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1
Q

LOS 18. a: Compare monetary and fiscal policy.

A

Fiscal policy is a government’s use of taxation and spending to influence the economy. Monetary policy deals with determining the quantity of money supplied by the central bank. Both policies aim to achieve economic growth with price level stability, although governments use fiscal policy for social and political reasons as well.

2
Q

LOS 18. a: Compare monetary and fiscal policy. Budget surplus

A

A budget surplus is a period when income or receipts exceed outlays or expenditures. A budget surplus often refers to the financial states of governments; individuals prefer to use the term ‘savings’ instead of the term ‘budget surplus.’ A surplus is an indication that the government is being effectively managed.

A budget surplus might be spent to make a purchase, pay off debt or save for the future. A city government that has a surplus may use the money to render improvements to a local decaying park, for example.

When expenditures exceed income, the outcome is a budget deficit, which is funded by borrowing funds and paying interest on the borrowed money, similar to an individual spending more than he earns and carrying a balance on a credit card. A balanced budget exists once expenditures equal income.

As of 2016, the U.S. government has undergone nine budget surpluses. The Clinton administration eliminated a large budget deficit, resulting in a surplus. A surplus is a positive value and is the sum by which government revenues are greater than government spending during a set period, usually a fiscal year. For example, June 2016 was the most recent U.S. government budget surplus. The receipts for the year totaled $330 billion, while expenditures for the year were $323 billion. This resulted in a budget surplus of approximately $6 billion.

3
Q

LOS 18. a: Compare monetary and fiscal policy. Budget deficit

A

A budget deficit is an indicator of financial health in which expenditures exceed revenue. The term budget deficit is most commonly used to refer to government spending rather than business or individual spending, but can be applied to all of these entities. When referring to accrued federal government deficits, the deficits are referred to as the national debt.

4
Q

LOS 18. a: Compare monetary and fiscal policy. Monetary policy

A

Monetary policy consists of the actions of a central bank, currency board or other regulatory committee that determine the size and rate of growth of the money supply, which in turn affects interest rates. Monetary policy is maintained through actions such as modifying the interest rate, buying or selling government bonds, and changing the amount of money banks are required to keep in the vault (bank reserves).

The Federal Reserve is in charge of monetary policy in the United States.

5
Q

LOS 18. a: Compare monetary and fiscal policy. Expansionary (or accommodative or easy)

A

When a central bank (such as the Federal Reserve) attempts to expand the overall money supply to boost the economy when growth is slowing (as measured by GDP). This is done to encourage more spending from consumers and businesses by making money less expensive to borrow by lowering the interest rate. Furthermore, the Federal Reserve also has the authority to purchase Treasuries on the open market to infuse capital into a weakening economy.

Also known as an “easy monetary policy”.

6
Q

LOS 18. a: Compare monetary and fiscal policy. Contractionary (or restrictive or tight)

A

Central banks around the world use monetary policy to regulate specific factors within the economy. Central banks most often use the federal funds rate as a leading tool for regulating market factors. Tightening policy occurs when central banks raise the federal funds rate, and easing occurs when central banks lower the federal funds rate.

The federal funds rate is used as a base rate throughout global economies. It refers to the rate at which federal banks lend to each other and is also known as the discount rate. An increase in the federal funds rate is followed by increases to borrowing rates throughout the economy. Rate increases make borrowing less attractive as interest payments increase with increasing rates. It affects all types of borrowing including personal loans, mortgages and interest rates on credit cards. An increase in rates also makes saving more attractive as savings rates also increase in an environment with tightening policy.

7
Q

LOS 18. b: Describe functions and definitions of money.

A

Money is defined as a widely accepted medium of exchange. Functions of money include a medium of exchange, a store of value, and a unit of account.

8
Q

LOS 18. b: Describe functions and definitions of money. Money

A

What is ‘Money’

Money is an officially-issued legal tender generally consisting of notes and coin, and is the circulating medium of exchange as defined by a government. Money is often synonymous with cash and includes various negotiable instruments such as checks. Each country has its own money that is used as a medium of exchange within that country.

BREAKING DOWN ‘Money’

Also referred to as currency, money is a liquid asset used in the settlement of debts that functions based on the general acceptance of its associated value within an economy. The value of money is not necessarily derived from the materials used to produce the note or coin and, instead, derives based on the amount shown on its face partnered with the public’s willingness to support the value as displayed.

9
Q

LOS 18. b: Describe functions and definitions of money. Narrow money

A

What is ‘Narrow Money’

Narrow money is a category of money supply that includes all physical money like coins and currency along with demand deposits and other liquid assets held by the central bank. In the United States, narrow money is classified as M1 (M0 + demand accounts), while in the U.K., M0 is referenced as narrow money.

BREAKING DOWN ‘Narrow Money’

The name comes from the fact that M1/M0 are the narrowest or most restrictive ideas of money that are the basis for the medium of exchange within the economy. This category of money is considered to be the most readily available for transactions and commerce.

