33.2: The 2007-2009 Crisis

33.2.1: Causes and Immediate Impacts of the Crisis

Learning Objective

Summarize the causes that led to the 2007 banking crisis

Key Points

• The recent financial crisis, commonly referred to as the sub-prime mortgage crisis of 2007-2008, began with the failure of a series of derivative-based consolidation of mortgage-backed securities that encapsulated extremely high risk loans to home-owners into a falsely ‘safe’ investment.
• Banks offered loans to debtors that couldn’t afford them, and then bundles these debt instruments and sold them.
• The banking crisis spread into a broader financial crisis as companies were negatively affected by the crisis in financial institutions to which they were connected.
• The government did not regulate the housing market at all, as a result of the elimination of two critical clauses: verification of income and a 20% down payment.
• The U.S. stock market, realizing the scale of errors of the banks, lost all investment confidence. This cut the NYSE in half, drastically reducing the value of the U.S. economy.

Key Terms

CDO

A type of asset-backed security and structured credit product constructed from a portfolio of fixed-income assets.

Sub-prime

Designating a loan (typically at a greater than usual rate of interest) offered to a borrower who is not qualified for other loans (e.g. because of poor credit history).

The recent financial crisis, commonly referred to as the sub-prime mortgage crisis of 2007-2008, was borne of the failure of a series of derivative-based consolidation of mortgage-backed securities that encapsulated extremely high risk loans to homeowners into a falsely ‘safe’ investment. To simplify this, banks pushed mortgages on prospective home owners who could not afford to repay them. Then they combined and packaged varying mortgage-backed securities based off of these loans and sold them as highly dependable and safe investments, either through a lack of due diligence (negligence) or lack of ethical consideration. This created an economic meltdown, starting with the United States, that spread across the global markets.

The inherent complexity of the causes and dramatic repercussions (most of which are still ongoing) require a great deal of context. It is a fiercely debated and widely discussed issue in the field of economics (and in mainstream media), providing a real-life case study for many of the critical concepts of economic theory.

How Did This Happen?

The inputs to the 2007-2008 economic collapse, briefly touched upon above, are complex and still evolving. That being said, there are a few key talking points from an economic perspective that should be discussed. A useful perspective to take is the various stakeholders and their contributions :

• Banks: Simply put, the banks made two critical errors. First, they lent money to people who could not pay it back (to buy homes). They pursued what is referred to as ‘predatory lending,’ or lending to individuals they knew could never pay it back. Secondly, banks knowingly grouped these loans into bundles called collateralized debt obligations (CDOs) and sold them as extremely safe derivative investments. They were not safe.
• Consumers: Consumers played their role as well, acting as easy prey for the banks predatory practices. Individuals bought homes they could not afford utilizing loans they could not pay back. This drove them into debt, to the extent at which they had to default. This meant that the capital banks expected to get back did not arrive, it simply was not there.
• Government: The government did not regulate the housing market, as a result of the elimination of two critical legal clauses that required the verification of income and a 20% down payment. In short, the U.S. government used to ensure that prospective home buyers could put down 20% of the their borrowing in addition to verify that their income could cover their mortgage payments. Without such verification, it became easier for people to get mortgages they could not afford.

Combining these factors, the problem largely revolved around irresponsible lending and borrowing which was then turned into derivatives that were labeled safe despite their massive risks. This resulted in an economic realization of loans that could not be repaid, which spread through the banking system and turned into large scale obligations that could not be met.

Economic Impact

What happened next is well captured in the . In short, the banks eventually failed due to their investments. In order to prevent the entire financial system from collapsing, some of the banks (and other financial institutions) were bailed out.

Of course the negative effects did not stop there. The U.S. stock market lost confidence in financial institutions and some of the companies connected to them and subsequently crashed. The NYSE fell by half, drastically reducing the value of the U.S. economy. This was then telegraphed into a loss of consumer confidence and business access to investment. Within a few months, there were job cuts, bankruptcies, and reduced spending, as the crisis spread throughout the economy (both domestically and globally).

33.2.2: Recovery

Learning Objective

Discuss the characteristics of the recovery from the 2007 crisis

Key Points

• One of the key components to the crisis recovery in the United States is an act called the American Recovery and Reinvestment Act of 2009 (ARRA). It invests money in the economy to drive spending and recovery.
• ARRA is largely based on the Keynesian macro-environmental concept of driving spending through enabling spending, in turn driving up demand, creating jobs, and driving spending up further.
• The Troubled Asset Relief Program (TARP) was another recovery strategy, buying toxic assets off the banks to prevent them from failing.
• TARP was criticized for protecting banks who behaved unethically and with a lack of strategic intelligence as businesses, essentially implying that they should have failed.
• While the stock market has recovered and the banks are in better shape now than before the collapse, the average American is still less likely to have a job or to be underemployed.

Key Terms

Economic crises

A period of economic slowdown characterized by declining productivity and devaluing of financial institutions often due to reckless and unsustainable money lending.

stimulus

Anything that may have an impact or influence on a system. In 2009, it is the monetary investments in the economy to recover from the collapse.

The 2007-2009 economic crisis has had far-reaching and profound effects on both the domestic and global markets, primarily as a result of the sub-prime mortgage disaster originating in the United States. Addressing these economic ramifications to induce recovery has been the focal point of global governments and global agencies such as the International Monetary Fund (IMF). The objective of economic recovery when in crisis is to stabilize the economy, and from there recapture the value lost through economic stimulus strategies while addressing the factors which contributed to the collapse in the first place.

Stimulus Package

One of the key components to the crisis recover in the United States is an act called the American Recovery and Reinvestment Act of 2009 (ARRA), put into place by the Obama administration just as the first days of his term were beginning. This act has seen substantial debate, both positively and negatively, as to the efficacy and overall implementation of the program. Understanding the inputs, and expected outcomes, is critical to understanding the economics behind reacting to economic crises (particularly from a Keynesian perspective).

The stimulus package can be broken down via the attached figure in regards to monetary investment in specific places , totaling $831 billion (USD) between 2009 and 2019. The goal of investing or providing tax relief and subsidies for individuals and companies is to drive up purchasing behavior and offset the positive feedback loop attributed to economic crises. This is largely based on the Keynesian concept of driving spending through enabling spending, in turn driving up demand, creating jobs, and driving spending up further. President Obama’s administration was criticized by classical economists for employing this as well as Keynesian economists (such as Paul Krugman) for not employing it enough. That being said, the efficacy in the attached figure demonstrates that it was likely a strategic reaction to the economic crisis .

Troubled Asset Relief Program (TARP)

Perhaps more debatable still, is the reaction to the inevitable and deserved bankruptcy of the banks and insurers involved in the toxic mortgage-backed securities (i.e. CDO’s) that drove the economy into disaster were bailed out by the government. These companies, such as AIG, Bank of America, Citigroup, and other distributors of toxic investments were handed the required capital by the government to offset their massive losses due to undue risk and poor leveraging. This was in the form of the government utilizing tax money to purchase these securities, removing the toxic assets from the books of the companies involved (who were deemed ‘too big to fail’). This move saved the economic decline and restored consumer confidence through direct government intervention.

TARP was also largely criticized, with a high number of seemingly reasonable objections. The first, and most intuitive, is that these businesses deserved to go under. Bad business practice, poor investment, and grossly unethical behavior deserves bankruptcy. Instead, the government demonstrated that, as long as certain fiscal influence is achieved, these competitive rules are negligible. Secondly, and slightly more complex, is the implementation of the TARP act (which necessitated SIG-TARP, an oversight group ensuring that TARP money went out to those who it was intended for). It was noted on many occasions that TARP money was ill-used.

