■ a required real return; ■ a component compensating investors for expected inflation; and ■ a risk premium to compensate them for uncertainty

risk

Normally, the maturity of repo agreements ranges from overnight to two weeks. In effect, this represents a X loan to the banks, and the lender (in this case the central bank) earns the repo rate

secured

the successful operation of any monetary policy—that is, the achievement of price X

stability

these monopolists supplied money that could be converted into a pre- specified amount of gold; they adhered to a gold X

standard

Because precious metals like gold had a high value relative to their bulk and were not perishable, they could act as a X of wealth

store

Some central banks are both operationally and X independent. This means that they not only decide the level of interest rates, but they also determine the definition of inflation that they target, the rate of inflation that they target, and the horizon over which the target is to be achieved

target

operational independence; it was free to set interest rates in the way that it thought would best meet the inflation X

target

Money in all major economies today is not convertible by law into anything else, but it is, in law, legal X - This means that it must be accepted when offered in exchange for goods and services.

tender

reserve requirement

the percentage of deposits that banking institutions must hold in reserve

monetary X mechanism. This is the process whereby a central bank's interest rate gets transmitted through the economy and ultimately affects the rate of increase of prices—that is, inflation.

transmission

A barter economy has no common measure of X that would make multiple transactions simple.

value

The size of the transactions balances will tend to increase with the average X of transactions in an economy

value

A balanced budget leads to a rise in output, which in turn leads to further rises in output and incomes via the X effect

multiplier

The amount of money that the banking system creates through the practice of fractional reserve banking is a function of 1 divided by the reserve requirement, a quantity known as the money X

multiplier

The recipients of the increase in government spending will typically save a proportion 1 - c of each additional dollar of disposable income, where c is the marginal propensity to X (MPC) this additional income

consume

In a recession, governments can raise spending (expansionary fiscal policy) in an attempt to raise employment and output. In boom times—when an economy has full employment and wages and prices are rising too fast—then government spending may be reduced and taxes raised (X fiscal policy).

contractionary

they might increase interest rates, thereby reducing liquidity. In these cases, market analysts describe such actions as X because the policy is designed to cause the rate of growth of the money supply and the real economy to contract

contractionary

Monetarists tend not to advocate using monetary policy for X adjustment of aggregate demand

countercyclical

The target might have little X if the organization's likelihood of sticking to it is in doubt

credibility

The IMF model implies that if governments run persistently high budget deficits, real interest rates rise and X out private investment, reducing each country's productive potential

crowd

Government borrowing may divert private sector investment from taking place (an effect known as X out

crowding

No monetary accommodation: Government spending increases have a much bigger effect (six times bigger) on GDP than similar size social transfers because the latter are not considered permanent,

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increases in government spending may be accompanied by even bigger rises in tax receipts and hence may not be X

expansionary

when the economy is slowing and inflation and monetary trends are weakening, central banks may increase liquidity by cutting their target rate. In these circumstances, monetary policy is said to be X

expansionary

Money neutrality implies that

increasing the money supply will not affect the level of output.

Central Bank X In most cases, the central bank that is charged with targeting inflation has a degree of independence from its government

independence

"X taxes" refer to such taxes as sales taxes and value- added taxes that are levied on goods and services rather than directly on individuals and companies.

indirect

Japan's central bank, the Bank of Japan (BoJ), does not target an explicit measure of X

inflation

The Fisher effect also demonstrates that embedded in every nominal interest rate is an expectation of future X

inflation

f unused resources reflect a low supply of labour or other factors rather than a shortage of demand, then discretionary fiscal policy will not add to demand and will be ineffective, raising the risk of X pressures in the economy

inflationary

The interest rate that a central bank sets and that it announces publicly is normally the rate at which it is willing to X money to the commercial banks

lend

X levels of inflation has higher economic costs than moderate levels, all else equal; unanticipated inflation has greater costs than anticipated inflation.

