Economics - Fiscal and Monetary Policy and Central Banks

Start 1:15 pm

Fiscal Policy

Fiscal policy is the taxing and spending decisions of the government

• Budgets = Tax Revenues - Govt Expenditures
• Surplus, Deficit, and balance = pos, neg, 0
• Goal is to stabilize cycles
• During inflationary times: increase taxes/reduce spend
• During recession times: decrease taxes/increase spend

Supply Side Effects - fiscal policy (esp tax) affects LRAS

• Income taxes reduce incentive to work - tax wedge b/w pre and after tax wages
• Reduces potential GDP because it reduces labor supply
• Increase in consumption taxes has a similar effect - reduces purchasing power of wages

Laffer Curve

• Plots total tax revenue as function of tax rate
• Supply side effects mean it eventual goes down
• Laffer begins and ends at 0 tax revenues, at 0% tax and 100% tax

Investment

• Major component of GDP - spending on fixed productive assets and inventory
• Sources of investment financing: national savings, borrowings from foreigners, government savings
• Gov surpluses increase investment spending (and vv)
• Taxes on capital income directly impact investment
• Larger deficits require governments to borrow, increasing interest rates and decreasing investment
• This is the crowding out effect
• BUT there is also the Ricardo Barro effect
• Since increases in deficit mean higher taxes in future, people will increase savings to offset effect of higher tax in future
• Ricardo Barro Equivalence - goes further and says borrowing or taxes are the same net effect
• In reality it is probably somewhere between the two - there is crowding out, partly offset by reduced consumption

Generational Effects - effects of postponing imbalances

• Equal to present value of future expected deficits
• Major source of imbalance in the US is Medicare
• Generational Imbalance - PV of govt benefits to current generation is not fully paid by the taxes on the current generation
• Current policy is to just postpone

Discretionary Fiscal Policy

• Actions of fiscal policy meant to stabilize the economy
• Changes in spending have magnified effects on aggregate demand
• Government Expenditure Multiplier - final effect per dollar change on agg demand
• Applies equally to increases/decreases
• Changes in taxes also have magnified effect but smaller due to savings
• Autonomous Tax Multiplier
• Since Gov Ex Mult > Autonomous Tax Mult, the Balanced Budget Mult > 0
• Increase in spending with equal increase in taxes will net expand the economy
• Limitations
• Economic forecasts may be wrong
• There can be significant delay in recognition, administrative/lawmaking, and actual impact/implementation

Automatic Stabilizers - built in devices triggered by state of economy

• Induced taxes
• As incomes rise, so do tax rates/revenues
• Needs tested spending
• E.g. unemployment benefits are paid more (i.e. spending stimulus increases) in a recession and less in a boom
• Both actions are countercyclical
• These both also affect the budget deficit; budgets have a structural and cyclical component
• Structural is what there would be if at full employment
• Cyclical exists because economy is above or below proper GDP
• Cyclical is 0 when economy is at right GDP

Monetary Policy

Goals

• 3 main goals: Maximum employment, stable prices, moderate long-term interest rates
• Increase money supply commensurate with growth of economy (monetarist)

Fed focuses on core inflation - increase of CPI excluding most volatile components (food and energy) - and inflationary/recessionary output gaps

• CPI calc is also adjusted for overstatement bias
• Don't worry about output gap calc but just know it is important to the fed
• If output too high, decrease money credit aggregates
• If output too low, increase money supply

Implementation of policy

• Mainly happens through changing federal funds rate - increase rate to decrease supply and vv
• Rules for implementation - Fed decides b/w instrument rules and target rules
• Instrument rules - base target rate on current performance of economy
• Taylor Rule - targeting 2% inflation, FFR = 2% + actual inflation + 0.5*(actual inflation - 2%) + 0.5 (output gap)
• With no output gap and inflation at target, FFR = 4%
• Fed doesn't explicitly follow but this trend is pretty solid for last 20 yrs
• Targeting rules - based on a future forecast of inflation
• Requires FFR be set so forecast inflation = target inflation (2%)
• Accomplishes this through open market ops to influence supply/demand
• This is the fed's most commonly used tool

Example chain of events - policy action to final goal

• Goal is to stimulate economy and growth

1. Fed buys treasuries, this increases banks reserves
2. Reserves decrease the FFR as banks will lend their excess reserves
3. Other interest rates decrease as supply of loanable funds increases
4. Long-term rates also decline
5. Decrease makes investment in other countries attractive; reduced demand for US dollars; dollar depreciates
6. Decrease in rates on loans means businesses invest
7. Consumers increase purchases of durables
8. Demand for exports increases
9. 6, 7, and 8 mean aggregate demand goes up
10. Increase in aggregate demand means price, employment, and inflation all go up

Loose links

• Link between short and long term rates is loose
• Significant time lag - can make cycles more severe if it is really lagged

Other Monetary Policy Rules (non-Taylor) and why the Fed doesn't use them

• McCallum Rule - focuses on quantity theory of money
• Matches growth of money to long term real GDP growth, adds target inflation, and adjusts for changes in velocity of money
• Drawback: demand for money can cause variations in interest rates and therefore demand
• Friedman - similar
• Grow money proportional to potential real GDP
• Drawback: fluctuations in money velocity and demand can lead to interest rate swings
• Exchange Rate Rule
• Keep exchange rate constant to a basket of other currencies
• This is bad - you just get the inflation of all the other countries
• Inflation Targeting
• Practiced by many central banks
• Use open market ops to target stated inflation rate, usually 2% +/- 1%
• Very transparent and predictable
• Still debatable if this or Taylor is better

Overview of Central Banks

• Primary function: control a country's money supply
• Goals are usually price stability and max sustainable GDP growth
• Countries' goals vary mainly in how much emphasis there is on promoting growth
• Usually issue currency and regulate the banking system

Three policy tools in U.S.

• Discount rate - rate at which banks can borrow from Fed - lower rate, more funds
• Bank reserve requirements - higher reserve means less money supply
• Only works if banks willing to lend and consumers to borrow
• Open Market Operations - buying/selling treasury securities
• This is the most common tool

Tools in the other countries are essentially the same

• UK - repo rate is the interbank rate
• Australia - cash rate
• Canada - overnight rate

Federal Funds Rate is market determined - but central bank usually changes discount rate at same time

Using either discount or overnight rate, goal is to keep inflation in bounds

Inflation-targeting is the goal in most countries, exceptions are the US and Japan.  Most countries target 2% with acceptable range of 1-3%.  Measure of inflation can vary - core/non-core etc.

Implementation is complex - policy changes that promote growth might also cause inflation.  Changes in interest rates affect asset prices, income from saving/lending, investment flows b/w countries, forex, and import/export levels.

End

2:45 pm

1.5 hours