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1 Printable Lesson Materials Print these materials as a study guide These printable materials allow you to study away from your computer, which many students find beneficial. These materials consist of two parts: graphic summaries of the content and a multiple choice quiz. Graphic Summaries This portion of your printable materials consists of dozens of frames that summarize the content in this lesson. The frames are arranged on the page to make it easy for you to study the material and add your own notes from your textbook or the online course. Quizzes Many students learn best from sets of questions, and this multiple choice quiz allows you to focus your review of the material to important topics Rockwell Institute NE 20th Street Bellevue, WA

2 Financing Residential Real Estate Lesson 2: Federal Fiscal and Monetary Policy Introduction In this lesson, we will cover: the federal government s fiscal policy taxation the federal government s monetary policy the Federal Reserve system tools for implementing monetary policy Introduction The federal government affects real estate finance by influencing the cost of mortgage funds. The major cost of borrowing money is the interest rate charged by the lender.

3 Introduction The federal government affects real estate finance by influencing the cost of mortgage funds. The major cost of borrowing money is the interest rate charged by the lender. Market interest rates = current cost of $ Introduction The cost of borrowing money is influenced by the federal government in two ways: 1. fiscal policy, and 2. monetary policy. Introduction Fiscal policy Government s actions in raising revenue, spending money, and managing its debt. Monetary policy Government s direct efforts to control the money supply and the cost of money.

4 Set by the government s executive and legislative branches (the president and Congress), who establish federal tax laws and federal budget. Set by the government s executive and legislative branches (the president and Congress), who establish federal tax laws and federal budget. U.S. Treasury Department manages the government s finances, carrying out fiscal policy. Spending and debt financing Federal deficit The shortfall that results when the government spends more money than it takes in.

5 Spending and debt financing Federal deficit The shortfall that results when the government spends more money than it takes in. Treasury obtains funds to cover shortfall by issuing interest-bearing securities. Spending and debt financing Federal deficit The shortfall that results when the government spends more money than it takes in. Treasury obtains funds to cover shortfall by issuing interest-bearing securities. By selling securities to investors, government is borrowing money from the private sector. Leaves less money available for private borrowers. Spending and debt financing Some economists believe federal deficit has little effect on interest rates. Others believe federal borrowing pushes interest rates up.

6 Taxation Tax policies affect how much money taxpayers have left for other purposes: Low taxes = more $ to lend and invest High taxes = less $ to lend or invest Taxation Tax policies affect how much money taxpayers have left for other purposes: Low taxes = more $ to lend and invest High taxes = less $ to lend or invest Tax policies also affect investment choices: High taxes = tax-exempt securities preferred Low taxes = taxable investments attractive Real estate, MBS are taxable. Taxation Taxes also used to implement social policy by providing benefits and incentives, such as: Mortgage interest deductions Exclusion of gain on sale of principal residence

7 Deduction of mortgage interest Taxpayer can deduct (from taxable income) interest paid on one or more home mortgages: Loans for buying, building, or improving 1 st or 2 nd residence Home equity loans Deduction of mortgage interest Loans for buying, building, or improving 1 st or 2 nd residence: Can deduct all interest on loans totaling up to $1,000,000 ($500,000 for married taxpayer filing separately). If total loan amount exceeds that limit, interest paid on excess not deductible. Deduction of mortgage interest Home equity loans can deduct interest paid on smaller of these two amounts: total loan amount up to $100,000 ($50,000 for married taxpayer filing separately), or difference between property value and remaining acquisition debt (purchase loan).

8 Gain on sale of a home Homeowners allowed to exclude from taxation a gain (profit) on the sale of their principal residence. Gain on sale of a home Homeowners allowed to exclude from taxation a gain (profit) on the sale of their principal residence. May exclude up to $250,000 ($500,000 for married couple filing jointly). Gain on sale of a home Homeowners allowed to exclude from taxation a gain (profit) on the sale of their principal residence. May exclude up to $250,000 ($500,000 for married couple filing jointly). Excess taxed at capital gains rate.

