Download Chapter 13 - Fiscal Policy

Macroeconomics
Econ 2301
Dr. Jacobson
Coach Stuckey
Chapter 13
Fiscal Policy
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-1
Fiscal and Monetary Policies
Should Mesh
• In 1990s there was little coordination in the making of fiscal and
monetary policies
– Fiscal policies are made by the federal government
– Monetary policy is determined by the Fed
– Fiscal policy at best is described as a series of compromises
between Congress and the President
– Monetary policy is determined by the Fed
– Fiscal and monetary policy should mesh, but obviously
different people with different objectives cause these to work
at cross-purposes all too often
– A step in the right direction could be to allow every President
to appoint the Chairman of the Board at the Fed when he
begins his term
• What about doing away with the Fed and allow the elected leaders
of the federal government to determine both fiscal and monetary
policy?
14-53
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
HOW FISCAL POLICY
INFLUENCES AGGREGATE
DEMAND
• Fiscal policy refers to the government’s
choices regarding the overall level of
government purchases or taxes.
• Fiscal policy influences saving, investment,
and growth in the long run.
• In the short run, fiscal policy primarily affects
the aggregate demand.
Changes in Government
Purchases
• When policymakers change the money
supply or taxes, the effect on aggregate
demand is indirect—through the spending
decisions of firms or households.
• When the government alters its own
purchases of goods or services, it shifts the
aggregate-demand curve directly.
Changes in Government
Purchases
• There are two macroeconomic effects from
the change in government purchases:
– The multiplier effect
– The crowding-out effect
The Multiplier Effect
• Government purchases are said to have a
multiplier effect on aggregate demand.
– Each dollar spent by the government can raise
the aggregate demand for goods and services by
more than a dollar.
• The multiplier effect refers to the additional
shifts in aggregate demand that result when
expansionary fiscal policy increases income
and thereby increases consumer spending.
Price
Level
Figure 4 The Multiplier Effect
2. . . . but the multiplier
effect can amplify the
shift in aggregate
demand.
$20 billion
AD3
AD2
Aggregate demand,
0
1. An increase in government purchases
of $20 billion initially increases aggregate
demand by $20 billion . . .
AD1
Quantity of
Output
A Formula for the Spending
Multiplier
• The formula for the multiplier is:
– Multiplier = 1/(1 – MPC)
– An important number in this formula is the
marginal propensity to consume (MPC).
• It is the fraction of extra income that a household
consumes rather than saves.
A Formula for the Spending
Multiplier
• If the MPC = 3/4, then the multiplier will be:
Multiplier = 1/(1 – 3/4) = 4
• In this case, a $20 billion increase in government
spending generates $80 billion of increased demand
for goods and services.
• A larger MPC means a larger multiplier in an
economy.
• The multiplier effect is not restricted to changes in
government spending.
Changes in Taxes
• When the government cuts personal income
taxes, it increases households’ take-home
pay.
• Households save some of this additional
income.
• Households also spend some of it on
consumer goods.
• Increased household spending shifts the
aggregate-demand curve to the right.
Changes in Taxes
• The size of the shift in aggregate demand
resulting from a tax change is affected by
the multiplier and crowding-out effects.
• It is also determined by the households’
perceptions about the permanency of the tax
change.
The Case for Active Stabilization
Policy
• The Employment Act has two implications:
– The government should avoid being the cause
of economic fluctuations.
– The government should respond to changes in
the private economy in order to stabilize
aggregate demand.
Automatic Stabilizers
• Automatic stabilizers are changes in fiscal
policy that stimulate aggregate demand
when the economy goes into a recession
without policymakers having to take any
deliberate action.
• Automatic stabilizers include the tax system
and some forms of government spending.
• Keynes proposed the theory of liquidity
preference to explain determinants of the
interest rate.
• According to this theory, the interest rate
adjusts to balance the supply and demand
for money.
• An increase in the price level raises money
demand and increases the interest rate.
• A higher interest rate reduces investment
and, thereby, the quantity of goods and
services demanded.
• The downward-sloping aggregate-demand
curve expresses this negative relationship
between the price-level and the quantity
demanded.
• Policymakers can influence aggregate
demand with fiscal policy.
• An increase in government purchases or a
cut in taxes shifts the aggregate-demand
curve to the right.
• A decrease in government purchases or an
increase in taxes shifts the aggregatedemand curve to the left.
• When the government alters spending or
taxes, the resulting shift in aggregate
demand can be larger or smaller than the
fiscal change.