The narrow money supply only contains the most liquid financial assets. These funds must be accessible on demand, which generally limits the category to physical notes and coins and funds held in the most accessible deposit accounts.

10
Q

LOS 18. b: Describe functions and definitions of money. Broad money

A

What is ‘Broad Money’

Broad money is the most inclusive method of calculating a given country’s money supply. The money supply is the totality of assets that households and businesses can use to make payments or to hold as short-term investments, such as currency, funds in bank accounts and anything of value resembling money. The formula for calculating money supply varies from country to country, but broad money is always the farthest-reaching; narrow money includes fewer elements in the calculation.

BREAKING DOWN ‘Broad Money’

Since cash can be exchanged for many different financial instruments, and it can be placed in various restricted accounts, it is not a simple task for economists to define how much money is currently in a given economy. Therefore, the money supply is measured in many different ways. Economists use a capital letter “M” followed by a number to refer to the calculation that they are using in a given context.

11
Q

LOS 18. c: Explain the money creation process.

A

In a fractional reserve system, new money created is a multiple of new excess reserves available for lending by banks. The potential multiplier is equal to the reciprocal of the reserve requirement and, therefore, is inversely related to the reserve requirement.

The total amount of money that can be created is calculated as:

Money created = (new deposit/reserve requirement)

The money multiplier = 1/reserve requirement

12
Q

LOS 18. c: Explain the money creation process. Promissory notes

A

What is a ‘Promissory Note’

A promissory note is a financial instrument that contains a written promise by one party (the note’s issuer or maker) to pay another party (the note’s payee) a definite sum of money, either on demand or at a specified future date. A promissory note typically contains all the terms pertaining to the indebtedness, such as the principal amount, interest rate, maturity date, date and place of issuance, and issuer’s signature.

Although financial institutions may issue them (see below), promissory notes are debt instruments that allow companies and individuals to get financing from a source other than a bank. This source can be an individual or a company willing to carry the note (and provide the financing) under the agreed-upon terms. In effect, anyone becomes a lender when he issues a promissory note.

BREAKING DOWN ‘Promissory Note’

The 1930 international convention that governs promissory notes and bills of exchange also stipulates that the term “promissory note” should be inserted in the body of the instrument and should contain an unconditional promise to pay.

In terms of their legal enforceability, promissory notes lie somewhere between the informality of an IOU and the rigidity of a loan contract. A promissory note includes a specific promise to pay, and the steps required to do so (like the repayment schedule), while an an IOU merely acknowledges that a debt exists, and the amount one party owes another. A loan contract, on the other hand, usually states the lender’s right to recourse – such as foreclosure – in the event of default by the borrower; such provisions are generally absent in a promissory note. While it might make note of the consequences of non-payment or untimely payments (such as late fees), it does not usually explain methods of recourse if the issuer does not pay on time.

Promissory notes that are unconditional and saleable become negotiable instruments that are extensively used in business transactions in numerous countries.

A promissory note is usually held by the party owed money. Once the debt has been fully discharged, it must be canceled by tthe payee, and returned to the issuer.

13
Q

LOS 18. c: Explain the money creation process. Fractional reserve banking

A

What is ‘Fractional Reserve Banking’

Fractional reserve banking is a banking system in which only a fraction of bank deposits are backed by actual cash on hand and are available for withdrawal. This is done to expand the economy by freeing up capital that can be loaned out to other parties. Many U.S. banks were forced to shut down during the Great Depression because too many people attempted to withdraw assets at the same time.

BREAKING DOWN ‘Fractional Reserve Banking’

Banks are required to keep a certain amount of the cash depositors give them on hand available for withdrawal. That is, if someone deposits $100, the bank can’t lend out the entire amount. That said, it isn’t required to keep the entire amount either. Most banks are required to keep 10% of the deposit, referred to as reserves. This reserve requirement is set by the Federal Reserve and is one of the Fed’s tools to implement monetary policy. Increasing the reserve requirement takes money out of the economy, while a decrease in the reserve requirement puts money into the economy.

14
Q

LOS 18. c: Explain the money creation process. Excess reserves

A

What are ‘Excess Reserves’

Excess reserves are capital reserves held by a bank or financial institution in excess of what is required by regulators, creditors or internal controls. For commercial banks, excess reserves are measured against standard reserve requirement amounts set by central banking authorities. These required reserve ratios set the minimum liquid deposits (such as cash) that must be in reserve at a bank; more is considered excess.

BREAKING DOWN ‘Excess Reserves’

Financial firms that carry excess reserves have an extra measure of safety in the event of sudden loan loss or significant cash withdrawals by customers. This buffer increases the safety of the banking system, especially in times of economic uncertainty. Boosting the level of excess reserves can also improve an entity’s credit rating, as measured by rating agencies such as Standard & Poor’s.

The Federal Reserve has many tools in its monetary normalization toolkit. In addition to setting the fed funds rate, it now has the ability to change the rate of interest that banks are paid on required (interest on reserves — IOR) and excess reserves (interest on excess reserves — IOER).

