Download Topic VIII

Econ 210D Intermediate Macroeconomics
Spring 2015
Professor Kevin D. Hoover
Topic 8
Monetary and Fiscal Policy
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
1
The Government’s Budget Constraint

G – (T – TR)
deficit
Fiscal Policy
=
BG + MB
change in government’s
financial portfolio
Monetary Policy
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
2
Pure Policy


G – (T – TR) = BG + MB
Pure Fiscal Policy: changes in taxes or
spending, holding government liabilities
constant (BG = 0 and MB = 0)
o

E.g., balanced budget stimulus
Pure Monetary Policy: changes in liability mix
BG = – MB), holding deficit constant
(G – (T – TR) = 0)
o
E.g., open-market operation
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
3
Mixed Policies

G – (T – TR) = BG + MB

Deficit finance:
o

G – (T – TR) = BG > 0
Monetizing the deficit:
o
G – (T – TR) = MB > 0
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
4
The Federal Reserve System
Figure 17.1
The Federal Reserve System
Notes:
Numbers represent the Federal Reserve Districts and cities indicate the location of the Federal Reserve Bank for each district. The Board of Governors
is located in Washington, D.C.
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
5
The Board of Governors of the Federal
Reserve System


7 Governors with 14-year terms
Chairman – governor with a 4-year term as
chairman
o
o

Current Chairman: Ben Bernanke
Replaced Alan Greenspan, who replaced Paul
Volcker
Duties
o
o
o
Bank regulation
Monetary policy
Lender of last resort
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
6
Federal Open-Market Committee (FOMC)


Main policy making body
Composition
o
o
o
o

7 Fed Governors
President of Federal Reserve Bank of New York
4 other district bank presidents on a rotating basis
Remaining 7 presidents present as non-voting
members
Meets about every 5 weeks
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
7
Fed and Commercial Bank Balance Sheets
Table 17.1 The Balance Sheets of the Federal Reserve and the Commercial Banks
Commercial Banks
Federal Reserve
Government Bonds
Discount Loans
Liabilities
Assets
Liabilities
Assets
Banknotes held by non-bank
public
Reserves
Reserves (reserve balances
and eligible vault cash)
Loans
Transactions Accounts
[Sources:
owned outright
borrowed at discount window
Federal funds borrowed]
Savings and large and small time
deposits
Coins held by Federal Reserve
Government and commercial Discount Loans
bonds and other assets
Foreign Exchange
(Federal funds lent)
Gold
(Federal funds borrowed)
Net worth
Net worth
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
8
Open-market Operations


Open-market operations = the Fed buys or
sells assets on the open market, paying with
reserves.
Open-market sale:
o
o

Public holdings of government bonds rises
Banks’ holdings of reserves falls
Open-market purchase:
o
o
Public holdings of government bonds fall
Banks’ holdings of reserves rises
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
9
The Discount Window




Discount borrowing (borrowing at the
“discount window”) = banks’ borrowing
reserves from the Fed using their assets
(typically short term bonds) as collateral.
Common in the early days of the Fed.
Rare later
On large scale in recent financial crisis.
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
10
Reserve Demand



Reserve requirements: banks must hold
reserves = 10% of the value of checking
accounts.
Check Clearing
Prudential Needs – costs of falling short
o
o
discount borrowing
interbank borrowing = Federal funds market
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
11
Holding Reserves: Banks’ Profit
Maximization Problem




Benefit of lending to another bank: rFF
Cost of not having reserves on hand to cover
withdrawals: probability of reserve loss × rFF
Opportunity Cost: Benefit – Cost:
rFF – prl × rFF = (1 – prl) rFF
The higher the opportunity cost, the lower
the demand to hold reserves.
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
12
Open-market Purchase



Public’s holdings of government bonds falls
Banks’ holdings of reserves rise
Interest rates fall
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
13
“Open-mouth” Operation



Fed announces Federal funds rate target
Market moves to target without an actual
open-market operation
Interest rates in other markets move in same
direction as the Federal funds rate:
substitution and arbitrage
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
14
Brief History of Monetary Policy




Monetization of debt at fixed short and long
rates during and after World War II
Fed-Treasury Accord of 1951 ends
compulsory monetization
Early 1960s: “bills only” doctrine
Recent Fed purchase of long-term and
nongovernmental assets.
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
15
Transmission Mechanism


Transmission Mechanism = means by which
monetary policy effects the real economy
Two types:
o
o
Interest-rate or Opportunity-cost Channel
Credit Channel
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
16
Interest-rate or Opportunity-cost Channel