9 Gain on sale of a home To qualify, the taxpayer must have owned and used property as principal residence for at least two of the last five years. Gain on sale of a home To qualify, the taxpayer must have owned and used property as principal residence for at least two of the last five years. If married, one spouse must meet ownership test, and both must meet use test. If only one spouse meets both tests, maximum exclusion is $250,000 (if filing jointly). Gain on sale of a home Reduced exclusions are allowed under special circumstances when taxpayers have owned the house for less than 2 years. For example, if home sold because of: change in health, place of employment, or unforeseen circumstances.

10 Cost recovery deductions for investors Owners of income property are allowed to take cost recovery deductions. Deduct cost of buildings and property improvements that will eventually have to be replaced. Cost recovery deductions for investors Owners of income property are allowed to take cost recovery deductions. Deduct cost of buildings and property improvements that will eventually have to be replaced. Cost spread out over a number of years, not deducted all at once. Summary Fiscal policy Federal deficit Taxation Deduction of mortgage interest Exclusion of gain on sale of home Cost recovery deductions

11 Monetary Policy Government uses its control over the money supply to keep the national economy running smoothly. Monetary Policy Monetary policy is set and implemented by the ( the Fed ). Historical background In early 19 th century, there was little government regulation of depository institutions. Security of bank deposits depended on the integrity of bank managers.

12 Historical background In 1863, Congress passed the National Bank Act. Established basic banking regulations and procedures for supervising commercial banks. Historical background Economic downturns would lead to financial panics, and bank depositors would withdraw all of their money at once. Caused even financially sound banks to fail. Historical background Economic downturns would lead to financial panics, and bank depositors would withdraw all of their money at once. Caused even financially sound banks to fail. Public resistant to idea of central national bank. Losses from panics of 1907 changed public opinion.

13 Historical background Federal Reserve Acts of 1913 and 1916 created the and established the modern banking system. Historical background Federal Reserve Acts of 1913 and 1916 created the and established the modern banking system. Reserve requirement Certain proportion of bank s deposits must be held in reserve, available for immediate withdrawal on demand. Historical background The Fed is lender of last resort, providing shortterm backup loans to banks that run low on funds.

14 Historical background Creation of the Fed helped, but did not solve, problem of financial panics. Historical background Creation of the Fed helped, but did not solve, problem of financial panics. In 1930s, the Federal Deposit Insurance Corporation (FDIC) and Federal Savings and Loan Insurance Corporation (FSLIC) were created to boost depositor confidence. Organization is made up of: 12 regional Federal Reserve Banks in 12 Federal Reserve Districts Federal Reserve Board Federal Open Market Committee advisory councils over 2,500 member banks

15 Organization Board of Governors Controls Federal Reserve system. 7 members, appointed by President, confirmed by Senate for 14-year terms. Chosen from different Federal Reserve Districts. Chairman chosen for 4-year term from among governors. Organization Board of Governors Sets reserve requirements for commercial banks. Controls discount rate (interest rate set by the Federal Reserve Banks). Organization Federal Reserve Banks Each district has one main Federal Reserve Bank. Some districts also have branch banks.

16 Organization Federal Reserve Banks Each district has one main Federal Reserve Bank. Some districts also have branch banks. Each reserve bank is owned by the member banks in its district. Organization Federal Reserve Banks Each district has one main Federal Reserve Bank. Some districts also have branch banks. Each reserve bank is owned by the member banks in its district. Each reserve bank appoints a banker to the Federal Advisory Council. Summary The Monetary policy Reserve requirements Lender of last resort Board of Governors Federal Reserve Board Federal Open Market Committee

17 Economic growth and inflation Fed s goal is to maintain a healthy U.S. economy. Economic growth that is too strong or too fast is accompanied by inflation. Economic growth and inflation Fed s goal is to maintain a healthy U.S. economy. Economic growth that is too strong or too fast is accompanied by inflation. Inflation = trend of general price increases throughout the economy Tools for implementing policy The Fed relies on three tools to implement its monetary policy and influence the economy: reserve requirements, interest rates, and open market operations.

18 Reserve requirements Banks required to maintain percentage of deposits on reserve in own vaults or at the district Federal Reserve Bank. Reserve requirements Banks required to maintain percentage of deposits on reserve in own vaults or at the district Federal Reserve Bank. May be as much as 10%, depending on amount of deposits at bank. Reserve requirements Depository Institutions Deregulation and Monetary Control Act of 1980 subjected all commercial banks to same reserve requirements as Federal Reserve members.