15
Q

LOS 18. c: Explain the money creation process. Money multiplier

A

What is the ‘Multiplier Effect’

The multiplier effect is the expansion of a country’s money supply that results from banks being able to lend. The size of the multiplier effect depends on the percentage of deposits that banks are required to hold as reserves. In other words, it is the money used to create more money and is calculated by dividing total bank deposits by the reserve requirement.

BREAKING DOWN ‘Multiplier Effect’

To calculate the effect of the multiplier effect on the money supply, start with the amount banks initially take in through deposits, and divide this by the reserve ratio. If, for example, the reserve requirement is 20%, for every $100 a customer deposits into a bank, $20 must be kept in reserve. However, the remaining $80 can be loaned out to other bank customers. This $80 is then deposited by these customers into another bank, which in turn must also keep 20%, or $16, in reserve but can lend out the remaining $64.

This cycle continues as more people deposit money and more banks continue lending it until finally the $100 initially deposited creates a total of $500 ($100/0.2) in deposits. This creation of deposits is the multiplier effect.

16
Q

LOS 18. c: Explain the money creation process. Quantity theory of money

A

What is the ‘Quantity Theory Of Money’

The quantity theory of money is a theory about the demand for money in an economy. The most common version, sometimes called the “neo-quantity theory” or Fisherian theory, suggests there a mechanical and fixed proportional relationship between changes in the money supply and the general price level. This popular, albeit controversial, formulation of the quantity theory of money is based upon an equation by American economist Irving Fisher.

BREAKING DOWN ‘Quantity Theory Of Money’

The Fisher equation is calculated as:

M x V = P x T

Where: M represents the money supply.

V represents the velocity of money.

P represents the average price level.

T represents the volume of transactions in the economy.

Generally speaking, the quantity theory of money assumes that increases in the quantity of money tend to create inflation, and vice versa. For example, if the Federal Reserve or European Central Bank doubled the supply of money in the economy, the long-run prices in the economy would tend to increase dramatically.

Economists disagree about how quickly and how proportionately prices adjust after a change in the quantity of money. The classical treatment in most economic textbooks is based on the Fisher Equation, but competing theories exist.

17
Q

LOS 18. c: Explain the money creation process. Quantity equation of exchange

A

What is the ‘Equation Of Exchange’

The equation of exchange is an economic equation that showcases the relationship between money supply, velocity of money, the price level and an index of expenditures. The equation was derived by John Stuart Mill, and based of the early ideas of David Hume. The equation of exchange is as follows:

M x V = P x T
Where:
M = money supply
V = velocity of money
P = average price level of goods
T = index of expenditures (such as the total number of economic transactions)

BREAKING DOWN ‘Equation Of Exchange’

The equation of exchange has two primary uses. It represents a founding principle used by the quantity theory of money, which relates increases in the money supply to increases in the overall level of prices. Additionally, solving the equation for ‘M’ can serve as an indicator of the demand for money.

18
Q

LOS 18. c: Explain the money creation process. Money neutrality

A

What is ‘Neutrality Of Money’

The neutrality of money, also called neutral money, says changes in the money supply only affect nominal variables and not real variables. In other words, an increase or decrease in the money supply can change the price level but not the output or structure of the economy. In modern versions of money neutrality theory, changes in the money supply might affect output or unemployment levels in the short run only, but neutrality is still assumed in the long run after money circulates throughout the economy.

BREAKING DOWN ‘Neutrality Of Money’

According to the neutrality of money theory, all markets for all goods clear continuously. Relative prices adjust flexibly and always towards equilibrium. Changes in the supply of money do not appear to change the underlying conditions in the economy. New money does not create or destroy machines, introduce new trading partners or affect existing knowledge and skill. Aggregate supply should remain constant.

19
Q

LOS 18. d: Describe theories of the demand for the supply of money.

A

Three factors influence money demand:

  • Transaction demand, for buying goods and services
  • Precautionary demand, to meet unforseen future needs
  • Speculative demand, to take advantage of investment opportunities

Money supply is determined by central banks with one goal of managing inflation and other economic objectives.

20
Q

LOS 18. e: Describe the Fisher effect.

A

The fisher effect states that a nominal interest rate is equal to the real interest rate plus the expected inflation rate.

Breaking Down Fisher effect

The Fisher effect equation reflects that the real interest rate can be taken by subtracting the expected inflation rate from the nominal interest rate. In this equation, all the provided rates are compounded.

The Fisher effect can be seen each time you go to the bank; the interest rate an investor has on a savings account is really the nominal interest rate. For example, if the nominal interest rate on a savings account is 4% and the expected rate of inflation is 3%, then the money in the savings account is really growing at 1%. The smaller the real interest rate the longer it will take for savings deposits to grow substantially when observed from a purchasing power perspective.

21
Q

LOS 18. f: Describe roles and objectives of central banks.