low

At a micro level, high inflation means that businesses constantly have to change the advertised prices of their goods and services. These are known as X costs or shoe leather costs

menu

simple idea that the price level, or at least the rate of inflation, could be controlled by manipulating the rate of growth of the money supply. Economists who believe this are referred to as X

monetarists

Finally, central banks are usually responsible for the operation of a country's X policy

monetary

If money were neutral in the short run, X policy would not be effective in influencing the economy

monetary

Ricardian equivalence because if tax cuts have no impact on private spending as individuals anticipate future higher taxes, then clearly this may lead policymakers to favour X tools

monetary

If the central bank purchases government securities on a large scale, it is effectively funding the budget deficit and the independence of monetary policy is an illusion. This so- called "printing of money" is feared by many economists as the X of the government deficit

monetization

Perhaps the least appreciated role of a central bank is its role in the X system. Central banks are usually asked to oversee, regulate, and set standards for a country's payments system

payments

Most central banks will adjust liquidity conditions by adjusting their official X rate

policy

money neutrality

the proposition that changes in the money supply do not affect real variables

The Bank of England's refinancing rate is the two- week X rate.

repo

money creation

the process by which money enters into circulation

x occurs when a country adopts the US dollar as their functional currency.

Dollarization

, the X effect states that the real rate of interest in an economy is stable over time so that changes in nominal interest rates are the result of changes in expected inflation

Fisher

X believe that fiscal policy can have powerful effects on aggregate demand, output, and employment when there is substantial spare capacity in an economy. Y believe that fiscal changes only have a temporary effect on aggregate demand and that monetary policy is a more effective tool for restraining or boosting inflationary pressures

Keynesians .. Monetarists

Incentives. Some economists believe that income taxes reduce the incentive to work, save, and invest and that the overall tax burden has become excessive. These ideas are often associated with supply- side economics and the US economist Arthur X

Laffer

Net tax rate

The increase in net tax revenue generated when national income rises by one dollar

as an economy slows and unemployment rises, government spending on social insurance and unemployment benefits will also rise and add to aggregate demand. This is known as an X stabilizer

automatic

when policy changes are finally decided on, they may take many months to implement. This is the X lag

action

If government spending and revenues are equal, then the budget is X

balanced

Direct government spending has a X impact on aggregate spending and output than income tax cuts or transfer increases

bigger

the X surplus/deficit, which is the difference between government revenue and expenditure for a fixed period of time, such as a fiscal or calendar year

budget

The issue of X out may occur: If the government borrows from a limited pool of savings, the competition for funds with the private sector may crowd out private firms with subsequent less investing and economic growth. In addition, the cost of borrowing may rise, leading to the cancellation of potentially profitable opportunities. This concept is the subject of continuing empirical debate and investigation.

crowding

Deflation raises the real value of X, while the persistent fall in prices can encourage consumers to put off consumption today, leading to a fall in demand that leads to further deflationary pressure

debt

if the real growth in the economy is lower than the real interest rate on the debt, then the X ratio will worsen even though the economy is growing because the debt burden (i.e., the real interest rate times the debt) grows faster than the economy

debt

A central bank would X an official interest rate to stimulate the economy. The setting in which an official interest rate is lowered to zero (or even slightly below zero) without stimulating economic growth suggests that there are limits to monetary policy.

decrease

The economic conditions for a liquidity trap are associated with the phenomenon of X

deflation

aiming to hit 0 percent could result in negative inflation, known as X

deflation

a X "trap" can develop, which is characterized by weak consumption growth, falling prices, and increases in real debt levels

deflationary

If this rise was caused by an increase in the confidence of consumers and business leaders, which in turn has led to increases in consumption and investment growth rates, then we could think of it as being a X shock. In this instance, it might be appropriate to tighten monetary policy in order to bring the inflationary pressures generated by these domestic demand pressures under control

demand

The amount of wealth that the citizens of an economy choose to hold in the form of money—as opposed to, for example, bonds or equities—is known as the X for money

demand

A "pay- as- you- go" rule is a X policy because any increases in spending or reductions in revenues would be offset. Accordingly, there would be no net impact on the budget deficit/surplus.

