Monetary Policy
Banks
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These are policies concerned with banking systems.
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The central bank is the organization responsible for
- Conducting monetary policy
- Promoting the stability of the financial system
- Providing banking services to commercial banks and other depository institutions and to the federal government
- Ensuring that there is enough currency circulating through the financial system to meet public demand.
- Assuring that banks are in compliance with consumer protection laws.
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Bank regulation is intended to maintain banks’ solvency by avoiding excessive risk. Regulation can come as:
- Requirements of minimum reserve
- Restrictions on the types of investments they are allowed to make
- Requirements to maintain minimum bank capital.
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The government can also conduct inspections if the banks are following regulations. Banks that have low net worth or are engaging in risky behavior can be required to change behavior or be forced to close.
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There are issues with measuring the net worth of a bank as it is contingent on whether or not borrowers can repay their loans. There are also political issues to consider.
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Bank Runs - situations wherein people race to withdraw their deposits after realizing that the bank is failing.
- The race arises because the sooner one can withdraw their money, the more likely the bank is to be able to repay them.
- Bank runs can cascade and escalate since more withdrawal = lower bank net worth = more fear = more withdrawal. This can spread to other solvent banks as well.
- There are two strategies against bank runs
- Deposit insurance - an insurance system to make sure depositors do not lose their money even if the bank goes bankrupt.
- Lender of Last Resort - the central bank lends to banks and other financial institutions when they cannot obtain funds from anywhere else. This also reassures customers that they will not lose their money.
Aggregate Demand
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Monetary Policy influences aggregate demand with the goal of influencing macroeconomic outcomes by proxy.
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Central Banks can implement monetary policy in three different ways
- Open market operations - the central bank buys or sells treasury bonds to influence the quantity of bank reserves and the interest rates.
- Change discount rate - If the central bank raises the discount rate, then commercial banks will reduce their borrowing of reserve and instead loan to replace their reserve. Fewer loans available means market interest rate rises.
- Compared to open market operations, changing the discount rate is less effective
- Change reserve requirements - the central bank raises or lowers reserve requirements. If the central bank raises the discount rate, then commercial banks will reduce their borrowing of reserves
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Expansionary Monetary Policy is one which lowers interest rates and stimulates borrowing
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Contractionary Monetary Policy is one which raises interest rates and reduces borrowing.
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Both expansionary and contractionary monetary policy will shift the aggregate demand.
- Contractionary policy reduces investments which lowers the quantity of aggregate demand.
- Expansionary policy increases aggregate demand and can help in the case of a recession or high unemployment.
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Monetary policy can push the entire spectrum of interest rates higher or lower, but the forces of supply and demand in those specific markets for lending and borrowing set the specific interest rates.
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Monetary policy should be countercyclical — it should act to counterbalance business cycles.
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Quantitative Easing - involves the purchase of long term government and private mortgage-backed securities by the central bank to make credit available to stimulate aggregate demand.
Pitfalls
- Monetary policy is subject to time lags Thus, it has no effect on the immediate future
- When many banks are choosing to hold excess reserves, expansionary monetary policy may not work well. This comes as an incongruence between banks’ concerns of a recession and the central bank’s desire to stimulate demand
- Unpredictable Movements in Velocity mean that trying to change the money supply becomes difficult as the effect of doing so to the nominal GDP becomes less predictable.
- Monetary policy tends to be neoclassical — it is more concerned with inflation than unemployment. This leads to inflation targeting where the central bank is legally required to focus on keeping inflation low
- Monetary policy might overlook asset bubbles and leverage cycles.
- Leverage cycles arise when good economic times mean more borrowing which exaggerates economic growth to unsustainable levels to the point banks are no longer willing to lend and loans become too expensive to pay off which leads to economic downturn.
Exchange Rate Policy
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Floating Exchange Rates - Exchange Rate is completely determined by market forces (i.e., the foreign exchange market)
- Disadvantage: Sharp fluctuations in the exchange rate can drastically affect both countries’ economies.
- Advantage: Exchange rates may fluctuate but if government policy focuses on preventing high inflation or deep recession, then exchange rate will not vary sharply
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Soft Exchange Rate Pegs - The market usually determines the exchange rate, but the central bank sometimes intervenes
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Hard Exchange Rate Pegs - Central bank intervenes in maker to keep currency fixed at a certain level
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Merging Currencies - Currency is made identical to the currency of another nation.