A

Central bank roles include supplying currency, acting as banker to the government and to other banks, regulating and supervising the payments system, acting as a lender of last resort, holding the nation’s gold and foreign currency reserves, and conducting monetary policy.

Central banks have the objective of controlling inflation, and some have additional goals of maintaining currency stability full employment, positive sustainable economic growth, or moderate interest rates.

22
Q

LOS 18. f: Describe roles and objectives of central banks. Legal tender

A

What is ‘Legal Tender’

Legal tender is any official medium of payment recognized by law that can be used to extinguish a public or private debt, or meet a financial obligation. The national currency is legal tender in practically every country. A creditor is obligated to accept legal tender toward repayment of a debt. Legal tender can only be issued by the national body that is authorized to do so, such as the U.S. Treasury in the United States and the Royal Canadian Mint in Canada.

BREAKING DOWN ‘Legal Tender’

Widely accepted currencies such as the U.S. dollar and euro are accepted as legal tender in many nations, especially those where foreign currencies are in short supply. Countries with extensive business and cultural ties may also accept each other’s currencies as legal tender in limited amounts. For example, some U.S. and Canadian merchants located close to the U.S.-Canada border accept both Canadian dollars and U.S. dollars as payment for goods and services.

The popularity of cross-border and online shopping is increasing demand for more forms of legal tender; however, given official objection to such alternatives, these may still be some years away. In May 2013, the governor of Arizona vetoed a bill that would have made gold and silver coins legal tender in the state, in addition to existing U.S. currency. Bitcoin, another popular payment alternative, is a virtual online currency that can be used for a growing number of transactions but is not considered legal tender.

23
Q

LOS 18. f: Describe roles and objectives of central banks. Fiat money

A

What is ‘Fiat Money’

Fiat money is currency that a government has declared to be legal tender, but it is not backed by a physical commodity. The value of fiat money is derived from the relationship between supply and demand rather than the value of the material that the money is made of. Historically, most currencies were based on physical commodities such as gold or silver, but fiat money is based solely on the faith and credit of the economy.

BREAKING DOWN ‘Fiat Money’

Fiat is the Latin word for “it shall be.”

Because fiat money is not linked to physical reserves, it risks becoming worthless due to hyperinflation. If people lose faith in a nation’s paper currency, like the U.S. dollar bill, the money will no longer hold any value. This differs from gold, which, historically, has been used in jewelry and decoration and has many modern economic uses including its use in the manufacture of electronic devices, computers and aerospace vehicles.

Most modern paper currencies are fiat currencies; they have no intrinsic value and are used solely as a means of payment. Historically, governments would mint coins out of a physical commodity, such as gold or silver, or would print paper money that could be redeemed for a set amount of physical commodity. Fiat money is inconvertible and cannot be redeemed. Fiat money rose to prominence in the 20th century, specifically after the collapse of the Bretton Woods system in 1971, when the United States ceased to allow the conversion of the dollar into gold.

24
Q

LOS 18. f: Describe roles and objectives of central banks. Menu costs

A

What are ‘Menu Costs’

Menu costs refer to an economic term used to describe the cost incurred by firms in order to change their prices. How expensive it is to change prices depends on the type of firm. For example, it may be necessary to reprint menus, update price lists or retag merchandise on the shelf. Even when there are few apparent costs to changing prices, changing prices may make customers apprehensive about buying at a given price, resulting in a menu cost of lost sales.

BREAKING DOWN ‘Menu Costs’

The net result of menu costs is that prices are sticky. That is to say, firms are hesitant to change their prices until there is a sufficient disparity between the firm’s current price and the equilibrium market price. In theory, a firm should not change its price until the price change will result in enough additional revenues to cover the menu costs. In practice, however, it may be difficult to determine the equilibrium market price or to account for all menu costs, so it is hard for firms and consumers to behave precisely in this manner.

25
Q

LOS 18. f: Describe roles and objectives of central banks. Shoe leather costs

A

Shoe leather cost refers to the cost of time and effort (or opportunity costs of time and effort) that people expend by holding less cash in order to reduce the inflation tax that they pay on cash holdings when there is high inflation. These costs include, having to make additional trips to the bank, not being able to make change, or not being able to make unexpected purchases.[1][2] The term comes from the fact that more walking is required (historically, although the rise of the Internet has reduced it) to go to the bank and get cash and spend it, thus wearing out shoes more quickly.[1] A significant cost of reducing money holdings is the additional time and convenience that must be sacrificed to keep less money on hand than would be required if there were less or no inflation.

26
Q

LOS 18. f: Describe roles and objectives of central banks. Pegging

A

What is ‘Pegging’

Pegging is a method of stabilizing a country’s currency by fixing its exchange rate to that of another country. This term also refers to the practice of an investor buying large amounts of an underlying commodity or security close to the expiration date of a derivative held by that investor. This is done to encourage a favorable move in market price of the underlying security or commodity, which may increase the value of the derivative.

