Econ 1202 1st Edition Lecture 21 Outline of Lecture 20 (Money and Banking (continued)/Monetary and Fiscal Policy)I. How is Money Created?II. Multiple Expansion of Money SupplyIII. Simple Money or Deposit MultiplierIV. What is Happening and its Significance?V. One Tool of Monetary PolicyVI. Prices and MoneyVII. Price RevolutionVIII. Quantity Theory of MoneyIX. From an Identity to a “Monetary Workhorse”X. Reformation of QTMXI. Monetary PolicyXII. Tools of Monetary PolicyXIII. Monetary Policy TargetsXIV. Critical PointXV. Second Critical PointXVI. Money MarketOutline of Lecture 21 (Monetary and Fiscal Policy (continued))I. Money DemandII. Shifts in the Money Demand CurveIII. Money SupplyIV. Equilibrium in the Money MarketV. Expansionary Monetary PolicyVI. Contractionary Monetary PolicyVII. Policy TargetsVIII. Taylor RuleIX. Fiscal PolicyX. Expansionary Fiscal PolicyXI. Contractionary Fiscal PolicyXII. Multiplier: How Much Bang for each Buck of Expenditure?XIII. The “Math” Behind the MultiplierXIV. Simple MultiplierMonetary and Fiscal Policy (continued)I. Money Demanda. Money is mostly a liquid asseti. Can be used to buy goods and servicesb. Interest rate is the opportunity cost of holding moneyc. Money demand curve is downward slopingi. Increase in the interest rate…1. Raises the cost of holding money2. Reduces the quantity of money demandedII. Shifts in the Money Demand Curvea. A change in the need to hold money, to engage in transactionsb. Decreases in real GDP or the price level decreases money demandIII. Money Supplya. Controlled by the Fedi. Critical assumption: the Fed can completely control the money supply 1. Not true because then we would always be in equilibriumb. Quantity of money suppliedi. Fixed by Fed policyii. Does not vary with interest ratec. Fed alters the money supplyi. Changing the quantity of reserves in the banking system1. Purchase and sale of government bonds in open-market operationsIV. Equilibrium in the Money Marketa. Interest rate adjusts to balance the supply and demand for moneyi. Equilibrium interest rateb. Quantity of money demanded exactly balances the quantity of money suppliedV. Expansionary Monetary Policya. Expansionary Monetary Policy-efforts by the fed to expand the level of (orrate of growth in) aggregate demand, and thus, real GDP by expanding the (or rate of growth in) money supply and lowing interest rates and the targets federal funds rateb. How?i. Change in reserves goes up, change in money goes up, change in interest rates goes down, change in consumption and investment goes up, and change in aggregate demand goes upc. When the fed increases the money supply, the short-term interest rate must fall until it reaches a level at which households and firms are willing to hold the additional moneyVI. Contractionary Monetary Policya. Contractionary Money Policy-efforts by the Fed to contract (or reduce therate of growth) in the level of aggregate demand, and thus inflation, by contracting (or reducing the rate of growth) in the money supply and raising interest rates and the targets federal funds ratesb. How?i. Change in reserves goes down, change in money goes down, change in interest rates goes up, change in consumption and investment goes down, and change in aggregate demand goes downc. When the Fed decreases the money supply, the short-term interest rate must rise until it reaches a level at which households and firms are willingto hold less moneyVII. Policy Targetsa. Federal Funds Rateb. Money Supplyc. Monetary Growth Rated. Inflation Rule e. GDP MeasuresVIII. Taylor Rulea. Targeted Federal Funds Rate=Inflation Rate+Equilibrium Real Federal Funds Rate+1/2(Actual Inflation-Targets Inflation)+1/2(Actual GDP Growth-Potential GDP Growth)b. Example:i. Actual Rate of Inflation=4%ii. Equilibrium Federal Funds Rate=2iii. Targeted Inflation=2%iv. Real GDP Growth=4%v. Potential GDP Growth=3%vi. Expected Targeted Federal Funds Rate=4%+25+1/2(4%-2%)+1/2(4%-3%)=4.5%IX. Fiscal Policya. Fiscal Policy-the purposeful spending and taxing policies of the Federal Government to achieve macroeconomic policy objectivesb. Basic Idea: set the level of government spending and taxation to alter the level of aggregate demandi. Multiplier Effectii. Crowding-Out Effectc. Automatic Stabilizer-government spending and taxes that automatically increase or decrease along with the business cyclei. Example: unemployment insurance paymentsd. Discretionary Fiscal Policy-purposeful or intentional government spendingand taxes that intended to achieve macroeconomic goals X. Expansionary Fiscal Policya. Involves the increasing of government purchases or decreasing taxesb. Increasing government purchases directly increases aggregate demandc. Decreasing taxes indirectly affects aggregate demand by increasing disposable income and hence consumption spendingXI. Contractionary Fiscal Policya. Involves decreasing government purchases or increasing taxesb. This works just like expansionary fiscal policy, but only in reverseXII. Multiplier: How Much Bang for each Buck of Expenditure?a. The theory of the multiplier effecti. Additional shifts in aggregate demand1. Result when expansionary fiscal policy increases income and thereby increases consumer spendingii. Example: increase in government purchases by $20 billion1. Aggregate demand curve shifts to the right $20 billion, but government’s expenditure is income for someone else Consumers respond by increasing their spendingaggregate demand curve shifts to the right againXIII. The “Math” Behind the Multipliera. Basic Idea: we spend a certain fraction of our income on goods and save the resti. That fraction (of which we spend) is called the marginal propensityto consumer (MPC)1. The MPC is the fraction of extra income that consumers spend or change in consumption/change in GDPii. Each round of expenditure creates a round of income, which in turn, brings another round of expenditure and so onb. Basic Conclusion: size of the multiplier depends on the MPCi. With a larger MPC results a larger multiplierii. Because of the multiplier effect, $1 of government purchases can generate>$1 of aggregate demand, but an increase in aggregate demand won’t only result in real GDP rising1. It will also result in a price level increase because the short-run aggregate supply curve is upward slopingXIV. Simple Multipliera. Simple Spending