neutral

The Xrate of interest is often taken as the point of comparison. One way of characterizing the neutral rate is to say that it is that rate of interest that neither spurs on nor slows down the underlying economy

neutral

the X policy rate for any economy comprises two components: ■ Real trend rate of growth of the underlying economy, and ■ Long- run expected inflation

neutral

An expansion in the money supply would most likely: A lead to a decline in X interest rates

nominal

A formal definition of the multiplier would be the ratio of the change in equilibrium output to the change in autonomous spending that caused the change

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A rise in capital gains taxes reduces income available for spending and hence reduces aggregate demand, other things being equal. Cutting income tax raises disposable income, while new road building raises employment and incomes; in both cases, aggregate demand rises and hence policy is expansionary

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Aggregate demand is the amount companies and households plan to spend

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An increase in a central bank's policy rate might be expected to reduce inflationary pressures by: A reducing consumer demand

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Capital expenditure includes infrastructure spending on roads, hospitals, prisons, and schools. This investment spending will add to a nation's capital stock and affect productive potential for an economy.

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Capital spending is much slower to implement than changes in indirect taxes; and indirect taxes affect alcohol consumption more directly than direct taxes

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Direct taxes are levied on income, wealth, and corporate profits and include capital gains taxes, national insurance (or labour) taxes, and corporate taxes. They may also include a local income or property tax for both individuals and businesses. Inheritance tax on a deceased's estate will have both revenue- raising and wealth- redistribution aspects. ■ Indirect taxes are taxes on spending on a variety of goods and services in an economy—such as the excise duties on fuel, alcohol, and tobacco as well as sales (or value- added tax)—and often exclude health and education products on social grounds. In addition, taxes on gambling may also be considered to have a social aspect in deterring such activity, while fuel duties will have an environmental purpose in making fuel consumption and hence travel more expensive

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Direct taxes are more difficult to change without considerable notice, often many months, because payroll computer systems will have to be adjusted (although the announcement itself may well have a powerful effect on spending behaviour more immediately). The same may be said for welfare and other social transfers. ■ Capital spending plans take longer to formulate and implement, typically over a period of years Of course, the slower the impact of a fiscal change, the more likely other exogenous changes will already be influencing the economy before the fiscal change kicks in.

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Easy fiscal policy/tight monetary policy: If taxes are cut or government spending rises, the expansionary fiscal policy will lead to a rise in aggregate output. If this is accompanied by a reduction in money supply to offset the fiscal expansion, then interest rates will rise and have a negative effect on private sector demand. We have higher output and higher interest rates, and government spending will be a larger proportion of overall national income.

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Easy monetary policy/easy fiscal policy: If both fiscal and monetary policy are easy, then the joint impact will be highly expansionary—leading to a rise in aggregate demand, lower interest rates (at least if the monetary impact is larger), and growing private and public sectors.

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Economists typically consider four desirable attributes of a tax policy: ■ Simplicity: This refers to ease of compliance by the taxpayer and enforcement by the revenue authorities. The final liability should be certain and not easily manipulated. ■ Efficiency: Taxation should interfere as little as possible in the choices individuals make in the market place Fairness: This refers to the fact that people in similar situations should pay the same taxes ("horizontal equity") and that richer people should pay more taxes ("vertical equity"). ■ Revenue sufficiency: Although revenue sufficiency may seem obvious as a criterion for tax policy, there may be a conflict with fairness and efficiency.

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Fiscal policy cannot stabilize aggregate demand completely because the difficulties in executing fiscal policy cannot be completely overcome. First, the policymaker does not have complete information on how the economy functions

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For example, an expansionary policy could take one or more of the following forms: ■ Cuts in personal income tax raise disposable income with the objective of boosting aggregate demand. ■ Cuts in sales (indirect) taxes to lower prices which raises real incomes with the objective of raising consumer demand. ■ Cuts in corporation (company) taxes to boost business profits, which may raise capital spending. ■ Cuts in tax rates on personal savings to raise disposable income for those with savings, with the objective of raising consumer demand. ■ New public spending on social goods and infrastructure, such as hospitals and schools, boosting personal incomes with the objective of raising aggregate demand.