• The multiplier effect tends to amplify the
effects of fiscal policy on aggregate
demand.
• The crowding-out effect tends to dampen
the effects of fiscal policy on aggregate
demand.
Objectives
• The organization of the Federal Reserve
System
• Reserve requirements
• The deposit expansion multiplier
• The tools of monetary policy
• The Feds effectiveness in fighting
inflation and recession
• The Banking Act of 1980 and 1999
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-2
The Federal Reserve System
• The Federal Reserve Act of 1913 created the
Federal Reserve System
– To provide for the establishment of Federal reserve
banks, to furnish an elastic currency, to afford
means of rediscounting commercial paper, to
establish a more effective supervision of banking in
the United States, and for other purposes
– First United States Bank [ 1791 - 1811]
– Second United States Bank [ 1816 - 1836]
• The charters of both were allowed to lapse
– The 1907 bank crises caused the public to demand
the government do something to keep this from
happening again
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-3
The Federal Reserve System
• The Federal Reserve has five main jobs
– Conduct monetary policy which is, by far,
the most important job
• Monetary policy is the control of the rate of
growth of the money supply to foster relatively
full employment, price stability, and a
satisfactory rate of economic growth
– Serve as lender of last resort to commercial
banks, savings banks, savings and loan
associations, and credit unions
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-4
The Federal Reserve System
• The Federal Reserve has five main jobs
– Issue currency
– Provide banking services to the U.S.
government
– Supervise and regulate our financial
institutions
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-5
The Federal Reserve District
Banks
• Each Federal Reserve District Bank is owned
by the several hundred member banks in that
district
– A commercial bank becomes a member by buying
stock in the Federal Reserve District Bank
– So, the Fed is a quasi public-private enterprise, not
controlled by the President or Congress
• Effective control is really exercised by the Federal Reserve
Board of Governors in Washington, D.C.
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-6
The Federal Reserve System
• Board of Governors
– Seven members
– Appointed by President
– Confirmed by Senate
• Sets reserve requirements
• Supervises and regulates
member banks
• Establishes and
administers regulations
• Oversees Federal Reserve
Banks
• 12 District Banks
• Propose discount rates
• Hold reserve balances
for member institutions
• Lends reserves
• Furnish currency
• Collects & clears checks
• Handle U.S. government
debt & cash balances
Federal Open Market Committee (Board of Governors plus 5 Reserve
Bank Presidents. This committee directs open market operations which
is the primary instrument of monetary policy
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-7
The Federal Reserve System
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-8
Independence of the Board of Governors
• Neither the President nor Congress has
any control over the Board of Governors
– The President gets to appoint Board
members when a vacancy occurs
• Sometime this may be the Chairman
– Once the Senate confirms the President’s
appointment the person appointed is not
answerable to the President nor the Senate
– This independence allows them to follow
unpopular policies if they feel it is in the best
economic interest of the nation
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-9
Legal Reserve Requirements
• The most important job of the Federal Reserve
is to control the money supply
• The focal point of the Federal Reserve’s control
of our money supply is legal reserve
requirements
– Every financial institution in the country is legally
required to hold a certain percentage of its deposits
on reserve, either in the form of deposits and/or cash
at its Federal Reserve District Bank or its own
vaults
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-10
Legal Reserve Requirements
• Technical Term Meanings
– Required Reserves (RR) is the minimum
amount of vault cash and deposits (RD) at
the Federal Reserve District Bank that must
be held (kept on the books) by the financial
institution
– Actual Reserves (RD) is what the bank is
holding (on the books)
– Excess Reserves = Actual Reserves - Required
Reserves
• ER = RD - RR
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-11
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-12
If a bank had $100 million in checking deposits (DD), how
much reserves would it be required to hold?
First $7.8 million of deposits: 0% reserve requirement
Next 40.5 million: $40,500,000 X .03 = 1,215,000
Next 51.7 million: $51,700,000 X .10 = 5,170,000
Required Reserves = $6,385,000
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-13
What About Negative Excess
Reserves?
