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Fiscal Policy
The counter cyclical use of gov't spending and taxation powers to stabalize the economy
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Employment act
- 1946
- Federal gov't has responsibility to maintain full employment with stable prices.
- This act created the economic councle of advisors
- Fallow up was Humphrey Hawkins act
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Ressecionary gap
- Economy in recession then increase gov't spending and reduce taxes
- Actual GDP is below potential.
- To the left of Yxp
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Inflationary Gap
- Economy is beyond capacity then decrease gov't spending and incrase taxes
- Actual GDP is above potential
- to right of Yxp
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How to fix Ressecionalry gap
- Use expansionalry fiscal policy
- Must increase G
- Change in Y = Change in G * Me
- Me is slope from Consumption function.
- This incrase in G with close the recesionary gap
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Costs of Fixing Recesionary gap
- Anticipateion of higher taxes
- Deficit and debt
- Inflation and lower real wages
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Benefits of fix Ressecionary Gap
- GDP up so stimulte growth in economy
- Unemployment goes down
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Suppose lower taxes
- Taxes opporate through households
- It will opporate throught the consumption function
- C = 300 + .6y - T
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How much to lower taxes?
- Change in Y = Mt * change in T
- The negative number means we would have to lower taxes by that much to get to full employment
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Problems with Activist fiscal Policy
- 1) Time Lags: the political process can interfear and bog down
- 2) Actual size of Multiplier: due to inflation and high interest rates
- 3) The Political business cycle: politicians won't dow hat is neeeded for the economyh in an election year
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Automatic Fiscal Stabilizers
- 1) Progressive tax system
- 2) Unemployment insurances- if strong then pays taxes
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The Deficit
- Budget surplus = T - G - TR
- TR = Tax revenue
- If T > G + TR then Positive BS
- If T < G + TR then Negative BS ( deficit)
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The Debt
- The money the gov't borrows to finance the deficit
- The Gov't borrow by selling bonds, treasury bills, treasury notes
- Debt is sum of deficits
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Argument for balancing budget
- 1) Deficits cause inflation
- 2) Deficts cause high interest rates that crowd out private investment
- 3) Deficits cause high interest rates that crowd out Nx
- 4) Sound finance argument
- 5) The burden argument
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If we push AD past capacity (right)
This results in negative cyclical unemployment so there are jobs and employee's demand higher nominal wages which puts it back at equilibrium but at a higher price level which is inflation
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High interest rates...
- Appreciate the ]dollar relative to other currencies. Foreigers want to invest in foreing secruites so that puts pressure on dollare and price of dollar rises
- Therefore cost of Nx goes up so reduces SAles abroad
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Coutner arguments
- For 1,2,3: it depends on where we are in the business cycle
- If we are below full employment inflation and crowding out is less of a problem
- For 4,5: depends on what the defecxt and debt purchase like bridges (role of gov't)
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Funcitonal Finance
- Balance the duget over the business cycle
- What drives the debate today is libertain view that governemnt should be radically reduced
- Starve the beast
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Financial System
- 1) Reduce trasactions costs: get together so can made a deal in limiting debt
- 2) Reduce financial risk: provide differenet typs of investment which allows to spread out to diff kinds
- 3) To provided liquid assests: assest easiliy turned into cash
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4 Main types of financial assets
- Loans
- Bonds
- Stocks
- Bank Deposits
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Main types of Financial intermediaries
- 1) Mutual Funds
- 2) Pension Funds
- 3) Life insurance
- 4) Banks
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Mutual Funds
These create stock porfolios and sell shares in those portfolios to individuals
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Pension Fund
Type of mutual fund which holds assets to p;rovide for retirement
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Life Insurance
Life insurance guarentees payments to beneficiaries when the policy holder dies
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Banks
Provide liquid assets based on band deposits to finance the spending needs of borrowers
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The efficient Market hypotheiss
- Eugene Fama
- It argus that asset prices will in the long run reflect their true value, due to the assumption that people are rational.
