LM05 Monetary and Fiscal Policy

Part 1

1.  Introduction to Monetary and Fiscal Policy

As compared to households and corporations, the economic decisions made by governments can have an enormous impact on economies because governments are usually the largest employers, largest spenders and largest borrowers in an economy.

There are two types of government policy:

Monetary policy: Refers to central bank activities directed towards influencing the level of interest rates and money supply in the economy.

Fiscal policy: Refers to government decisions about taxation and spending.

The overall goal of these policies is to create an economic environment of stable growth and low inflation.

1.1.  Monetary Policy

As stated above, monetary policy refers to central bank activities directed towards influencing the level of interest rates and money supply in the economy.

• To understand how monetary policy is implemented, we must first understand the functions and role of money.

2. Money: Functions, Creation, and Definition

Money is generally defined as a medium of exchange. Instead of using the barter system to exchange goods and services, money facilitates an indirect exchange and helps overcome the drawbacks of a barter system.

2.1 The Functions of Money

For money to be a medium of exchange, it must:

• Be readily acceptable.
• Have a known value.
• Be easily divisible.
• Have a high value relative to its weight (easy to carry).
• Be difficult to counterfeit.

Money fulfills three important functions. It:

• acts as a medium of exchange.
• provides individuals with a way of storing wealth.
• provides society with a convenient measure of value and unit of account. (For example, if a car is sold for $20,000, you know what it is worth.)

2.2 Paper Money and the Money Creation Process

Fractional reserve banking: Our modern banking system is known as fractional reserve banking because at any point in time, banks hold with them only a fraction of total deposits as reserves; this is based on the premise that not all customers want all of their money back at the same time.

Let us take the exhibit below (reproduced from the curriculum) to illustrate how fractional reserve banking results in money creation:

Money creation via Fractional Reserve Banking

Now let us go over the example. Assume the reserve requirement is 10%, that is, banks are required to retain only 10% of the total deposits as balances with them. The rest can be lent out.

First Bank of Nations: If a customer makes a deposit of €100, then the bank must retain €10 and the remaining €90 can be loaned out to another customer.

Second Bank of Nations: Now suppose, the person who receives this €90 loan from First Bank uses this money to purchase some goods of this value and the seller of the goods deposits €90 in another bank, the Second Bank of Nations. Again, the Second Bank must retain 10% of €90, which is €9, and may loan out the remaining €81 to another customer.

Third Bank of Nations: This customer in turn spends €81 on some goods and services. The recipient of this money deposits it at the Third Bank of Nations. Once again, the Third Bank must retain 10% of €81, which is €8.1, as part of its reserves and may loan out the remaining €72.9 to another customer.

This process continues until there is no more money to be deposited and loaned out. How much total money is created from an initial deposit of €100 in this process?, If you ask the first customer how much money he has, he will say €100, while the second customer will say €90, the third €72.9 and so on. It is the sum of all the deposits in the banking system. It can be calculated using this formula:

Amount of money created =

Money multiplier =

The money created in our example is which is 1,000. Money multiplier is 10.

Example

Given a reserve requirement of 8 per cent, how much money can be created by depositing an additional $500?

1. $800
2. $5,000
3. $6,250

Solution: C

The expression used to calculate the amount of money created is . Therefore, = $6,250

2.3 Definitions of Money

Most economies distinguish money into two categories ‘Narrow money’ and ‘Broad money’.

Narrow money: Notes and coins in circulation plus other very highly liquid deposits.

Broad money: Narrow money plus the entire range of liquid assets used to make purchases.

Because financial systems, practice and institutions vary from economy to economy, so do the definitions of money.

3. Money: Quantity Theory, Supply and Demand, Fisher Effect

The Quantity Theory of Money

We looked at this concept in a previous reading. Quantity theory of money states that total spending (in money terms) is proportional to the quantity of money.

M * V = P * Y

where:

M = quantity of money

V = velocity of circulation of money

P = average price level

Y = real output

If velocity is assumed to be constant as per quantity theory, then spending (P x Y) is proportional to the quantity of money (M).

