Term
|
Definition
| -government's or central bank's manipulation of money supply to influence the quantity of money and credit in the economy |
|
|
Term
|
Definition
-government's use of spending and tax policies to influence various aspects of the economy
--> level AD
--> distribution of wealth
--> allocation of resources between different sub sectors and economic agents |
|
|
Term
|
Definition
-medium of exchange: eliminates the requirement of a double coincidence of wants
--> must be readily acceptable, have known value, easily divisible, have high value relative to its weight, difficult to counterfeit
-store of value
-unit of account: provides a common measure of the value of goods and services being exchanged |
|
|
Term
|
Definition
-any medium that can be used to purchase goods and services
-stock of money consists of notes and coins in circulation, plus deposits in banks and other financial institutions that can be readily used to purchased goods and services in the economy
-narrow and broad money |
|
|
Term
|
Definition
-Banks have excess reserves --> lend the excess reserves --> bank deposits increase --> quantity of money increases --> deposits in the banking system increase --> these deposits in turn create excess reserves which are loaned out
-cycle continues with dwindling numbers and eventually, the total quantity of money in the economy will have increased by a multiple of the initial increase in the monetary base (money multiplier) |
|
|
Term
|
Definition
-increase in MS will not result in an increase in real output. therefore, it will cause the aggregate price level to rise
make sense with quantity theory of money
M*V=P*Y (assuming V is constant)
-reason behind this is that simply increasing MS does not change the availability of factors of production that influence the economy;s ability to produce REAL things |
|
|
Term
|
Definition
| -amount of wealth that households choose to hold int he form of money (instead of bonds or equities) |
|
|
Term
| Three Reasons for Demand for Money |
|
Definition
1)Transactions-related demand for money:
arises from need to use money to finance transactions. positively related to average transaction size and overall GDP
2) Precautionary Money balances
held for use in unforeseen circumstances. positively related to average transactions size, total volume of transactions, overall GDP
3)Speculative or Portfolio Demand for Money
related to perceived opportunities and risks of holding other financial instruments. positively related to perceived risk of financial assets and inversely related to returns available on financial assets |
|
|
Term
|
Definition
-assumed fixed (vertical line)
-if central bank were to raise MS, interest rates would fall. if money neutrality were assumed to hold in LR, price level would increase but no change in output and employment |
|
|
Term
|
Definition
-states that nominal interest rate reflects the real interest rate and the expected rate of inflation
-according to money neutrality, MS should not effect REAL interest rates, only inflation
-does not consider uncertainty; nominal interest rate reflects a risk premium associated with an uncertain future |
|
|
Term
|
Definition
-Monopoly Supplier of currency
central bank must safeguard the value of fiat currency and maintain confidence in them
-Banker to the govt. and lender of last resort
ready to supply funds to banks when they face reserve shortfalls. this promotes confidence in banks
-Supervise the banking system (solely or w another authority)
-Oversee, regulate and set the standards for a country's payments system so that procedures are robust and standardized such that the system can handle the millions of transactions that take place daily. coordinates pmt systems internationally
-manage the country's foreign currency and gold reserves
-conducting monetary policy |
|
|
Term
| Objectives of Monetary Policy/Central Bank |
|
Definition
-central bank: maintain price stability!