Outcomes

While the long-term outcomes of these practices cannot yet be predicted, the progress made so far is worth analyzing economically. First and foremost, job numbers have improved, although not as much as had been hoped or expected (see ). While this is positive, it does not capture the large number of people who are underemployed or the individuals who have abandoned the search for employment. GDP growth has inched along to positive numbers, as has the profitability of many businesses and industries. Interestingly enough, as of the end of 2013, the stock market has not only recovered but expanded beyond 2007 levels.

33.2.3: Global Impacts

Learning Objective

Analyze the extent to which the 2007 crisis was global

Key Points

• Modern markets are dependent upon one another across national borders, where global trends in economic growth and well-being will have a dramatic impact on national economic well-being and vice versa.
• In December 2007, the U.S. officially fell into an 18-month long recessionary period of negative GDP growth, which This spread rapidly around the map to create a global recession in Q3 and Q4 in 2008 and Q1 of 2009.
• Another indirect global impact that occurred as a result of the economic collapse was political instability, primarily due to the inability of developed nations to pursue altruistic investments and global poverty reduction processes during recessionary times.
• On the upside, many global organizations and countries are actively employing policies to minimize the likelihood of a re-occurrence in the future.

Key Term

recession

A significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, and industrial production.

Modern markets are dependent upon one another across national borders, where global trends in economic growth and well-being will have a dramatic impact on national economic well-being and vice versa. As a result, the 2007-2009 economic collapse had large effects not only at the origin (in the United States), but also on a global scale. The speed in which the market decline spread across the globe underlines just how far globalization and international interdependence has come, with GDP growth numbers in 2009 already demonstrating substantial losses across the map (see ).

Recession: Domestic to Global

In December 2007, the U.S. officially fell into an 18-month long recessionary period of negative GDP growth (over two consecutive quarters). This recessionary period spread rapidly around the map, creating a global recession in Q3 and Q4 in 2008 and Q1 of 2009 (defined as a contraction in global GDP growth during that time) as is represented in this figure . To provide additional context to the global adverse effects of the sub-prime mortgage crisis, of 65 countries that record and report GDP only 11 escaped a recessionary period between 2006 and today.

Even countries where double-digit economic growth had been a consistent trend going into 2008, such as China, began to experience growth reductions due to reduced consumer purchasing power on a global scale. China has seen reductions towards the 7%-8% economic GDP growth (year on year), from clear double-digits in previous years.

Political Instability

Another indirect global impact that occurred as a result of the economic collapse is political instability, primarily due to the inability of developed nations to pursue social welfare investments and global poverty reduction processes during recessionary times. Indeed, these instabilities are not only isolated to developing nations. Countries in the EU, such as Greece, Spain and Italy, have seen dramatic GDP decreases and unemployment numbers reaching or exceeding 20% in some cases. This instability has placed a great deal of pressure on government officials to solve these huge economic problems in the short-term. The United States has also seen an incredible reduction in governmental efficacy with the least effective house of representatives for nearly a century alongside dramatic polarization of public opinion towards left-wing and right-wing ideas.

Global Responses

Positively, many global organizations and countries are actively employing policies to minimize the likelihood of a re-occurrence in the future. Reducing interest rates to drive up borrowing and investment, providing tax benefits to the unemployed and underemployed, and subsidizing new business have created positive steps towards meaningful recovery globally.

There have also been a series of banking and financial regulatory changes across the world.These global safety nets and prevention policies are setting the tone for future strategies to avoid economic crises and minimize the prospective damage that occurs as a result of these unethical practices.

32.2: Exchange Rates

32.2.1: Introducing Exchange Rates

Learning Objective

Explain the concept of a foreign exchange market and an exchange rate

Key Points

• Exchange rates are determined in the foreign exchange market, which is open to a wide range of buyers and sellers where currency trading is continuous.
• In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers.
• The foreign exchange rate is also regarded as the value of one country’s currency in terms of another currency.

Key Term

exchange rate

The amount of one currency that a person or institution defines as equivalent to another when either buying or selling it at any particular moment.

In finance, an exchange rate (also known as a foreign-exchange rate, forex rate, or rate) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency . For example, an inter-bank exchange rate of 91 Japanese yen (JPY, ¥) to the United States dollar (USD, US$) means that ¥91 will be exchanged for each US$1 or that US$1 will be exchanged for each ¥91.

Exchange rates are determined in the foreign exchange market, which is open to a wide range of buyers and sellers where currency trading is continuous. The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today, but for delivery and payment on a specific future date.

How the Foreign Exchange Market Works

In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers. Most trades are to or from the local currency. The buying rate is the rate at which money dealers will buy foreign currency, and the selling rate is the rate at which they will sell the currency. The quoted rates will incorporate an allowance for a dealer’s margin (or profit) in trading, or else the margin may be recovered in the form of a commission or in some other way.

Different rates may also be quoted for different kinds of exchanges, such as for cash (usually notes only), a documentary form (such as traveler’s checks), or electronic transfers (such as a credit card purchase). There is generally a higher exchange rate on documentary transactions (such as for traveler’s checks) due to the additional time and cost of clearing the document, while cash is available for resale immediately.

32.2.2: Finding an Equilibrium Exchange Rate

Learning Objective

Differentiate between the Balance of Payment and Asset Market Models

Key Points

• The balance of payment model holds that foreign exchange rates are at an equilibrium level if they produce a stable current account balance.
• The balance of payments model focuses largely on tradeable goods and services, ignoring the increasing role of global capital flows.
• The asset market model of exchange rate determination states that the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies. This includes financial assets.

Key Terms

depreciate

To reduce in value over time.

purchasing power parity

A theory of long-term equilibrium exchange rates based on relative price levels of two countries.

Countries have a vested interest in the exchange rate of their currency to their trading partner’s currency because it affects trade flows. When the domestic currency has a high value, its exports are expensive. This leads to a trade deficit, decreased production, and unemployment. If the currency’s value is low, imports can be too expensive though exports are expected to rise.

Purchasing Power Parity

Purchasing power parity is a way of determining the value of a product after adjusting for price differences and the exchange rate. Indeed, it does not make sense to say that a book costs $20 in the US and £15 in England: the comparison is not equivalent. If we know that the exchange rate is £2/$, the book in England is selling for $30, so the book is actually more expensive in England

If goods can be freely traded across borders with no transportation costs, the Law of One Price posits that exchange rates will adjust until the value of the goods are the same in both countries. Of course, not all products can be traded internationally (e.g. haircuts), and there are transportation costs so the law does not always hold.

The concept of purchasing power parity is important for understanding the two models of equilibrium exchange rates below.

Balance of Payments Model

The balance of payments model holds that foreign exchange rates are at an equilibrium level if they produce a stable current account balance. A nation with a trade deficit will experience a reduction in its foreign exchange reserves, which ultimately lowers, or depreciates, the value of its currency. If a currency is undervalued, its nation’s exports become more affordable in the global market while making imports more expensive. After an intermediate period, imports will be forced down and exports will rise, thus stabilizing the trade balance and bringing the currency towards equilibrium.

Asset Market Model

Like purchasing power parity, the balance of payments model focuses largely on tangible goods and services, ignoring the increasing role of global capital flows . In other words, money is not only chasing goods and services, but to a larger extent, financial assets such as stocks and bonds. The flows from transactions involving financial assets go into the capital account item of the balance of payments, thus balancing the deficit in the current account. The increase in capital flows has given rise to the asset market model.

The asset market model views currencies as an important element in finding the equilibrium exchange rate. Asset prices are influenced mostly by people’s willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of the assets. The asset market model of exchange rate determination states that the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies. These assets are not limited to consumables, such as groceries or cars. They include investments, such as shares of stock that is denominated in the currency, and debt denominated in the currency.