Money neutrality

If money neutrality holds, then increasing money supply (M), and keeping the velocity (V) constant, will increase the price level (P) but real output (Y) will stay the same. In short, output cannot be increased by increasing the money supply. Money neutrality implies that an increase in money supply will ultimately lead to an increase in price level; real variables such as output and employment will not change in the long-run.

3.1 The Demand for Money

The amount of wealth that the citizens of an economy choose to hold in the form of money rather than in bonds or equities is known as the demand for money.

Motives for holding money:

Transaction-related

• Money balances held to finance transactions are called transactions money balances. As real GDP increases, the size and number of transactions will increase, and the transaction-related demand for money increases.

Precautionary

• More like an emergency fund.
• Precautionary money balances are held as a buffer for unforeseen events.
• These balances are also proportional to growth in GDP.

Speculative

• As the name indicates, it is the demand to hold money in anticipation that assets will decline in value in future as the current risk in those assets is high. It is directly proportional to perceived risk, if perceived risk is high, people choose to hold money rather than invest it.
• It is inversely proportional to return on assets, as return increases people choose to invest money rather than hold it for speculative purposes.

3.2 The Supply and Demand for Money

As with other markets, the price of money is determined by the interaction of demand and supply.

Interpretation of graph:

• Plots interest rates on the y-axis and quantity of money on the x-axis.
• The demand curve (MD) is downward sloping because as interest rates go up, the speculative demand for money goes down. Interest rate here means the returns on stocks and bonds.
• The supply curve MS is vertical because there is a fixed nominal amount of money circulating at any time.
• The equilibrium interest rate is at the intersection of the MS and MD curves, represented here by I₀.
• Let’s consider two cases to understand why no excess money balance exists at the equilibrium rate I₀.
• Consider an interest rate I₁ higher than I₀. At this rate, demand for money would be M₁, which is less than M₀. The excess supply of money is M₁-M₀. The demand for bonds will be higher with this excess money; hence, the price of bonds would go up, and the interest would come down back to I₀.
• Now, consider an interest rate I₂ lower than I₀. At this rate, demand for money would be M₂ which is higher than M₀. The shortage of money is M₂-M₀. Firms and individuals would sell bonds to get money and remove this shortage. Hence, the price of bonds would go down, and the interest rate would go up back to I₀.
• What is the short-run impact of an increase in money supply? If the central bank increases the money supply from M₀ to M₂, the vertical MS curve moves to the right. Since money is available in plenty, interest rate (its price) falls and price level increases.
  • Excess money may mean more demand for goods and services, money loaned to others, or increase in bank deposits. Aggregate demand goes up in the short run and so may the output.
  • However, excess demand for goods and services will not necessarily mean an increase in production in the long run because of limited availability of natural resources. The output will be back to equilibrium. So, the increase in the money supply does not increase output or unemployment in the long-run. This is the concept of money neutrality.

3.3 The Fischer Effect

According to Fischer effect, the nominal interest rate is simply the sum of real interest rate and expected inflation.

Fischer Effect: R_nom = R_real + π^e

where:

R_nom = nominal interest rate

R_real = real interest rate

π^e = expected rate of inflation over any given time horizon

Fischer effect states that the real rate of interest in an economy is relatively stable and changes in nominal interest rates are due to changes in expected inflation. This is directly related to the concept of money neutrality.

But, investors can never be sure of how much inflation or real growth would be in the future. They, therefore require an additional return for bearing this risk, which is called the risk premium.

When we consider uncertainty, nominal interest rates have three components:

• Required real return
• Expected inflation
• Risk premium

For example: Let us assume an investor invests in a corporate bond that offers a yield of 15% over the next year. It can be broken down into three components: real return of 4%, expected inflation of 8% and risk premium of 3%. (You will learn in ‘fixed income’ section that we can further divide this risk premium into credit risk premium, liquidity risk premium and so on.)

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