MONETARY AND FISCAL POLICIES

2. MONETARY AND FISCAL POLICIES Barbulean

3. STAGES OF INFLATION • 1. CREEPING INFLATION (0%-3%) • 2. WALKING INFLATION ( 3% - 7%) • 3. RUNNING INFLATION (10% - 20 %) • 4. HYPER INFLATION ( 20% and abv)

4. TYPES OF INFLATION 1. Demand Pull Inflation 2. Cost Push Inflation

5. Causes of Inflation • 1. Demand pull Inflation Causes for Increase in Demand :- • Increase in Money Supply • Increase in Black Marketing • Increase in Hoarding • Repayment of Past Internal Debt • Increase in Exports • Increase in Income

6. 2) Cost Push Inflation Causes for Increase in Cost :- • Increase in cost of raw materials • Shortage of Supplies • Natural calamities • Industrial Disputes • Increase in Exports • Increase in Wages • Increase in Transportation Cost • Huge Expenditure on Advertisement

7. Effects of Inflation • Inflation can have positive and negative effects on an economy. Negative effects of inflation include loss in stability in the real value of money and other monetary items over time; uncertainty about future inflation may discourage investment and saving, and high inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future. Positive effects include a mitigation of economic recessions, and debt relief by reducing the real level of debt.

8. What is the Monetary Policy? • The Monetary and Credit Policy is the policy statement, traditionally announced twice a year, through which the Federal Reserve Bank seeks to ensure price stability for the economy. • These factors include - money supply, interest rates and the inflation. In banking and economic terms money supply is referred to as M3 - which indicates the level (stock) of legal currency in the economy. • Besides, the Fed also announces norms for the banking and financial sector and the institutions which are governed by it.

9. How is the Monetary Policy different from the Fiscal Policy? • The Monetary Policy regulates the supply of money and the cost and availability of credit in the economy. It deals with both the lending and borrowing rates of interest for commercial banks. • The Monetary Policy aims to maintain price stability, full employment and economic growth. • The Monetary Policy is different from Fiscal Policy as the former brings about a change in the economy by changing money supply and interest rate, whereas fiscal policy is a broader tool within the government. • The Fiscal Policy can be used to overcome recession and control inflation. It may be defined as a deliberate change in government revenue and expenditure to influence the level of national output and prices.

10. What are the objectives of the Monetary Policy? • The objectives are to maintain price stability and ensure adequate flow of credit to the productive sectors of the economy. • Stability for the national currency (after looking at prevailing economic conditions), growth in employment and income are also looked into. The monetary policy affects the real sector through long and variable periods while the financial markets are also impacted through short-term implications.

11. Fed’s Tools of Monetary Control The Fed has 3 “tools” in its monetary toolbox: • Changing the Reserve Requirement • Open-Market Operations(buying & selling government securities performed by the Federal Open-Market Committee) • Changing the Discount Rate R.O.D.

12. Monetary Policy Tools CONTROLLING THE MONEY SUPPLY THROUGH BANKSTHE RESERVE REQUIREMENT • Reserves are deposits that banks have received but have not loaned out. • In the U.S. we have a fractional reserve banking system: • banks hold a fraction of the money deposited as reserves and lend out the rest.

13. Monetary Policy Tools CONTROLLING THE MONEY SUPPLY THROUGH BANKSTHE RESERVE REQUIREMENT The money supply in America is affected by the amount deposited in banks and the amount that banks loan out. • The fraction of total deposits that a bank has to keep as reserves is called the reserve requirement ratio. • Put another way, the reserve requirement is the amount (10%) of a bank’s total reserves that may not be loaned out.

14. Open Market Operations:the buying and selling of U.S. securities (national debt in the form of bonds) by the Fed. • This is the primary tool used by the Fed. • Fed buys bonds – the money supply expands: • bond buyers acquire money • bank reserves increase, placing banks in a position to expand the money supply through the extension of additional loans. • Fed sells bonds – the money supply contracts: • bond buyers give up money for securities • bank reserves decline, causing them to extend fewer loans.

15. Monetary Policy Tools CONTROLLING MONEY SUPPLY THROUGH THE INTEREST RATETHE DISCOUNT RATE (Federal Funds Rate) • TheDiscount Rateis the interest rate the Fed charges banks for loans. • Increasingthe discount ratedecreasesthe money supply. • Decreasingthe discount rateincreasesthe money supply. “The Discount Window”

16. Discount Rate:the interest rate the Fed charges banking institutions for borrowed funds. • An increase in the discount rate decreases the money supply (restrictive) because it discourages banks from borrowing from the Federal Reserve to extend new loans. • A reduction in the discount rate increases the money supply (expansionary) because it makes borrowing from the Federal Reserve less costly.