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Government revenue includes tax revenues net of transfer payments; government spending includes interest payments on the government debt

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If the budget deficit is already large relative to GDP and further fiscal stimulus is required, then the necessary increase in the deficit may be considered unacceptable by the financial markets when government funding is raised, leading to higher interest rates on government debt and political pressure to tackle the deficit.

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In the United States, the formal plan for QE mainly involved the purchase of mortgage bonds issued or guaranteed by Freddie Mac and Fannie Mae

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Indirect taxes can be adjusted almost immediately after they are announced and can influence spending behaviour instantly and generate revenue for the government at little or no cost to the government. ■ Social policies, such as discouraging alcohol or tobacco use, can be adjusted almost instantly by raising such taxes.

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Inflation targeting is the most common monetary policy—although exchange rate targeting is also used, particularly in developing economies

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Monetary accommodation: Except for the case of the cut in labour taxes, fiscal multipliers are now much larger than when there is no monetary accommodation

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Neutral rate = Trend growth + Inflation target

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Targeted social transfers to the poorest citizens have double the effect of the non- targeted transfers, while labour tax reductions have a slightly bigger impact than the latter

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Taxes are formally defined as compulsory, unrequited payments to the general government (they are unrequited in the sense that benefits provided by a government to taxpayers are usually not related to payments)

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Taxes on income and profits have been fairly constant for the Organisation for Economic Co- Operation and Development (OECD) countries overall at around 12.5-13 percent of GDP since the mid- 1990s

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The addition of 1 unit of additional reserves to a fractional reserve banking system can support an expansion of the money supply by an amount equal to the money multiplier, defined as 1/reserve requirement (stated as a decimal).

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The arguments against being concerned about national debt (relative to GDP) are as follows: The scale of the problem may be overstated because the debt is owed internally to fellow citizen; A proportion of the money borrowed may have been used for capital investment projects or enhancing human capital; ● Large fiscal deficits require tax changes which may actually reduce distortions caused by existing tax structures. ● Deficits may have no net impact because the private sector may act to offset fiscal deficits by increasing saving in anticipation of future increased taxes. This argument is known as "Ricardian equivalence" and is discussed in more detail later. ● If there is unemployment in an economy, then the debt is not diverting activity away from productive uses

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The arguments in favour of being concerned are: ● High levels of debt to GDP may lead to higher tax rates in the search for higher tax revenues. This may lead to disincentives to economic activity as the higher marginal tax rates reduce labour effort and entrepreneurial activity, leading to lower growth in the long run. ● If markets lose confidence in a government, then the central bank may have to print money to finance a government deficit. This may lead ultimately to high inflation, as evidenced by the economic history of Germany in the 1920s and more recently in Zimbabwe. ● Government borrowing may divert private sector investment from taking place (an effect known as crowding out);

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The study clearly showed that direct spending by the government leads to a larger impact on GDP than changes in taxes or benefits.

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The ultimate challenge for central banks as they try to manipulate the supply of money to influence the economy is that they cannot control the amount of money that households and corporations put in banks on deposit, nor can they easily control the willingness of banks to create money by expanding credit. Taken together, this also means that they cannot always control the money supply. Therefore, there are definite limits to the power of monetary policy

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The ultimate problem for monetary authorities as they try to manipulate the supply of money in order to influence the real economy is that they cannot control the amount of money that households and corporations put in banks on deposit, nor can they easily control the willingness of banks to create money by expanding credit

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Thus, when policy rates are high, monetary policy may be described as contractionary; when low, they may be described as expansionary

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Tight fiscal policy/easy monetary policy: If a fiscal contraction is accompanied by expansionary monetary policy and low interest rates, then the private sector will be stimulated and will rise as a share of GDP, while the public sector will shrink.

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Tight monetary policy/tight fiscal policy: Interest rates rise (at least if the monetary impact on interest rates is larger) and reduce private demand. At the same time, higher taxes and falling government spending lead to a drop in aggregate demand from both public and private sectors.