27
Q

LOS 18. g: Contrast the costs of expected and unexpected inflation.

A

High inflation, even when it is perfectly anticipated, imposes costs on the economy as people reduce cash balances because of the higher opportunity cost of holding cash, More significant costs are imposed by unexpected inflation, which reduces the information value of price changes, can make economic cycles worse, and shifts wealth from lenders to borrowers. Uncertainty about the future rate of inflation increases risk, resulting in decreased business investment.

28
Q

LOS 18. h: Describe tools used to implement monetary policy.

A

Policy tools available to central banks include the policy rate, reserve requirements, and open market operations. The policy rate is called the discount rate in the United States, the refinancing rate by the ECB, and the 2-week repo rate in the United Kingdom.

Decreasing the policy rate, decreasing reserve requirements, and making pen market purchases of securities are all expansionary.

Increasing the policy rate, increasing reserve requirements, and making open market sales of securities are all contractionary.

29
Q

LOS 18. i: Describe the monetary transmission mechanism.

A

The transmission mechanism for changes in the central bank’s policy rate through to prices and inflation includes one or more of the following:

  • Short-term bank lending rates
  • Asset prices
  • Expectations for economy activity and future policy rate changes
  • Exchange rates with foreign currencies
30
Q

LOS 18. j: Describe qualities of effective central banks.

A

Effective central banks exhibit independence, credibility, and transparency.

Independence: The central bank is free from political interference

Credibility: The central bank follows through on its stated policy intentions.

Transparency: The central bank makes it clear what economic indicators it uses and reports on the state of those indicators.

31
Q

LOS 18. j: Describe qualities of effective central banks. Operational independence & Target independence.

A

Independence can be evaluated based on both operational independence and target independence. Operational independence means that the central bank is allowed to independently determine the policy rate. Target independence means the central bank also defines how inflation is computed, sets the target inflation level, and determines the horizon over which the target is to be achieved. The ECB has both target and operational independence, while most other central banks have only operational independence.

32
Q

LOS 18. j: Describe qualities of effective central banks. Inflation reports

A

Transparency means central banks periodically disclose the state of the economic environment by issuing inflation reports.

33
Q

LOS 18. k: Explain the relationships between monetary policy and economic growth, inflation, interest, and exchange rates.

A

A contractionary money policy (increase in policy rate) will tend to decrease economic growth, increase market interest rates, decrease inflation, and lead to appreciation of the domestic currency in foreign exchange markets.

An expansionary monetary policy (decrease in policy rate) will have opposite effects, tending to increase economic growth, decrease market interest rates, increase inflation, and reduce the value of the currency in foreign exchange markets.

34
Q

LOS 18. l: Contrast the use of inflation, interest rate, and exchange rate targeting by central banks.

A

Most central banks set target inflation rates, typically 2% to 3%, rather than targeting interest rates as was once common. When inflation is expected to rise above (fall below) the target band, the money supply is decreased (increased) to reduce (increase) economic growth.

Developing economies sometimes target a stable exchange rate for their currency relative to that of a developed economy, selling their currency when its value rises above the target rate and buying their currency with foreign reserves when the rate falls below the target. The developing country must follow a monetary policy that supports the target exchange rate and essentially commits to having the same inflation rate as the developed country.

35
Q

LOS 18. l: Contrast the use of inflation, interest rate, and exchange rate targeting by central banks. Inflation targeting

A

What is ‘Inflation Targeting’

Inflation targeting is a central banking policy that revolves around meeting preset, publicly displayed targets for the annual rate of inflation. The benchmark used for inflation targeting is typically a price index of a basket of consumer goods, such as the Consumer Price Index (CPI) in the United States.

Along with inflation target rates and calendar dates to be used as performance measures, an inflation targeting policy may also have established steps that are to be taken depending on how much the actual inflation rate varies from the targeted level, such as cutting lending rates or adding liquidity to the economy.

BREAKING DOWN ‘Inflation Targeting’

While the U.S. central bank doesn’t typically have an explicit target for inflation (unlike other countries such as Canada, Australia and New Zealand), keeping inflation low is one of the Federal Reserve’s primary concerns, along with stable growth in gross domestic product and low unemployment levels.

Inflation levels of 1-2% per year are generally considered acceptable (even desirable in some ways), while inflation rates greater than 3% represent a dangerous zone that could cause the currency to become devalued.

36
Q

LOS 18. m: Determine whether a monetary policy is expansionary or contractionary.

A

The real trend rate is the long-term sustainable real growth rate of an economy. The neutral interest rate is the sum of the real trend rate and the target inflation rate. Monetary policy is said to be contractionary when the policy rate is above the neutral rate and expansionary when the policy rate is below the neutral rate.

37
Q

LOS 18. n: Describe limitations of monetary policy.

