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International Finance Lecture 3 & 4 Chara Charalambous 1 Learning Outcomes: Why study Money, Monetary and Fiscal Policy ? Monetary Policy definition and tools. Central Bank’s balance sheet. Players in the money supply process. Fiscal Policy definition and tools. Impact of both policies in the money market and goods market. Chara Charalambous 2 Why study Money, Monetary and Fiscal Policy ? Money, also referred to as the money supply, is defined as anything that is generally accepted in payment for goods and services or in the repayment of debts. Movements in Money Supply affect interest rates and are also linked to changes in other economic variables that affect all of us and are important to the health of the economy. Deposits at Banks are by far the largest component of the money supply. Monetary and Fiscal Policy are strategy sisters with which the monetary authority of a country influences a nation's money supply. These two policies are used in various combinations in an effort to direct a country‘s economic goals. Chara Charalambous 3 1. Monetary Policy Monetary Theory is the theory that relates changes in the quantity of money to changes in aggregate economic activity and the price level. Monetary Policy is the management of money – supply and availability - and interest rates. Is one of the tools that the monetary authority of a country uses to influence its economy. Usually this goal is ‘macroeconomic stability’: low unemployment, law rate of inflation-price stability, economic growth and balance of external payments. Chara Charalambous 4 Money and Inflation Data shows a connection between the money supply and the price level When we say that money affects prices we mean the aggregate price level. The aggregate price level is the average price of goods and services in an economy A continual rise in the price level (inflation) affects all economic players Chara Charalambous 5 FIGURE 1: Aggregate Price Level and the Money Supply in the United States, 1950–2008 Sources: www.stls.frb.org/fred/data/gdp/gdpdef; www.federalreserve.gov/releases/h6/hist/h6hist10.txt. Chara Charalambous 6 Money and Inflation Figure1 shows the movement of average prices in the U.S economy from 1950 to 2005 : the prices of most items are quite higher now than they were then. What explains this (inflation)? As we can see in figure 1 the price level and the money supply generally rice together. These data indicate that a continuing increase in the money supply is an important factor in causing the continuing increase in the price level that we call inflation. Chara Charalambous 7 Money and Interest Rates Interest Rates are the price / cost of money! Chara Charalambous 8 Why is the interest rate referred to as the price of money? If you wanted an extra €100, you'd have to 'get' it from someone else. Hence you're 'renting' their €100 from them, for your use. Of course you have to pay them back, plus a fee (interest) for them letting you use it. The price of BORROWING money is the interest rate you will pay on a fixed amount. Lower interest rates means more spending today, which can lead to inflation. This all works backwards if interest rates go up. Savers" want interest rates to go up. "Spenders" want interest rates to go down. Chara Charalambous 9 Thus as money supply increases, causing prices to go (because people buy more things), the money looses purchase power because we need more money to buy anything and therefore the cost of money, interest rates, falls.. As the money supply increases, money becomes less scarce and easier to obtain. As with any other good, as supply increases, while demand remains constant, the price will fall. In this case the price of the money is the interest rate. Chara Charalambous 10 Money plays an important role in interest rate fluctuations which are of great concern to business and consumers. Chara Charalambous 11 Interest rate and quantity of money How does the Monetary Authority (Central Bank) affect the Money Market? Increasing the money supply .This will shift the money supply schedule to the right and the interest rate falls. Decreasing the money supply via contractionary monetary policy will shift the money supply schedule to the left and will increase interest rate . Chara Charalambous 12 Monetary Policy is referred to as either being expansionary or contractionary. An expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to fight unemployment in a recession of the economy by lowering interest rates, as a result of money increase, in the hope that easy credit will attract businesses into expanding. So the firms will undertake loans. As a result investments increases, aggregate demand for goods and services increases and therefore production increases and consequently demand for labour increases and unemployment falls. Contractionary policy is intended to slow inflation because if money supply decreases then prices will also be reduced and interest rates will be increased. Chara Charalambous 13 Four Players in the Money Supply process The Central bank – the government agency that supervises the banking system and is responsible for the contact of monetary policy (in the U.S is called Federal Reserve System) Banks (depository institutions – the financial intermediaries that accept deposits from individuals and institutions and make loans: commercial banks, savings and loan associations. Depositors – individuals and institutions that hold deposits in Banks Borrowers from Banks – individuals and institutions that borrow from the depository institutions Of the four players the Central Bank is the most important and when it conducts Monetary Policy its actions affect it's Balance Sheet. Chara Charalambous 14 Central Bank’s Balance Sheet Federal Reserve System Assets Liabilities Government securities Currency in circulation Discount loans Reserves Monetary Base Monetary Liabilities Currency in circulation — the amount of currency in the hands of the public Reserves — Consists of deposits of the commercial banks in the Central Bank and currency that is physically held by Banks. All banks have an account in the CB that hold deposits. Assets Government securities — holdings by the CB: The CB provides reserves to the banking system by purchasing securities (e.g. bonds) and thus increasing its holdings of these assets. An increase in government securities held by the CB leads to an increase in the money supply. Discount loans — CB provide reserves to the banking system by making discount loans to banks which bear interest rate. An increase in discount loans can also be the source of an increase in money supply. (also called borrowed reserves) Chara Charalambous 15 Three Policy Tools that CB uses to conduct Monetary Policy Manipulation of many supply and Interest Rates through: 1) Open Market Operations: affect the quantity of reserves and the monetary base= currency in circulation+reserves 2) Discount Rate Policy/Discount Lending: changes in borrowed reserves which affect the monetary base 3) Reserve Requirements : changes in reserve requirements affect the money multiplier (m) which tell us how much the many supply changes for a given change in the monetary base (MB). Chara Charalambous 16 1st. Open Market Operations Is the primary tool for conducting monetary policy A purchase of securities by CB is open market purchase and a sale of securities by the CB is open market sale. Open Market Purchase: If CB purchases € 100 bonds from a bank or from the public the result is: increase of the reserves of the bank or the increase of the currency in circulation and also increase of the securities of the CB. So the Monetary Base increases! Hence Money Supply expanded and Interest Rates are lowering! Open Market Sale: has the opposite results: The Monetary Base decreases! Hence Money Supply lowers and Interest Rates are becoming higher! Chara Charalambous 17 Open market purchases and sales have permanent affects on the monetary base, but sometimes the CB will want to change the monetary base only temporarily. At these times, it engages in two other types of transactions: Repurchase Agreement (repo) = The CB purchases government securities with the agreement that the seller- Commercial Banks will buy them back (repurchase them) at a specified price on a specified date, usually within two weeks. Reverse repo= The CB sells government securities with an agreement that the buyer - Commercial Banks will sell them back at a specified price on a specified date, again usually within two weeks. Both of them are carried out with the method of auction (bid) A repo and a reverse repo are therefore a temporary open market purchase and sale respectively, temporarily increasing and decreasing the monetary base. Chara Charalambous 18 2nd. Discount Policy The facility at which a bank receives a discount loan (borrow reserves) from the CB is called the “discount window.” The CB can affect the volume of discount loans by setting the discount rate: A higher discount rate makes discount borrowing less attractive to banks and will therefore reduce the volume of discount loans. A lower discount rate makes discount borrowing more attractive to banks and will therefore increase the volume of discount loans. Discount lending is most important during financial panics: When depositors lose confidence in the financial system, they will rush to withdraw their money. This large deposit outflow puts the banking system in great need of reserves. The CB stands ready to supply these reserves by making discount loans. In such situations, the CB acts asCharalambous a lender of last resort Chara 19 3rd . Changes in Reserved Requirements Central Bank sets the minimum reserves each commercial bank must hold , rather than lend out, of customer deposits and notes. It is normally in the form of cash stored physically in a bank vault or deposits made with the central bank. This policy tool is influencing the country's borrowing and interest rates by changing the amount of funds available for banks to make loans with. A rise in reserve requirements reduces the money supply and raises the interest rates and vice versa. Chara Charalambous 20 Which of the 3 tools is most effective? 1 2 3 4 Open market operations are by far the most effective tool with which the CB can conduct monetary policy on a day-to-day basis. There are a number of advantages for open market operations comparing with the other two: They are under the direct and complete control of the Central Bank. They can be large or small. They can be easily reversed. They can be implemented quickly Chara Charalambous 21 2. Fiscal Policy Fiscal Policy is the use of government spending (G) and revenue collection (Ttaxes) to influence the economy. The policy-maker in this case is the government not the central bank. Fiscal Policy also aims at economic objectives of price stability, full employment and economic growth. Chara Charalambous 22 Fiscal Policy This theory basically states that governments can manipulate (influence and control) the level of aggregate demand in the economy by increasing or decreasing tax levels and public spending. While monetary policy manipulates the money supply in order to reach its aims. This influence, in turn, controls inflation , which generally considered to be healthy when is at a level between 2-3% , increases employment and maintains a healthy value of money. A budget deficit is the excess of government spending over tax revenues for a particular time period, typically a year, while a budget surplus arises when tax revenues exceed government spending. Chara Charalambous 23 Two fiscal Policy Tools: 1st Taxes Distinguished in the two following categories: Direct Taxes which are imposed directly to natural or legal persons based on their income (income taxes) or their property (property tax) and they are paid directly to the state. Indirect Taxes are imposed to products and charge indirectly those who buy it and are paid to the state through third parties. (e.g. vat, import