32.2.3: Real Versus Nominal Rates

Learning Objective

Calculate the nominal and real exchange rates for a set of currencies

Key Points

• The measure of the differences in price levels is Purchasing Power Parity. The concept of purchasing power parity allows one to estimate what the exchange rate between two currencies would have to be in order for the exchange to be on par with the purchasing power of the two countries’ currencies.
• If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would hold for the exchange rate and price levels of the two countries, and the real exchange rate would always equal 1.
• When you go online to find the current exchange rate of a currency, it is generally expressed in nominal terms.
• Changes in the nominal value of currency over time can happen because of a change in the value of the currency or because of the associated prices of the goods and services that the currency is used to buy.
• To calculate the nominal exchange rate, simply measure how much of one currency is necessary to acquire one unit of another. The real exchange rate is the nominal exchange rate times the relative prices of a market basket of goods in the two countries.

Key Terms

nominal exchange rate

The amount of currency you can receive in exchange for another currency.

real exchange rate

The purchasing power of a currency relative to another at current exchange rates and prices.

Currency is complicated and its value can be measured in several different ways. For example, a currency can be measured in terms of other currencies, or it can be measured in terms of the goods and services it can buy. An exchange rate between two currencies is defined as the rate at which one currency will be exchanged for another. However, that rate can be interpreted through different perspectives. Below are descriptions of the two most common means of describing exchange rates.

Nominal Exchange Rate

A nominal value is an economic value expressed in monetary terms (that is, in units of a currency). It is not influenced by the change of price or value of the goods and services that currencies can buy. Therefore, changes in the nominal value of currency over time can happen because of a change in the value of the currency or because of the associated prices of the goods and services that the currency is used to buy.

When you go online to find the current exchange rate of a currency, it is generally expressed in nominal terms. The nominal rate is set on the open market and is based on how much of one currency another currency can buy.

Real Exchange Rate

The real exchange rate is the purchasing power of a currency relative to another at current exchange rates and prices. It is the ratio of the number of units of a given country’s currency necessary to buy a market basket of goods in the other country, after acquiring the other country’s currency in the foreign exchange market, to the number of units of the given country’s currency that would be necessary to buy that market basket directly in the given country. The real exchange rate is the nominal rate adjusted for differences in price levels.

A measure of the differences in price levels is Purchasing Power Parity (PPP) . The concept of purchasing power parity allows one to estimate what the exchange rate between two currencies would have to be in order for the exchange to be on par with the purchasing power of the two countries’ currencies. Using the PPP rate for hypothetical currency conversions, a given amount of one currency has the same purchasing power whether used directly to purchase a market basket of goods or used to convert at the PPP rate to the other currency and then purchase the market basket using that currency.

If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would hold for the exchange rate and price levels of the two countries, and the real exchange rate would always equal 1. However, since these assumptions are almost never met in the real world, the real exchange rate will never equal 1.

Calculating Exchange Rates

Imagine there are two currencies, A and B. On the open market, 2 A’s can buy one B. The nominal exchange rate would be A/B 2, which means that 2 As would buy a B. This exchange rate can also be expressed as B/A 0.5.

The real exchange rate is the nominal exchange rate times the relative prices of a market basket of goods in the two countries. So, in this example, say it take 10 A’s to buy a specific basket of goods and 15 Bs to buy that same basket. The real exchange rate would be the nominal rate of A/B (2) times the price of the basket of goods in B (15), and divide all that by the price of the basket of goods expressed in A (10). In this case, the real A/B exchange rate is 3.

32.2.4: Exchange Rate Policy Choices

Learning Objective

Explain the factors countries consider when choosing an exchange rate policy

Key Points

• A free floating exchange rate increases foreign exchange volatility, which can be a significant issue for developing economies since most of their liabilities are denominated in other currencies.
• Floating exchange rates automatically adjust to trade imbalances while fixed rates do not.
• A big drawback of adopting a fixed-rate regime is that the country cannot use its monetary or fiscal policies with a free hand. Because these tools are reserved for preserving the fixed rate, countries can’t use its monetary or fiscal policies to address other economic issues.

Key Terms

fixed exchange rate

A system where a currency’s value is tied to the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold.

floating exchange rate

A system where the value of currency in relation to others is allowed to freely fluctuate subject to market forces.

When a country decides on an exchange rate regime, it needs to take several important things in account. Unfortunately, there is no system that can achieve every possible beneficial outcome; there is a trade-off no matter what regime a nation picks. Below are a few considerations a country needs to make when choosing a regime.

Stage of Economic Development

A free floating exchange rate increases foreign exchange volatility, which can be a significant issue for developing economies . Developing economies often have the majority of their liabilities denominated in other currencies instead of the local currency. Businesses and banks in these types of economies earn their revenue in the local currency but have to convert it to another currency to pay their debts. If there is an unexpected depreciation in the local currency’s value, businesses and banks will find it much more difficult to settle their debts. This puts the entire economy’s financial sector stability in danger.

Balance of Payments

Flexible exchange rates serve to adjust the balance of trade. When a trade deficit occurs in an economy with a floating exchange rate, there will be increased demand for the foreign (rather than domestic) currency which will increase the price of the foreign currency in terms of the domestic currency. That in turn makes the price of foreign goods less attractive to the domestic market and decreases the trade deficit. Under fixed exchange rates, this automatic re-balancing does not occur.

Monetary and Fiscal Policy

A big drawback of adopting a fixed-rate regime is that the country cannot use its monetary or fiscal policies with a free hand. In general, fixed-rates are not established by law, but are instead maintained through government intervention in the market. The government does this through the buying and selling of its reserves, adjusting its interest rates, and altering its fiscal policies. Because the government must commit its monetary and fiscal tools to maintaining the fixed rate of exchange, it cannot use these tools to address other macroeconomics conditions such as price level, employment, and recessions resulting from the business cycle.

32.2.5: Exchange Rate Systems

Learning Objective

Differentiate common exchange rate systems

Key Points

• A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency’s value is allowed to freely fluctuate according to the foreign exchange market.
• A fixed exchange-rate system (also known as pegged exchange rate system) is a currency system in which governments try to maintain their currency value constant against a specific currency or good.
• Pegged floating currencies are pegged to some band or value, either fixed or periodically adjusted. These are a hybrid of fixed and floating regimes.

Key Terms

pegged float exchange rate

A currency system that fixes an exchange rate around a certain value, but still allows fluctuations, usually within certain values, to occur.

fixed exchange rate

A system where a currency’s value is tied to the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold.

floating exchange rate

A system where the value of currency in relation to others is allowed to freely fluctuate subject to market forces.

exchange rate regime

The way in which an authority manages its currency in relation to other currencies and the foreign exchange market.

Example

• Examples of floating currencies include the US dollar, the European Union euro, the Japanese yen, and the British pound. Examples of fixed currencies include the Hong Kong dollar, the Danish krone, and the Bermudian dollar.

One of the key economic decisions a nation must make is how it will value its currency in comparison to other currencies. An exchange rate regime is how a nation manages its currency in the foreign exchange market. An exchange rate regime is closely related to that country’s monetary policy. There are three basic types of exchange regimes: floating exchange, fixed exchange, and pegged float exchange .

The Floating Exchange Rate

A floating exchange rate, or fluctuating exchange rate, is a type of exchange rate regime wherein a currency’s value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency. The dollar is an example of a floating currency.

Many economists believe floating exchange rates are the best possible exchange rate regime because these regimes automatically adjust to economic circumstances. These regimes enable a country to dampen the impact of shocks and foreign business cycles, and to preempt the possibility of having a balance of payments crisis. However, they also engender unpredictability as the result of their dynamism.