A

Reasons that monetary policy may not work as intended:

  • Monetary policy changes may affect inflation expectations to such an extent that long-term interest rates move opposite to short-term interest rates.
  • Individuals may be willing to hold greater cash balances without a change in short-term rates (liquidity trap)
  • Banks may be unwilling to lend greater amounts, even when they have increased excess reserves.
  • Short-term rates cannot be reduced below zero.
  • Developing economies face unique challenges in utilizing monetary policy due to undeveloped financial markets, rapid financial innovation, and lack of credibility of the monetary authority.
38
Q

LOS 18. n: Describe limitations of monetary policy. Bond market vigilantes

A

A bond vigilante is a bond market investor who protests monetary or fiscal policies he considers inflationary by selling bonds, thus increasing yields.[1]

In the bond market, prices move inversely to yields. When investors perceive that inflation risk or credit risk is rising they demand higher yields to compensate for the added risk.[2] As a result, bond prices fall and yields rise, which increases the net cost of borrowing. The term references the ability of the bond market to serve as a restraint on the government’s ability to over-spend and over-borrow.

39
Q

LOS 18. n: Describe limitations of monetary policy. Liquidity trap

A

What is the ‘Liquidity Trap’

The liquidity trap is the situation in which prevailing interest rates are low and savings rates are high, making monetary policy ineffective. In a liquidity trap, consumers choose to avoid bonds and keep their funds in savings, because of the prevailing belief that interest rates will soon rise. Because bonds have an inverse relationship to interest rates, many consumers do not want to hold an asset with a price that is expected to decline.

BREAKING DOWN ‘Liquidity Trap’

Should the regulatory committee try to stimulate the economy by increasing the money supply, there would be no effect on interest rates, as people do not need to be encouraged to hold additional cash.

As part of the liquidity trap, consumers continue to hold funds in standard deposit accounts, such as savings and checking accounts, instead of in other investment options, even when the central banking system attempts to stimulate the economy through the injection of additional funds. These consumer actions, often spurred by the belief of a negative economic event on the horizon, causes monetary policy to be generally ineffective.

40
Q

LOS 18. n: Describe limitations of monetary policy. Quantitative easing

A

What is ‘Quantitative Easing’

Quantitative easing is an unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity. Quantitative easing is considered when short-term interest rates are at or approaching zero, and does not involve the printing of new banknotes.

BREAKING DOWN ‘Quantitative Easing’

In quantitative easing, central banks target the supply of money by buying or selling government bonds. When the economy stalls and the central bank wants to encourage economic growth, it buys government bonds. This lowers short-term interest rates and increases the money supply. This strategy loses effectiveness when interest rates approach zero, at which point banks have to implement other strategies to kick start the economy. Another strategy they can use is to target commercial bank and private sector assets in an attempt to spur economic growth by encouraging banks to lend money. Note that quantitative easing is often referred to as “QE.”

41
Q

LOS 18. o: Describe roles and objectives of fiscal policy.

A

Fiscal policy refers to the taxing and spending policies of the government. Objectives of fiscal policy can include (1) influencing the level of economic activity, (2) redistributing wealth or income, and (3) allocating resources among industries.

42
Q

LOS 18. o: Describe roles and objectives of fiscal policy. Keynesian economists view of fiscal policy

A

Keynesian economists believe that fiscal policy, through its effect on aggregate demand, can have a strong effect on economic growth when the economy is operating at less than full employment. Monetarists believe that the effect of fiscal stimulus is only temporary and that monetary policy should be used to increase or decrease inflationary pressures over time. Monetarists do not believe that monetary policy should be used in an attempt to influence aggregate demand to counter cyclical movements in the economy.

43
Q

LOS 18. o: Describe roles and objectives of fiscal policy. Discretionary fiscal policy and Automatic Stabilizers

A

Discretionary fiscal policy refers to the spending and taxing decisions of a national government that are intended to stabilize the economy. In contrast, automatic stabilizers are built-in fiscal devices triggered by the state of the economy. For example, during a recession, tax receipts will fall, and government expenditures on unemployment insurance payments will increase. Both of these tend to increase budget deficits and are expansionary. Similarly, during boom times, higher tax revenues coupled with lower outflows for social programs tend to decrease budget deficits and are contractionary.

44
Q

LOS 18. p: Describe tools of fiscal policy, including their advantages and disadvantages.

A

Fiscal policy tools include spending tools and revenue tools. Spending tools include transfer payments, current spending (goods and services used by government), and capital spending (investment projects funded by government). Revenue tools include direct and indirect taxation.

An advantage of fiscal policy is that indirect taxes can be used to quickly implement social policies and can also be used to quickly raise revenues at a low cost.

Disadvantage of fiscal policy include time lags for implementing changes in direct taxes and time lags for capital spending changes to have an impact.

45
Q

LOS 18. p: Describe tools of fiscal policy, including their advantages and disadvantages. Transfer payments

A

What is a ‘Transfer Payment’

A transfer payment, in the United States, is a one-way payment to a person for which no money, good, or service is given or exchanged. Transfer payments are made to individuals by the federal government through various social benefit programs. These types of payments are executed by the United States to individuals through programs such as Social Security.