17. (1) (2) Easy money policy (Expansionary) Tight money policy (Contractionary) Problem: unemployment and recession Problem: inflation Federal Reserve buys Federal Reserve sells bonds, increases bonds, lowers reserve ration, or reserve ratio, or increases the discount rate lowers the discount rate Excess reserves increase Excess reserves decrease Money supply rises Money supply falls Interest rates fall Interest rate rises Investment spending increases Investment spending decreases Aggregate demand increases Aggregate demand decreases Real GDP rises by a multiple Inflation declines of the increase in investment The 3 Tools the Fed Uses to Control the Money Supply

18. Monetary Policy Tools REVIEW: TOOLS OF MONETARY POLICY Open-Market Operations The Reserve Ratio The Discount Rate What will happen to the money supply in the following situations? • Examples: • Buy securities • Increase Reserve Ratio • Raise Discount Rate • Sell Securities • Decrease Reserve Ratio • Lower Discount Rate MONEY DECREASES MONEY INCREASES MONEY DECREASES MONEY INCREASES MONEY DECREASES MONEY INCREASES

19. Banks are any institution holding deposits. People deposit money in a bank. Banks must hold a specific percentage of the deposit as reserves; this percentage is called the required reserve ratio. The deposit that is not part of required reserves is called excess reserves. The bank may loan excess reserves or buy government securities. A bank makes a loan by creating a checkable deposit for the borrower; this results in an increase in the money supply. The money supply equals currency, checkable deposits and traveler’s checks. The total increase in the money supply may be less than predicted by the money expansion multiplier if - borrowers do not spend all of the money they borrow, - banks do not lend out all their excess reserves and - people hold part of their money as cash.

20. Activity 37 The Multiple Expansion of Checkable Deposits

21. Assume thatthe required reserve ratio is 10% of checkable deposits and banks lend out the other 90% (banks wish to hold no excess reserves) andall money lent out by one bank is re-deposited in another bank • 1. Under these assumptions, if a new checkable deposit of $1,000 is made in Bank 1 • (A) how much will Bank 1 keep as required reserves? • (B) how much will Bank 1 lend out? • (C) how much will be re-deposited in Bank 2? • (D) how much will Bank 2 keep as required reserves? • (E) how much will Bank 2 lend out? • (F) how much will be re-deposited in Bank 3?

22. Assume thatthe required reserve ratio is 10% of checkable deposits and banks lend out the other 90% (banks wish to hold no excess reserves) andall money lent out by one bank is re-deposited in another bank • 1. Under these assumptions, if a new checkable deposit of $1,000 is made in Bank 1 • (A) how much will Bank 1 keep as required reserves? • (B) how much will Bank 1 lend out? • (C) how much will be re-deposited in Bank 2? • (D) how much will Bank 2 keep as required reserves? • (E) how much will Bank 2 lend out? • (F) how much will be re-deposited in Bank 3? $100.00 $900.00 $900.00 $90.00 $810.00 $810.00

23. Checkable deposits, Reserves and Loans in seven banks

24. Figure 37.1Checkable deposits, Reserves and Loans in seven banks

25. In the example from figure 37.1: • The original deposit of $1,000 increased total bank reserves by ________ . Eventually this led to a total $10,000 expansion of bank deposits, ________ of which was because of the original deposit, while ________ was because of repeated bank lending activity. • Therefore, if the fractional reserve had been 15% instead of 10%, the amount of deposit expansion would have been (more / less) than in this example. • Therefore, if the fractional reserve had been 5% instead of 10%, the amount of deposit expansion would have been (more / less) than in this example. • If banks had not loaned out all of their excess reserves, the amount of deposit expansion would have been (more / less) than in this example. • If all loans had not been re-deposited in the banking system, the amount of deposit expansion would have been (more / less) than in this example.

26. In the example from figure 37.1: • The original deposit of $1,000 increased total bank reserves by $1,000 . Eventually this led to a total $10,000 expansion of bank deposits, $1,000 of which was because of the original deposit, while $9,000 was because of repeated bank lending activity. • Therefore, if the fractional reserve had been 15% instead of 10%, the amount of deposit expansion would have been LESS than in this example. • Therefore, if the fractional reserve had been 5% instead of 10%, the amount of deposit expansion would have been MORE than in this example. • If banks had not loaned out all of their excess reserves, the amount of deposit expansion would have been LESS than in this example. • If all loans had not been re-deposited in the banking system, the amount of deposit expansion would have been LESS than in this example.

27. Double Entry Bookkeeping Arguably, the greatest innovation in practical mathematics since the decimal system

28. A T-account is an accounting relationship that looks at changes in balance sheet items. Since balance sheets must balance, so must T-accounts T-account entries on the asset side must be balanced by an offsetting asset or liability For a bank Assets include vault cash, accounts at the Federal Reserve district bank, Treasury securities loans. Liabilities are deposits. Net worth is Assets minus Liabilities The T-account Assets Liabilities Loans $900 Deposits $1000 Reserves $100

29. Assume that $1000 is deposited in a bank, that each bank lends out all excess reserves (banks wish to hold no excess reserves) all money lent out by one bank is re-deposited in another bank Required Reserve Ratio

30. Assume that $1000 is deposited in a bank, that each bank lends out all excess reserves (banks wish to hold no excess reserves) all money lent out by one bank is re-deposited in another bank Required Reserve Ratio

31. Why don’t we want an infinite growth of the money supply? (remember the equation of exchange) 6. If the required reserve requirement were 0%, then the money supply expansion would be infinite.