The Fixed Exchange Rate

A fixed exchange rate system, or pegged exchange rate system, is a currency system in which governments try to maintain a currency value that is constant against a specific currency or good. In a fixed exchange-rate system, a country’s government decides the worth of its currency in terms of either a fixed weight of an asset, another currency, or a basket of other currencies. The central bank of a country remains committed at all times to buy and sell its currency at a fixed price.

To ensure that a currency will maintain its “pegged” value, the country’s central bank maintain reserves of foreign currencies and gold. They can sell these reserves in order to intervene in the foreign exchange market to make up excess demand or take up excess supply of the country’s currency.

The most famous fixed rate system is the gold standard, where a unit of currency is pegged to a specific measure of gold. Regimes also peg to other currencies. These countries can either choose a single currency to peg to, or a “basket” consisting of the currencies of the country’s major trading partners.

The Pegged Float Exchange Rate

Pegged floating currencies are pegged to some band or value, which is either fixed or periodically adjusted. These are a hybrid of fixed and floating regimes. There are three types of pegged float regimes:

• Crawling bands: The market value of a national currency is permitted to fluctuate within a range specified by a band of fluctuation. This band is determined by international agreements or by unilateral decision by a central bank. The bands are adjusted periodically by the country’s central bank. Generally the bands are adjusted in response to economic circumstances and indicators.
• Crawling pegs:A crawling peg is an exchange rate regime, usually seen as a part of fixed exchange rate regimes, that allows gradual depreciation or appreciation in an exchange rate. The system is a method to fully utilize the peg under the fixed exchange regimes, as well as the flexibility under the floating exchange rate regime. The system is designed to peg at a certain value but, at the same time, to “glide” in response to external market uncertainties. In dealing with external pressure to appreciate or depreciate the exchange rate (such as interest rate differentials or changes in foreign exchange reserves), the system can meet frequent but moderate exchange rate changes to ensure that the economic dislocation is minimized.
• Pegged with horizontal bands:This system is similar to crawling bands, but the currency is allowed to fluctuate within a larger band of greater than one percent of the currency’s value.

32.2.6: Fixed Exchange Rates

Learning Objective

Explain the mechanisms by which a country maintains a fixed exchange rate

Key Points

• A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to.
• A fixed exchange rate regime should be viewed as a tool in capital control. As a result, a fixed exchange rate can be viewed as a means to regulate flows from capital markets into and out of the country’s capital account.
• Typically, a government maintains a fixed exchange rate by either buying or selling its own currency on the open market.
• Another method of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate.

Key Term

fixed exchange rate

A system where a currency’s value is tied to the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold.

A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime where a currency’s value is fixed against the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold.

Reasons for Fixed Exchange Rate Regimes

A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to. This makes trade and investments between the two countries easier and more predictable and is especially useful for small economies in which external trade forms a large part of their GDP.

This belief that fixed rates lead to stability is only partly true, since speculative attacks tend to target currencies with fixed exchange rate regimes, and in fact, the stability of the economic system is maintained mainly through capital control. Capital controls are residency-based measures such as transaction taxes, other limits, or outright prohibitions that a nation’s government can use to regulate flows from capital markets into and out of the country’s capital account. A fixed exchange rate regime should be viewed as a tool in capital control.

How a Fixed Exchange Regime Works

Typically a government maintains a fixed exchange rate by either buying or selling its own currency on the open market. This is one reason governments maintain reserves of foreign currencies. If the exchange rate drifts too far below the desired rate, the government buys its own currency in the market using its reserves. This places greater demand on the market and pushes up the price of the currency. If the exchange rate drifts too far above the desired rate, the government sells its own currency, thus increasing its foreign reserves.

Another, method of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate. This method is rarely used because it is difficult to enforce and often leads to a black market in foreign currency. Some countries, such as China in the 1990s, are highly successful at using this method due to government monopolies over all money conversion. China used this method against the U.S. dollar .

32.2.7: Managed Float

Learning Objective

Describe a managed float exchange rate and explain why countries choose managed floats

Key Points

• Generally the central bank will set a range which its currency’s value may freely float between. If the currency drops below the range’s floor or grows beyond the range’s ceiling, the central bank takes action to bring the currency’s value back within range.
• Management by the central bank generally takes the form of buying or selling large lots of its currency in order to provide price support or resistance.
• A managed float regime is a hybrid of fixed and floating regimes. A managed float captures the benefits of floating regimes while allowing central banks to intervene and minimize the risk of harmful effects due to radical currency fluctuations that are a characteristic of floating regimes.

Key Term

Managed Float Regime

A system where exchange rates are allowed fluctuate from day to day within a range before the central bank will intervene to adjust it.

Managed float regimes, otherwise known as dirty floats, are where exchange rates fluctuate from day to day and central banks attempt to influence their countries’ exchange rates by buying and selling currencies. Almost all currencies are managed since central banks or governments intervene to influence the value of their currencies. So when a country claims to have a floating currency, it most likely exists as a managed float.

How a Managed Float Exchange Rate Works

Generally, the central bank will set a range which its currency’s value may freely float between. If the currency drops below the range’s floor or grows beyond the range’s ceiling, the central bank takes action to bring the currency’s value back within range .

Management by the central bank generally takes the form of buying or selling large lots of its currency in order to provide price support or resistance. For example, if a currency is valued above its range, the central bank will sell some of its currency it has in reserve. By putting more of its currency in circulation, the central bank will decrease the currency’s value.

Why Do Countries Choose a Managed Float

Some economists believe that in most circumstances floating exchange rates are preferable to fixed exchange rates. Floating exchange rates automatically adjust to economic circumstances and allow a country to dampen the impact of shocks and foreign business cycles. This ultimately preempts the possibility of having a balance of payments crisis. A floating exchange rate also allows the country’s monetary policy to be freed up to pursue other goals, such as stabilizing the country’s employment or prices.

However, pure floating exchange rates pose some threats. A floating exchange rate is not as stable as a fixed exchange rate. If a currency floats, there could be rapid appreciation or depreciation of value. This could harm the country’s imports and exports. If the currency’s value increases too drastically, the country’s exports could become too costly which would harm the country’s employment rates. If the currency’s value decreases too drastically, the country may not be able to afford crucial imports.

This is why a managed float is so appealing. A country can obtain the benefits of a free floating system but still has the option to intervene and minimize the risks associated with a free floating currency. If a currency’s value increases or decreases too rapidly, the central bank can intervene and minimize any harmful effects that might result from the radical fluctuation.

31.2: Gains from Trade

31.2.1: Exports: The Economic Impacts of Selling Goods to Other Countries

Learning Objective

Evaluate the effects of international trade on exporting countries

Key Points

• Export is defined as the act of shipping goods and services out of the port of a country.
• Legal restrictions and trade barriers are in place internationally to control trade, whether goods are being exported or imported.
• When legal restrictions and trade barriers are lessened or lifted the producer surplus increases and so does the amount of the goods and services that are exported from the country.
• Exporting allows a country’s producers to gain ownership advantages and develop low-cost and differentiated products.
• Due to an extra layer in the chain of distribution which squeezes the margins, exporters may have to offer lower prices to the importers than to domestic wholesalers in order to move their product and generate business.

Key Terms

export

Any good or commodity, transported from one country to another country in a legitimate fashion, typically for use in trade.

trade

Buying and selling of goods and services on a market.

Exports

Export is defined as the act of a country shipping goods and services out of the port of a country. In international trade, an export refers to the selling of goods and services produced in the home country to other markets (other countries) . The seller of the goods and services is referred to as the “exporter. “

Protecting Exports

In order to protect exports, commercial goods are subject to customs authorities for both the exporting and importing countries. Legal restrictions and trade barriers are in place internationally to control trade, whether goods are being exported or imported. When legal restrictions and trade barriers are lessened or lifted the producer surplus increases and so does the amount of the goods and services that are exported to other countries.

