Econ Chapter 34

changing the targeted federal funds rate is equivalent to

changing the money supply. In fact monetary policy can be described either in terms of the money supply or in terms of the interest rate.

Monetary Policy

control of the money supply in the economy. The central bank (the Federal Reserve in the United States) has control over the money supply.

Fiscal Policy

governmental spending and taxation policy. In the United States fiscal policy is determined by the President and Congress

changes in government spending or taxes will clearly have an effect on aggregate demand.

if government spending increases (or if taxes decreases) this will shift the aggregate demand curve to the right, while if government spending decreases (or if taxes increases) this will shift the aggregate demand curve to the left.

In order to lower the interest rate,

it must purchase bonds in the open market, which injects reserves into the banking system and would increase the money supply. In the graph of the money market the money supply curve will shift to the right and lower the interest rate to the target interest rate.

money demand curve

shows the negative relationship associated between the interest rate and the amount of money held. idea of interest rate acting as the opportunity cost of holding money

the way the Federal Reserve conducts its monetary policy is through

targeting the federal funds rate (the interest rate that banks charge one another for short-term loans)

the problem with holding lots of currency is

that you don't earn any interest in holding cash. That can be a problem when interest rates are high. If you could earn 10% interest at a bank, then keeping $1000 in currency will cost you $100 over the year. Thus the interest rate is the opportunity cost of holding money. As interest rates increase, the opportunity cost of holding money increases and thus a rational person will want to hold less money in cash. Conversely, if interest rates decrease then the opportunity cost of holding money is lower and people might want to hold more money.

money supply in the economy is determined by

the Federal Reserve independent of the interest rate. We assume that the Fed chooses some given amount of money to supply to the economy. Thus the money supply curve is vertical.

contractionary monetary policy (decrease in the money supply) or contractionary fiscal policy (decrease in government spending or decrease in taxes) then

the aggregate demand curve will shift to the left

if we have expansionary monetary policy (increase in the money supply) or expansionary fiscal policy (increase in government spending or decrease in taxes) then

the aggregate demand curve will shift to the right

automatic stabilizers

-programs that will either change government spending or change taxes automatically whenever an economic fluctuation occurs -acts as fiscal policy without requiring any action by either policymakers or Congress

Change in the price level

If prices of all goods were to suddenly double overnight, people will need twice the currency as before to purchase the same amount of goods. This will increase the demand for money

Change in the income level (Y)

If suddenly you were to achieve the wealth of Oprah overnight, that will drastically affect your consumption patterns. As income goes up, people tend to purchase more goods and thus will need more currency in order to conduct these transactions. Thus as the income level increases money demand will increase and shift to the right.

transaction demand for money

One of the reasons we like to hold money is because we use it to conduct transactions of goods and services.

Changing the Reserve Requirement Ratio

Think about how changing the ratio will affect money supply. Suppose that the Fed decides to increase the reserve requirement ratio. The result would be that the banks will have to hold more of the deposits as reserves and thus will have less to lend out in loans. Thus increasing the reserve requirement ratio will decrease the supply of money. Conversely by decreasing the reserve requirement ratio will increase the supply of money.

Outside Lags

Time it takes for the fiscal policy to work after it has been enacted. Typically outside lags do not last very long for fiscal policy

Some examples of automatic stabilizers are:

Unemployment Benefits & taxes

unemployment benefits

When an economy enters a recession, unemployment will go up and this will lead to an increase in government spending on unemployment insurance. The effect is that it lessens the impact on the fall in income and consumption won't decline as much. A similar argument can be made for food stamps

Changing the Discount Rate

When banks want to borrow from the Federal Reserve the Fed charges them a special interest rate called the discount rate. The discount rate is the interest that the banks have to pay to the Fed. Decreasing the discount rate will increase the supply of money. If the Fed decreases the interest rate it charges banks, banks will be more willing to borrow the money from the Fed. They can then use the money to issue out loans and thus more money is created through the system. An increase in the discount rate will have the opposite effect.

Open market sales

When the Federal Reserve wishes to DECREASE THE MONEY SUPPLY they will conduct open market sales. In this process, the Fed will now sell bonds and government securities to individual investors. These investors will write checks to purchase these bonds. Thus the deposits in the bank will decrease and through the money multiplier system deposits will decrease throughout the banking system.

Open Market Operations

The principal tool at the disposal of the Federal Reserve is something called open market operations. Open market operations is nothing more than the buying and selling of U.S. government securities (bonds). There are two open market operations

taxes

During bad economic times, taxes are lower on average. The reason is that income tax is progressive, which means that the richer you are the more you pay in taxes. As your income declines, you move to a lower tax bracket. Again your consumption won't decline as much because of this tax cut.

Open market purchases

When the Federal Reserve wishes to INCREASE THE MONEY SUPPLY they will conduct open market purchases. The way it works is that the Fed will buy bonds and other government securities from individual investors (and sometimes banks directly). What will then happen is that these investors will deposit the money that was given to them by the Fed into their checking accounts. As we saw in Chapter 29, an increase in deposits will lead to an increase in total deposits (and hence money) through the money multiplier.

once the Fed sets its target interest rate, it either

buys or sells enough bonds to make sure that the equilibrium interest rate in the money market is equal to the target interest rate. Thus when you hear in the news that the Fed has lowered interest rate to 1% from 2% keep in mind what it must be doing behind the scenes

contractionary fiscal policies

either a decrease in government spending or an increase in taxes. The result of these policies is a shift of the Aggregate Demand curve to the left. In cases when the economy has current output above potential output, contractionary fiscal policies would be effective in bringing about stabilization

expansionary fiscal policies

either an increase in government spending or a decrease in taxes. The result of these policies is a shift of the Aggregate Demand curve to the right. Thus whenever current output is below potential output, policymakers might want to use expansionary fiscal policies.

Inside Lags

the time it takes to identify an economic fluctuation and come up with a policy solution. -The first problem is that the fact that policymakers have to first identify an economic fluctuation. With so much economic data available, just being able to identify a recession or boom may be difficult. Even when policymakers can finally identify an economic fluctuation, finding a solution is problematic. It takes time to pass tax or spending bills through Congress. Inside lags are the main reason why fiscal policies take time to be effective.

money market equilibrium

where the money demand curve intersects the money supply curve. Note that we can find equilibrium interest rate, where money supply and money demand intersects