Monetary Fiscal Part VIII: Short-Run and 26. Short-Run 27. 1 / 52
Monetary Chapter 27 Fiscal 2017.8.31. 2 / 52
Monetary Fiscal 1 2 Monetary 3 Fiscal 4 3 / 52
Monetary Fiscal Project funded by the American Recovery and Reinvestment Act Q: How much does government expenditure stimulate GDP? 4 / 52
Monetary Fiscal policies attempt to reduce the intensity of economic fluctuations and smooth the growth rates of employment, GDP, and prices. monetary policy reduces economic fluctuations by manipulating bank reserves and interest rates. Expansionary monetary policy increases bank reserves and decreases interest rates. Contractionary monetary policy decreases bank reserves and increases interest rates. 5 / 52
Monetary Fiscal fiscal policy reduces fluctuations by manipulating government expenditures and taxes. Expansionary fiscal policy increases government expenditure and decreases taxes. Contractionary fiscal policy decreases government expenditure and increases taxes. 6 / 52
Monetary Fiscal 27.1 Policies in In the previous chapter, we looked at how the economy experiences recessions and expansions in the short run. Exhibit 26.2 Percent Deviation Between U.S. Real GDP and Its Trend Line (1929-2013) 7 / 52
Monetary Fiscal The dotted red line is the path of GDP without countercyclical policy, and the solid blue line is the path of GDP after countercyclical policy. policies attempt to reduce the intensity of economic fluctuations and smooth GDP growth rate. Expansionary policy aims to reduce the severity of an economic recession by shifting labor demand to the right and expanding economic activity (GDP). It is meant to heat up the economy. 8 / 52
Monetary Fiscal Exhibit 27.1 Panel (a) The Effect of on the Labor Market Panel, Flexible wage case 9 / 52
Monetary Fiscal Exhibit 27.1 Panel (b) The Effect of on the Labor Market Panel, Rigid wage case 10 / 52
Monetary Fiscal Exhibit 26.15 Rightward Shift in the Labor Demand Curve 11 / 52
Monetary Fiscal Contractionary policy is used to slow down the economy when it grows too fast, or overheats. Question: Why would policymakers want to reduce employment and GDP growth? Answer 1: A contractionary policy can reduce inflation by slowing the growth rate of the money supply. Answer 2: A contractionary policy can reduce the risks of an extreme contraction by trying to cool off the economy before it overheats. 12 / 52
Monetary Fiscal 27.2 Monetary monetary policy is conducted by the central bank, the Federal Reserve, or the Fed. The Fed influences short-term interest rates, especially the federal funds rate. An expansionary monetary policy lowers short-term interest rates to increase economic activity. Question: How does a reduction in the overnight federal funds rate lead to more production? 13 / 52
Answer: Monetary Fiscal Exhibit 27.2 Expansionary Monetary 14 / 52
Monetary Fiscal Controlling the Federal Funds Rate The primary tool of monetary policy is the Fed s control of the federal funds rate. The Fed influences the federal funds rate through open market operations. In an open market operation, the Fed transacts with private banks to increase or decrease bank reserves held at the Fed. The Fed can increase the supply of reserves through open market purchases. The Fed can decrease the supply of reserves through an open market sale. 15 / 52
Monetary Fiscal Exhibit 27.3 The Federal Funds Market 16 / 52
Monetary Fiscal Exhibit 27.4 Balance Sheet of Citibank Before and After $1 Billion Bond Sale to the Fed 17 / 52
Monetary Fiscal Exhibit 27.5 Balance Sheet of the Fed Before and After $1 Billion Bond Purchase from Citibank 18 / 52
Monetary Fiscal Most of the time, total reserves held at the Fed fluctuate between $40 billion and $80 billion. During and after the 2007-2009 recession, the Fed drastically expanded the quantity of reserves banks held to $2.5 trillion to drive down interest rates. This dramatic increase was mostly due to an expansion in excess reserves reserves above and beyond the regulatory minimum. 19 / 52
Monetary Fiscal Exhibit 27.6 Total Reserves on Deposit at the Federal Reserve Bank (Monthly Data from January 1959 Through December 2013) 20 / 52
Monetary Fiscal Other Tools of the Fed The Fed has other tools available to impact bank reserves: Changing the reserve requirement Changing the interest rate paid on reserves deposited at the Fed Lending from the discount window to banks Quantitative easing Buy long-term bonds to increase bank s reserves, which drive up the price of bonds, and thus drive down long-term interests. e.g. The Fed joined with the U.S. Treasury Department to prop up AIG by extending AIG loans, credit lines, and other guarantees for a total of nearly $200 billion. 21 / 52