Impact of Exports

Exporting goods and services has both advantages and disadvantages for countries involved in international trade.

Exporting allows a country’s producers to gain ownership advantages and develop low-cost and differentiated products. It is viewed as a low-risk mode of production and trade. Exporters also experience internationalization advantages which are the benefits of retaining a core competence within a company and threading it through the value chain instead of obtaining a license to outsource or sell the goods or services.

Disadvantages of exporting are mainly the result of manufacturers having to sell their goods to importers. In domestic sales, manufacturers sell directly to wholesalers or even directly to the retailer or customer. For exports, manufacturers face and extra layer in the chain of distribution which squeezes the margins. As a result, manufacturers may have to offer lower prices to the importers than to domestic wholesalers in order to move their product and generate business.

31.2.2: Imports: The Economics Impacts of Buying Goods from Other Countries

Learning Objective

Evaluate the effects of international trade on an importing country

Key Points

• Imports are defined as purchases of good or services by a domestic economy from a foreign economy.
• Protectionism is the economic policy of restraining trade between countries through tariffs on imported goods, restrictive quotas, and government regulations.
• In most countries, international trade and importing goods represents a significant share of the gross domestic product (GDP).
• International trade is generally more expensive than domestic trade due to additionally imposed costs, taxes, and tariffs.
• On a business level, companies take part in direct-imports; a major retailer imports goods from an overseas manufacturer in order to save money.

Key Terms

protectionism

A policy of protecting the domestic producers of a product by imposing tariffs, quotas or other barriers on imports.

trade

Buying and selling of goods and services on a market.

import

To bring (something) in from a foreign country, especially for sale or trade.

Imports

Imports are defined as purchases of good or services by a domestic economy from a foreign economy. The domestic purchaser of the good or service is called an importer. Imports and exports are critical for many economies and they are the defining financial transactions of international trade.

Protecting Imports

Due to the economic importance of imports, countries enact specific laws, barriers, and policies in order to regulate international trade. Protectionism is the economic policy of restraining trade between countries through tariffs on imported goods, restrictive quotas, and government regulations. When trade barriers and policies of protectionism are eliminated, consumer surplus increases. The price of a good or service will decrease while the quantity consumed will increase.

Impacts of Buying Imported Goods

On a national level, in most countries international trade and importing goods represents a significant share of the gross domestic product (GDP). International trade has a significant economic, social, and political importance in many countries. Imports provide countries with access to goods and services from other nations. Without imports, a country would be limited to the goods and services within its own borders .

International trade is generally less expensive than domestic trade despite additionally imposed costs, taxes, and tariffs. However, the factors of production are usually more mobile domestically than internationally (capital and labor). It is common for countries to import goods rather than a factor of production. For example, the U.S. imports labor-intensive goods from China. Instead of importing Chinese labor, the U.S. imports goods that were produced in China by Chinese labor.

On a business level, companies take part in direct-imports, which occur when a major retailer imports goods that are designed locally from an overseas manufacturer. The direct-import program allows the retailer to bypass the local supplier and purchase the final product directly from the manufacturer. Direct imports save retailers money by eliminating the local supplier.

31.2.3: Costs of Trade

Learning Objective

Identify the groups that benefit and the groups that are harmed by free trade policies

Key Points

• Free trade eliminates export tariffs, import quotas, and export quotas; all of which cause more losses than benefits for a country.
• With free trade in place the producers in exporting countries and the consumers in importing countries all benefit.
• One of the main disadvantages is the selective application of free trade. Economic inefficiency can be created through trade diversion.
• Trade restricts displaces workers, makes overcoming unemployment challenging, increases economic inequality, and can lower wages.
• When free trade is applied to only the high cost producer it can lead to trade diversion and a net economic loss.
• Another disadvantage is that by increasing returns to scale, can cause certain industries to settle in an geographically area where there is not comparative advantage.

Key Terms

welfare

Health, safety, happiness and prosperity; well-being in any respect.

tariff

A system of government-imposed duties levied on imported or exported goods; a list of such duties, or the duties themselves.

free trade

International trade free from government interference, especially trade free from tariffs or duties on imports.

Free Trade

Free trade is a policy where governments do not discriminate against exports and imports. There are few or no restrictions on trade and markets are open to both foreign and domestic supply and demand.

Advantages

Free trade is beneficial to society because it eliminates import and export tariffs. Restricted trade affects the welfare of society because although producers experience increases in surplus and additional revenue, the loss faced by consumers is greater than any benefit obtained . When a country trades freely with the rest of the world, it should theoretically produce a net gain for society and increases social welfare. Free trade policies consist of eliminating export tariffs, import quotas, and export quotas; all of which cause more losses than benefits for a country. With free trade in place, the producers of the exported good in exporting countries and the consumers in importing countries all benefit.

Disadvantages

One of the main disadvantages is the selective application of free trade. Economic inefficiency can be created through trade diversion. It is economically efficient for a good to be produced in the country with the lowest production costs. However, this does not always occur if a high cost producer has a free trade agreement and the low cost producer does not. When free trade is applied to only the high cost producer it can lead to trade diversion to not the most efficient producer, but the one facing the lowest trade barriers, and a net economic loss. Free trade is highly effective and provides society with a net gain, but only if it is applied.

Due to industry specializations, many workers are displaced and do not receive retraining or assistance finding jobs in other sectors. The nature of industries and trade increases economic inequality. As a result of unskilled workers the wages within the various industries may decline.

Another disadvantage is that by increasing returns to scale, can cause certain industries to settle in an geographically area where there is not comparative advantage. Despite this disadvantage, the level of output that is generated by free trade for both the “winner” and the “loser” is increased substantially.

The Results of Free Trade

Economists have studied free trade extensively and although it creates winners and losers, the main consensus is that free trade generates a large net gain for society. In a 2006 survey of American economists, it was found that 85.7% believed that the U.S. should eliminate any remaining tariffs and trade barriers. Economists professor N. Gregory Mankiw explained that, “few propositions command as much consensus among professional economists as that open world trade increases economic growth and raises living standards. “

29.2: Tools of Finance

29.2.1: Present Value and the Time Value of Money

Learning Objective

Calculate the present and future value of money

Key Points

• Time value of money: (1 + r)^t x (the value of the initial investment) = future value; where r is the annual interest rate and t is the number of years.
• The time value of money is the central concept in finance theory. However, the explanation of the concept typically looks at the impact of interest and assumes, for simplicity, that inflation is neutral.
• The time value of money is the principle that a certain amount of money today has a different buying power (value) than the same currency amount of money in the future.

Key Terms

time value of money

The principle that a certain currency amount of money today has a different buying power (value) than the same currency amount of money in the future.

present value

The value of an asset in today’s dollars after adjusting for an increase in the asset values as a result of interest earned during the period.

The time value of money is the principle that a certain amount of money today has a different buying power (value) than the same currency amount of money in the future. The value of money at a future point of time would take account of interest earned or inflation accrued over a given period of time. This notion exists both because there is an opportunity to earn interest on the money and because inflation will drive prices up, thus changing the “value” of the money.

For example, assume that an investor has $100 today and can invest this money at a 5% return for one year. A year from now the original investment will equal $105, (100)*(1.05). The return of $5 represents the time value of money over the one year interval .

Time value of money: (1 + r)^t x (the value of the initial investment) = future value; where r is the annual interest rate and t is the number of years.

Alternatively, if an investment is valued at $125 and this value includes the 7% return generated over a one year time horizon, the original value of the investment or its present value is equal to (125)/(1.07) or 117.

Present value: (the value of the investment at a future time)/(1 + r)ⁿ; where r is the annual interest rate and n is the number of years the investment has occurred.

The time value of money is the central concept in finance theory. However, the explanation of the concept typically looks at the impact of interest and assumes, for simplicity, that inflation is neutral.