Monetary policy to promote:
-maximum employment
-stable prices
-moderate long term interest rates |
|
|
Term
| Costs of Expected Inflation |
|
Definition
-Menu costs
costs of repeatedly changing the advertised prices of goods and services
-Shoe leather costs
time and effort put in by people to deal with the effects of inflation, such as holding less cash on hand and making frequent trips to the bank when in need of cash
-reflected in all long-term contracts
-when inflation is expected, it becomes a self fulfilling polic |
|
|
Term
| Costs of Unexpected Inflation |
|
Definition
-all costs of expected inflation plus:
Inequitable transfers of wealth between borrowers and lenders
Higher risk premium in borrowing rates: higher uncertain leads to lenders demanding a higher risk premium, which inflates the nominal interest rate and hurts economic activity
-reduction in the information content of market prices
--> business may attribute increase in prices to increase in demand (when really it was just price increase bc of inflation) and increase production but then struggle to sell output and build up inventories. cut back production and ultimately hurt the economy |
|
|
Term
| Monetary Policy Implementation (Tools) |
|
Definition
1) Required Reserve Ratio:
increase in the required reserve ratio results in a decrease in MS
2) Central Bank's policy rate:
-higher the policy rate, the higher the penalty that banks will have to pay the central bank if they run short of liquidity , making banks more conservative in lending
-discount rate
-Federal Funds Rate is interest rate which banks make overnight loans of reserves to each other
3) Open Market Operations:
open market sale directly reduces bank reserves and causes broad money growth to decline |
|
|
Term
|
Definition
| -central bank aims to have a diffract effect on inflation expectations by setting the official policy rate a particular level. by resetting expectations of inflation, it hopes to eventually have a real impact on aggregate demand, which subsequently influences actual domestic inflation |
|
|
Term
| Qualities of Effective Central Banks |
|
Definition
-Independent (not come under political pressures when formulating policy)
--> operational and target independence
-Credibility
-Transparency
-Realistic, forward - looking inflation target
RIT CIT |
|
|
Term
| Monetary Policy and economic growth |
|
Definition
| -if central bank increases official policy rate then banks respond to increase in official interest rate by increasing base rates--> individuals and businesses borrow less--> economic agent's expectations regarding economy are damped as they associated higher interest rates with slower future economic growth and reduced profits-->economic agents change their behavior to reflect these expectations --> decline in consumption, borrowing nd asset prices will reduce aggregate demand |
|
|
Term
| Monetary Policy and inflation |
|
Definition
| -when AD falls bc of an increase in official interest rate, along with lower import prices, put a downward pressure on actual inflation |
|
|
Term
| Monetary Policy and exchange rate |
|
Definition
| -increase in official interest rate will cause domestic currency to appreciate (as hot money flows in) making domestic goods and services more pricey in international market, leading to a decline in exports and higher imports |
|
|
Term
|
Definition
-central bank makes a public commitment to achieving an explicit inflation target and to explaining how its actions will achieve that target
-CPI |
|
|
Term
|
Definition
-target their current's exchange rate rather than level of inflation
-central bank supports by buying and selling the domestic currency in the foreign exchange market
--> 'import' the inflation experience of an economy with a good track record on inflation by tying the domestic currency to the currency of that economy |
|
|
Term
| Contractionary Monetary Policy |
|
Definition
-reduces MS and increases interest rates to rein in an overheating economy
-done if current growth rate of economy looks like it will lead to inflation |
|
|
Term
| Expansionary Monetary Policy |
|
Definition
-increase MS and reduce interest rates to stimulate a receding economy
-done if current level of economic growth is too flow and inflation is weakening |
|
|
Term
|
Definition
-rate of interest that neither slows down, nor spurs growth in the underlying economy
-when policy rate is below the natural rate, monetary policy is expansionary
-two components: real trend of growth in the underlying economy; long run expected inflation |
|
|
Term
| Demand shock vs supply shock |
|
Definition
-important to know SOURCE of shock to system before deciding policy response
-demand shock that causes inflationary pressure --> tighten monetary policy
-supply shock that causes inflationary pressure --> tightening monetary policy would push economy further into recession |
|
|
Term
| Limitations of Monetary Policy |
|
Definition
-central banks cannot control the amount of money that households and businesses choose to save
--> liquidity trap (cut interest rates to near 0% but still cannot reduce saving rate, stimulate consumption nor eliminate deflation)
-central banks cannot control the willingness of banks to extend loans and create credit
-->quantitative easing involves the central bank printing money and pumping large quantities into the economy by purchasing risky assets
-if central bank lacks credibility, lower change of its policy message being successfully transmitted through the conomy |
|
|
Term
| Roles and Objectives of Fiscal Policy |
|
Definition
-main aim: regulate the economy's real GDP by influencing AD
-influence the distribution of wealth and the allocation of resrouces between different sub sectors and economic agent |
|
|
Term
| Automatic stabilizers vs discretionary fiscal actions |
|
Definition
1) Budget surplus/deficit
-increase in budget surplus is contractionary
-increase in budget deficit is expansionary
2) Automatic Stabilizers
-work in the absence of explicit action by the govt. to bring the economy towards full employment
