Enu macroecon policy 040812

Go Global !Global Economic Environment :Global Economic Environment :The Effect of Government Macroeconomic Policy on Business

By

Stephen OngStephen OngEdinburgh Napier University Business School

[email protected] Professor, College of Management, Shenzhen

University4 August 2012

Learning Objectives

To identify the fiscal policy instruments of Government to manage the economy

To critically assess the effectiveness of fiscal policy

To identify the principal instruments of monetary policy

To evaluate the nature and effectiveness of monetary policy

AgendaAgenda

1.1.Fiscal PolicyFiscal Policy2.2.Monetary Monetary

PolicyPolicy

Fiscal PolicyFiscal Policy

Government Policy Government Policy DilemmaDilemma

Aggregate DemandAggregate Demand

Fiscal PolicyFiscal Policy

IssuesIssues

1. Impact of Government Economic Policy

2. Aggregate Demand

2.1 Movements vs Shifts

2.2 Economic Downturn

2.3 National Income & Consumption

2.4 National Output (GDP)

2.5 GDP=C+I

2.6 Multiplier Model

2.7 Taxes (-T)

2.8 Government Spending (+G)

2.9 GDP=C+I+G

2.9.1 GDP=C+I+G

2.10 Economic Boom & Defence Spending

18

3. Fiscal Policy3. Fiscal Policy

• Council of Economic Advisers Council of Economic Advisers (CEA)(CEA)• Discretionary fiscal policyDiscretionary fiscal policy• Eliminate recessionary or Eliminate recessionary or

inflationary gapinflationary gap• Countercyclical Countercyclical

• Nondiscretionary fiscal policyNondiscretionary fiscal policy• Passive or automaticPassive or automatic

19

• Expansionary fiscal policyExpansionary fiscal policy• Increased spending and/or Increased spending and/or

lower taxeslower taxes• Budget deficitBudget deficit

• Contractionary fiscal policyContractionary fiscal policy• Lower spending and/or higher Lower spending and/or higher

taxestaxes• Budget surplusBudget surplus

• Policy options?Policy options?

3.1 Fiscal Policy

20

3.2 Expansionary Fiscal 3.2 Expansionary Fiscal PolicyPolicy

Real Domestic Output, GDP

Pri

ce L

evel

AD2

RecessionsDecreaseAggregateDemand

AD1

$5 Billion AdditionalSpending

Full $20 Billion Increase in

Aggregate Demand

AS

$490 $510

P1

21

3.3 Contractionary Fiscal 3.3 Contractionary Fiscal PolicyPolicy


Pri

ce L

evel

AD3

Reduce Demand Pull

Inflation

AD4

$5 Billion Initial Decrease

In Spending

Full $20 Billion Decrease in

Aggregate Demand

AS

$510 $522

P1

22

3.4 Built-In Stability3.4 Built-In Stability

• Automatic Automatic stabilizersstabilizers• Taxes and transfersTaxes and transfers

• Economic importanceEconomic importance• Tax progressivityTax progressivity• Progressive tax systemProgressive tax system• Proportional tax systemProportional tax system• Regressive tax systemRegressive tax system

23

3.5 Built-In Stability3.5 Built-In Stability

G

T

Deficit

Surplus

GDP1 GDP2 GDP3


Go

vern

men

t E

xpen

ses,

Gan

d T

ax R

even

ues

, T

24

3.6 Evaluating Fiscal Policy3.6 Evaluating Fiscal Policy

• Standardized budget Standardized budget • Full-employment budgetFull-employment budget

• Cyclical deficitCyclical deficit• Recent U.S. fiscal policyRecent U.S. fiscal policy• Budget deficits and Budget deficits and

projectionsprojections• Social security considerationsSocial security considerations

25

3.6.1 Evaluating Fiscal Policy3.6.1 Evaluating Fiscal Policy

G

T

GDP2 GDP1


Go

vern

men

t E

xpen

ses,

Gan

d T

ax R

even

ues

, T

(Year 2) (Year 1)

$500

$450

ab

c

Cyclical deficitFiscal policy neutral

26

3.6.2 Evaluating Fiscal Policy3.6.2 Evaluating Fiscal Policy

G

T1

GDP4 GDP3


Go

vern

men

t E

xpen

ses,

Gan

d T

ax R

even

ues

, T

(Year 4) (Year 3)