29.2.2: Measuring and Managing Risk

Learning Objective

Explain the relationship between time, money, and risk

Key Points

• Investment returns compensate holders for the time to maturity via a risk premium.
• Risk premium compensates holders for risks inherent to an investment and are incorporated in the rate of return quoted for an investment.
• To compensate investors for taking on reinvestment risk, issuers will provide a risk premium to incentivize the investor to purchase the investment.

Key Terms

time horizon

A fixed point of time in the future where certain processes will be evaluated or assumed to end.

risk premium

The minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset

Assets can have varying maturity dates and potential for default, the attribution of time to maturity and timely payments involve an assessment of risk. Risk is pervasive in the economy and is an essential component in the derivation of an asset’s investment return.

Time and Risk

Time is a component of risk for varying reasons; however, the two most common are related to the increase in general uncertainty rising with the time horizon and reinvestment risk.

In our everyday lives, we are faced with momentary uncertainties that become increasingly harder to predict as we move from a five minute horizon to a five day, five month, or even five year period. This same phenomenon is true of financial assets. Though the attribution of acceptable inflation can be incorporated into an investment return, the actual pricing and resulting purchasing power of the investment at maturity is unknown and the uncertainty increases with time. Therefore, investment returns compensate holders for the time to maturity via a risk premium .

Risk premium compensates holders for risks inherent to an investment and are incorporated in the rate of return quoted for an investment. For example, if asset A and asset B both pay a 5% coupon on an annual basis, but asset B matures in 5 years and asset A matures in 1 year, all else equal (asset quality and issuer solvency), we would expect asset A to trade at a higher price than asset B. Remembering that yield and price are inversely related, the higher price on A implies that it has a lower yield than B. The differential in yield can be attributed to a risk premium for time to maturity.

Another aspect of time horizon is reinvestment risk. For some investments, there is a potential for an issuer to call or redeem a security prior to maturity. Given that at the time that the investment is called prevailing rates may be lower than at the purchase of the asset, the holder is taking a reinvestment risk at the time of purchase. To compensate investors for taking on this type of risk, the issuer will provide a risk premium to incentivize the investor to purchase the investment.

29.2.3: The Value of Diversification

Learning Objective

Explain the rationale for diversification

Key Points

• Diversification strategies can be as simple as not “placing all your eggs in one basket” or be as complex as routine evaluation of investment correlation and risk and dynamic rebalancing of investment holdings.
• Whether a common sense or highly quantitative approach is taken, the benefit of diversification is to limit risk and enhance consistency of return. A diversified portfolio will earn a return that is always higher than its lowest performing asset.
• Most asset managers would advocate holdings that are diversified across sectors and asset classes to further the benefit of growth and reduce the risk of performance volatility that may be attributable to a company, sector, or asset class.
• Investors may enter into hedging strategies in order to ensure a constant return over market volatility. For a fee, a hedging strategy offers a constant return on an investment. The party on the other side of the hedge absorbs the volatility of the investment and pays out a consistent return.

Key Terms

asset clas

A group of economic resources sharing similar characteristics, such as riskiness and return.

risk premium

The minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset

prospectus

A document, distributed to prospective members, investors, buyers, or participants, which describes an institution (such as a university), a publication, or a business and what it has to offer.

Each asset class has specific investment objectives; these are typically stated in a prospectus or investment description. However, all investments have some degree of risk in meeting the stated investment objectives or return.

The risks that are inherent to a specific investment can be compensated for by a market-assessed risk premium, whereby market participants adjust the price of an asset, impacting its overall return, based on the risk characteristics of the asset. However, the compensation adjustment for holding an asset of a given risk profile can be further enhanced through asset diversification.

The Value of Diversification

Diversification strategies can be as simple as not “placing all your eggs in one basket. ” It can also be as complex as a routine evaluation of investment correlation and risk, and dynamic rebalancing of investment holdings. However, whether a common sense or a highly quantitative approach is taken, the benefit of diversification is to limit risk and enhance consistency of return.

By holding varying investments, even if they are within the same company or sector, an investor still has the benefit of reducing risk inherent from the default of one asset. For example, stock and bonds provide different returns; while a stock may exhibit no growth for a period of time, the bond may continue to pay its coupon and provide a return. Through diversification, an investor’s entire portfolio can perform better than its worst-performing asset.

In general, most asset managers would advocate holdings that are diversified across sectors and asset classes to further the benefit of growth and reduce the risk of performance volatility that may be attributable to a company, sector, or asset class . In some cases where the return on investment needs to be met, managers may advocate for the use of hedging instruments to transfer risk of return objectives being met to another party in lieu of a consistent return.

Hedging strategies can be relatively complex but, in general, they serve the role of insuring that an investor is able to meet investment performance objectives. Typically, an investor pays a fee and enters into the hedging strategy, which transfer the risk inherent in an investment for a constant return. The party on the opposite side of the hedge absorbs both the upside and downside return potential of the asset, along with the fee for taking on the risk of uncertainty, and pays the first party a constant return as part of the agreement.

Systematic Risk

It’s important to note that diversification does not remove all of the risk from the portfolio. Diversification can reduce the risk of any single asset, but there will still be systematic risk (or undiversifiable risk). Systematic risk arises from market structure or dynamics which produce shocks or uncertainty faced by all agents in the market. For example, government policy, international economic forces, or acts of nature can shock the entire market. Systematic risk will affect the portfolio, regardless of how diversified it is.

29.2.4: The Relationship Between Risk and Return and the Security Market Line

Learning Objective

Explain how the security market line relates risk and return

Key Points

• In finance, the capital asset pricing model (CAPM) is used to determine the required rate of return of an asset taking into account an asset’s sensitivity to non-diversifiable risk.
• The security market line essentially graphs the results from the capital asset pricing model formula. The intercept of the SML is the nominal risk-free rate available for the market, while the slope is the market premium.
• If the security’s expected return versus risk is plotted above the SML, it is undervalued since the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalued since the investor would be accepting less return for the amount of risk assumed.

Key Terms

systematic risk

The risk associated with an asset that is correlated with the risk of asset markets generally, often measured as its beta.

non-systematic risk

Risk that is unique to a specific company; can be reduced through diversification.

capital asset pricing model

Used to determine the required rate of return of an asset taking into account an asset’s sensitivity to non-diversifiable risk (also known as systematic risk or market risk).

security market line

A line representing the relationship between expected return and systematic risk; thus a graphical representation of the capital asset pricing model.

Investment assets are typically characterized as having two performance risks: systematic (or market risk) and non-systematic risk. Systematic risk arises from market structure or dynamics, which produce shocks or uncertainty faced by all agents in the market. Non-systematic risk is unique to a specific company and can be reduced through diversification.

Capital Asset Pricing Model (CAPM)

In finance, the capital asset pricing model (CAPM) is used to determine the required rate of return of an asset, taking into account an asset’s sensitivity to non-diversifiable or systematic risk. Non-diversifiable risk is noted by the variable beta (β), where beta is greater than one if the asset’s price sensitivity is greater than the market; equal to one when the asset’s sensitivity is equal to the market; and less than one if the asset exhibits less pricing volatility than the market.

The CAPM is a model for pricing an individual security or portfolio. The expected return of an asset is equal to the risk free rate plus the excess return of the market above the risk-free rate, adjusted for the asset’s overall sensitivity to market fluctuations or its beta. Mathematically, the capital asset pricing model can be written as: E(R_i) = R_f + β(E(R_m) – R_f), where R is the return, E(R) is the expected return, i denotes any asset, f is the risk-free asset, and m is the market.

