Reading 19: Monetary and Fiscal Policy

Compare monetary and fiscal policy

Fiscal policy is a government's use of taxation and spending to influence the economy. Monetary policy deals with determining the quantity of money supplied by the central bank. Both policies aim to achieve economic growth with price level stability, although governments use fiscal policy for social and political reasons as well.

Describe functions and definitions of money

Money is defined as a widely accepted medium of exchange. Functions of money include a medium of exchange, a store of value, and a unit of account.

Explain the relationship between monetary policy and economic growth, inflation, interest, and exchange rates

A contractionary monetary policy (increase in policy rate) will tend to decrease economic growth, increase market interest rates, decrease inflation, and lead to appreciation of the domestic currency in foreign exchange markets. An expansionary monetary policy (decrease in policy rate) will have the opposite effects, tending to increase economic growth, decrease market interest rates, increase inflation, and reduce the value of the currency in foreign exchange markets

Determine whether a fiscal policy is expansionary or contractionary

A government has a budget surplus when tax revenues exceed government spending and a deficit when spending exceeds tax revenue An increase (decrease) in government budget surplus is indicative of a contractionary (expansionary) fiscal policy. Similarly, an increase (decrease) in a government budget deficit is indicative of an expansionary (contractionary) fiscal policy.

Describe the arguments about whether the size of a national debt relative to GDP

Arguments for being concerned with the size of fiscal deficit: 1) Higher future taxes leas to disincentives to work, negatively affecting long-term economic growth 2) Fiscal deficits may not be financed by the market when debt levels are high 3) Crowding-out effect as government borrowing increases interest rates and decreases private sector investment Arguments against being concerned with the size of the fiscal deficit: 1) Debt may be financed by domestic citizens 2) Deficits for capital spending can boost the productive capacity of the economy 3) Fiscal deficits may prompt needed tax reform 4) Ricardian equivalence may prevail: private savings rise in anticipation of the need to repay principal on government debt 5) When the economy is operating below full employment, deficits do not crowd out private investment

Describe roles and objectives of central banks

Central bank roles include supplying currency, acting as banker to the government and to other banks, regulating and supervising the payments system, acting as a lender of last resort, holding the nation's gold and foreign currency reserves, and conducting monetary policy . Central banks have the objective of controlling inflation, and some have additional goals of maintaining currency stability, full employment, positive sustainable economic growth, or moderate interest rates.

Describe qualities of effective central banks

Effective central banks exhibit independence, credibility, and transparency. Independence: the central bank is free from political interference. Credibility: The central bank follows through on its stated policy intentions Transparency: The central bank makes it clear what economic indicators it uses and reports on the state of those indicators

Explain the implementation of fiscal policy and difficulties of implementation

Fiscal policy is implemented by the government changes in taxing and spending policies. Delays in realizing the effects of fiscal policy changes limit their usefulness. Delays can be caused by: 1) Recognition lag: Policymakers may not immediately recognize when fiscal policy changes are needed 2) Action lag: governments take time to enact needed fiscal policy changes 3) Impact lag: Fiscal policy changes take time to affect economic activity

Describe roles and objectives of fiscal policy

Fiscal policy refers to the taxing and spending policies of the government. Objectives of fiscal policy can include 1) influencing the level of economic activity 2) redistributing wealth or income 3) allocating resources among industries

Describe tools of fiscal policy, including their advantages and disadvantages

Fiscal policy tools include spending tools and revenue tools. Spending tools include transfer payments, current spending (goods and services used by government), and capital spending (investing projects funded by government). Revenue tools include direct and indirect taxation. An advantage of fiscal policy is that indirect taxes can be used to quickly implement social policies and can be used to quickly raise revenues at a low cost. Disadvantages of fiscal policy include time lags for implementing changes in direct taxes and time lags for capital spending changes to have an impact.

Contrast the costs of expected inflation

High inflation, even when it is perfectly anticipated, imposes costs on the economy as people reduce cash balances because of higher opportunity cost of holding cash. More significant costs are imposed by unexpected inflation, which reduces the information value of price changes, can make economic cycles worse, and shifts wealth from lenders to borrowers. Uncertainty about the future rate of inflation increases risk, resulting in decreased business investment.

Explain the money creation process

In a fractional reserve system, new money created is a multiple of new excess reserves available for lending by banks. The potential multiplier is equal to the reciprocal of the reserve requirement and, therefore, is inversely related to the reserve requirement.

Contrast the use of inflation, interest rate, and exchange rate targeting by central banks

Most central banks set target inflation rates, typically 2% to 3%, rather than targeting interest rates as once common. When inflation is expected to rise above (fall below) the target band, the money supply is decreased (increased) to reduce (increase) economic activity. Developing economies sometimes target a stable exchange rate for their currency relative to that of a developed economy, selling their currency when its value rises above the target rate and buying their currency with foreign reserves when the rate falls below the target. The developing country must follow a monetary policy that supports the target exchange rate and essentially commits to having the same inflation rate as the developed country.

Describe the tools used to implement monetary policy

Policy tools available to the central bank include the policy rate, reserve requirements, and open market operations. The policy rate is called the discount rate in the United States, the refinancing rate by the ECB, and the two-week repo rate in the United Kingdom. Decreasing the policy rate, decreasing reserve requirements, and making open market purchases of securities are all expansionary. Increasing the policy rate, increasing the reserve requirements, and making open market sales of securities are all contractionary .

Describe limitations of monetary policy

Reasons monetary policy may not work as intended: 1) Monetary policy changes may affect inflation expectations to such an extent that long-term interest rates move opposite to short-term interest rates 2) Individuals may be willing to hold greater cash balances without a change in short-term rates (liquidity trap) 3) Banks may be unwilling to lend greater amounts, even when they have increased excess reserves 4) Short-term rates cannot be reduced below zero. 5) Developing economies face unique challenges in utilizing monetary policy due to undeveloped financial markets, rapid financial innovation, and lack of credibility of the monetary authority

Describe the Fisher Effect

The Fisher effect states that a nominal interest rate is equal to the real interest rate plus the expected inflation rate

Determine whether a monetary policy is expansionary or contractionary

The real trend rate is the long-term sustainable real growth rate of an economy. The neutral interest rate is the sum of the real trend rate and the target inflation rate. Monetary policy is said to be contractionary when the policy rate is above the neutral rate and expansionary when the policy rate is below the neutral rate.

Describe the monetary transmission mechanism

The transmission mechanism for changes in the central bank's policy rate through to prices and inflation includes one or more of the following: 1) Short-term bank lending rates 2) Asset prices 3) Expectations for economic activity and future policy rate changes 4) Exchange rates with foreign currencies

Describe theories of the demand for and supply of money

Three factors influence money demand: 1) Transaction demand, for buying goods and services 2) Precautionary demand, to meet unforeseen future needs. 3) Speculative demand, to take advantage of investment opportunities Money supply is determined by central banks with the goal of managing inflation and other economic objectives.