Interest Rate or Opportunity-Cost Channel =
monetary policy changes interest rates
which effects the opportunity cost of
investing.
Mechanism:
A.
B.
Fed controls short rates in order to manipulate
long rates through the term structure.
Real long rates affect investment; investment
affects aggregate demand through the multiplier.
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
17
Credit Channel


Credit Channel = monetary policy effects
economy through reduction in funds
available to borrowers with or without
changing interest rates.
Two types:
o
o
Narrow credit channel
Broad credit channel
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
18
Narrow Credit Channel

Narrow Credit Channel = change in reserves
owing to monetary policy action reduces
volume of bank lending.
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
19
Broad Credit Channel

Broad Credit Channel = changes in interest
rates change credit-worthiness of borrowers,
changing the availability of bank and
nonbank credit.
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
20
Transmission Mechanism and the Real
Economy


Interest-rate or Opportunity-cost channel 
movement along IS curve
Credit channel (narrow or broad)  shift of
IS curve
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
21
Monetary Policy and the Recent Financial
Crisis


Lender of last resort
“Quantitative Easing” = purchases of longterm (government and private) bonds
o
o

Interest-rate channel: similar to other openmarket operations except at long end of term
structure.
Direct relief of credit rationing.
Challenge: How to unwind without
squelching recovery.
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
22
Fiscal Policy
Fiscal policy =


Tax Policy
Expenditure Policy
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
23
Types of Fiscal Policy

Automatic stabilizers

Discretionary Policy
o
o
Inadvertent
Intentional
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
24
Shocks Shift IS Curve

Y
~
Y  Pot
Y

Demand shocks = Y holding Ypot constant

Supply shocks = Ypot holding Y constant

Mixed shocks = both Y and Ypot
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
25
Limits to Fiscal Policy

Lags
o
Inside Lag
•
•
o
Outside Lag
•
•

Recognition Lag
Implementation Lag
Recognition Lag
Implementation Lag
State and Local Governments as Automatic
Destabilizers
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
26
Fiscal Policy in the Long Run – 1

G – (T – TR)
deficit
Fiscal Policy
=
BG + MB
change in government’s
financial portfolio
Monetary Policy
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
27
Figure 18.5
U.S. Federal Taxes and Spending, 1790-1990
logarithmic scale
40.0
War of 1812
Civil War
Mexican-American
War
20.0
SpanishAmerican
War
15.0
Share of Potential GDP
(percent)
World War I
Spending
10.0
5.0
Taxes
Vietnam War
World War II
Korean
War
1.0
0.5
1790
1810
1830
1850
1870
1890
Professor K.D. Hoover, Econ 210D
8 Spring 2015
1910
1930
1950
1970
1990
Topic
28
Federal Government Expeditures and Revenues
25
24
23
Expenditures
Percent of GDP
22
21
20
19
18
Revenues
17
16
15
1980
1982
1984
1986
1988
1990
1992
1994
1996
Professor K.D. Hoover, Econ 210D
8 Spring 2015
1998
2000
2002
2004
2006
2008
Topic
29
Dynamics of the Debt



G – (T – TR) = interest payments + primary
deficit
BtG  BtG1  rt 1 BtG1  PDt
G
t
G
t 1
B
PDt
G
ˆ
Bt 
 1  rt 1  G
B
Bt 1
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
30
Functional Finance – 1



Deficits and debt not bad in and of
themselves.
Balanced budgets not good in and of
themselves.
Must be judged by their effects on the real
economy.
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
31
Functional Finance – 2: types of effect




Aggregate demand
Interactions between public and private
sectors
Redistribution
Incentives
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
32
Crowding Out

Crowding Out = increases in government
expenditure reduce private expenditure or,
more particularly, private investment
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
33
Types of Crowding Out




Zero-sum crowding out = at full employment
any increase in G or TR must reduce private
expenditure
Displacement of private expenditure – e.g.,
public schools replace private schools
Monetary snubbing of aggregate demand =
deficits in face of fixed monetary policy raise
interest rates, lowering investment
Crowding In = government expenditure
promotes private investment – e.g., R&D
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
34
Burden of the Debt

Debt to GDP Ratio: B/pY

G

B
In Growth Rates:  t 
 pY 
 t t
^
Professor K.D. Hoover, Econ 210D
8 Spring 2015
 Bˆ tG  pˆ t  Yˆt
Topic
35
The Federal Debt
12,000.0
140
Debt as a Percentage of GDP (right axis)
120
10,000.0
100
80
6,000.0
60
Percent of GDP
Dollars (billions)
8,000.0
4,000.0
40
2,000.0
Debt (left axis)
0.0
20
0
1938 1942 1946 1950 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
36
END of Topic 8
END OF COURSE
Professor K.D. Hoover, Econ 210D
8 Spring 2015
Topic
37