Fiscal Monetary Policy Rob Mrkonich October 22 2013 This document is designed to simplify monetary and fiscal policy into a sequence of manageable steps It first goes through fiscal policy before addressing monetary policy Note What is called CISOM in the class slides I refer to as C I G The reason for this is both to make notation simpler and to remind you of what CISOM actually means a change in one of consumption government expenditure or investment No graphs are included but I would suggest drawing them while reading to help visualize what is happening 1 For both Monetary and Fiscal Policy What is the GDP Gap Y Y Y Where Y is observed output and Y is long run aggregate supply AKA NRO Natural Rate of Output This tells us that the change in Y necessary to return the economy to equilibrium is Y 2 For both Monetary and Fiscal Policy What change is necessary in C I G to close this gap Y 1 C I G 1 mpc Solve for C I G as we know both Y and the mpc 3 For Fiscal Policy What change in G will close the gap Y 1 G 1 mpc This means G C I G from above Note On exams we will also give you an initial level of government spending and ask what the final level is To calculate the final level simply add the change in government spending to the intial level 4 For Fiscal Policy What change in T will close the gap This one is harder We know that Y 1 C 1 mpc 1 Gets us back to NRO But how do taxes affect C Taxes first go to consumers before their effect is felt in the output market When we give wealth to consumers in our model they behave simply They save some of it and the spend some of it Thus if for example we give a tax cut to households the wealth they receive gets hit by the marginal propensity to consume mpc and then is spent as C Furthermore we think that the relation between taxes and consumption is negative meaning if the government taxes consumers more they spend less and vice versa This yields the following relationship Y 1 C 1 mpc C mpc T Thus for fiscal policy using taxes we get the following formula Y mpc T 1 mpc 5 For Monetary Policy What is the change in investment necessary We know this from part 2 Y 1 I 1 mpc 6 For Monetary Policy What is the initial money supply In order to implement monetary policy we must find a relationship between changes in the money supply and changes in investment This will be a somewhat lengthy ordeal but it is a logical and linear path We have two markets the money market and the loanable funds market They both share a common price the nominal interest rate i Thus using changes in the money supply we can hypothetically affect the amount of loanable funds meaning we can change loanable funds demanded which in turn equals I How does this work We first notice we are in equilibrium in both markets to start If in equilibrium I The Federal Reserve increase the money supply suddenly you the consumer find yourself holding too many pieces of paper for the given interest rate note this is not an increase in wealth simply an increase in green pieces of paper in your pocket 2 What do you do with the excess paper You bring it to the bank to get interest on it because you have as much money on you as you want at the current interest rate This increases savings or loanable funds supplied This shift in loanable funds supplied decreases the interest rate and increases quantity of loanable funds supplied and demanded Thus investment increases Given the functional forms we can calculate these changes explicitly The first step in this process then is to calculate our intial conditions First we will calculate the money supply M Sinitial 1 ID RR 7 For Monetary Policy Use the money demand M D equation to calculate the initial interest rate We know that in equilibrium M S M D so we can calculate iinitial 8 For Monetary Policy Use initial interest rate in loanable funds demand LFd equation to calculate Iinitial Note LFd I 9 For Monetary Policy Find the final level of I that corresponds with closing the GDP gap Iinitial I If inal 10 For Monetary Policy Plug in the final level of investment into LFd to get if inal 11 For Monetary Policy Plug if inal into M D to get M Sf inal Again in equilibrium M S M D 12 For Monetary Policy Find the change in either i the change in the amount of initial deposits or ii the new reserve ratio necessary to achieve M Sf inal i M Sf inal 1 IDf inal RR Which gives us the answer ID IDf inal ID This is called open market operations The change in initial deposits is accomplished through the buying and selling of bonds on the open market If I the Fed buy bonds I am injecting dollar bills into the economy and if I sell them I am taking currency out of it 3 ii M Sf inal 1 ID RRnew Changing the reserve ratio is simpler than OMO but it is also not done as often in practice As a final note while the numbers associated with the equations might change this process will not 4
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