BREAKING DOWN ‘Transfer Payment’

A transfer payment is a process used by governments as a way to redistribute money through programs such as old age or disability pensions, student grants and unemployment compensation. Transfer payments, however, do not include subsidies that are paid to domestic farmers, manufacturers and exporters, even though they are technically a one-way payment to a person on behalf of the government.

Government transfer payments, although no services are performed, are considered to be a component of personal income. These payments can be made at the federal, state and local level of governments.

46
Q

LOS 18. p: Describe tools of fiscal policy, including their advantages and disadvantages. Direct taxes

A

What is a ‘Direct Tax ‘

A direct tax is paid directly by an individual or organization to an imposing entity. A taxpayer, for example, pays direct taxes to the government for different purposes, including real property tax, personal property tax, income tax or taxes on assets. Direct taxes are different from indirect taxes, where the tax is levied on one entity, such as a seller, and paid by another, such as a sales tax paid by the buyer in a retail setting.

BREAKING DOWN ‘Direct Tax ‘

Direct taxes are based on the ability-to-pay principle. This principle is an economic term that states that those who have more resources or earn higher income should pay more taxes. The ability to pay taxes is a way to redistribute the wealth of a nation. Direct taxes cannot be passed onto a different person or entity; the individual or organization upon which the tax is levied is responsible for the fulfillment of the full tax payment.

However, this sometimes acts as a negative. Direct taxes, especially in a tax bracket system, can become a disincentive to work hard and earn more money, because the more money a person earns, the more taxes he pays.

47
Q

LOS 18. p: Describe tools of fiscal policy, including their advantages and disadvantages. Indirect taxes

A

What is an ‘Indirect Tax’

An indirect tax is a tax that is paid to the government by one entity in the supply chain, but it is passed on to the consumer as part of the price of a good or service. The consumer is ultimately paying the tax by paying more for the product. An indirect tax is shifted from one taxpayer to another.

BREAKING DOWN ‘Indirect Tax’

Import duties, fuel, liquor and cigarette taxes are all considered examples of indirect taxes.

Indirect taxes are defined by contrasting them with direct taxes. In the case of direct taxes, the person immediately paying the tax is the person that the government is seeking to tax. Income tax is the clearest example of a direct tax, since the person earning the income is the one immediately paying the tax. Admission fees to a national park is another clear example of direct taxation.

48
Q

LOS 18. p: Describe tools of fiscal policy, including their advantages and disadvantages. Disposable income

A

What is ‘Disposable Income’

Disposable income, also known as disposable personal income (DPI), is the amount of money that households have available for spending and saving after income taxes have been accounted for. Disposable personal income is often monitored as one of the many key economic indicators used to gauge the overall state of the economy.

BREAKING DOWN ‘Disposable Income’

For example, consider a family with a household income of $100,000, and the family has an effective income tax rate of 25%. This household’s disposable income would then be $75,000 ($100,000 - $25,000). Economists use DPI as a starting point to gauge households’ rates of savings and spending.

49
Q

LOS 18. p: Describe tools of fiscal policy, including their advantages and disadvantages. Fiscal multiplier

A

What is the ‘Fiscal Multiplier’

The fiscal multiplier is the ratio of a country’s additional national income to the initial boost in spending that led to that extra income.

BREAKING DOWN ‘Fiscal Multiplier’

The fiscal multiplier is a Keynesian idea first proposed by John Maynard Keynes’ student Richard Kahn in a 1931 paper. It rests on the idea of marginal propensity to consume (MRC): the portion of an additional sum of income a person, household or society will spend rather than save. So long as a country’s overall MRC is greater than zero, the theory goes, an initial infusion of government spending will lead to a larger increase in national income. The fiscal multiplier expresses how much greater – or, if stimulus turns out to be counterproductive, smaller – the overall gain in national income is than the amount of extra spending.

For example, say that a national government enacts a $1 billion fiscal stimulus and that its consumers’ MRC is 0.75. Consumers who receive the initial $1 billion will save $250 million and spend $750 million, effectively initiating another, smaller round of stimulus. The recipients of that $750 million will spend $562.5 million, and so on.

The total change in national income is the initial increase in government or “autonomous” spending, times the fiscal multiplier, which is in turn equal to:

Fiscal Multiplier = 1 / (1 – MPC)

In the example above, the marginal propensity to consume is 0.75, yielding a fiscal multiplier of 4. Keynesian theory would therefore predict an overall boost to national income of $4 billion as a result of the initial $1 billion fiscal stimulus.

50
Q

LOS 18. p: Describe tools of fiscal policy, including their advantages and disadvantages. Ricardian equivalence

A

What is the ‘Ricardian Equivalence’

Ricardian equivalence is an economic theory that suggests when a government tries to stimulate an economy by increasing debt-financed government spending, demand remains unchanged. This is due to the fact the public saves its excess money to pay for expected future tax increases that will be used to pay off the debt. This theory was developed by David Ricardo in the 19th century but was revised by Harvard professor Robert Barro into a more elaborate version of the same concept.