• If actual reserves (RD) are less than
Required Reserves (RR), the excess
Reserves (ER) are negative
– If a bank does find itself short, it will usually
borrow reserves from another bank that
does have excess reserves. These are called
federal funds and the interest rate charge is
called the federal funds rate
– A bank may also borrow reserves (RD) from
its Federal Reserve District Bank at its
discount window
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-14
Primary and Secondary
Reserves
• A bank’s primary reserves are its
vault cash and its deposits at the the
Federal District Bank
–These reserves pay no interest,
therefore the banks try to hold no
more than the Federal Reserve
requires
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-15
Primary and Secondary
Reserves
• Every bank holds secondary reserves,
mainly in the form of very short-term
U.S. government securities
– Treasury bills, notes, certificates, and bonds
(that will mature in less than a year) are
generally considered a bank’s secondary
reserves
– These can be quickly converted to cash
without loss if a bank suddenly needs money
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-16
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-17
Deposition Expansion
(Continued)
How Deposit Expansion Works
Bank A
RD + 100
DD + 100
FED
A> RD +100
Assume a 10% RR
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-18
Deposition Expansion
How Deposit Expansion Works
Bank A
RD + 100
RR
10
ER + 90
DD + 100
Bank B
RD + 90
DD + 90
RR
9
ER + 81
FED
A> RD +100
When RDs
B> RD + 90
C> RD + 81.0
at the Fed
increase the
Etc.
money
Etc.
supply is
increasing
Etc.
Bank C
RD + 81
DD + 81.0
ER
8.1
ER + 72.9
Assume a 10% RR
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
RD + $1,000,000
14-19
Deposit Expansion Multiplier
(DEM)
1
DEM =
Reserve Ratio
Assume a RR of 10%
1
DEM =
.10
= 10
Assume a RR of 25%
DEM =
1
.25
When RR decreases
When RR increases
DEM increases
DEM decreases
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=4
14-20
Three Modifications of the
Deposit Expansion Multiplier
• Not every dollar of deposit expansion will
actually be re-deposited again and lent
out repeatedly
– Some people may choose to hold or spend
some money as currency
• It is also possible that some banks will
carry excess reserves
– This is not likely in times of high inflation
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-21
Three Modifications of the
Deposit Expansion Multiplier
• There are leakages of dollars to foreign
countries
– This is caused mainly by our foreign trade
imbalance
• The Deposit Expansion Multiplier is, in
reality, quite a bit lower than if we based
it solely on the reserve ratio
– If the reserve ratio tells us it is 10, perhaps
it’s only 6
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-22
Cash, Checks, and Electronic Money
• One of the jobs of the Federal Reserve is check
clearing
• In 2004 Congress passed the Check Clearing Act of
the 21st Century
– This was intended to hasten the adoption of
electronic check processing
• When you use your debit card the amount is
deducted within seconds after the card is swiped
• We still carry out about 80 percent of our
transactions in cash
– However cash covers less than one percent of
monetary transactions
– Electronic transfers account for five out of every
six dollars that move in the economy
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-23
Cash, Checks, and Electronic Money
One of the jobs of the Federal Reserve is check clearing
$50
00
$50
Bank of
A merica
00
$50
00
Branch off ice
Me
Bob
Bob
New York
Federal Reserve
District Bank
San Francisco
Federal Reserve
$50
00
Bank of
A merica
00
Deducts $50 f rom
Citibank Õ
s
reserves
$50
BobÕ
s checking
account rises
by $50
$50
District Bank
00
Main off ice
Bank of A mericaÕ
s
reserves rise by $50
Citibank
$50
Main off ice
Citibank
00
Branch off ice
Deducts $50 f rom
my checking account
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-24
Cash, Checks, and Electronic
Money
• Increasingly, money is changing hands electronically
– Today, $1.5 trillion a day is transferred electronically
– About one-third of these transfers are carried out by
the Federal Reserve’s electronic network
– About two-thirds are done by the Clearing House
Interbank Payment System (CHIPS) which is owned
by 10 big New York Banks
• Does all this mean that we are well on our way to a
checkless, cashless society?
– Yes and no
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14-25
Cash, Checks, and Electronic
Money
• Does all this mean that we are well on our way to a
checkless, cashless society?