- If people are tarional they will use all avialable info to evaluate value of assets. As a result, asset prices will reflect value
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What is money?
- An asset that can easily be used to purchase goods and services
- Consists of cash and other things that are highly liquidible
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3 Types of money
- 1) Commodity money
- 2) Commodity backed money
- 3) Fiat money
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Commodity money
- The medium of exchange is a good
- gold and silver
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Commodity backed money
Paper currency issued that is backed by gold or silver
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Fiat Money
- Money whose vaulue derives entirely from it's status as the official currensy
- U.S. $ is fiat money
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The functions of money
- 1) Medium of exchange
- 2) Unit of account
- 3) Store of Value
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Medium of Exchange
- Money facilitates the exchange of goods by eliminating the double concidence of wants.
- paying for somthing in exchange for somthing
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Unit of Acount
Money is the standard of value in which we express the value of all goods and services
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Store of value
- Money holds purchsing power oaver time
- Money is a unit through which we express future values
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Measues of Money
- The federal reserve calcutes to measues of money
- 1) m1: currency in circulation + travelors checks + chekcing (demand) demands
- 2) m2: m1 + savings deposstis + small time deposties ( CD < 100,000) + mutual funds
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Commercial banks
- 2 Primary functions:
- 1) Hold demand depsoties and honor checks drawn on the deposites: helps trades take place
- 2) Make loans, lend money: important to facilitate investment int he private sector
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The Fractional reserve
Becaues banks are only required to hold a portion of total deposites on reserve
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To ensure conficence in bank
- 1) Deposit insurence (FDIC ensures depostis up to 250000)
- 2) Capital requirements: capital = assets - deposits
- 3) Reserve requirements: rules set by the fed establishing the iminimum reserves, 10 % min
- 4) The discount window: The federal reserve will provide loans to banks that are in trouble
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Fraction Reserve banking and Creation of Money
- Assume:
- 1) The fed sets reserve ration =.2 (required reserves)
- 2) No bank in the system holds excess reserves
- 3) No cash reserves are ever leaked out of the systme
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Demand Deposit Multiplier
1/Reserve ratio
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DDM Dependable on
- 1) No leakage of cash from the banking system
- 2) Banks do not hold excess reserves
- 3) The willingness fo the individual actors to borrow and lend
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The Federal Reserve System
- Federal reserve is the central bank of the U.S
- Established in 1913 in respons to serices of financial panics
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Functions of the FED
- 1) Control the money supply
- 2) To serve as a lnder of last resort
- 3) Check clearing facilities for the banking systems
- 4) Issue currency
- 5) Act a s a fiscal agent for the Fed (gov't assist in making purchases)
- 6) Supervices and regulates the finacial sector
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The Structure of the Fed
- Board of Governs
- FOMC
- 12 Districts
- Board of Directors
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The board of Governers
- 7 Members appointed by the president approved by senate
- 14 year terms
- Every 2 years a new member comes on
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FOMC
- Federal Open market committee
- 12 member; 7 board of governer, 5 district bank presidents
- New Yourk District bank is permanent mameber
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Board of Directors
- Banks in private sector
- 1 selected in ach istrcit to serve on the board
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Monetary Policy
- A major funcito of the fed is to control the money supply for:
- 1) price stability
- 2) to attain "full employment"
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Tools for Monetary Polity
- 1) Reserve requirements
- 2) Open market poerations
- 3) the discount rate
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Reserve Requiremennts
- If the Fed reduces teh reserve requiremnt theyn the money supply would increaset
- Banks able to loan more money
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Open Market operations
- The primay means by which the fed influences the money supply
- The FOMC buys and sells bonds in the opne market
- If the FOMC puchases bonds, the money supply will incdrease
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Discount Rate
- If the Fed lowers the discount rate, it signals that it will increase the money supply
- If the Fed increases the disount rate, it siganls that it will decrease the money supply
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The Federal funds rate
The rate banks charge each other for overnight loan
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The Reconstruction Finance Corporation (RFC)
- 1932
- was established and given authority tomake loans to troubled banks.
