agri 2312 chapter 13 macroeconomic policy fundamentals

Introduction to Agricultural Economics, 5th edPenson, Capps, Rosson, and Woodward

© 2010 Pearson Higher Education,Upper Saddle River, NJ 07458. • All Rights

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MacroeconomicPolicy

Fundamentals

Chapter 13



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Discussion TopicsCharacteristics of moneyFederal Reserve SystemChanging the money supplyMoney market equilibriumEffects of monetary policy on economyThe federal budget deficitThe national debtFiscal policy options



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Functions of Money

Medium of exchange – facilitates payment to others for goods and services

Unit of accounting – assessing profitability of businesses, household budgets and aggregate variables like GDP

Store of value – money is a liquid asset which has value in investment portfolios and cash flow decisions of businesses and households

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Functions of the Fed1. Supply the economy with paper currency2. Supervise member banks3. Provide check collection and clearing services4. Maintain the reserve balances of depository

institutions5. Lend to depository institutions6. Act at the federal government’s banker and

fiscal agent7. Regulate the money supply

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Location of the 12 DistrictFederal Reserve Banks

Location of the 12 DistrictFederal Reserve Banks



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The Fed’s Policy Tools

Reserve requirements – depository institutions are required to maintain a specific fraction of their customers’ deposits as reserves.

Discount rate – rate depository institutions pay when they borrow from the Fed

Open market operations – Fed can buy or sell government securities to alter the money supply

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Role of the Board ofGovernors of theFederal Reserve System

Role of the Board ofGovernors of theFederal Reserve System



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Key role played by theFederal Open MarketCommittee or FOMC

Key role played by theFederal Open MarketCommittee or FOMC



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Recent Fed Rate Actions



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Role of the 12 DistrictFederal Reserve Bankslocated throughoutthe country

Role of the 12 DistrictFederal Reserve Bankslocated throughoutthe country



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Determinantsof the

Money Supply



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Existing money supplycurve. Note it isperpendicular to thequantity axis, implyingit is unaffected by theinterest rate.

Existing money supplycurve. Note it isperpendicular to thequantity axis, implyingit is unaffected by theinterest rate.



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Expansionary monetary policyactions will shift the MScurve to the right over a period of 12 months or so.

Expansionary monetary policyactions will shift the MScurve to the right over a period of 12 months or so.



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Contractionary monetary policy actions, on theother hand, will shift themoney supply curve to left over a similar timeperiod.

Contractionary monetary policy actions, on theother hand, will shift themoney supply curve to left over a similar timeperiod.



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Suppose a depositor in Bank Ag sells $1 million in government securitiesto the Fed. He then deposits the proceeds from the sale in his bank. Ifthe fractional reserve requirement ratio is 20 percent, Bank Ag canincrease the volume of its loans by $800,000. Suppose the proceeds of these loans are deposited in Bank B. Follow the trail to the Total line.

Suppose a depositor in Bank Ag sells $1 million in government securitiesto the Fed. He then deposits the proceeds from the sale in his bank. Ifthe fractional reserve requirement ratio is 20 percent, Bank Ag canincrease the volume of its loans by $800,000. Suppose the proceeds of these loans are deposited in Bank B. Follow the trail to the Total line.



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Change in the Money SupplyWe can skip tracing deposits through the economy byusing the following money supply (MS) equation:

MS = (1.0 ÷ RR) × TR = MM × TR

where TR represents total reserves and RR is thereserve requirement ratio. The expression with thebrackets is known as the money multiplier.

We can restate this equation in terms of the change in the money supply as follows:

MS = (1.0 ÷ RR) × TR = MM × TRPage 252-253



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Change in the Money SupplyUsing the example in Table 13.3 of the $1 million deposit on page 307 and 20% reserve requirements ratio, we see that the change in the money supply is:

MS = (1.0 ÷ .20) x TR = 5.0 x $1 million = $5 million

This results in a change in loans of

loans = MS - TR = $5 million - $1 million = $4 million

See bottom line in Table 13.3

See bottom line in Table 13.3

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Change inmoney supply

Change inmoney supply

Change inloan volume

Change inloan volume

Initialinfusion

Initialinfusion+=



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Impacts of Policy ToolsExpansionary actions: Effects of action:Fed buys securities Total reserves increaseFed lowers the discount rate Total reserves increaseFed lowers required reserve ratio Money multiplier increases

Page 253Bernanke



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Impacts of Policy ToolsExpansionary actions: Effects of action:Fed buys securities Total reserves increaseFed lowers the discount rate Total reserves increaseFed lowers required reserve ratio Money multiplier increases

Contractionary actions: Effects of action:Fed sells securities Total reserves decreaseFed raises the discount rate Total reserves decreaseFed raises required reserve ratio Money multiplier decreases

Page 253Bernanke



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Determinantsof the

Money Demand



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Demand for Money

Transactions demand for money – carry cash to pay for normal expenditures

Precautionary demand for money – carry cash to cover unexpected expenditures

Speculative demand for money – hold cash as an asset in investment portfolios since the value of cash does not decline during periods of falling asset prices.