-Induced taxes: revenue from income taxes rise in an expansion and falls in a recession bringing about budget surplus and deficit when necessary
-Needs-tested spending: govt. programs pay benefits to qualified individual and businesses, govt spending brings surplus and deficit when necessary
3) Discretionary fiscal policy
changing tax rates or the level of government spending |
|
|
Term
|
Definition
Govt. spending:
-transfer payments
-current govt. spending
-capital expenditures
Taxes
-Direct Taxes
-Indirect Taxes |
|
|
Term
| Arguments for concern with the size of a fiscal deficit (relative to GDP) |
|
Definition
-high debt levels may lead to high tax rates (to service the debt) going forward. expected future tax rates may serve as a disincentive for labor and entrepreneurial activity
-if markets lose confidence in the government, the central bank may have to print money to finance the deficit. would lead to high inflation
-govt. spending may crowd out private investment. higher demand for borrowing (to finance the deficit) by the govt. would raise interest raise, reducing private sector investment |
|
|
Term
| Reasons against concern w size of fiscal deficit |
|
Definition
-problem is not a major issue if debt is owed to the country's own citizens bc govt. can just print money to retire the debt (risk of high inflation)
-borrowed funds may have been used for capital investment projects, which would raise the economy's productive capacity (and tax revenues) going forward
-private sector may adjust to offset fiscal deficits by increasing savings in anticipation of future tax increases
--> Ricardian equivalence: increase in govt. spending meant t stimulate AD will have no impact on economic activity as economic agents will save more bc they expect govt to finance the deficit by increasing taxes int he future
-if widespread unemployment in the economy, fiscal deficits will not be diverting any resources away from productive uses so total output will increase
-large fiscal deficits require tax changes, which may correct the distortions created by the current tax structure |
|
|
Term
|
Definition
-transfer payments: provide a way for the govt. to change the overall distribution of income in the economy
-current govt spending: spending on g&s that are provided on a recurring, regular basis. impacts quality of human capital and on labor productivity
-capital expenditure: infrastructure spending. contributes to the economy's capital stock and adds to its productive capacity |
|
|
Term
|
Definition
-Direct taxes: levied on income, wealth and corporate profits
-indirect taxes: taxes on spending g&s (taxes on fuel and tobacco)
Desirable Properties of Tax Policy:
-Simplicity--> should be easy to comply w tax laws and should be easy to enforce
-Efficiency --> minimize disincentives to work and invest. aim of attaining efficient outcomes must be balanced against the urge to promote 'good' economic activities or the urge to discourage 'bad' activities (smoking)
-Revenue sufficiency --> can be in conflict w fairness and efficient
-Fairness --> people in similar situations should pay similar taxes and richer people should pay more taxes
***remember: we are SERFs to the govt bc we pay taxes |
|
|
Term
| Advantages and Disadvantages of Fiscal policy tools |
|
Definition
Advantages:
-indirect taxes can be adjusted very quickly; very effective in influencing spending behavior and in generating rev at little cost to the govt
-social objectives can easily be met by raising indirect taxes
Disadvantages
-direct taxes and welfare and other transfers are difficult to change without significant notice. have an impact soon after announcement
-capital spending decisions are slow to plan, implement and execute
-all have strong expectational effects
direct govt. spending has bigger impact on aggregate spending an output than income tax cuts or transfer increases. BUT if transfer increases target the poorest, whose MPC is highest, can have relatively strong impact on spending |
|
|
Term
| Implementation of Fiscal Policy |
|
Definition
-net impact of govt sector on AD is G-T+B= budget deficit (surplus) where B is govt. transfers
-the fiscal multiplier measures that for every dollar of government spending, given tax rate and MPC, how much the increase is in aggregate spending/income
-Balanced Budget multiplier: situation in which a govt. increases spending and taxes at a rate that keeps its budget in balance. it is thought that some of the money collected in increased taxes come from what people otherwise would have saved. bc the govt then spends the money, spending is creased in the aggregate, which drives economic growth |
|
|
Term
| Issues in Fiscal Policy Implementation |
|
Definition
1)Deficits and Fiscal Stance
-size of fiscal deficit cannot determine whether fiscal policy is expansionary or contractionary
-automatic stabilizers lead to changes in the budgetary status that are unrelated to fiscal policy changes
-so economists look at structural budget deficit as an indicator of govt fiscal stance (the deficit that would exist were the economy working at full employment)
-also, govt expenditure includes cash amount of payments on debt which inflates the actual deficit bc real value of outstanding debt falls w inflation
2) Difficulties in executing fiscal policy
-Recognition Lag
-Action Lag
-Impact Lag
AIR |
|
|
Term
| Interaction between Monetary and Fiscal policy |
|
Definition
-Easy fiscal policy/tight monetary policy: decrease in taxes/ increases govt. spending would increase AD. MS was reduced and interest rates increased, private sector demand would fall. end results: higher output, higher interest rates, and govt expenditure would form a larger component of NI
-Tight Fiscal Policy/Easy Monetary policy: private sectors share of overall GDP would rise (bc of lower interest rates) while public sector's share would fall
-Easy Fiscal Policy/easy monetary policy: sharp increase in AD, lowering interest rates and growing private and public sectors
-Tight Fiscal policy/Tight monetary policy: sharp decrease in AD, higher interest rates and a decrease in demand from both private and public sectors |
|
|
