Fiscal And Monetary Policy

MONETARY AND FISCAL POLICY

Overview The government has four primary objectives when it intervenes in the macro economy: (2) Promote full employment (high employment) (3) Promote price stability (low inflation) (4) Promote Economic Growth (5) Promote the Stability of Financial Markets

Overview The government pursues those objective through its use of fiscal and monetary policy.

Fiscal Policy • Fiscal Policy: The use of government spending and taxation to promote price stability, full employment and economic growth • Fiscal policy influences saving, investment, and economic growth in the long run. • In the short run, fiscal policy primarily affects the aggregate demand.

Fiscal Policy and Full Employment LRAS P

During a recession, the government can stimulate the economy by increasing government spending or decreasing taxes. SRAS

P2 P1

AD1 Y1

Yp

AD2 Real GDP

Fiscal Policy and Price Stability LRAS

During an inflationary period, the government can contract the economy by decreasing government spending or increasing taxes.

P

SRAS P1 P2

AD2 Yp

Y1

AD1 Real GDP

Monetary Policy • Monetary Policy: The actions the Federal Reserve takes to manage the money supply and interest rates to pursue policy objectives. • In the short-run, monetary policy affects aggregate demand through its effect on interest rates.

Monetary Policy Targets •

Monetary Policy Targets: Variables the Fed uses to implement its goals of price stability, low unemployment, and economic growth. • The two main monetary policy targets are: 3) The money supply 4) The interest rate The Fed typically uses the interest rate as its main policy target.

The Demand for Money • The money demand curve illustrates the relationship between the amount of money individuals want to hold and the interest rate. • The quantity of money demanded is inversely related to the interest rate. – When interest rates rise, the opportunity cost of holding money increases.

The Money Demand Curve Interest Rate

The money demand curve slopes downward: as interest rates rise, the opportunity cost of holding money increases and hence the quantity of money demanded decreases

r2

r1

Money Demand

M2

M1

Quantity of Money

The Money Supply The money supply is controlled by the Fed through: • Open-market operations (buying and selling of Treasury securities). • Changing the reserve requirements • Changing the discount rate Because it is fixed by the Fed, the quantity of money supplied does not depend on the interest rate. The fixed money supply is represented by a vertical supply curve.

The Money Supply Curve Interest Rate

Money Supply

M1

Because the Fed controls the money supply, the money supply is independent of the interest rate and hence the money supply curve is vertical

Quantity of Money

Equilibrium in the Money Market Interest Rate

Money Supply The demand and supply of money determines the equilibrium interest rate in the economy. Equilibrium in the money market occurs where the quantity of money demanded equals the quantity of money supplied.

r1 Equilibrium Money Demand M1

Quantity of Money

An Increase in the Money Supply Interest Rate

MS1

MS2

r1

If the Fed increases the Money supply (buys Treasury securities), the money supply curve shifts right. As a result, interest rates fall.

r2

Money Demand M1

M2

Quantity of Money

A Decrease in the Money Supply Interest Rate

MS2

MS1

r2

If the Fed decreases the money supply (sells Treasury securities), the money supply curve shifts left. As a result, interest rates rise.

r1

Money Demand M2

M1

Quantity of Money

The Federal Funds Rate • Recall that the Fed can use either the money supply or the interest rate as its monetary policy target. • Since 1990, the Fed has increased its reliance on interest rate targeting. • The interest rate the Fed targets for monetary policy purposes is known as the federal funds rate. • Federal Funds Rate: The interest rate banks charge each other for overnight loans.

The Federal Funds Rate • Note that the federal funds rate is NOT set by the Fed. • Instead, the Fed announces a target for the federal funds rate and then uses it control over open market operations (buying and selling of Treasury securities) to insure they hit their target. • When the Fed lowers the federal funds rate, other interest rates tend to also decline (mortgage rates, etc). • Similarly, when the Fed increases the federal funds rate, other interest rates tend to rise.