BREAKING DOWN ‘Ricardian Equivalence’

Ricardian equivalence, also known as the Barro-Ricardo equivalence proposition, stipulates that a person’s consumption is determined by the lifetime present value of his after-tax income. Therefore, the Ricardian equivalence says a government cannot stimulate spending since people assume that whatever is gained now will be offset by higher taxes in the future. Thus, the underlying idea behind Ricardo’s theory is that no matter how a government chooses to increase spending, whether with debt financing or tax financing, the outcome is the same and demand remains unchanged.

51
Q

LOS 18. q: Describe the arguments about whether the size of a national debt relative to GDP matters.

A

Arguments for being concerned with the size of fiscal deficit

  • Higher future taxes lead to disincentives to work, negatively affecting long-term economic growth.
  • Fiscal deficits may not be financed by the market when debt levels are high.
  • Crowding-out effect as government borrowing increases interest rates and decreases private sector investment.

Arguments against being concerned with the size of fiscal deficit:

  • Debt may be financed by domestic citizens
  • Deficits for capital spending can boost the productive capacity of the economy
  • Fiscal deficits may prompt needed tax reform
  • Ricardian equivalence may prevail: private savings rise in anticipation of the need to prepay principal on government debt.
  • When the economy is operating below full employment, deficits do not crowd out private investment.
52
Q

LOS 18. q: Describe the arguments about whether the size of a national debt relative to GDP matters. Crowding-out

A

What is the ‘Crowding Out Effect’

The crowding out effect is an economic theory arguing that rising public sector spending drives down or even eliminates private sector spending.

BREAKING DOWN ‘Crowding Out Effect’

One of the most common forms of crowding out takes place when a large government, like that of the United States, increases its borrowing. The sheer scale of this borrowing can lead to substantial rises in the real interest rate, which has the effect of absorbing the economy’s lending capacity and of discouraging businesses from making capital investments. Because firms often fund such projects in part or entirely through financing, they are now discouraged from doing so because the opportunity cost of borrowing money has risen, making traditionally profitable projects funded through loans cost-prohibitive.

For example, suppose a firm has been planning a capital project that with an estimated cost of $5 million and return of $6 million, assuming the interest rate on its loans remains 3%. The firm anticipates earning $1 million in net income. Due to the shaky state of the economy, however, the government announces a stimulus package that will help businesses in need but will also raise the interest rate on the firm’s new loans to 4%. Because the interest rate the firm had factored into its accounting has increased by 33.3%, its profit model shifts wildly and the firm estimates that it will now need to spend $5.75 million on the project in order to make the same $6 million in returns. Its projected earnings have have now dropped by 75% to $250,000, so the company decides that it would be better off pursuing other options.

53
Q

LOS 18. r: Explain the implementation of fiscal policy and difficulties of implementation.

A

Fiscal policy is implemented by governmental changes in taxing and spending policies. Delays in realizing the effects of fiscal policy changes limit their usefulness. Delays can be caused by:

Recognition lag: Policymakers may not immediately recognize when fiscal policy changes are needed.

Action lag: governments take time to enact needed fiscal policy changes.

Impact lag: Fiscal policy changes take time to affect economic activity.

54
Q

LOS 18. s: Determine whether a fiscal policy is expansionary or contractionary.

A

A government has a budget surplus when tax revenues exceed government spending and a deficit when spending exceeds tax revenues.

An increase (decrease) in a government budget surplus is indicative of a contractionary (expansionary) fiscal policy. similarly, an increase (decrease) in a government budget deficit is indicative of an expansionary (contractionary) fiscal policy.

55
Q

LOS 18. s: Determine whether a fiscal policy is expansionary or contractionary. Structural (or cyclically adjusted) budget deficit

A

A budget deficit that results from a fundamental imbalance in government receipts and expenditures, as opposed to one based on one-off or short-term factors. [1]

A government budget deficit occurs when a government spends more than it receives in tax revenue, while a structural deficit is when a budget deficit persists for some time.

Structural deficits will eventually pose a problem for any government. Deficits are financed by borrowing, and continued borrowing leads to an accumulation of debt. The ability to pay off this debt is measured by a country’s debt relative to its GDP, referred to as its debt-to-GDP ratio.

If a country’s debt-to-GDP ratio gets too high, investors will worry that the government will either default on this debt, or will deflate its value away by monetising the debt and thereby engineer a high inflation rate.

The cyclically adjusted budget balance, sometimes known as the full employment budget balance, is the budget balance that would obtain when GDP is at potential. In principle, the cyclically adjusted measure better measures the stance of fiscal policy, as it removes the endogenous components of spending and revenues.

56
Q

LOS 18. t: Explain the interaction of monetary and fiscal policy.

A

Decks in Kyle CFA (Hold File) Class (41):