19 Reserve requirements Increase in reserve requirements = decrease in funds available for investment and increase in interest rates. Reserve requirements Increase in reserve requirements = decrease in funds available for investment and increase in interest rates. Decrease in reserve requirements = increase in supply of funds and decrease in interest rates. Interest rates The Fed has control over two key interest rates: federal discount rate, and federal funds rate.

20 Interest rates Federal discount rate Interest rate charged when a bank borrows money from a Federal Reserve Bank to cover shortfall in funds. Interest rates Federal funds rate Interest rate banks charge each other for overnight, unsecured loans. Interest rates Federal funds rate Interest rate banks charge each other for overnight, unsecured loans. Banks can borrow funds from other banks to meet reserve requirements.

21 Interest rates Federal funds rate Interest rate banks charge each other for overnight, unsecured loans. Banks can borrow funds from other banks to meet reserve requirements. Rate set by banks. Interest rates Federal funds rate Interest rate banks charge each other for overnight, unsecured loans. Banks can borrow funds from other banks to meet reserve requirements. Rate set by banks. Federal Open Market Committee sets target for federal funds rate. Interest rates When the Fed raises or lowers either rate, it s an indication of its overall view of the economy.

22 Interest rates When the Fed raises or lowers either rate, it s an indication of its overall view of the economy. Lenders often make corresponding changes to the interest rates they charge customers. Interest rates When the Fed raises or lowers either rate, it s an indication of the overall view of the economy. Lenders often make corresponding changes to the interest rates they charge customers. Some change rates in anticipation of rate changes by the Fed. Interest rates Short-term interest rates most affected by changes in discount and federal funds rates. Long-term interest rates (mortgage rates) don t respond directly to Fed s rate adjustments.

23 Open market operations The Fed also buys and sells government securities in transactions called open market operations. Open market operations The Fed also buys and sells government securities in transactions called open market operations. Conducted by Securities Department of Federal Reserve Bank of New York (the Trading Desk ). Federal Open Market Committee (FOMC) issues directives for these transactions. Open market operations FOMC is the most important policy-making organization in the Fed.

24 Open market operations FOMC is the most important policy-making organization in the Fed. 8 regularly scheduled meetings per year Open market operations FOMC is the most important policy-making organization in the Fed. 8 regularly scheduled meetings per year 12 members: 7 members of Federal Reserve Board president of NY Federal Reserve Bank 4 other Reserve Bank presidents Open market operations Open market operations are the Fed s primary means of controlling the money supply.

25 Open market operations Open market operations are the Fed s primary means of controlling the money supply. The money supply: increases when Fed buys government securities, and Open market operations Open market operations are the Fed s primary means of controlling the money supply. The money supply: increases when Fed buys government securities, and decreases when Fed sells government securities. Open market operations Increased money supply is supposed to lower interest rates. But other factors can put pressure on rates.

26 Open market operations Increased money supply is supposed to lower interest rates. But other factors can put pressure on rates. The Fed uses open market operations and other tools to balance complicated forces. Changes in monetary policy Monetary policy is experimental, and the Fed changes strategies from time to time. Changes in monetary policy Monetary policy is experimental, and the Fed changes strategies from time to time. 1970s: Fed moderated interest rates by increasing money supply when interest rates rose.

27 Changes in monetary policy Monetary policy is experimental, and the Fed changes strategies from time to time. 1970s: Fed moderated interest rates by increasing money supply when interest rates rose. When inflation became a concern, Fed tried to control it by restricting growth of money supply. Changes in monetary policy Monetary policy is experimental, and the Fed changes strategies from time to time. 1970s: Fed moderated interest rates by increasing money supply when interest rates rose. When inflation became a concern, Fed tried to control it by restricting growth of money supply. Then interest rates soared. Changes in monetary policy By 1982, inflation was under control.

28 Changes in monetary policy By 1982, inflation was under control. Fed once again focused on preventing large fluctuations in interest rates. Changes in monetary policy By 1982, inflation was under control. Fed once again focused on preventing large fluctuations in interest rates. Remainder of 20 th century: moderate inflation lower, stable interest rates Changes in monetary policy New century: economy slowed.