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When an economy is close to full employment a fiscal expansion raising aggregate demand can have little impact on output because there are few spare unused resources (e.g., labour or idle factories); instead, there will be upward pressure on prices (i.e., inflation)

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With regard to monetary policy, what is the hoped for benefit of adopting an exchange rate target? - To "import" the inflation experience of the economy whose currency is being targeted

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aggregate spending falls less than the tax rise

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detailed research paper using the IMF'S Global Integrated Monetary and Fiscal Model (IMF 2009), IMF researchers examined four forms of coordinated global fiscal loosening over a two- year period, which will be reversed gradually after the two years are completed. These are: ■ an increase in social transfers to all households, ■ a decrease in tax on labour income, ■ a rise in government investment expenditure, and ■ a rise in transfers to the poorest in society. The two types of monetary policy responses considered are: ■ no monetary accommodation, so rising aggregate demand leads to higher interest rates immediately; or ■ interest rates are kept unchanged (accommodative policy) for the two years.

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disposable income = national income - net taxes

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economists often look at the structural (or cyclically adjusted) budget deficit as an indicator of the fiscal stance. This is defined as the deficit that would exist if the economy was at full employment (or full potential output)

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fiscal policy: These involve the use of government spending and changing tax revenue to affect a number of aspects of the economy: ■ Overall level of aggregate demand in an economy and hence the level of economic activity. ■ Distribution of income and wealth among different segments of the population. ■ Allocation of resources between different sectors and economic agents

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government spending + aggregate demand - taxes = budget surplus or deficit

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in a scenario in which inflation in the developing country fell relative to the United States, the central bank would need to sell the domestic currency to support the target, tending to increase the domestic money supply and reduce the rate of interest

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the real value of the outstanding debt will fall if the overall price level rises (i.e., inflation, and hence a rise in nominal GDP even if real GDP is static) and thus the ratio of debt to GDP may not be rising. But if the general price level falls (i.e., deflation), then the ratio may stay elevated for longer

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The fiscal multiplier is important in macroeconomics because it tells us how much X changes as exogenous changes occur in government spending or taxation

output

both the Federal Reserve and the Bank of England effectively printed money and pumped it in to their respective economies. This "unconventional" approach to monetary policy, known as X easing (QE), is operationally similar to open market purchase operations but conducted on a much larger scale

quantitative

e data appear with a considerable time lag and even then are subject to substantial revision. This is often called the X lag

recognition

Current government spending involves spending on goods and services that are provided on a X, recurring basis—including health, education, and defense

regular

Therefore, the speculative demand for money will tend to fall as the returns available on other financial assets X

rises

We define s as the marginal propensity to X (MPS), the amount saved out of an additional dollar of disposable income

save

As individuals realize that deficits will persist, inflation expectations and longer- term interest rates rise: This reduces the effect of the X by half.

stimulus

However, suppose instead that the rise in inflation was caused by a rise in the price of oil (for the sake of argument). In this case, the economy is facing a X shock, and raising interest rates might make a bad situation worse.

supply

Ricardian equivalence after the economist David Ricardo. If people do not correctly anticipate all the future X required to repay the additional government debt, then they feel wealthier when the debt is issued and may increase their spending, adding to aggregate demand.

taxes

X payments are welfare payments made through the social security system and, depending on the country, comprise payments for state pensions, housing benefits, tax credits and income support for poorer families, child benefits, unemployment benefits, and job search allowances. Transfer payments exist to provide a basic minimum level of income y. Note that these payments are not included in the definition of GDP because they do not reflect a reward to a factor of production for economic activity. Also, they are not considered to be part of general government spending on goods and services

transfer

interest rate changes made today will take some time to have their full effect on the real economy as they make their way through the monetary X mechanism

transmission

double coincidence of wants

two traders are willing to exchange their products directly

Economic forecasts from models will always have an element of X attached to them and thus are not unambiguous or precise in their prescriptions

uncertainty

bond market X. These "vigilantes" are bond market participants who might reduce their demand for long- term bonds, thus pushing up their yields, if they believe that the monetary authority is losing its grip on inflation.

vigilantes

When the central bank or monetary authority chooses to target an exchange rate, interest rates and conditions in the domestic economy must adapt to accommodate this target and domestic interest rates and money supply can become more X

volatile