$500

$450

de

f

$475

$425 g

T2

h

Standardized deficitExpansionary fiscal policy

27

• Problems of timingProblems of timing• Recognition lagRecognition lag• Administrative lagAdministrative lag• Operational lagOperational lag

• Political considerationsPolitical considerations• Future policy reversalsFuture policy reversals• Offsetting state and local financeOffsetting state and local finance• Crowding-out effectCrowding-out effect• Current thinking on fiscal policyCurrent thinking on fiscal policy

Problems, Criticisms, and Complications4. Fiscal Policy Issues4. Fiscal Policy Issues

28

(1)Year

(2)Actual

Deficit (-) orSurplus (+)

(3)StandardizedDeficit (-) orSurplus (+)

4.1 Budget Balances as % of 4.1 Budget Balances as % of GDPGDP

1992199319941995199619971998199920002001200220032004200520062007

-4.5%-3.8%-2.9%-2.2%-1.4%-0.3%+0.8%+1.4%+2.5%+1.3%-1.5%-3.4%-3.5%-2.6%-1.9%-1.3%

-2.9%-2.9%-2.1%-2.0%-1.2%-1.0%-0.4%+0.1%+1.1%+1.0%-1.2%-2.5%-2.4%-1.9%-1.8%-1.4%

Source: Congressional Budget Office

29

4.2 Standardized Budget 4.2 Standardized Budget BalanceBalance

Percentage of Potential GDP, 2007

Source: Organization for Economic Cooperation and Development

Denmark

New Zealand

Ireland

Canada

Norway

France

United States

United Kingdom

Japan

-6 -4 -2 0 2 4 6Deficits Surpluses

30

4.3 Federal Budget Balance4.3 Federal Budget BalanceActual and Projected, Fiscal 1994-2014

Source: Congressional Budget Office

$300

200

100

0

-100

-200

-300

-400

-500

Bu

dg

et D

efic

it (

-) o

r S

urp

lus,

Bill

ion

s

1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Actual Projected (as of March 2008)

31

4.4 The Public Debt4.4 The Public Debt

• National or public debt $9.01 National or public debt $9.01 trilliontrillion• OwnershipOwnership

• U.S. securitiesU.S. securities• 53% owned by federal 53% owned by federal

government and Federal Reservegovernment and Federal Reserve• 47% held outside the federal 47% held outside the federal

government and Federal Reservegovernment and Federal Reserve

32

Debt Held by theFederal Government

and FederalReserve (53%)

Debt Held OutsideThe FederalGovernmentand Federal

Reserve (47%)

FederalReserve

U.S.Government

AgenciesU.S.Individuals

ForeignOwnership

U.S. BanksAnd otherFinancial

Institutions

Other, IncludingState and LocalGovernments

Source: U.S. Treasury

9%

7%

25%

8% 7%

44%

4.5 The Public Debt

Total Debt: $9.01 trillion

33

4.6 Debt and GDP4.6 Debt and GDP

Federal debt held by the public, percentage of GDP

Source: Economic Report of the President, 2006

Per

cen

t o

f G

DP

Year

50

45

40

35

30

25

20

15

10

5

01970 1975 1980 1985 1990 1995 2000 2005

34

4.7 Debt and GDP4.7 Debt and GDPPublicly Held Debt: International Comparisons

As a Percentage of GDP, 2007

ItalyJapan

BelgiumHungaryGermany

United StatesUnited Kingdom

FranceNetherlands

CanadaSpain

Poland

0 20 40 60 80 100


35


• Interest chargesInterest charges• Primary burdenPrimary burden• 1.7% of GDP 20071.7% of GDP 2007

• False concernsFalse concerns• BankruptcyBankruptcy• RefinancingRefinancing• TaxationTaxation• Burdening future Burdening future

generationsgenerations

36


• Substantive issuesSubstantive issues• Income distributionIncome distribution• IncentivesIncentives• Foreign-owned public debtForeign-owned public debt

• Crowding-out effect revisitedCrowding-out effect revisited• Burden on future generationsBurden on future generations• Public investment as an offsetPublic investment as an offset

• Graphically Graphically

37

4.10 Crowding Out4.10 Crowding Out

5 10 15 20 25 30 35 400

2

4

6

8

10

12

14

16

Rea

l In

tere

st R

ate

(P

erce

nt)

Investment (Billions of Dollars)