duties) If demand is low, the government can decrease taxes. This increases disposable income, thereby motivating demand. Chara Charalambous 24 2nd Spending: Distinguished in the two following categories: Current Expenditure: is the public consumption to cover current needs such as salaries and wages of state personnel, purchases of goods and services, interest on state loans and the transfer payments of allowances, pensions, scholarships and so forth. Capital Expenditure: spending on goods and services for the construction of projects such as roads, ports, airports, hospitals e.t.c which will satisfied the needs of the state for a long period. If inflation is high, the government can reduce its spending thereby removing itself from demand for resources in the market of goods and services. This is a contractionary policy that would lower prices. Conversely, when there is a recession and aggregate demand is declining, increased government spending in transportation projects (roads and rails network) would lead to higher demand and employment. Chara Charalambous 25 Fiscal Policy Both tools affect the fiscal position of the government i.e. the budget deficit goes up whether the government increases spending or lowers taxes. This deficit is financed by debt: the government borrows money to cover the deficit in its budget. Chara Charalambous 26 The Impact of Monetary Policy in the Economy According to the Monetary Transmission Mechanism there is a direct link between the money market and the goods and services market explained below: An increase in the money supply means interest rates falls and this encourage investment because the cost of borrowing is low. The increased investment is an injection to new spendingconsumption so aggregate demand in goods market increases and therefore prices increases. But the fall in interest rates makes the domestic currency to depreciate and therefore exports of domestics goods are more attractive to other nations and so they are increasing. The above transmission channel makes GDP to rise and therefore unemployment decline and wages are greater than before. Chara Charalambous 27 Impact of Monetary Policy Recall GDP= Y=AD=C+I+G+(X-M) monetary policy, used separately or together, in an expansionary policy exertion increase the amount of money in circulation with corresponding reduce in interest rates. This combination of extra money and lower interest rates stimulate the economy and makes CDP to increase. All three tools of Chara Charalambous 28 Monetary Stimulus 7 6 0 E1 E2 Demand for money g1 g2 Quantity Of Money More investment increases aggregate demand (including multiplier effects) Aggregate Supply 7 Investment demand 6 0 I1 I2 Rate Of Investment Chara Charalambous AS Price Level Interest Rate Supply of money A reduction in the rate of interest stimulates investment Interest Rate An increase in the money supply lowers the rate of interest AD1 Y1 AD2 Aggregate Demand Y2 Income (Output) 29 The Monetarists’ Transmission Mechanism (cont.) There can only be a short-run increase in real GDP due to an expansionary monetary policy because in the end the public cannot buy more of everything: people simply bid up prices so the price level rises. Chara Charalambous 30 Impact of contractionary Monetary Policy Contractionary monetary policy is a decrease in the quantity of money in circulation, with corresponding increases in interest rates, for the expressed purpose of putting the brakes on an overheated business-cycle expansion and to address the problem of inflation. A decrease in the money supply means decreased Aggregate Demand, Decreased Real GDP, decreased Prices and an increase in unemployment Chara Charalambous 31 The impact of Fiscal Policy Expansionary Fiscal Policy: a combination of increased government spending and reduced taxes. Is the remedy for the contraction (reduction) of the business cycle G increase in government spending (both government purchases and transfer payments) causes AD to increase and shift to the right T decrease in taxes raises income and consumption and thus causes AD to increase and shift to the right Chara Charalambous 32 The impact of Fiscal Policy Contraction Fiscal Policy needed when demand-pull causes inflation. A in G reduces AD and shifts it back left and the price level returns to its pre-inflationary level but GDP remains at full – employment level. An in T will reduce income and then consumption. Chara Charalambous 33 . When we have a downturn, expansionary fiscal policy means more spending than tax. When we have a boom, contractionary fiscal policy keeps taxation above spending. Simplified model of budget and growth is below: G T Chara Charalambous 34 Who Does Fiscal Policy Affect? Taxes Unfortunately, the effects of any fiscal policy are not the same on everyone. Depending on the political orientations and goals of the policymakers, a tax cut could affect only the middle class, which is typically the largest economic group. In times of economic decline and rising taxation, it is this same group that may have to pay more taxes than the wealthier upper class. Government Spending Similarly, when a government decides to adjust its spending, its policy may affect only a specific group of people. A decision to build a new bridge, for example, will give work and more income to hundreds of construction workers. A decision to spend money on building a new space shuttle , on the other hand , benefits only a small, specialized group of experts, which would not do much to increase the aggregate levels of employment in a nation. Chara Charalambous 35 Conclusion So now it is clear that there is a difference in the tools of monetary and fiscal policy and the way they influence economy ( through manipulation of different economic values) but the two policies are dependent to each other. As we show in previous slide monetary policy is dependent on fiscal policy for price stability. Fiscal Policy on the other hand needs monetary to control budget deficit. Chara Charalambous 36