Monetary Fiscal Expectations, Inflation, The effectiveness of monetary policy depends on expectations about interest rates and inflation. Long-term expected real interest rate = Long-term nominal interest rate - Long-term expected inflation rate The Fed can communicate (and hopefully convince the public) that it will maintain an expansionary monetary policy, holding down the federal funds rate and propping up the inflation rate, for a long period of time. 22 / 52
Monetary Fiscal Exhibit 27.7 The Path from Reserves to Inflation 23 / 52
Monetary Fiscal Contractionary Monetary : Control of Inflation What about contractionary monetary policy? It is the opposite of expansionary policy: Contractionary monetary policy slows down growth in bank reserves, raises interest rates, reduces borrowing, slows growth in the money supply, and reduces the rate of inflation. In 1979, the U.S. public expected that inflation would remain at a high level for the foreseeable future. The new Fed chairman, Paul Volcker, stepped in with a sharply contractionary monetary policy. He drastically slowed the growth rate of money, which raised the federal funds rate to 20% and resulted in the 1981 recession and a unemployment rate of 10.8%. Volcker managed to reclaim the Fed s credibility for fighting inflation. 24 / 52
Zero Lower Bound What happens if the central bank pushes the policy rate to the zero lower bound? Let s use the example of Japan from 1990 to 2010. Monetary Fiscal Exhibit 27.8 Japan s Interbank Lending Rate from 1987 to 2013 25 / 52
Monetary Fiscal 26 / 52
Monetary Fiscal Banks generally won t lend money at an interest rate that is below zero (zero lower bond). The combination of the zero lower bound and deflation is a problem for monetary policy. Why? Households and firms make investment decisions based on: Expected real interest rate =Nominal interest rate - Expected inflation rate = 0% - (-1%) = 1% If the inflation rate keeps falling (further below) zero, the real interest rate will rise, reducing investment and shifting the labor demand curve to the left. 27 / 52
Monetary Fiscal Trade-offs Monetary policymakers face many conflicting considerations: The Fed would like to stimulate the economy during a recession, but the Fed does not want to risk runaway inflation. How should the Fed make this trade-off? 28 / 52
Monetary Fiscal The Taylor rule, named after economist John Taylor who first suggested it, provides one answer: Federal funds rate = Long run federal funds rate target +1.5 (Inflation rate Inflation rate target) +0.5 (Output gap in % points) GDP Trend GDP where Output gap = 100 Trend GDP The Fed raises the federal funds rate 1.5% for each 1% increase in the inflation rate. The Fed raises the federal funds rate 0.5% for each 1% increase in the output gap. 29 / 52
Monetary Fiscal In early 2014, inflation was 1.5%, output gap is -5%, funeral fund rate target is 3.5%, and inflation target is 2%. The Taylor rule recommends Federal funds rate at: 3.5% + 1.5 (1.5% 2.0%) + 0.5 ( 5%) = 0.25% The Taylor rule is just a rule of thumb. Monetary policy is as much an art as a science policymakers need to use their intuition and wisdom, not just a simple formula. However, the Taylor rule is a good starting point for their deliberations and a rough-and-ready summary of the trade-offs that central banks have made in the past. 30 / 52
Monetary Fiscal 27.3 Fiscal fiscal policy is passed by the legislative branch (i.e., Congress) and signed into law by the executive branch (i.e., the president). Expansionary fiscal policy uses higher government expenditure and lower taxes to increase the growth rate of real GDP. It shifts the labor demand curve to the right. Contractionary fiscal policy uses lower government expenditure and higher taxes to reduce the growth rate of real GDP. It shifts the labor demand curve to the left. 31 / 52
Monetary Fiscal Fiscal Over the Business Cycle: Automatic and Discretionary Components 1. Automatic countercyclical components are aspects of fiscal policy that automatically partially offset economic fluctuations for example, falling tax collection, unemployment insurance and food stamps. These mechanisms are referred to as automatic stablizers. 2. Discretionary countercyclical components are aspects of fiscal policy that policymakers deliberately enact in response to economic fluctuations for example, the $152 billions of tax cut in Stimulus Act of 2008, and the $787 billion American Recovery and Reinvestment Act of 2009. 32 / 52