ID1

ID2

a

b c

Interest RateRise WillDecrease

Investmenta to b

Crowding-Out Effect

A Large Public Debt to Finance Public Investment Will Cause…

If Public SpendingSpurs More Private

Investment WillIncrease to ID2

38

4.11 The Leading Indicators4.11 The Leading Indicators1.1. Average workweekAverage workweek2.2. Initial claims for Initial claims for

unemployment insuranceunemployment insurance3.3. New orders for consumer New orders for consumer

goodsgoods4.4. Vendor performanceVendor performance5.5. New orders for capital goodsNew orders for capital goods6.6. Building permits for housesBuilding permits for houses7.7. Stock pricesStock prices8.8. Money supplyMoney supply9.9. Interest-rate spreadInterest-rate spread10.10.Consumer expectationsConsumer expectations Source: The Conference Board

Monetary PolicyMonetary Policy

MoneyMoney

The Central Banker : FRS The Central Banker : FRS

The Banking SystemThe Banking System

Monetary PolicyMonetary Policy

The US Subprime CrisisThe US Subprime Crisis

1. Functions of Money 1. Functions of Money

• Medium of exchangeMedium of exchange• Used to buy/sell goodsUsed to buy/sell goods

• Unit of accountUnit of account• Goods valued in dollarsGoods valued in dollars

• Store of valueStore of value• Hold some wealth in money Hold some wealth in money

formform• Money is liquidMoney is liquid

31-40

1.1 Money Defined1.1 Money Defined

• MM11• CurrencyCurrency• Checkable depositsCheckable deposits

• Institutions offering checkable Institutions offering checkable depositsdeposits• Commercial banksCommercial banks• Savings and loan associationsSavings and loan associations• Mutual savings banksMutual savings banks• Credit unionsCredit unions

31-41

1.2 Money Defined1.2 Money Defined

• MM22• M1 plus near-moniesM1 plus near-monies• Savings deposits including Savings deposits including

money market deposit money market deposit accounts (MMDA)accounts (MMDA)• Small time depositsSmall time deposits• Money market mutual funds Money market mutual funds

(MMMF)(MMMF)

31-42

1.3 Money Defined1.3 Money DefinedM1 M256%

44%M118%

Savings Deposits,Including Money Market

Deposit Accounts

Small Time Deposits

Money Market MutualFunds Held By Individuals

Currency

Checkable Deposits

16%

14%

52%

$1,365Billion

$7,499Billion

January 2008

Totals

++

+

+

+

Source: Federal Reserve System31-43

1.4 Money Supply1.4 Money Supply

• Are credit cards money?Are credit cards money?• What “backs” the money What “backs” the money

supply?supply?• Nothing!Nothing!

• Why is money valuable?Why is money valuable?• AcceptabilityAcceptability• Legal tenderLegal tender• Relative scarcityRelative scarcity 31-44

1.5 Money and Prices1.5 Money and Prices

• Prices affect purchasing power Prices affect purchasing power of moneyof money• Hyperinflation renders money Hyperinflation renders money

unacceptableunacceptable• Stabilizing money’s purchasing Stabilizing money’s purchasing

powerpower• Intelligent management of the Intelligent management of the

money supply – monetary policymoney supply – monetary policy• Appropriate fiscal policyAppropriate fiscal policy 31-45

2. Federal Reserve System2. Federal Reserve System

• Historical backgroundHistorical background

• Board of GovernorsBoard of Governors

• 12 Federal Reserve Banks 12 Federal Reserve Banks

• Serve as the central bankServe as the central bank

• Quasi-public banksQuasi-public banks

• Banker’s bankBanker’s bank

31-46

2.1 Federal Reserve System2.1 Federal Reserve System

Commercial BanksThrift Institutions

(Savings and Loan Associations,Mutual Savings Banks,

Credit Unions)

The Public(Households and

Businesses)

12 Federal Reserve Banks

Board of Governors

Federal Open Market Committee

31-47


The 12 Federal Reserve Banks

Source: Federal Reserve Bulletin

31-48


• Federal Open Market CommitteeFederal Open Market Committee• Aids Board of Governors in setting Aids Board of Governors in setting

monetary policymonetary policy• Conducts open market operationsConducts open market operations

• Commercial banks and thriftsCommercial banks and thrifts• 7,300 commercial banks7,300 commercial banks• 11,000 thrifts11,000 thrifts

31-49

2.4 Federal Reserve Functions2.4 Federal Reserve Functions

• Issue currencyIssue currency• Set reserve requirementsSet reserve requirements• Lend money to banks Lend money to banks • Set discount rateSet discount rate• Check collectionCheck collection• Fiscal agent for U.S. governmentFiscal agent for U.S. government• Supervise banksSupervise banks• Control the money supplyControl the money supply