32. Why don’t we want an infinite growth of the money supply? (remember the equation of exchange) We know that with a given population and A given quantity of capital At a given level of technology for the natural resources available Real Output (Q) cannot increase beyond full employment The result would be hyper-inflation 6. If the required reserve requirement were 0%, then the money supply expansion would be infinite.

33. Should it raise or lower the reserve requirement? Why? 7. If the Federal Reserve wants to increase the money supply,

34. Should it raise or lower the reserve requirement? Why? The FRB should lower the reserve requirement. Lowering the percentage of required reserves, increases the excess reserves available in the banking system Increasing the deposit expansion multiplier 7. If the Federal Reserve (FRB) wants to increase the money supply,

35. What will happen to nominal GDP? Why? 8. If the Federal Reserve increases the reserve requirement and velocity remains stable,

36. What will happen to nominal GDP? Why? Nominal GDP would decrease. Because the equation of exchange is an accounting identity, both products MV and PQ must balance – If the money supply (M) decreases, because of the increase in required reserves reduces excess reserves for loans; and velocity (V) remains constant Then (PQ) nominal GDP must also decrease 8. If the Federal Reserve increases the reserve requirement and velocity remains stable,

37. Maximum employment Maintain price stability Moderate long term interest rates 9. What economic goal might the Federal Reserve try to meet by reducing the money supply?

38. Maximum employment Maintain price stability Moderate long term interest rates (B) Price stability 9. What economic goal might the Federal Reserve try to meet by reducing the money supply?

39. 10. Why might the money supply not expand by the amount predicted by the deposit expansion multiplier?

40. 10. Why might the money supply not expand by the amount predicted by the deposit expansion multiplier? • Banks may not choose to lend out all excess reserves • Banks may be unable to lend out all excess reserves because households or firms may not want to borrow • All loans may not be re-deposited into the banking system

41. How Banks Create Money by Extending Loans

42. Fractional Reserve Banking • The U.S. banking system is a fractional reserve system where banks maintain only a fraction of their assets as reserves to meet the requirements of depositors. • Under a fractional reserve system, an increase in reserves(excess reserves) will permit banks to extend additional loans and thereby expand the money supply (by creating additional checking deposits).

43. Creating Money from New Reserves New cash deposits:Actual Reserves Potential demand deposits created byextending new loans NewRequired Reserves Bank Initial deposit (bank A) $1,000.00 $200.00 $800.00 Second stage (bank B) 800.00 160.00 640.00 Third stage (bank C) 640.00 128.00 512.00 Fourth stage (bank D) 512.00 102.40 409.60 Fifth stage (bank E) 409.60 81.92 327.68 Sixth stage (bank F) 327.68 65.54 262.14 Seventh stage (bank G) 262.14 52.43 209.71 All others (other banks) 1,048.58 209.71 838.87 Total $5,000.00 $1,000.00 $4,000.00 • When banks are required to maintain 20% reserves against demand deposits, the creation of $1,000 of new reserves will potentially increase the supply of money by $5,000.

44. What is the Purpose of changing the Money Supply? • The assumption is that the increased excess reserves from an expansionary monetary policy are going to be loaned out and going to be used to purchase Goods/Services – INCREASING GDP (Recession, less than full-employment) • The assumption is that the decrease in excess reserves from a contractionary monetary policy are going to decrease loans and is going to discourage the purchases of Goods/Services – DECREASING GDP (Inflation, greater than full-employment)

45. The Money Multiplier: II • MoneyMultiplier = 1/ ReserveRatio • So in the example above, if RR is .10, Money Multiplier is ten. • And ten times the original $1,000 increase in demand deposits is $10,000.

46. The Money Multiplier: III • Now suppose the RR is instead 50%, what’s the money multiplier?

47. The Money Multiplier: III • That’s right, it’s two – one divided by .50. • So if Bank 1 receives a new demand deposit of $1,000, it can lend out $500, Bank 2 can lend out $250, and so on until a total of $2,000 of new money is in circulation.

48. The Money Multiplier Point • The bigger the RR, the smaller the MM and the lessmoney created by a new dollar of demand deposits.

49. How Banks Create Money by Extending Loans • The lower the percentage of the reserve requirement, the greater the potential expansion in the money supply resulting from the creation of new reserves. • The fractional reserve requirement places a ceiling on potential money creation from new reserves. • The actual deposit multiplier will be less than the potential because: • Some persons will hold currency rather than bank deposits. • Some banks may not use all their excess reserves to extend loans.

50. Government in the Economy • Nothing arouses as much controversy as the role of government in the economy. • Government can affect the macroeconomy in two ways: • Fiscal policy is the manipulation of government spending and taxation. • Monetary policy refers to the behavior of the Federal Reserve regarding the nation’s money supply.