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The Glass-Stegall Act passed
- 1932
- created federal deposit insurance
- Increased the ability of banks to borrow from the Fed
- Seperated banks into two categories:
- Commercial (covered by deposit insurance)
- Investment (less regulated and allowed to trade in more risky financial assets)
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Regulation Q
- Prevented banks from paying interest on checking accounts.
- Argued it would lead to unhealthy competition.
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Depository Institutions and Deregulation and Monetary Control Act
- 1980
- Removed Regulation Q.
- Allowed S & L’s to offer checkable deposits.
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Gar st. Germain Depository Institutions Act
- 1982
- Allowed S & L’s to undertake riskier investments (i.e., real estate development).
- With deregulation S & L’s faced a profit squeeze. Due to paying higher rates on deposits. At the same time they were locked into long-term fixed mortgages (though this legislation allowed new loans to have
- adjustable rates).
- Facing a profit squeeze, and with questionable regulatory oversight, S & L’s undertake risky investments that did not pay off.
- S & L’s begin to fail. Over 1,000 S & L’s closed between 1986-1995. costing tax payers $124 billion.
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The Financial Services Moderization Act (Gramm-Leach-Bliley Act).
- 1999
- Eliminates Glass-Stegal rules that separate investment and commercial banks.
- Exempts financial derivatives (i.e., credit default swaps) from regulation.
- Note:
- Joseph Stiglitz argues this legislation allowed the risk-taking culture of investment banking to overtake the conservative culture of commercial banking.
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The Policy Response
- ThevTroubled Assets Relief Program TARP—Allowed the U.S. Treasury to purchase or insure up to $700 billion of ‘troubled assets.”
- The American Recovery and Reinvestment Act—2009.
- The Dodd-Frank Wall Street Reform and Consumer Protection Act—2010
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The Dodd-Frank Wall Street Reform and Consumer Protection Act
- 2010
- Increasescapital requirements of investment banks.
- Regulatesderivatives (must be traded on exchanges). This repeals exemptions made under Gramm-Leach-Bliley Act).
- Creates“Bureau of Consumer Financial Protection” within the Federal Reserve.
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Monetary theory: Classical model
- Money is Neutral
- It only affects prices, and does not affect employment and output
- Depict Quantity theory using the equation of exchange
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The Equation of Exchange
- Ms * V = P * Y
- Y= real GDP
- P = Price level
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Quantity Theory assumes
- 1) Ms is exogenour ( its determend by the central bank)
- 2) Assumes velocity is contsnt because of peoples spending habits are stable
- 3) People demand money to carry out transactions
- 4) Y (GDP) is at potential so economy is self adjsuting
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In terms of AD and AS model
- Is is pure inflation where if money is increased, then price is increased in full proportion
- Moves AD right which just increases price
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Policy for this
- Early monetarists: argued for the gold standard, commodity backed money linked to gold
- Later monetarists: argued for policy rule
- Early example policy rule was milton freedment who argued fed should incrase money supply as same rate GDP was increaseing
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Keynesain Liquidity preference theory of money
- Keynes like the nometarist saw that poeple demand moeny for transaction purposes.
- In addition, keynes argued that people also demand money for specualate purpose
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The Speculative Demand for Money
- Money is viewed as an alternative form of wealth
- An alternavie asses tha is part of a a finacial portolio
- If money is an asset thent ehre is an opportunity cost to holding money. that opportunity cost is therate of recuts on the other assets (bonds)
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In terms of graph
- Indierect relationship
- If the real rat of interest is low, then there is a high demand for money
- If iterests rate low then people hold money because opportunity cost of holding it is lower
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Determeinets of Money demand
- 1) Changes in the price level
- 2) changes in teh real GDP
- 3) Technology changes
- 4) Changes in instituition
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Price level increases...