31-50


• Federal Reserve independenceFederal Reserve independence• Recent developmentsRecent developments• Relative decline of banks and Relative decline of banks and

thriftsthrifts• Consolidation Consolidation • Convergence of services provided Convergence of services provided

by financial institutionsby financial institutions• Globalization of financial marketsGlobalization of financial markets• Electronic paymentsElectronic payments

31-51

2.6 Financial Institutions2.6 Financial Institutions

World’s 12 Largest Financial Institutions, 2007

Barclays (UK)BNP Paribas (France

Citigroup (USA)HSBC Group (UK)UBS (Switzerland)

Royal Bank of Scotland (UK)ING Group (Netherlands)

Mitsubishi UFJ (Japan)Deutsche Bank Group (Ger)

Bank of America (US)Allianz Worldwide (Ger)JPMorgan Chase (USA)

0 1,300,000 1,600,000 1,900,000


Assets (Billions of U.S. Dollars)

31-52

2.7 U.S. Financial Institutions2.7 U.S. Financial Institutions

• Commercial banksCommercial banks• ThriftsThrifts• Insurance companiesInsurance companies• Mutual fund companiesMutual fund companies• Pension fundsPension funds• Securities firmsSecurities firms• Investment banksInvestment banks

31-53

2.8 The Global Greenback2.8 The Global Greenback

• U.S. currency circulating abroadU.S. currency circulating abroad• Russia $80 billionRussia $80 billion• Argentina $50 billionArgentina $50 billion• $450 billion total$450 billion total• 60% of total US currency 60% of total US currency

• U.S. profits from dollars leavingU.S. profits from dollars leaving• Black markets and illegal activitiesBlack markets and illegal activities• Dollar offers stable purchasing powerDollar offers stable purchasing power• Exchange rate riskExchange rate risk

31-54

3. Fractional Reserve Banking3. Fractional Reserve Banking

• The GoldsmithsThe Goldsmiths• Stored gold and gave a receiptStored gold and gave a receipt• Receipts used as money by publicReceipts used as money by public• Made loans by issuing receiptsMade loans by issuing receipts

• CharacteristicsCharacteristics• Banks create money through Banks create money through

lendinglending• Banks are subject to “panics” Banks are subject to “panics”

32-55

3.1 Fractional Reserve System3.1 Fractional Reserve System

• Balance sheetBalance sheet• Assets = Liabilities + Net Assets = Liabilities + Net

WorthWorth• Both sides balanceBoth sides balance

• Necessary transactionsNecessary transactions• Create a bankCreate a bank• Accept deposits Accept deposits • Lend excess reservesLend excess reserves

32-56

Assets Liabilities and Net Worth

3.2 Creating a Bank3.2 Creating a Bank

• Transaction #1Transaction #1• Vault cash: cash held by the Vault cash: cash held by the

bankbankCreating a Bank

Balance Sheet 1: Wahoo Bank

Cash $250,000 Stock Shares $250,000

32-57


3.2.1 Creating a Bank3.2.1 Creating a Bank

• Transaction #2Transaction #2• Acquiring property & equipmentAcquiring property & equipment

Acquiring Property and EquipmentBalance Sheet 2: Wahoo Bank

Cash $10,000 Stock Shares $250,000Property 240,000

32-58



• Transaction #3Transaction #3• Commercial bank Commercial bank

functionsfunctions• Accepting depositsAccepting deposits• Making loans Making loans Accepting Deposits


Cash $110,000 Checkable Deposits $100,000Property 240,000Stock Shares 250,000

32-59


• Transaction #4Transaction #4• Depositing reserves in a Depositing reserves in a

Federal Reserve bankFederal Reserve bank• Required reservesRequired reserves• Reserve ratioReserve ratio

Reserveratio =

Commercial bank’sRequired reserves

Commercial bank’sCheckable-deposit liabilities

32-60

3.2.4 Reserve Requirements3.2.4 Reserve Requirements

Type of DepositCurrent

RequirementStatutory

Limits

Checkable deposits:

$0-$9.8 Million$9.3-$43.9 MillionOver $43.9 Million

Noncheckable nonpersonalsavings and time deposits

0% 310

3% 38-14

0 0-9

• Fed can establish and vary reserve ratio within limits set by Congress

• Required reserves help Fed control lending abilities of commercial banks

32-61



Depositing Reserves at the FedBalance Sheet 4: Wahoo Bank

Cash $0 Checkable Deposits $100,000

Property 240,000 Stock Shares 250,000

Reserves 110,000

• Transaction #4• Assume the bank deposits all

cash on reserve at the Fed

32-62

3.2.6 Reserve Requirements3.2.6 Reserve Requirements

• Excess reservesExcess reserves• Actual reserves - required Actual reserves - required

reservesreserves

• Required reservesRequired reserves• Checkable deposits x reserve ratioCheckable deposits x reserve ratio

• Example:Example:• Checkable deposits $100,000Checkable deposits $100,000• Reserve ratio 20%Reserve ratio 20% 32-63



• Transaction #5Transaction #5• Clearing a checkClearing a check• $50,000 check reduces reserves $50,000 check reduces reserves

and checkable deposits and checkable deposits Clearing a Check


Checkable Deposits $50,000


Reserves $60,000

32-64


3.3 Money Creating Transactions3.3 Money Creating Transactions

• Transaction #6aTransaction #6a• Granting a loanGranting a loan• $50,000 loan deposited to $50,000 loan deposited to

checkingcheckingWhen a Loan is NegotiatedBalance Sheet 6a: Wahoo Bank



Reserves $60,000

Loans 50,000

32-65


3.3.1 Money Creating Transactions3.3.1 Money Creating Transactions

• Transaction #6bTransaction #6b• Using the loanUsing the loan• $50,000 loan cashed $50,000 loan cashed

After a Check is Drawn on the Loan Balance Sheet 6b: Wahoo Bank



Reserves $10,000

Loans 50,000

A single bank can only lend an amountequal to their preloan excess reserves

32-66


3.3.2 Money Creating Transactions3.3.2 Money Creating Transactions

• Transaction #7Transaction #7• Bank buys government Bank buys government

securities from dealersecurities from dealer• Deposits payment into Deposits payment into

checking checking Buying Government SecuritiesBalance Sheet 7: Wahoo Bank



Reserves $60,000

Securities 50,000

New money is created 32-67

3.4 Commercial Banks3.4 Commercial Banks

• Conflicting goalsConflicting goals• Earn profitEarn profit• Make loans to earn interestMake loans to earn interest• Buy securities to earn interestBuy securities to earn interest

• Maintain liquidityMaintain liquidity• Alternative?Alternative?• Overnight bank loansOvernight bank loans• Federal funds rateFederal funds rate

32-68

3.5 The Banking S3.5 The Banking Systemystem

• Multiple-deposit expansionMultiple-deposit expansion• Assumptions:Assumptions:• 20% required reserves20% required reserves• All banks “loaned up”All banks “loaned up”• Banks lend all of excess reservesBanks lend all of excess reserves

• A $100 bill is found and A $100 bill is found and depositeddeposited• Multiple deposits can be createdMultiple deposits can be created

32-69

Bank

(1)AcquiredReserves

and Deposits

(2)RequiredReserves

(3)Excess

Reserves(1)-(2)

(4)Amount Bank CanLend; New Money

Created = (3)

Bank A $100 $20 $80 $80

Bank B $80 $16 $64 $64

Bank C $64 $12.80 $51.20 $51.20

Bank D $51.20 $10.24 $40.96 $40.96

The process will continue…

3.6 The Banking System

32-70

Bank ABank BBank CBank DBank EBank FBank GBank HBank IBank JBank KBank LBank MBank NOther Banks

Bank

(1)AcquiredReserves

and Deposits

(2)RequiredReserves(Reserve

Ratio = .2)

(3)Excess

Reserves(1)-(2)

(4)Amount Bank CanLend; New Money

Created = (3)

$100.0080.0064.0051.2040.9632.7726.2120.9716.7813.4210.748.596.875.50

21.99

$20.0016.0012.8010.248.196.555.244.203.362.682.151.721.371.104.40

$80.0064.0051.2040.9632.7726.2120.9716.7813.4210.748.596.875.504.40

17.59

$80.0064.0051.2040.9632.7726.2120.9716.7813.4210.748.596.875.504.40

17.59$400.00

3.6.1 The Banking System

32-71

3.7 The Monetary Multiplier3.7 The Monetary Multiplier

Monetarymultiplier =

1

required reserve ratio

New Reserves$100

$20RequiredReserves

$80Excess

Reserves

$100Initial

Deposit

$400Bank System Lending

Money Created

GraphicExample

=1

R

32-72

3.7.1 The Monetary Multiplier3.7.1 The Monetary Multiplier

• Maximum amount of new Maximum amount of new money created by single money created by single dollar of excess reservesdollar of excess reserves• Higher R, lower mHigher R, lower m• ReversibilityReversibility• Making loans creates moneyMaking loans creates money• Loan repayment destroys Loan repayment destroys

