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The Government’s Budget Constraint

Econ 210D Intermediate Macroeconomics Spring 2015 Professor Kevin D. Hoover Topic 8 Monetary and Fiscal Policy. The Government’s Budget Constraint.

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The Government’s Budget Constraint

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  1. Econ 210D Intermediate MacroeconomicsSpring 2015Professor Kevin D. HooverTopic 8Monetary and Fiscal Policy Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  2. The Government’s Budget Constraint • G – (T – TR) = BG + MB deficit change in government’s financial portfolio Fiscal Policy Monetary Policy Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  3. Pure Policy • G – (T – TR) = BG + MB • Pure Fiscal Policy: changes in taxes or spending, holding government liabilities constant (BG = 0 and MB = 0) • E.g., balanced budget stimulus • Pure Monetary Policy: changes in liability mix BG = –MB), holding deficit constant (G – (T – TR) = 0) • E.g., open-market operation Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  4. Mixed Policies • G – (T – TR) = BG + MB • Deficit finance: • G – (T – TR) = BG > 0 • Monetizing the deficit: • G – (T – TR) = MB > 0 Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  5. The Federal Reserve System Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  6. The Board of Governors of the Federal Reserve System • 7 Governors with 14-year terms • Chairman – governor with a 4-year term as chairman • Current Chairman: Ben Bernanke • Replaced Alan Greenspan, who replaced Paul Volcker • Duties • Bank regulation • Monetary policy • Lender of last resort Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  7. Federal Open-Market Committee (FOMC) • Main policy making body • Composition • 7 Fed Governors • President of Federal Reserve Bank of New York • 4 other district bank presidents on a rotating basis • Remaining 7 presidents present as non-voting members • Meets about every 5 weeks Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  8. Fed and Commercial Bank Balance Sheets Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  9. Open-market Operations • Open-market operations = the Fed buys or sells assets on the open market, paying with reserves. • Open-market sale: • Public holdings of government bonds rises • Banks’ holdings of reserves falls • Open-market purchase: • Public holdings of government bonds fall • Banks’ holdings of reserves rises Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  10. The Discount Window • Discount borrowing (borrowing at the “discount window”) = banks’ borrowing reserves from the Fed using their assets (typically short term bonds) as collateral. • Common in the early days of the Fed. • Rare later • On large scale in recent financial crisis. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  11. Reserve Demand • Reserve requirements: banks must hold reserves = 10% of the value of checking accounts. • Check Clearing • Prudential Needs – costs of falling short • discount borrowing • interbank borrowing = Federal funds market Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  12. Holding Reserves: Banks’ Profit Maximization Problem • Benefit of lending to another bank: rFF • Cost of not having reserves on hand to cover withdrawals: probability of reserve loss × rFF • Opportunity Cost: Benefit – Cost: rFF – prl × rFF = (1 – prl) rFF • The higher the opportunity cost, the lower the demand to hold reserves. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  13. Open-market Purchase • Public’s holdings of government bonds falls • Banks’ holdings of reserves rise • Interest rates fall Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  14. “Open-mouth” Operation • Fed announces Federal funds rate target • Market moves to target without an actual open-market operation • Interest rates in other markets move in same direction as the Federal funds rate: substitution and arbitrage Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  15. Brief History of Monetary Policy • Monetization of debt at fixed short and long rates during and after World War II • Fed-Treasury Accord of 1951 ends compulsory monetization • Early 1960s: “bills only” doctrine • Recent Fed purchase of long-term and nongovernmental assets. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  16. Transmission Mechanism • Transmission Mechanism = means by which monetary policy effects the real economy • Two types: • Interest-rate or Opportunity-cost Channel • Credit Channel Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  17. Interest-rate or Opportunity-cost Channel • Interest Rate or Opportunity-Cost Channel = monetary policy changes interest rates which effects the opportunity cost of investing. • Mechanism: • Fed controls short rates in order to manipulate long rates through the term structure. • Real long rates affect investment; investment affects aggregate demand through the multiplier. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  18. Credit Channel • Credit Channel = monetary policy effects economy through reduction in funds available to borrowers with or without changing interest rates. • Two types: • Narrow credit channel • Broad credit channel Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  19. Narrow Credit Channel • Narrow Credit Channel = change in reserves owing to monetary policy action reduces volume of bank lending. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  20. Broad Credit Channel • Broad Credit Channel = changes in interest rates change credit-worthiness of borrowers, changing the availability of bank and nonbank credit. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  21. Transmission Mechanism and the Real Economy • Interest-rate or Opportunity-cost channel  movement along IS curve • Credit channel (narrow or broad)  shift of IS curve Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  22. Monetary Policy and the Recent Financial Crisis • Lender of last resort • “Quantitative Easing” = purchases of long-term (government and private) bonds • Interest-rate channel: similar to other open-market operations except at long end of term structure. • Direct relief of credit rationing. • Challenge: How to unwind without squelching recovery. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  23. Fiscal Policy Fiscal policy = • Tax Policy • Expenditure Policy Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  24. Types of Fiscal Policy • Automatic stabilizers • Discretionary Policy • Inadvertent • Intentional Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  25. Shocks Shift IS Curve • Demand shocks = Y holding Ypot constant • Supply shocks = Ypotholding Y constant • Mixed shocks = both Y and Ypot Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  26. Limits to Fiscal Policy • Lags • Inside Lag • Recognition Lag • Implementation Lag • Outside Lag • Recognition Lag • Implementation Lag • State and Local Governments as Automatic Destabilizers Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  27. Fiscal Policy in the Long Run – 1 • G – (T – TR) = BG + MB deficit change in government’s financial portfolio Fiscal Policy Monetary Policy Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  28. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  29. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  30. Dynamics of the Debt • G – (T – TR) = interest payments + primary deficit Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  31. Functional Finance – 1 • Deficits and debt not bad in and of themselves. • Balanced budgets not good in and of themselves. • Must be judged by their effects on the real economy. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  32. Functional Finance – 2: types of effect • Aggregate demand • Interactions between public and private sectors • Redistribution • Incentives Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  33. Crowding Out • Crowding Out = increases ingovernment expenditure reduce private expenditure or, more particularly, private investment Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  34. Types of Crowding Out • Zero-sum crowding out = at full employment any increase in G or TR must reduce private expenditure • Displacement of private expenditure – e.g., public schools replace private schools • Monetary snubbing of aggregate demand = deficits in face of fixed monetary policy raise interest rates, lowering investment • Crowding In = government expenditure promotes private investment – e.g., R&D Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  35. Burden of the Debt • Debt to GDP Ratio: B/pY • In Growth Rates: Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  36. Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

  37. END of Topic 8 END OF COURSE Professor K.D. Hoover, Econ 210D Topic 8 Spring 2015

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