– Yes and no
– We still carry out nearly 85 percent of our
monetary transactions in cash
– When the total dollars actually spent is
considered, cash covers less than 1 percent of the
total value
– Electronic transfers account for five out of every
six dollars that move in the economy
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-26
The Tools of Monetary Policy
• The most important job of the Fed is to
control the rate of growth of the money
supply
• This effort focuses on the reserves held
by financial institutions
– The most important policy tool to do this is
open-market operations
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
14-27
How Open-Market Operations
Work
• Open-Market operations are the buying and
selling of U.S. government securities
– U.S. government securities are treasury bills, notes,
certificates, and bonds
– The Fed buys and sells securities that have already
been marketed by the treasury
• The total value of all outstanding U.S. government
securities is more than $4.0 trillion. This is our national
debt
– What open market operations consist of, then, is the
buying and selling of chunks of the national debt
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
14-28
How the Fed Increases the
Money Supply
The FED buys U. S. Government Securities
The Fed writes a check for, say, $100 million (this is money created out of nothing)
Securities Firm
RD + $100 DD + $100
RR - 10
ER + 90
The multiplier would be 10
10 X 90 million = 900 million X .60 = approximate increase in the
money supply of 540 million over a period of time
Assume 10% RR
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
14-29
How the Fed Increases the
Money Supply
The FED buys U. S. Government Securities
The Fed writes a check for, say, $100 million (this is money created out of nothing)
Securities Firm
RD + $100 DD + $100
RR - 10
ER + 90
IR =
Interest Paid
Price of Bond
If the Fed goes on a buying spree, it will quickly drive up the
prices of U.S. government securities
Assume 10% RR
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
14-30
How the Fed Increases the
Money Supply
The FED buys U. S. Government Securities
The Fed writes a check for, say, $100 million (this is money created out of nothing)
Securities Firm
RD + $100 DD + $100
RR - 10
ER + 90
IR =
$80
$1000
If the Fed goes on a buying spree, it will quickly drive up the
prices of U.S. government securities
Assume 10% RR
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
14-31
How the Fed Increases the
Money Supply
The FED buys U. S. Government Securities
The Fed writes a check for, say, $100 million (this is money created out of nothing)
Securities Firm
RD + $100 DD + $100
RR - 10
ER + 90
IR =
$80
$1000
= 8%
If the Fed goes on a buying spree, it will quickly drive up the
prices of U.S. government securities
Assume 10% RR
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
14-32
How the Fed Increases the
Money Supply
The FED buys U. S. Government Securities
The Fed writes a check for, say, $100 million (this is money created out of nothing)
Securities Firm
RD + $100 DD + $100
RR - 10
ER + 90
IR =
$80
$1000
$80
IR =
$1200
= 8%
= 6.67%
Suppose this pushed the price of the bond up to $1200?
Assume 10% RR
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
14-33
How the Fed Increases the
Money Supply
The FED buys U. S. Government Securities
The Fed writes a check for, say, $100 million (this is money created out of nothing)
Securities Firm
RD + $100 DD + $100
RR - 10
ER + 90
IR =
$80
$1000
$80
IR =
$1200
= 8%
= 6.67%
When the Fed goes into the open market to buy securities, it bids
up their price and lowers their interest rate
Assume 10% RR
14-34
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
How the Fed Decreases the
Money Supply
The FED sells U. S. Government Securities
The Security firm writes a check for, say, $100 million to the Fed (this check is, in effect,
destroyed)
Securities Firm
RD - $100 DD - $100
The money supply decreases by
approximately $540 million over time
When the Fed goes into the open market to sell securities, bond,
and notes prices fall and interest rates climb Assume 10% RR
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-35
How the Fed Decreases the
Money Supply
The FED sells U. S. Government Securities
The Security firm writes a check for, say, $100 million to the Fed (this check is, in effect,
destroyed)
Securities Firm
RD - $100 DD - $100
IR =
$80
$1000
$80
IR =
$1200
= 8%
= 6.67%
The money decreases by
approximately $540 million over time
When the Fed goes into the open market to sell securities, bond
prices fall and interest rates climb
Assume 10% RR
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14-36
The Federal Open-Market
Committee (FOMC)
• Open-market operations are conducted by the
Federal Open-Market Committee (FOMC)
– This committee consist of 12 people
• Eight permanent members – the board of
Governors and the president of the New
York Federal Reserve District Bank
• The other four are presidents of the other
11 Federal Reserve District Banks
–They serve on a rotating basis
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14-37
The Federal Open-Market
Committee (FOMC)
• The FOMC meets about once every six weeks to
decide what policy to follow
– To fight recessions, the FOMC buys securities
• This increases the rate of growth of the
money supply
– To fight inflation, the FOMC sells securities
• This decreases the rate of growth of the
money supply
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14-38
Borrowing Reserve Deposits
• The discount rate is the interest rate paid by
member banks when they borrow reserve
deposits (RD) at their Federal Reserve District
Bank
• The federal funds rate is the interest rate banks
charge each other for borrowing reserve
deposits (RD) from each other
– This is higher than the discount rate
• Banks borrow to maintain their required
reserves (RR)
– Banks tend to borrow reserve deposits from each