moneymoney 32-73

3.8 Bank Panics of 1930-19333.8 Bank Panics of 1930-1933

• Before deposit insuranceBefore deposit insurance• Bank failure led to mass withdrawals Bank failure led to mass withdrawals • Forced loan reductionForced loan reduction• 25-33% decline in money supply25-33% decline in money supply• 1933 national bank holiday to 1933 national bank holiday to

evaluate all banksevaluate all banks• Contributed to the Great DepressionContributed to the Great Depression• Regulation protects the system Regulation protects the system

todaytoday 32-74

4. Interest Rates4. Interest Rates

• Price paid for the use of Price paid for the use of moneymoney• Many different interest ratesMany different interest rates• Speak as if only one interest Speak as if only one interest

raterate• Determined by money supply Determined by money supply

and money demandand money demand

33-75

4.1 Demand for Money4.1 Demand for Money• Why hold money?Why hold money?• Transactions demand, Transactions demand, DD11

• Determined by nominal GDPDetermined by nominal GDP• Independent of the interest rateIndependent of the interest rate

• Asset demand, Asset demand, DD22

• Money as a store of valueMoney as a store of value• Varies inversely with the interest Varies inversely with the interest

raterate

• Total money demand,Total money demand, D Dmm33-76

4.1.1Demand for Money4.1.1Demand for MoneyR

ate

of

inte

rest

, i p

erce

nt

10

7.5

5

2.5

0

50 100 150 200 50 100 150 200 50 100 150 200 250 300

Amount of moneydemanded

(billions of dollars)

Amount of moneydemanded


Amount of moneydemanded and supplied


=+

(a)Transactionsdemand formoney, Dt

(b)Asset

demand formoney, Da

(c)Total

demand formoney, Dm

and supply

Dt Da Dm

Sm

5

33-77

4.2 Interest Rates4.2 Interest Rates

• Equilibrium interest rateEquilibrium interest rate• Changes with shifts in money Changes with shifts in money

supply and money demandsupply and money demand• Interest rates and bond Interest rates and bond

pricesprices• Inversely relatedInversely related• Bond pays fixed annual Bond pays fixed annual

interest paymentinterest payment• Lower bond price will raise the Lower bond price will raise the

interest rateinterest rate 33-78

4.3 Federal Reserve Balance Sheet4.3 Federal Reserve Balance Sheet

• AssetsAssets• SecuritiesSecurities• Loans to commercial banksLoans to commercial banks

• LiabilitiesLiabilities• Reserves of commercial banksReserves of commercial banks• Treasury depositsTreasury deposits• Federal Reserve Notes Federal Reserve Notes

outstandingoutstanding33-79

SecuritiesLoans to Commercial BanksAll Other Assets

Total

Reserves of Commercial BanksTreasury DepositsFederal Reserve Notes (Outstanding)All Other Liabilities and Net WorthTotal

February 14, 2008 (in Millions)


Source: Federal Reserve Statistical Release, H.4.1, February 14, 2008

$713,369

60,039111,689

$885,097

$ 11,3124,979

778,93789,869

$885,097

4.3.1 Federal Reserve Balance Sheet

33-80

4.4 Central Banks4.4 Central Banks

Reserve Bank of Australia (RBA)

Bank of Canada

European Central Bank (ECB)

Bank of Japan (BOJ)

Banco de Mexico (Mex Bank)

Central Bank of Russia

Sveriges Riksbank

Bank of England

Federal Reserve System (the “Fed”)

(12 Regional Federal Reserve Banks)

Bank Negara Malaysia

Australia:

Canada:

Euro Zone:

Japan:

Mexico:

Russia

Sweden:

United Kingdom:

United States:

Malaysia :

Selected Nations

33-81

4.5 Tools of Monetary Policy4.5 Tools of Monetary Policy

• Open market operationsOpen market operations• Buying and selling of government Buying and selling of government

securities (or bonds)securities (or bonds)• Commercial banks and the Commercial banks and the

general publicgeneral public• Used to influence the money Used to influence the money

supplysupply• When the Fed sells securities, When the Fed sells securities,

commercial bank reserves are commercial bank reserves are reducedreduced

33-82

4.5.1 Open Market Operations4.5.1 Open Market Operations

New Reserves$1000


Total Increase in the Money Supply, ($5,000)