29 Changes in monetary policy New century: economy slowed. Fed lowered interest rates sharply to stimulate economic growth. Changes in monetary policy New century: economy slowed. Fed lowered interest rates sharply to stimulate economic growth. Growth led to inflation concerns again, so Fed gradually increased interest rates. Changes in monetary policy New century: economy slowed. Fed lowered interest rates sharply to stimulate economic growth. Growth led to inflation concerns again, so Fed gradually increased interest rates. 2007: as credit crisis began, Fed started lowering interest rates again.

30 Summary Implementing Monetary Policy Interest rates Discount rate Federal funds rate Federal Open Market Committee Open market operations Inflation

31 Real Estate Finance Lesson 2 Cumulative Quiz 1. The federal government's actions in raising revenue, spending money, and managing debt are referred to as: A. deficit policy B. fiscal policy C. monetary policy D. trade policy 2. A federal deficit occurs when, in a given year, the federal government: A. receives more revenue than it spends B. reduces the amount it spends compared with the previous year C. spends more than it receives in revenue D. spends more than it spent in the previous year 3. An unmarried homeowner may deduct mortgage interest on a loan to purchase a first or second residence, up to a loan amount of: A. $100,000 B. $250,000 C. $500,000 D. $1,000, Which of the following is a type of deduction that an owner of income-producing property can take, but a homeowner can't? A. Cost recovery (depreciation) deduction B. Exclusion of gain from sale C. Mortgage interest deduction D. All of the above 5. The was created through the: A. Federal Reserve Acts of 1913 and 1916 B. Financial Institutions Reform, Recovery, and Enforcement Act of 1989 C. Glass-Steagall Act of 1933 D. National Bank Act of How many members of the Federal Reserve Board are there? A. 7 B. 9 C. 12 D Rockwell Publishing 1

32 7. Frequent and widespread bank panics led to the creation of the: A. mortgage interest deduction B. federal deficit C. Federal Open Market Committee D. Federal Deposit Insurance Corporation 8. Which of the following is not a tool the may use to influence the economy? A. Interest rates B. Open market operations C. Reserve requirements D. Tax rates 9. The interest rate that banks charge each other for overnight loans is the: A. discount rate B. federal funds rate C. prevailing market rate D. prime rate 10. A bank must keep a certain percentage of its deposits either in its own vault or on deposit with the Federal Reserve Bank in order to comply with the Fed's: A. federal funds rate targeting B. rules for open market operations C. reserve requirements D. fiscal policy 11. When the Fed buys and sells government securities, the transactions are known as: A. convertible sales B. open market operations C. reserve requirements D. secured transactions 12. If the government wants to increase the money supply, it can: A. buy government securities and decrease reserve requirements B. buy government securities and increase reserve requirements C. sell government securities and decrease reserve requirements D. sell government securities and increase reserve requirements 13. When the Fed tried to control inflation by decreasing the money supply in the early 1980s: A. reserve requirements dropped sharply B. interest rates dropped sharply C. interest rates went up sharply D. it caused widespread bank failures 2009 Rockwell Publishing 2

33 14. Which of the following is not a component of the federal government's fiscal policy? A. Debt financing B. Key interest rates C. Spending D. Taxation 15. An unmarried taxpayer sells her principal residence and turns a large profit on the transaction. How much of the gain is excluded from taxation? A. $100,000 B. $250,000 C. $500,000 D. $1,000, Which of the following is not one of the responsibilities of the? A. Impose reserve requirements B. Issue interest-bearing securities C. Perform periodic bank examinations D. Regulate commercial banks 17. A Federal Reserve Bank is 'owned' by: A. individual investors B. large investors such as insurance companies and pension funds C. member banks within its district D. the Treasury Department 18. If the economy grows too quickly, what is likely to be the undesirable result? A. Deflation B. Federal deficit C. Inflation D. Trade deficit 19. Which of the following is set by each Federal Reserve Bank, with the approval of the Federal Reserve Board? A. Discount rate B. Federal funds rate C. Inflation targets D. Reserve requirements 2009 Rockwell Publishing 3

34 20. The Federal Open Market Committee could try to stimulate a sluggish economy by: A. increasing interest rates in an effort to keep inflation in control B. lowering the discount rate while increasing the federal funds rate C. increasing certain reserve requirements and decreasing others D. buying government securities in an effort to reduce market interest rates 2009 Rockwell Publishing 4