- Advantage: Eliminates concerns about exchange rate fluctuations
- Disadvantage: The interest rate policy of the country is in another country’s hands.
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The central bank can deliberately induce depreciation using either
- An expansionary monetary policy that leads to lower interest rates
- Trade directly in the foreign exchange market and expanding the supply of domestic currency, purchasing foreign currency, and avoiding the selling of domestic currency
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The central bank can deliberately induce appreciation using either
- A contractionary monetary policy that raises interest rates
- Trade directly in the foreign exchange market and use its reserves of foreign currency to demand its own currency.
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The following tradeoffs apply to hard and soft pegs
- Using a monetary policy to alter exchange rate means it cannot use monetary policy to address inflation or recession. This is especially apparent in hard pegs.
- If it uses the foreign exchange market, then it must manage its reserves of foreign currency.
- It might end up with a large reserve of foreign currency which creates large aggregate demand (i.e., inflation)
- It may run out of foreign currency in its reserves which means it can no longer sell foreign currency to strengthen its currency
- A pegged exchange rate can create additional movements of the exchange rate.
- This is more apparent in soft pegs. In fact soft pegs risk ore drastic effects than hard pegs.
- In hard pegs, the effect can be drastic long term when the government does not anticipate the effects of a volatile exchange rate.
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Tobin Taxes - taxes on international capital flows that aim to stabilize the exchange rate
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In general, we observe the following. The order of strictness when it comes to exchange rate policy goes Floating Exchange Rate -> Soft Peg -> Hard Peg -> Merged Currency
- Less strict = More considerable effects of short term fluctuations in exchange rate.
- Less strict = Long term fluctuations happen more often
- More strict = Less power for the central bank to conduct a countercyclical monetary policy.
- More strict = Less ability of the exchange rate to adjust to respond to trade imbalances
Fiscal Policy
- The government runs a budget deficit when it spends more money than it receives in taxes. When it spends less than it receives, it runs a budget surplus. If spending and taxes are equal, then there is a balanced budget.
Taxes and National Debt
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The Marginal Tax Rate is the amount of additional tax paid for every unit income.
- A Progressive Tax has a tax rate that increases as income increases.
- A Proportional Tax has a tax rate that is a flat percentage of income. It does not change due to changes in income
- A Regressive Tax has a tax rate that decreases as income increases.
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Direct Taxes are those that are imposed on a person or property. Indirect Taxes are levied upon goods and services before they reach the customer (who pays the indirect tax as part of market price). Alternatively, the entity who pays the tax does not suffer a corresponding reduction in income
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Per Unit Taxes are based on a fixed amount for each unit of a good or service sold regardless of price. Ad Valorem Taxes are based on the value of the transaction
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Capital Gains Tax - tax on profits realized through the sale of non-inventory assets such as investments in the Financial Market.
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Stamp Tax - tax on single property purchases or documents.
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Value Added Tax - levied on the price of a product at each stage of production, distribution, or sale to the end customer.
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Sales Tax - tax on the sale of a particular good
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Excise Tax - tax on the production or consumption of a good
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Estate Tax - tax on the estate of a deceased person that is to be given to someone for inheritance
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Gift Tax - tax on money or property that one living entity gives to another.
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Green Tax - tax imposed on something that is considered harmful to the environment.
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Severance Tax - tax imposed on the removal of natural resources.
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Carbon Tax - tax levied on carbon emission for the production of goods and services.
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Sin Tax - an excise tax specifically levied on certain goods deemed harmful to society and individuals.
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Income Tax - tax imposed on entities with respect to the income or profits earned by them.
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Land Value Tax - tax imposed on the value of land without regard to personal property, buildings, or improvements on it.
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Luxury Tax - tax on luxury goods not deemed essential. Mainly aimed at the wealthy.
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Payroll Tax - tax imposed on employers or employees based on the salary employers paid to their employees.
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Pigouvian Tax - tax imposed on anything that causes negative externalities to counteract the negative social costs.
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Surtax - a tax levied upon another tax
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Property Tax - ad valorem tax imposed on a single property.