MD shifts right becasue more money demanded at every price level becase price increased
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Money Market equilibrium
- Above equilibrium: surplus so interset rates should fall to clear market
- Below equilibrium: md>ms, shortage so upward pressur on interest ratses
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The Fed incrases Money supply
Ms Shifts to the right, surplus so downward pressure on interst ratse
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Liquidity Preference Theory
- Regarding why interst rates fall whent he fed increases the omeny supply
- the fed increses ms peole how now hold more money, people will increase their demand for bonds
- this increases demand for bonds, increse price of bonds and if price of bonds increases then interst rate on bonds will fall
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Present Value theory of Asset Pricing
PV= FV/(1 + r)
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Monetary Policy and Aggregate damand
- Keynesiand transmisson mechansim:
- Suupose the fed increases ms (purchanse bonds in open market)
- This will make consumption move up and stimulate ad out to right and ms move out to right
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Non neutral money
- Output and employmebnt afffected
- Money supply increases to rates down, so consumpution and investment increase and Ad increates so potential increases
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Monetarist and the rate of interest
- An increase in the money suply will not change the real rate of interst due to inflation formula
- r = i -rate of inflation
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Monetary Policy in Practie
Have historically argued for an activits central bank
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The Taylor Rule
- Developed by John Taylor
- In seetting monetary policy, the fed should target the federal funds rate, keeping inflation and ouptu in mind by taking account of both inflation and output
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Federal Fujds RAte
- 1 + 1.5* inflation + .5*output Gdp
- If actual GDP above potential then RFF increase so FRR would reduce moeney to dool down
- If Actual GDP below potential then reduce RFF which would increase money suppl
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Inflation Targeting
- Central Bank targets only inflation and strives to keep a very low rate of inflation
- Argument:
- 1) It is more transparent (can better judge what is going to be forward looking)
- 2) This promotes a greateer accoutnability becasue you can judge if cnetal bank has achieve its target
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New classical ecomics
- Emerged in the 1970 as critique of keynesian ecoomics and policy
- 1) Milton Feedmen -"fooling" or natural rae model
- 2) Rober Lucas- rational expectaions model
- 3) Fin Kydland and Edward prescott- real business cycle model
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The Natural RAte of fooling model
- Assume:
- 1) Workers mispercieve movement in the price level
- 2) The economy is at capacity (unemployment = naturea)
- 3) Policy makers do not recogine the natual rate of unemploymebnt
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Equilibrium in Macro econ
- In long run economy will adjust to effeicndet equilibuium
- SRAS acknolege price rigidity and that actual GDP can differ
- The polidy maker swant to sitmualte AD to reduce uneimployment and grow GDP. Policy would increase Ms, or down tax up g
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If Fed increses ms so AD shift right
- Go to point b becasue workers have been fooled.
- They see the incres in nominal wage but bno tin price, so they don't see real wage is acually lower
- Over time they catch on, the demand and SRAS shifts up and back to potential
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Rational Expectaions
- Assumes
- 1) both employuers and workers can mispercieve movment in the price level
- 2) both the eoplyers na d woreker aer rational wehre ratiaonality incidcate the contiually seek all availabe info in ordder to acccuraely predict movement in the price level
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In terms of graph
- Same graph
- At point B both workers an demplyer are mispercieveing. workers daony see fall in real ages whild employers don't see fall in real profi
- Over time woerkes and employers see the rise in prices and sras shifts up
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Friedmenn (fooling model)
The economy moesv from A to B becasue workers are fooled. they dont see their real wagtes falling
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Rational expecations
- the econly moves from A to B becaseu both workers and emplyers mispercieve prices
- also it is possible both can form rational expecatiosn that accuratly prdice movemtn in the price leve. if this occures then economy moves ffrom a to c
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The real busiiness cycle theory
- Assumes:
- 1) Prices are fully flexiable (no rigidity)
- 2) Fluctuations in output are due to changes in real GDP
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