Monetary Fiscal Exhibit 27.9 U.S. Government Accounts from 2007 to 2010 Combining Federal, State, and Local Governments (Constant 2009 Dollars) The basic idea is that higher government expenditure and lower taxation increase spending by households, firms, and government, which translates into demand for firm s products, and in turn increases demand for labor, shifting the labor demand to the right. 33 / 52
Monetary Fiscal Analysis of Expenditure-Based Fiscal National income accounting identity: Y = C + I + G + X M A $1 increase in G under the first scenario: [Y + 1] = C + I + [G + 1] + X M The government expenditure multiplier is the $m change in GDP resulting from a $1 change in government expenditures. Question: What is the value of the multiplier? Answer: The government expenditure multiplier m under the first scenario is $1/$1 = 1. 34 / 52
Monetary Fiscal A $1 increase in G under the second scenario, assume that the multiplier effect raises household consumption by $1 (in addition to the original $1 increase in G): [Y + 2] = [C + 1] + I + [G + 1] + X M Question: What is the value of the multiplier? Answer: The government expenditure multiplier m under the second scenario is $2/$1 = 2. Advocates of expenditure-based fiscal policy believe that the government expenditure multiplier lies between 1 and 2 but can be as high as 3 for certain types of government spending. 35 / 52
Monetary Fiscal Crowding Out Crowding out occurs when rising government expenditures partially or even fully displace expenditures by households and firms. As the government borrows to pay its bills, the interest rate in the credit market rises. If private investment becomes too expensive, it might fall by $1. A $1 increase in G under the crowding out scenario: Y = C + [I 1] + [G + 1] + X M Question: What is the value of the multiplier? Answer: The government expenditure multiplier m under the crowding out scenario is $0/$1 =0. Critics of expenditure-based fiscal policy emphasize crowding out and believe that the multiplier is well below 1 and might even be close to zero. 36 / 52
Monetary Fiscal Question: Which is the right scenario? Answer: Economists are not completely sure. However, they do believe that the multiplier is closer to zero when the economy is already booming. Envision an economy suffering from an extreme contraction, and further assume that monetary policy has been rendered less effective because interest rates have already been lowered to zero and can t be lowered any further, this is the situation of the U.S. economy in the aftermath of the 2007-2009 recession. Additional government expenditure might only weakly crowed out private consumption and investment, and can then encourage the utilization of some of the idle capacity and unemployed workers. 37 / 52
Monetary Fiscal Question: What was the impact of the $120 billion in government expenditures of the American Recovery and Reinvestment Act in 2009? Caveat: We assume a multiplier of 1.5 since the economy was in a deep recession. Answer: or 1.5 $120 billion = $180 billion $180 billion 100 = 1.3% of GDP $14 trillion Real GDP fell by 2.8% in 2009. 38 / 52
Monetary Fiscal Analysis of Taxation-Based Fiscal National income accounting identity: Y = C + I + G + X M A $1 decrease in taxes under the first scenario: [Y + 1] = [C + 1] + I + X M Question: What is the value of the multiplier? Answer: m=$1/$1 = 1. What if the $1 tax cut has multiplier effect where consumption leads to more income and thus more consumption. A $1 decrease in taxes under the second scenario: [Y + 2] = [C + 2] + I + G + X M Question: What is the value of the multiplier? Answer: m is $2/$1 = 2. 39 / 52
Monetary Fiscal A $1 decrease in taxes under the third scenario with crowding out in investment: [Y + 1] = [C + 2] + [I 1] + G + X M or, increase in consumption are provided by $1 increase in imports: [Y + 1] = [C + 2] + [I ] + G + X [M+1] Answer: The government expenditure multiplier m is $1/$1 = 1. 40 / 52
Monetary Fiscal Which is the right scenario? Critics of using tax policy to manage short-run economic contractions point out that optimizing consumers might not actually spend much of their tax cut right away because: 1. If consumption offers diminishing returns, consumers might try to smooth their consumption by spreading the extra spending over the long term. 2. Consumers might recognize that the government will have to raise taxes in the future. They may decide to save the tax cut for higher taxes in the future. Economists believe that the government taxation multiplier is between 0 and 2. 41 / 52