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5

The money demand curve is given by equation (16.5):MD = c –d(R) + e(NI)where R is the rate of interest and NI is nationalincome. The coefficient d is the slope of the curve and e represents MD÷ NI.

The money demand curve is given by equation (16.5):MD = c –d(R) + e(NI)where R is the rate of interest and NI is nationalincome. The coefficient d is the slope of the curve and e represents MD÷ NI.



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Page 255MD = c –d(R) + e(NI)MD = c –d(R) + e(NI)

Increase in incomeincreases demand

for money

Increase in incomeincreases demand

for money



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Money market interestrate given by intersectionof demand and supply

Money market interestrate given by intersectionof demand and supply



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MS*

0.06

Expansionarymonetary policylowers interestrates

Expansionarymonetary policylowers interestrates



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MS*

0.14 Contractionarymonetary policyraises interestrates

Contractionarymonetary policyraises interestrates



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The full effects of this changecould take 12 months or moreto register in bank deposits

The full effects of this changecould take 12 months or moreto register in bank deposits



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A change in the moneysupply will alter theequilibrium interest ratein the money market

A change in the moneysupply will alter theequilibrium interest ratein the money market



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We know from Chapter 12that a change in interest rates will lead to movementalong the planned investmentfunction….increasing ordecreasing new investment

We know from Chapter 12that a change in interest rates will lead to movementalong the planned investmentfunction….increasing ordecreasing new investment



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We also know from Chapter12 that increased investmentexpenditures, a componentof GDP, increases the demandfor labor, lowers unemploymentand thus fuels further growthin national income…

We also know from Chapter12 that increased investmentexpenditures, a componentof GDP, increases the demandfor labor, lowers unemploymentand thus fuels further growthin national income…



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EliminatingRecessionary andInflationary Gaps



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What is the magnitude of therecessionary gap?

What is the magnitude of therecessionary gap?



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What is the magnitude of therecessionary gap?It is YFE – Y1

What is the magnitude of therecessionary gap?It is YFE – Y1



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The use of expansionarymonetary policy actionsto push aggregate demandfrom AD1 to AD3 increasesreal GDP from Y1 to Y3

while only increasing thegeneral price level to P3.

The use of expansionarymonetary policy actionsto push aggregate demandfrom AD1 to AD3 increasesreal GDP from Y1 to Y3




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Inflation rate(P3 – P0) ÷P0


Recessionary gapof YFE – Y1 ispartially closed toYFE – Y3

Recessionary gapof YFE – Y1 ispartially closed toYFE – Y3



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The further use of expansionary monetary policy to push aggregatedemand from AD3 to AD4 increases real GDP from Y3 to YFE (full employmentGDP), but increases the general price level to P4.

The further use of expansionary monetary policy to push aggregatedemand from AD3 to AD4 increases real GDP from Y3 to YFE (full employmentGDP), but increases the general price level to P4.



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Inflation rate(P4 – P3) ÷P3 Recessionary gap

fully closed

Recessionary gapfully closed



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The use of expansionarymonetary policy to attainYPOT by shifting aggregatedemand to AD5 will increasethe general price level to P5.

The use of expansionarymonetary policy to attainYPOT by shifting aggregatedemand to AD5 will increasethe general price level to P5.


Inflation rate(P5 – P4) ÷P4 Inflationary gap

created…..

Inflationary gapcreated…..



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MicroeconomicInterest RateImplications



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Interest Rate Impacts on a 10-Year $150K Business Loan

Interest

rate

Annual

total PI payment

Annual interest

payment

Total interest

payment

8 percent $22,354.69 $7,354.69 $73,546.90

14 percent 28,757.67 13,757.67 137,576.88

20 percent 35,782.44 20,782.44 207,824.40

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Interest Rate Impacts on a 20- Year $100K Home Mortgage

Interest

rate

Monthly

total PI

payment

Monthly

interest

payment

Total

interest

payment8 percent $848.78 $432.08 $103,707.46

12 percent 1,115.73 699.06 167,773.46

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What is Fiscal Policy?

Taxation by federal, state and local governments

Government spending by federal state and local governments

Budget deficit and the national debt

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States Without Income Tax

Eight states do not have a state income tax

Eight states do not have a state income tax



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State and Local Taxes

Alaska, thanks to oil reserves, has the lowest tax burden

Maine registered the highest the highest state tax burden

Major sources are sales taxes and property taxes



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Our focus is on fiscal policy at the federal level….