Fed buys $1,000 bond from a commercial bank

$1000Excess

Reserves

33-83

4.5.2 Open Market Operations4.5.2 Open Market Operations

Check is DepositedNew Reserves

$1000

Total Increase in the Money Supply, ($5000)

Fed buys $1,000 bond from the public

$200RequiredReserves

$800Excess

Reserves

$1000Initial

CheckableDeposit


33-84

4.6 Tools of Monetary Policy4.6 Tools of Monetary Policy

• The reserve ratioThe reserve ratio• Changes the money multiplierChanges the money multiplier

• The discount rateThe discount rate• The Fed as lender of last resortThe Fed as lender of last resort• Short term loansShort term loans

• Term auction facilityTerm auction facility• Introduced December 2007Introduced December 2007• Banks bid for the right to borrow Banks bid for the right to borrow

reservesreserves 33-85

4.6.1 Tools of Monetary Policy4.6.1 Tools of Monetary Policy

• Open market operations most Open market operations most importantimportant• Reserve ratio last changed 1992Reserve ratio last changed 1992• Discount rate was a passive toolDiscount rate was a passive tool• Term auction facility is newTerm auction facility is new• Guaranteed amount lent by the Guaranteed amount lent by the

FedFed• Anonymous Anonymous 33-86

4.7 The Federal Funds Rate4.7 The Federal Funds Rate

• Rate charged by banks on Rate charged by banks on overnight loansovernight loans• Targeted by the Federal ReserveTargeted by the Federal Reserve• FOMC conducts open market FOMC conducts open market

operations to achieve the targetoperations to achieve the target• Demand curve for Federal fundsDemand curve for Federal funds• Supply curve for Federal fundsSupply curve for Federal funds

33-87

4.7.1 The Federal Funds Rate4.7.1 The Federal Funds Rate

Fed

eral

Fu

nd

s R

ate,

Per

cen

t

3.5

Quantity of Reserves

Df

Sf3

4.0

4.5

Sf1

Sf2

Qf3 Qf1 Qf2

Using Open Market Operations

33-88

4.8 Monetary Policy4.8 Monetary Policy

• Expansionary monetary Expansionary monetary policypolicy• Economy faces a recessionEconomy faces a recession

• Lower target for federal funds rateLower target for federal funds rate

• Fed buys securities Fed buys securities

• Expanded money supplyExpanded money supply

• Downward pressure on other interest ratesDownward pressure on other interest rates

• Contractionary monetary Contractionary monetary policypolicy

33-89

4.9 Taylor Rule4.9 Taylor Rule

• Rule of thumb for tracking actual Rule of thumb for tracking actual monetary policymonetary policy• Fed has 2% target inflation rateFed has 2% target inflation rate• If real GDP = potential GDP and If real GDP = potential GDP and

inflation is 2% then target inflation is 2% then target federal funds rate is 4%federal funds rate is 4%• Target varies as inflation and Target varies as inflation and

real GDP varyreal GDP vary 33-90


• Affect on real GDP and price Affect on real GDP and price levellevel• Cause-effect chainCause-effect chain

• Market for moneyMarket for money

• Investment and the interest rateInvestment and the interest rate

• Investment and aggregate demandInvestment and aggregate demand

• Real GDP and pricesReal GDP and prices

• Expansionary monetary policy Expansionary monetary policy • Restrictive monetary policyRestrictive monetary policy 33-91

4.11 Monetary Policy and GDP4.11 Monetary Policy and GDP

10

8

6

0

Rat

e o

f In

tere

st, i

(P

erce

nt)

Amount of moneydemanded and

supplied(billions of dollars)

Amount of investment (billions of dollars)

Pri

ce

Le

ve

l

Real GDP(billions of dollars)

Q1 Qf Q3$125 $150 $175 $15 $20 $25

P2

P3

Sm1 Sm2 Sm3

Dm

IDAD1

I=$15

AD2

I=$20

AD3

I=$25

(a)The marketfor money

(b)Investment

demand

(c)Equilibrium real

GDP and thePrice level

AS

33-92

4.12 Expansionary Monetary Policy4.12 Expansionary Monetary Policy

Problem: unemployment and recession

Fed buys bonds, lowers reserve ratio, lowers the discount rate, or increases reserve auctions