Security Market Line (SML)

For individual securities, the security market line (SML) and its relation to expected return and systematic risk (beta) depicts an individual security in relation to their security risk class . The SML essentially graphs the results from the capital asset pricing model formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML. The relationship between β and required return is plotted on the SML, which shows expected return as a function of β. The intercept is the nominal risk-free rate available for the market, while the slope is the market premium, E(R_m)− R_f.

The SML is a useful tool in determining if an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security’s expected return versus risk is plotted above the SML, it is undervalued since the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalued since the investor would be accepting a smaller return for the amount of risk assumed.

28.2: Monetary Policy Tools

28.2.1: The Reserve Ratio

Learning Objective

Identify the effects of reserve requirements on monetary policy

Key Points

• The required reserve ratio is a tool in monetary policy, given that changes in the reserve ratio directly impacts the amount of loanable funds available.
• Money growth in the economy can occur through the multiplier effect resulting from the reserve ratio.
• The higher the reserve requirement is set, the less the amount of funds banks will have to loan out, leading to lower money creation. Alternatively, the higher the reserve requirement the, lower the supply of loanable funds, the higher the interest rate and the slower the resulting economic growth.

Key Terms

loanable funds

Money available to be issued as debt.

money supply

The total amount of money (bills, coins, loans, credit, and other liquid instruments) in a particular economy.

monetary policy

The process by which the central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets.

Banks assume responsibility for consumer deposits and make money by loaning out deposited finds. Therefore, banks with relatively higher deposits are able to supply a larger amount of loanable funds. The supply of loanable funds directly impacts growth and interest rates in an economy. Typically, an increase in the supply of loanable funds is associated with a decrease in interest rates. The greater the accessibility of loanable funds, as conferred by access and cost, the greater opportunity for businesses and consumers to make investment purchases and increase production and labor supply, respectively.

However, in economic downturns the amount of outstanding loans may be counter to a bank’s longevity, as depositors may seek to cash-out holdings. In order to reduce the risk of a panic or “run on bank” from the perception that a bank may not have adequate liquidity to meet depositor access to cash deposits, central banks have adopted policies to ensure that banks use prudent judgement when assessing the amount of deposits to loan.

Reserve Ratio

The reserve ratio is a central bank regulatory tool employed by most, but not all, of the world’s central banks. The ratio is a set percentage of customer deposits that a bank is required to hold in reserves, or funds that are not allowed to be loaned. Required reserves are normally in the form of cash stored physically in a bank vault (vault cash) or deposits made with a central bank. The required reserve ratio is a tool in monetary policy, given that changes in the reserve ratio directly impact the amount of loanable funds available .

Monetary policy tool

Money growth in the economy can occur through the multiplier effect resulting from the reserve ratio. For example, a reserve ratio of 20% will result in 80% of any given initial deposit being loaned out and if the process of loaning is assumed to continue, the maximum increase in money expansion specific to an initial deposit at a 20% reserve ratio will be equal to the reserve multiplier 1/(reserve ratio) x the initial deposit.

For example, with the reserve ratio (RR) of 20 percent, the money multiplier, m, will be calculated as:

This then signifies that any initial deposit will contribute to an expansion in money supply up to 5 times its original value.

The conventional view in economic theory is that a reserve requirement can act as a tool of monetary policy. The higher the reserve requirement is set, the theory supposes, the less the amount of funds banks will have to loan out, leading to lower money creation. Alternatively, the higher the reserve requirement the, lower the supply of loanable funds, the higher the interest rate and the slower the resulting economic growth.

28.2.2: The Discount Rate

Learning Objective

Illustrate the effects of the discount rate on monetary policy

Key Points

• The Fed targets the rate for federal funds via its open market operations.
• The Fed seeks to be the lender of last resort by charging banks a higher rate than the federal funds rate.
• The discount rate difference over the fed funds rate can be varied by the Fed based on bank liquidity needs.

Key Terms

fed funds rate

Short for Federal Funds rate. The interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis.

discount rate

An interest rate that a central bank charges to depository institutions that borrow reserves from it.

open market operations

An activity by a central bank to buy or sell government bonds on the open market. A central bank uses them as the primary means of implementing monetary policy.

The central bank of the United States is the Federal Reserve (the Fed). The Fed employs monetary policy through direct controls on the money supply through open market operations to achieve economic stability and growth.

Open market operations entail Fed intervention in the buying and selling of government bonds to achieve a change in the money supply and the corresponding change in the interest rate. The Fed sells bonds to reduce the money supply and increase the prevailing interest rate and buys bonds to increase the money supply and reduce the prevailing interest rate. The interest rate is an active target and is set as a target rate range by the Fed; it is conveyed to the public by the Federal Reserve Open Market Committee (FOMC) as the fed funds target rate (short for the Federal Funds rate).

Coincident with the Fed’s open market operations is the Fed’s selection of a reserve requirement which corresponds to a required percentage of deposits (reserves) that banks must keep on site or at the Fed on a daily basis. Given their daily activities, banks may fall short of their required daily reserve requirement. When this occurs, banks may either turn to the Fed or Fed member banks for overnight or short-term loans to satisfy their liquidity short-fall. The rate that member banks charge each other is referred to as the federal funds rate and the rate the Fed charges banks is referred to as the discount rate.

This distinction is particularly important. The discount rate is the rate that the central bank actual controls. It is the rate the central bank charges its member banks to borrow overnight. However, the rate that the central bank actually cares about is the fed funds rate. That is the rate banks charge each other, and is influenced by the discount rate.

The Fed targets the rate for federal funds via its open market operations and seeks to be the lender of last resort by charging banks a higher rate than the federal funds rate .

For example, the difference or spread of the primary credit rate (rate to member banks in solid financial standing) over the FOMC’s target federal funds rate was initially 1 percent. During the financial crisis, this spread was reduced to one-half of one percent on August 17, 2007, and was further reduced, to a quarter of 1 percent, on March 16, 2008.

Typically, the discount rate along with the fed funds target rate are mechanisms that the Fed uses to discourage banks from excess lending, as part of a contractionary or restrictive policy scheme. Given that lending has an expansionary effect, to the extent that the fed funds target rate and discount rate diminish the profitability of excess loaning, these parameters place limits to the expansion of the money supply via the loanable funds market. However, as noted in the aforementioned historical example, the discount rate, in conjunction with the fed funds target rate, may be purposely maintained at a lower interest level to encourage borrowing and increase growth when the economy is showing signs of either slowing or contracting. In this manner, the discount rate in tandem with the fed funds target rate are part of an expansionary policy mechanism.

28.2.3: The Federal Funds Rate

Learning Objective

Discuss the importance of the Federal Funds Rate as a monetary policy tool

Key Points

• Banks may borrow reserves from one another overnight in order to maintain their required reserve ratio. The rate of interest negotiated between banks for these loans is the Federal Funds rate.
• The Federal Funds rate is directly related to the interest rate paid by firms and individuals. If a bank can borrow reserves cheaply, it can afford to offer loans to the public at lower rates. Thus, a high Federal Funds rate is contractionary, while a low federal funds rate is expansionary.
• The Federal Reserve doesn’t control the Federal Funds rate directly, but it does set a target interest rate and uses open market operations in order to achieve that rate.
• The Fed doesn’t control the federal funds rate directly, but it does set a target interest rate and uses open market operations in order to achieve that rate.

Key Terms

reserve

Banks’ holdings of deposits in accounts with their central bank.

federal funds rate

The interest rate at which depository institutions actively trade balances held at the Federal Reserve with each other.

The Federal Funds rate (or fed funds rate) is the interest rate at which depository institutions (primarily banks) actively trade balances held at the Federal Reserve. In the US, banks are obligated to maintain certain levels of reserves, either in the form of reserves with the Fed or as vault cash. Each day, banks receive deposits, which contribute to a bank’s reserves, and issue loans, which are liabilities against the bank. These daily activities change their ratio of reserves to liabilities. If, by the end of the day, the bank’s reserve ratio has dropped below the legally required minimum, it must add to its reserves in order to remain compliant with the law. Banks do this by borrowing reserves from other banks with excess reserves, and the weighted average of these interest rates paid by borrowing banks determines the federal funds rate.

