Professor K.D. Hoover, Econ 210D Topic 8 Spring Econ 210D Intermediate Macroeconomics Spring 2015 Professor Kevin D. Hoover Topic 8 Monetary and Fiscal Policy
Professor K.D. Hoover, Econ 210D Topic 8 Spring The Government’s Budget Constraint G – ( T – TR ) = B G + MB deficit change in government’s financial portfolio Fiscal PolicyMonetary Policy
Professor K.D. Hoover, Econ 210D Topic 8 Spring 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
Professor K.D. Hoover, Econ 210D Topic 8 Spring 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
Professor K.D. Hoover, Econ 210D Topic 8 Spring The Federal Reserve System
Professor K.D. Hoover, Econ 210D Topic 8 Spring 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
Professor K.D. Hoover, Econ 210D Topic 8 Spring 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
Professor K.D. Hoover, Econ 210D Topic 8 Spring Fed and Commercial Bank Balance Sheets
Professor K.D. Hoover, Econ 210D Topic 8 Spring 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
Professor K.D. Hoover, Econ 210D Topic 8 Spring 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 Topic 8 Spring 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
Professor K.D. Hoover, Econ 210D Topic 8 Spring 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.
Professor K.D. Hoover, Econ 210D Topic 8 Spring Open-market Purchase Public’s holdings of government bonds falls Banks’ holdings of reserves rise Interest rates fall
Professor K.D. Hoover, Econ 210D Topic 8 Spring “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 Topic 8 Spring 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 Topic 8 Spring 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
Professor K.D. Hoover, Econ 210D Topic 8 Spring 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.
Professor K.D. Hoover, Econ 210D Topic 8 Spring 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
Professor K.D. Hoover, Econ 210D Topic 8 Spring 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 Topic 8 Spring 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 Topic 8 Spring 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 Topic 8 Spring 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.
Professor K.D. Hoover, Econ 210D Topic 8 Spring Fiscal Policy Fiscal policy = Tax Policy Expenditure Policy
Professor K.D. Hoover, Econ 210D Topic 8 Spring Types of Fiscal Policy Automatic stabilizers Discretionary Policy o Inadvertent o Intentional
Professor K.D. Hoover, Econ 210D Topic 8 Spring 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
Professor K.D. Hoover, Econ 210D Topic 8 Spring 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
Professor K.D. Hoover, Econ 210D Topic 8 Spring Fiscal Policy in the Long Run – 1 G – ( T – TR ) = B G + MB deficit change in government’s financial portfolio Fiscal PolicyMonetary Policy
Professor K.D. Hoover, Econ 210D Topic 8 Spring
Professor K.D. Hoover, Econ 210D Topic 8 Spring
Professor K.D. Hoover, Econ 210D Topic 8 Spring Dynamics of the Debt G – ( T – TR ) = interest payments + primary deficit
Professor K.D. Hoover, Econ 210D Topic 8 Spring 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 Topic 8 Spring Functional Finance – 2: types of effect Aggregate demand Interactions between public and private sectors Redistribution Incentives
Professor K.D. Hoover, Econ 210D Topic 8 Spring Crowding Out Crowding Out = increases in government expenditure reduce private expenditure or, more particularly, private investment
Professor K.D. Hoover, Econ 210D Topic 8 Spring 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 Topic 8 Spring Burden of the Debt Debt to GDP Ratio: B / pY In Growth Rates:
Professor K.D. Hoover, Econ 210D Topic 8 Spring
Professor K.D. Hoover, Econ 210D Topic 8 Spring END of Topic 8 END OF COURSE