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Rising spending andtax cuts to spur theeconomy brought backbudget deficits

Rising spending andtax cuts to spur theeconomy brought backbudget deficits



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Page 262Individuals and not businesses pay the Bulk of federal taxes.

Individuals and not businesses pay the Bulk of federal taxes.



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Page 263

A strong economy andcontrolled spending ledto the first budget surplusin more than 20 years…

A strong economy andcontrolled spending ledto the first budget surplusin more than 20 years…

The effects of the sub-prime lending defaults and subsequent financial crisis and deficit spending have led to record high deficits…

The effects of the sub-prime lending defaults and subsequent financial crisis and deficit spending have led to record high deficits…



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Recent Trends in Deficit

• Typically the economy runs a budget deficit at the federal level

• 1998-2001 were the exceptions in recent years

• Fueled by 2008-09 financial crisis and huge deficit spending in bailouts, etc.



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Debt and the Deficit

National debtT = National debtT-1 + DeficitT



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The growth in federal debt has grown rapidly over the last 25 years…

The growth in federal debt has grown rapidly over the last 25 years…



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While the national debt grew as deficit spending dominated theLast 30 years, debt as a percentof GDP stayed within post-WW IIexperience…

While the national debt grew as deficit spending dominated theLast 30 years, debt as a percentof GDP stayed within post-WW IIexperience…



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Federal government spending on Agriculture programs is the fourth highest on this list of total federal spending.

Federal government spending on Agriculture programs is the fourth highest on this list of total federal spending.



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Fiscal Policy Options

Automatic fiscal policy instruments: take effect without explicit action by policymakers (e.g., progressive tax rates)

Discretionary fiscal policy instruments: require explicit actions by the president or Congress (e.g., passing a law)

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Impacts of Policy ToolsExpansionary actions: Effects of action:Cut taxes Increase disposable incomeIncrease government spending Increase aggregate demand

Congress & Obama Page 269



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Impacts of Policy ToolsExpansionary actions: Effects of action:Cut taxes Increase disposable incomeIncrease government spending Increase aggregate demand

Contractionary actions: Effects of action:Increase taxes Decrease disposable incomeCut government spending Decrease aggregate demand

Congress & Obama Page 269



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A federal budget deficit requiresthe U.S. Treasury to issue moregovernment securities to balancesources and uses of funds…

A federal budget deficit requiresthe U.S. Treasury to issue moregovernment securities to balancesources and uses of funds…



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An increase in the sale ofgovernment securitiesreduces the pool of privatecapital available to financeinvestment expenditures,raising interest rates…

An increase in the sale ofgovernment securitiesreduces the pool of privatecapital available to financeinvestment expenditures,raising interest rates…



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We know from Chapter 12 that higher interest rates depresses investmentexpenditures…

We know from Chapter 12 that higher interest rates depresses investmentexpenditures…



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The use of expansionaryfiscal policy actionsto push aggregate demandfrom AD1 to AD3 increasesreal GDP from Y1 to Y3


The use of expansionaryfiscal policy actionsto push aggregate demandfrom AD1 to AD3 increasesreal GDP from Y1 to Y3




partially closed

Recessionary gappartially closed



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The use of expansionaryfiscal policy to push demandfrom AD3 to AD4 increasesreal GDP from Y3 to YFE

(full employment GDP), But increases the general price level to P4.

The use of expansionaryfiscal policy to push demandfrom AD3 to AD4 increasesreal GDP from Y3 to YFE

(full employment GDP), But increases the general price level to P4.



closed….

Recessionary gapclosed….



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The use of expansionaryfiscal policy to attainYPOT by shifting aggregatedemand to AD5 will Increase the general price level to P5.

The use of expansionaryfiscal policy to attainYPOT by shifting aggregatedemand to AD5 will Increase the general price level to P5.


Inflation rate(P5 – P4) ÷P4 Inflationary gap

created….

Inflationary gapcreated….



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Monetary Policy SummaryFunctions of money and the role of the

Federal Reserve System in the economyThe money multiplier and the growth of the

money supplyTools of monetary policyDemand for money and money market

equilibriumPolicy linkages and timing of full effectsElimination of recessionary and inflationary

gaps.



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Fiscal Policy Summary

Difference between discretionary and automatic fiscal policy tools

Expansionary and contractionary fiscal policy actions

Application to eliminating recessionary and inflationary gaps

Budget deficits, national debt and concept of “crowding out”



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Chapter 14 focuses on the key consequences of business fluctuations….

agri 2312 chapter 13 macroeconomic policy fundamentals

Economy & Finance

money supply page

tr page

money supply change

money supplyis

following money supply

households page

money transactions demand

money demand curveis