Excess reserves increase

Federal funds rate falls

Money supply rises

Interest rate falls

Investment spending increases

Aggregate demand increases

Real GDP rises

CA

US

E-E

FFEC

T C

HA

IN

33-93

4.13 Restrictive Monetary Policy4.13 Restrictive Monetary PolicyProblem: inflation

Fed sells bonds, increases reserve ratio, increases the discount rate, or decreases reserve auctions

Excess reserves decrease

Federal funds rate rises

Money supply falls

Interest rate rises

Investment spending decreases

Aggregate demand decreases

Inflation declines

CA

US

E-E

FFEC

T C

HA

IN

33-94


• Advantages over fiscal policyAdvantages over fiscal policy• Speed and flexibilitySpeed and flexibility• Isolation from political pressureIsolation from political pressure

• Recent U.S. monetary policyRecent U.S. monetary policy• Problems and complicationsProblems and complications• Recognition lagRecognition lag• Operational lag Operational lag • Cyclical asymmetry Cyclical asymmetry

33-95

4.15 The Big Picture4.15 The Big Picture

Levels ofOutput,

Employment,Income, and

Prices

AggregateDemand

AggregateSupply

InputResourcesWith Prices

ProductivitySources

Legal-InstitutionalEnvironment

Consumption(Ca)

Investment(Ig)

Net ExportSpending

(Xn)

GovernmentSpending

(G)

33-96

4.16 The Mortgage Debt Crisis4.16 The Mortgage Debt Crisis

• Home mortgage default 2007Home mortgage default 2007• Banks write off bad loansBanks write off bad loans• Reserves reducedReserves reduced• Fed as lender of last resortFed as lender of last resort• Term auction facilityTerm auction facility• Fed lowered federal funds rateFed lowered federal funds rate• Mortgage backed securities as a Mortgage backed securities as a

new innovationnew innovation• Bad incentivesBad incentives

33-97

5. The US Subprime Crisis

Video : Capitalism : A Love Video : Capitalism : A Love StoryStory

““Over all history, money has Over all history, money has oppressed people in one of oppressed people in one of two ways: either it has been two ways: either it has been abundant and very unreliable, abundant and very unreliable, or reliable and very scarce.”or reliable and very scarce.”

John Kenneth GalbraithJohn Kenneth Galbraith, The Age of Uncertainty , The Age of Uncertainty (1977)(1977)

ConclusionConclusion

““Understanding the forces that Understanding the forces that affect aggregate demand, including affect aggregate demand, including government fiscal and monetary government fiscal and monetary policies, can help economists and policies, can help economists and policymakers smooth out the cycle policymakers smooth out the cycle of boom and bust.” of boom and bust.”

Paul Samuelson

Casestudy : IKEACasestudy : IKEA

1.1. Read and prepare the Read and prepare the Casestudy on IKEA Casestudy on IKEA (Johnson, Whittington & (Johnson, Whittington & Scholes (2011)) for Scholes (2011)) for discussion and discussion and presentation next week. presentation next week.

2.2. Identify and evaluate the Identify and evaluate the challenges facing IKEA challenges facing IKEA during the global recession, during the global recession, by conducting External by conducting External Environment, Industry, Environment, Industry, Competitor analysis and Competitor analysis and SWOT.SWOT.

Core ReadingCore Reading

Juleff, L, Chalmers, A.. and Harte, P. (2008) Business Economics in a Global Juleff, L, Chalmers, A.. and Harte, P. (2008) Business Economics in a Global Environment, Napier University EdinburghEnvironment, Napier University Edinburgh

Daniels, J.D., Radebaugh, L.H. and Sullivan, D.P. (2012) International Daniels, J.D., Radebaugh, L.H. and Sullivan, D.P. (2012) International Business: Environments and Operations. 14Business: Environments and Operations. 14thth edition, Pearson edition, Pearson

Samuelson, P.A. and Nordhaus, W. D. (2010)Samuelson, P.A. and Nordhaus, W. D. (2010)“Economics”“Economics” Irwin/McGraw-Hill, 19Irwin/McGraw-Hill, 19thth Edition Edition

Porter, Michael E. (2004)Porter, Michael E. (2004)“Competitive Strategy – Techniques for Analyzing “Competitive Strategy – Techniques for Analyzing Industries and Competitors”Industries and Competitors” Free Press Free Press

Questions?Questions?

Enu macroecon policy 040812

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