Monetary Policy and the Economy in the Short-Run • Expansionary Monetary Policy: When the Fed increases the money supply and decreases interest rates to increase real GDP. • Contractionary Monetary Policy: When the Fed decreases the money supply and increases interest rates to reduce inflation.

Monetary Policy and the Economy in the Short-Run • Monetary policy affects the economy in the shortrun through its affect on interest rates and aggregate demand. • When the Fed increases the money supply (lowers the federal funds rate), interest rates fall. • The fall in interest rates stimulates household consumption and firm investment. As a result, the aggregate demand curve shifts right.

An Increase in the Money Supply Interest Rate

MS1

MS2

r1

If the Fed increases the Money supply, the money supply curve shifts right. As a result, interest rates fall.

r2

Money Demand M1

M2

Quantity of Money

An Increase in the Money Supply LRAS P

… Lower interest rates cause the aggregate demand curve to shift right. As a result, real GDP and the aggregate price level rise. SRAS

P2 P1

AD1 Y1

Yp

AD2 Real GDP

Monetary Policy Example Suppose the Fed is worried about inflation. In response, the Fed could lower the money supply by: (3) Selling Treasury securities (increase the federal funds rate) (4) Increasing the discount rate (5) Increasing the required reserve ratio

A Decrease in the Money Supply Interest Rate

MS2

MS1

r2

If the Fed decreases the money supply, the money supply curve shifts left. As a result, interest rates rise.

r1

Money Demand M2

M1

Quantity of Money

A Decrease in the Money Supply LRAS

… the rise in interest rates causes the aggregate demand curve to shift left. As a result, real GDP and the aggregate price level fall.

P

SRAS P1 P2

AD2 Yp

Y1

AD1 Real GDP

Summary of How Monetary Policy Works

Expansionary and Contractionary Monetary Policies

Monetary Policy and the 2001 Recession Events Surrounding the 2001 Recession: 3. End of the Dot-Com bubble in 2000. Stock prices fell about 25% between August 2000 and August 2001. 4. Decline in investment spending staring in 2001. 5. 9/11 Terrorist attacks. Terrorists attacks reduced consumer confidence and increased firm uncertainty.

Cause of the 2001 Recession LRAS P

The Dot-com bust, 9/11 and the decline in firm investment caused the aggregate demand curve to shift left. SRAS

P1 P2

AD1 AD2 Y2

Y1

Real GDP

The Fed’s Response In response to the events surrounding the 2001 recession the Fed increased the money supply by: (2) Lowering the discount rate (3) Buying Treasury securities (lowering the federal funds rate) Commentary of Fed’s Response

The Fed and the 2001 Recession Interest Rate

MS1

MS2

r1

r2

In response to the events surrounding the 2001 recession the Fed cut interest rates by purchasing Treasury securities via open market operations (lowering the federal funds rate).

Money Demand M1

M2

Quantity of Money

The Fed and the 2001 Recession LRAS P

… Lower interest rates caused the aggregate demand curve to shift right. As a result, real GDP and the aggregate price level rose. SRAS

P2 P1

AD1 Y1

Yp

AD2 Real GDP

Fiscal and Monetary Policy During Periods of Stagflation • Stagflation is characterized by a rising price level (inflation), rising unemployment and falling output. • During periods of stagflation, monetary and fiscal policy can be used to address only one of the problems: either the fall in output or the rise in the price level.

Monetary and Fiscal Policy with Stagflation LRAS P SRAS2 SRAS1 P2

Stagflation is caused by a shift left in the SRAS curve. During stagflation, monetary and fiscal policy can not stabilize both output and the price level.

P1

AD1 Y2

Y1

Real GDP

The Taylor Rule • How does the Fed actually choose a target for the federal funds rate? • The Taylor Rule: A rule developed by John Taylor that links the Fed’s target for the federal funds rate to economic variables.

The Taylor Rule Federal funds target rate = Current inflation rate + Real equilibrium federal funds rate + (1/2) x Inflation gap + (1/2) x Output gap

Inflation Gap: Difference between current inflation and a target level of inflation. Output Gap: Difference between current real GDP and potential real GDP.