1. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 1 Econ 210D Intermediate Macroeconomics Spring 2015 Professor Kevin D. Hoover Topic 8 Monetary and Fiscal Policy

2. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 2 The Government’s Budget Constraint G – ( T – TR ) =  B G +  MB deficit change in government’s financial portfolio Fiscal PolicyMonetary Policy

3. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 3 Pure Policy G – ( T – TR ) =  B G +  MB Pure Fiscal Policy : changes in taxes or spending, holding government liabilities constant (  B G = 0 and  MB = 0) o E.g., balanced budget stimulus Pure Monetary Policy : changes in liability mix  B G = –  MB ), holding deficit constant ( G – ( T – TR ) = 0) o E.g., open-market operation

4. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 4 Mixed Policies G – ( T – TR ) =  B G +  MB Deficit finance: o G – ( T – TR ) =  B G > 0 Monetizing the deficit: o G – ( T – TR ) =  MB > 0

5. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 5 The Federal Reserve System

6. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 6 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 Current Chairman: Ben Bernanke o Replaced Alan Greenspan, who replaced Paul Volcker Duties o Bank regulation o Monetary policy o Lender of last resort

7. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 7 Federal Open-Market Committee (FOMC) Main policy making body Composition o 7 Fed Governors o President of Federal Reserve Bank of New York o 4 other district bank presidents on a rotating basis o Remaining 7 presidents present as non-voting members Meets about every 5 weeks

8. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 8 Fed and Commercial Bank Balance Sheets

9. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 9 Open-market Operations Open-market operations = the Fed buys or sells assets on the open market, paying with reserves. Open-market sale : o Public holdings of government bonds rises o Banks’ holdings of reserves falls Open-market purchase : o Public holdings of government bonds fall o Banks’ holdings of reserves rises

10. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 10 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.

11. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 11 Reserve Demand Reserve requirements: banks must hold reserves = 10% of the value of checking accounts. Check Clearing Prudential Needs – costs of falling short o discount borrowing o interbank borrowing = Federal funds market

12. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 12 Holding Reserves: Banks’ Profit Maximization Problem Benefit of lending to another bank: r FF Cost of not having reserves on hand to cover withdrawals: probability of reserve loss × r FF Opportunity Cost: Benefit – Cost: r FF – prl × r FF = (1 – prl ) r FF The higher the opportunity cost, the lower the demand to hold reserves.

13. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 13 Open-market Purchase Public’s holdings of government bonds falls Banks’ holdings of reserves rise Interest rates fall

14. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 14 “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

15. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 15 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.

16. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 16 Transmission Mechanism Transmission Mechanism = means by which monetary policy effects the real economy Two types: o Interest-rate or Opportunity-cost Channel o Credit Channel

17. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 17 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. Fed controls short rates in order to manipulate long rates through the term structure. B. Real long rates affect investment; investment affects aggregate demand through the multiplier.

18. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 18 Credit Channel Credit Channel = monetary policy effects economy through reduction in funds available to borrowers with or without changing interest rates. Two types: o Narrow credit channel o Broad credit channel

19. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 19 Narrow Credit Channel Narrow Credit Channel = change in reserves owing to monetary policy action reduces volume of bank lending.

20. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 20 Broad Credit Channel Broad Credit Channel = changes in interest rates change credit-worthiness of borrowers, changing the availability of bank and nonbank credit.

21. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 21 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

22. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 22 Monetary Policy and the Recent Financial Crisis Lender of last resort “Quantitative Easing” = purchases of long- term (government and private) bonds o Interest-rate channel: similar to other open- market operations except at long end of term structure. o Direct relief of credit rationing. Challenge: How to unwind without squelching recovery.

23. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 23 Fiscal Policy Fiscal policy = Tax Policy Expenditure Policy

24. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 24 Types of Fiscal Policy Automatic stabilizers Discretionary Policy o Inadvertent o Intentional

25. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 25 Shocks Shift IS Curve Demand shocks =  Y holding Y pot constant Supply shocks =  Y pot holding Y constant Mixed shocks = both Y and Y pot

26. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 26 Limits to Fiscal Policy Lags o Inside Lag Recognition Lag Implementation Lag o Outside Lag Recognition Lag Implementation Lag State and Local Governments as Automatic Destabilizers

27. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 27 Fiscal Policy in the Long Run – 1 G – ( T – TR ) =  B G +  MB deficit change in government’s financial portfolio Fiscal PolicyMonetary Policy

28. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 28

29. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 29

30. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 30 Dynamics of the Debt G – ( T – TR ) = interest payments + primary deficit

31. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 31 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.

32. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 32 Functional Finance – 2: types of effect Aggregate demand Interactions between public and private sectors Redistribution Incentives

33. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 33 Crowding Out Crowding Out = increases in government expenditure reduce private expenditure or, more particularly, private investment

34. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 34 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

35. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 35 Burden of the Debt Debt to GDP Ratio: B / pY In Growth Rates:

36. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 36

37. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015 37 END of Topic 8 END OF COURSE