Monetary Fiscal What was the impact of the $65 billion in tax cuts of the American Recovery and Reinvestment Act in 2009? We assume a multiplier of 1.0. or: 1.0 $65 billion = $65 billion $65 billion 100 = 0.5% of GDP $14 trillion 42 / 52
Monetary Fiscal Fiscal Policies that Directly Target the Labor Market There are a few specific fiscal policies are directly targeted at the labor market: Unemployment insurance: The government extends eligibility for unemployment insurance from 26 to 52 weeks and, in some severe downturns, even to 99 weeks. Wage subsidies: Reduce unemployment by subsidizing wages and thereby encouraging job creation. 43 / 52
Monetary Fiscal Exhibit 27.10 The Impact of a $1 Wage Subsidy 44 / 52
Monetary Fiscal Waste and Lags However, government programs can suffer from: Government waste is often a problem. The government frequently funds pork barrel spending such as a bridge to nowhere. The urgency of new government expenditures makes it harder to identify and efficiently implement the projects that are socially beneficial. Many of the projects with the highest social return have already been funded. Politics and special interests sometimes get in the way, increasing the chances that wasteful projects with negative social value get funded. 45 / 52
Monetary Fiscal Another important determinant of the effectiveness of expenditure-based policies is the lag in implementation. For example, when the most recent recession officially ended in June 2009, practically none of the $230 billion in infrastructure spending legislated in the American Recovery and Reinvestment Act of (February) 2009 had yet been spent. In June 2010 almost a full year after the recession was over only a quarter of the infrastructure budget had been spent. Many of the largest infrastructure projects hadn t spent a penny one full year after the end of the recession. Lags like these raise the concern that by the time many of the projects are implemented, the economy might already be past the point where these projects would have been most useful. 46 / 52
Monetary Fiscal In contrast, taxation based fiscal policy can sometimes advance more quickly, for example it does not take long to mail every household a check. Taxation-based policies have the advantage that the additional spending is done by households themselves so that the money is spent on goods and services that they value. However, several expenditure-based policies are not plagued by waste and lags. For example, most economists endorse federal transfers that enable state and local government to reduce layoffs of teachers, firefighters, and police during recession. Most economists endorse infrastructure projects like repairs to bridges and highways that have already passed rigorous cost-benefit analysis. Such projects are said to be shovel ready. 47 / 52
Monetary Fiscal Q: How much does government expenditure stimulate GDP? 48 / 52
Monetary Fiscal Data: U.S. quarterly GDP data for 1939 to 2008 and historical news coverage. Problem: Government expenditure and GDP are simultaneously determined, so does expenditure cause GDP or vice versa? Solution: Economist Valerie Ramey identifies random government expenditure resulting from foreign events such as war-related events and the surprise launch in 1957 of the Soviet satellite Sputnik which sparked the space race. 49 / 52
Monetary Fiscal In Ramey s study, a foreign shock causes the government to spend more for reasons unrelated to the state of the economy. She then compared the growth of GDP after these large random spending shocks to the growth of GDP in periods that did not experience such shocks. Using such comparisons, Ramey estimated a government expenditure multiplier of $0.60 to $1.2. 50 / 52
Monetary Fiscal 27.4 Blur the Line Some countercyclical policies represent a mix of fiscal and monetary policy. One example is the Troubled Asset Relief Program (TARP), passed in October 2008. TARP authorized the Treasury Department to spend $700 billion to stabilize the banks. This amount was later reduced to $450 billion in 2010. 51 / 52
Monetary Fiscal $250 billion was spent to increase the capital base of U.S. banks. The remaining amount was spent on the nearly bankrupt companies General Motors, Chrysler, and AIG. 52 / 52