other because they may not like to call attention to
the fact they are having to borrow reserve deposits
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14-39
Increase in the Money Supply
Decrease in the Money Supply
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14-40
1954-2006
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14-41
Changing Reserve
Requirements
• The Federal Reserve Board has the
power to change reserve requirements
within the legal limits of 8 and 14
percent for checkable deposits
–Changing reserve requirements is the
ultimate weapon and is rarely used
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-42
Changing Reserve
Requirements
• To fight inflation, before the Board
would take the drastic step of raising
reserve requirements
– The District Banks would raise the discount
rate
– The FOMC will be actively selling securities
– Credit will be getting tighter
– The chairman will be publicly warning that
the banks are advancing too many loans
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-43
Changing Reserve
Requirements
• If the money supply is still growing too rapidly – the Fed
reaches for its biggest stick and raises
reserve requirements
– This weapon is so rarely used because it is simply too
powerful
– If the reserve requirement on demand deposits were
raised by just one half of 1 percent, the nation’s banks
and thrift institutions would have to come up with
nearly $4 billion in reserves
• This would drastically reduce the nation’s money
supply
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14-44
Summary: The Tools of
Monetary Policy
• To fight recession, the Fed will
–Lower the discount rate
–Buy securities on the open market
–Lower reserve requirements
•This would be done only as a
last resort
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14-45
Summary: The Tools of
Monetary Policy
• To fight inflation, the Fed will
–Raise the discount rate
–Sell securities on the open market
–Raise reserve requirements
•This would be done only as a
last resort
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14-46
The Fed’s Effectiveness in
Fighting Inflation
(Assume all the tools have been used)
• Bond prices have plunged
• Interest rates have soared
• The growth of the money supply has been
stopped dead in its tracks
• Banks find it impossible to increase their loan
portfolios
• Buying by consumers and businesses is
declining
• The inflation rate has no choice but to decline
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14-47
The Fed’s Effectiveness in
Fighting Recession
(Assume all the tools have been used)
• Bond prices have increased
• Interest rates have gone down
• Banks will have excess reserves and want to
make loans
– But who wants to borrow the money?
• Creditworthy individuals and business have little incentive
to borrow any money
• Businesses and individuals who really need to borrow
money can’t because the first rule of banking is: never
lend money to anyone who needs it.
• Easy money has little or no effect in ending a
recession
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14-48
The Fed’s Effectiveness in Fighting
Inflation and Recession
• Federal Reserve policy in fighting
inflation and recession has been likened
to pulling and then pushing on a string
– Like pulling on a string, when the Fed fights
inflation, it get results – provided of course,
it pulls hard enough
– Fighting a recession is another matter. Like
pushing on a string, no matter how hard the
Fed works, it might not get anywhere
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14-49
The Depository Institutions
Deregulation and Monetary Control
Act of 1980
• This Act is clearly the most important piece of
banking legislation passed since the 1930s
• Under this Act:
– All depository institutions are now subject to the
Fed’s legal reserve requirements
– All depository institutions are now legally
authorized to issue checking deposits that may be
interest bearing
– All depository institutions now enjoy all the
advantages that only Federal Reserve member
banks formerly enjoyed –including check clearing
and borrowing from the Fed (discounting)
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14-50
The Depository Institutions
Deregulation and Monetary Control
Act of 1980
• Another important consequence of this law is
that by the end of the 1990s, intense
competition reduced the 40,000-plus financial
institutions that existed at the beginning of the
1980s to a little 20,000 today
The lifting of the prohibition against interstate
banking combined with further advances in
electronic banking will create greater
consolidation, perhaps with just 30 to 40 giant
financial institutions doing most of the business
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-51
The Banking Act of 1999
• In 1980 the jurisdiction of the Federal Reserve
had been extended to all commercial banks and
thrift institutions
• In 1999 it was further extended to insurance
companies, pension funds, investment
companies, securities brokers, and finance
companies
• This new law allows banks, securities firms and
insurances companies to merge and sell each
other’s products
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14-52
Current Issue: Who Controls Our
Interest Rates?
• What can we expect over the next decade?
– The Federal Budget annual deficit will probably exceed $500
billion every year
– Americans will continue to spend not only all their incomes but
continue to spend more than they earn with credit cards
– The U.S. Treasury will become still more dependent on the
kindness of foreigners to finance our debt
• Who does control our interest rates?
– While the Fed is still the biggest kid on the block, it no longer
calls all of the shots
– If our financial dependency on foreigners continue to grow
• Our monetary policy will originate more and more in
Shanghai, Tokyo, , London, , Frankfort, and other financial
capitals
14-54
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