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User charge tax - a charge for the use of a product of service (for example, roads or toll gates)
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Corporate Tax - tax levied on the income or capital of corporations
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Wealth Tax - tax based on an entity’s holdings of assets or net worth.
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The national debt refers to the total amount that the government has borrowed over time.
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Deficit is not debt. Deficit is what happens to the budget each year. The debt is what is accrued over time due to past deficits and surpluses.
Meeting Macroeconomic Goals
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Expansionary Fiscal Policy shifts the aggregate demand outward with the goal of combatting recession. It accomplishes this through any of the following
- Increase consumption by raising disposable income through tax cuts
- Increasing investment spending by raising cuts in business taxes
- Increasing government purchases and raising federal grants.
- Increase the quantity of loans and reduce interest rates
- Increase the money supply.
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Contractionary Fiscal Policy shifts the aggregate demand inward. with the goal of combatting inflation It accomplishes this through any of the following
- Decreasing consumption by reducing disposable income through tax increases
- Decreasing investment spending by raising business tax rates
- Decreasing government purchases and Lowering federal grants.
- Decreasing the quantity of loans and Raising interest rates
- Decrease the money supply.
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Fiscal policy can address the effects of aggregate demand and aggregate supply shifting differently.
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The exact implementation of fiscal policy is often a political decision rather than an economic one.
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Consider the short term tradeoff between unemployment and inflation from a Keynesian Perspective.
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Discretionary Fiscal Policy - the government passes a new law that explicitly changes tax or spending levels.
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Automatic Stabilizers - programs that are already laws that stimulate aggregate demand in a recession and reduce aggregate demand during inflation.
- The impact of automatic stabilizers becomes apparent when examining the differences between the standardized budget deficit or surplus and the actual budget deficit or surplus
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Consider the following challenges when it comes to discretionary policies
- Fiscal policy can affect interest rates. This results in crowding out where the (expansionary) fiscal policy results in higher interest rates which reduces consumption and counteracts the intended effect of increasing aggregate demand.
- Temporal lags make adapting to the economic climate difficult.
- Recognition lag - the time it takes to determine that a recession has occurred
- Legislative lag - the time it takes to pass a bill
- Implementation lag - the time it takes to implement government programs.
- Reactions to temporary and permanent fiscal policies. Temporary policies allow for more finer adjustments but they are weaker. Permanent policies tend to have a lasting impact but people react strongly against this.
- Structural economic change takes time.
- Fiscal policy cannot raise output above the potential GDP without causing inflation.
- Politics remains an issue.
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In the short term, it is expected that budget deficits and surpluses fluctuate up and down due to automatic stabilizers.
- Economic recessions lead to larger budget deficits or smaller budget surpluses
- Economic booms lead to smaller budget deficits or larger budget surpluses.
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Balancing budgets in the long term is not a viable strategy.
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Government budgeting is not the same as household budgeting. The former relies on countercyclical policies to balance the economy. The latter aims to allocate money for various expenses.
Government Borrowing
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When governments are borrowers in the financial market, funds can come from (1) households saving more; (2) private firms borrowing less; (3) foreign financial investors and imports.
- In this case, governments are demanders of financial capital.
- Budget deficits mean that private investment falls or private savings rises, or trade deficit rises (or trade surplus falls)
- Budget surpluses mean that private investment rises or private savings falls, or trade surplus rises (or trade deficit falls) .
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The combination of less foreign investment capital and banks that are bankrupt can sharply reduce aggregate demand, which causes a deep recession.
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Extremely large budget deficits mean that aggregate demand may shift too far to the point of causing inflation.
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Governments should beware of a sustained pattern of high budget deficits and high trade deficits (i.e., twin deficits)
- When inflows of foreign financial investment reach high levels, foreign financial investors will be on the alert for any reason to fear that the country’s exchange rate may decline or the government may be unable to repay what it has borrowed on time
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Ricardian Equivalence - rational private households shift their saving to offset governments spending or borrowing. Save during budget deficits; Spend during budget surpluses.
- Corollary: Any change in government spending will be offset by a change in private saving.
- In practice, this does not hold for all households and firms, and the effects are not one-to-one with government spending.
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Government spending can encourage infrastructure towards long-term growth. However note that this is subject to both economic and political incentives and it may not always be effective.