The Federal Funds rate is directly related to the interest rate paid by firms and individuals. If a bank can borrow reserves cheaply, it can afford to offer loans to the public at lower rates and still make a profit. On the other hand, if the Federal Funds rate is high, banks will not borrow reserves in order to issue low-interest loans to the public. In fact, many mortgages and credit card interest rates are indexed to the Federal Funds rate – a homeowner might pay an adjustable interest rate that is set at the level of the Federal Funds rate plus four percent, for example. A high Federal Funds rate, therefore, has a contractionary effect on economic activity, while a low Federal Funds rate has an expansionary effect.

The Fed doesn’t control the Federal Funds rate directly – it is negotiated between borrowing and lending banks – but it does set a target interest rate and uses open market operations in order to achieve that rate. The target Federal Funds rate is decided by the governors at the Federal Open Market Committee (FOMC) meetings, who will either increase, decrease, or leave the target rate unchanged based on the economic conditions within the country . Influencing the Federal Funds rate is the primary monetary policy tool that the Fed uses to achieve its dual mandate of stable prices and low unemployment.

28.2.4: Open Market Operations

Learning Objective

Discuss the use of open market operations to implement monetary policy

Key Points

• In the United States, the Federal Reserve Bank of New York uses open market operations to implement monetary policy.
• This occurs under the oversight of the Federal Reserve Open Market Committee (FOMC).
• The short-term objective for open market operations is specified by the FOMC and is publicly communicated following the FOMC meeting.
• Historically, the Federal Reserve has used OMOs to adjust the supply of reserve balances so as to keep the federal funds rate–the interest rate at which depository institutions lend reserve balances to other depository institutions overnight–around the target established by the FOMC.

Key Terms

open market operations

An activity by a central bank to buy or sell government bonds on the open market. A central bank uses them as the primary means of implementing monetary policy.

fed funds target rate

The interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis.

The Federal Reserve has several tools at its disposal to reach its monetary policy objectives. These include the discount rate, the fed funds target rate, and the reserve requirement, and open market operations (OMOs). OMOs are considered to be the most flexible option for the Federal Reserve out of all of these.

On a general level, OMO are the purchase and sale of securities in the open market by a central bank, as a means of controlling the money supply and the related prevailing interest rate.

In the United States, the Federal Reserve Bank of New York conducts open market operations. They are under the oversight of the Federal Reserve Open Market Committee (FOMC). The FOMC makes a plan for open market operations over the short term, and publicly announce it after their regularly scheduled meetings. 

Historically, the Federal Reserve has used OMOs to adjust the supply of reserve balances so as to keep the federal funds rate–the interest rate at which depository institutions lend reserve balances to other depository institutions overnight–around the target established by the FOMC.

OMO Mechanism

OMOs are typically either expansionary or contractionary in nature. In an expansionary platform, the OMO will seek to increase the money supply and reduce interest rates in order to promote economic growth. In a contractionary scheme, the OMO will seek to reduce the money supply and increase interest rates in an effort to deter economic growth. Therefore, the implementation of contractionary policy will result in the selling of bonds (cash in exchange for debt holding) and an expansionary policy (buy bonds in exchange for cash) will result in an increase in the money supply at a lower interest rate as a means to enhance growth opportunities and revitalize the economy.

The interest rate targeted through the OMO manipulation of the money supply is the fed funds target rate or the rate that member Fed banks charge one another for overnight loans. The target rate is important monetary tool from the perspective that the higher the fed funds rate relative to the return on loanable funds, the greater the incentive for banks to meet their reserve requirement (the bank will lose money) thereby placing limits on the growth of the money supply through the loanable funds market. In addition to this direct interest rate channel, the fed funds rate influences many other interest rates in the economy and by so doing contributed to either incentivizing borrowing for growth or disincentivizing the same.

28.2.5: Setting and Achieving the Interest Rate Target

Learning Objective

Describe the way in which the Federal Reserve targets the interest rate

Key Points

• Though the Fed can directly influence the money supply through open market operations, the majority of the Fed’s activities seek to target interest rates, the outcome of changes in money supply.
• Using its open market channel, the Fed buys government bonds to increase the money supply and sells the same bonds to reduce it.
• The Fed actively adjusts the buying and selling of bonds to achieve the target interest rate. This in turn impacts the rate that Fed member banks are willing to charge each other for overnight loans, or the fed funds rate.

Key Terms

reserve ratio

A central bank regulation employed by most, but not all, of the world’s central banks, that sets the minimum fraction of customer deposits and notes that each commercial bank must hold as reserves (rather than lend out).

open market operations

An activity by a central bank to buy or sell government bonds on the open market. A central bank uses them as the primary means of implementing monetary policy.

fed funds rate

Short for Federal Funds rate. The interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis.

The Federal Reserve (Fed) has an ability to directly influence economic growth and stability through the use of monetary policy. Though the central bank can directly influence the money supply the majority of its activities center around interest rates, the outcome of changes to the money supply.

Interest Rate Mechanism

The Fed can set a reserve ratio, which is in effect the required reserves (percentage of deposits) that a bank must hold either on site or at the Fed. The requirement must be satisfied on a daily basis. However, given daily bank dynamics of withdrawals, deposits and loan of funds some banks may fall short of their daily reserve requirement. For banks in need of reserve funds, the overnight or short-term bank loan market is available.

Banks can seek to borrow from other banks holding funds at the Fed. The rate that Fed member banks charge one another is referred to as the Federal Funds rate, or Fed Funds rate for short (rate for funds held at the Fed). The rate is indirectly influenced and targeted by the Fed via a direct channel of open market operations and is communicated to the public as a Fed Funds target range as a standard part of the Fed Open Market Committee communications. It is important to note that the Fed does not set the fed funds target rate, it only issues a range that it targets through active management of the money supply.

Using its open market channel, the Fed buys government bonds to increase the money supply and sells the same bonds to reduce it. Adding to the money supply will typically lead to lower interest rates, while reducing the money supply will increase interest rates. The Fed actively adjusts the buying and selling of bonds to achieve the target interest rate. This in turn impacts the rate that Fed member banks are willing to charge each other for overnight loans, or the Fed Funds rate. The fed funds rate will be within the range of the target; if not the Fed will adjust its open market operations (buying and selling of bonds) to achieve the range .

28.2.6: Executing Expansionary Monetary Policy

Learning Objective

Explain common expansionary monetary policy tools

Key Points

• In an expansionary policy regime, the Fed would reduce the reserve requirement, thereby effectively increasing the amount of loans that a bank can issue.
• Expansionary monetary policy will seek to reduce the fed funds target rate (a range).
• In an expansionary policy regime, the Fed purchases government securities via open market operations from a bank in exchange for cash; the Fed’s purchase increases the supply of reserves (money) to the banking system, and the federal funds rate (interest rate) falls.

Key Terms

reserve requirement

The minimum amount of deposits each commercial bank must hold (rather than lend out).

open market operations

An activity by a central bank to buy or sell government bonds on the open market. A central bank uses them as the primary means of implementing monetary policy.

fed funds rate

Short for Federal Funds rate. The interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis.

Monetary policy is based on the relationship between money supply and interest rates, where the interest rate is essentially the price of money. The two variables have an inverse relationship. As a result, as the money supply in an economy is increased, the interest rate will generally decrease and if the money supply is contracted, interest rates will generally increase .

The money supply is a monetary policy mechanism available to a central bank as part of its mandate to promote economic growth and maintain full employment. Central banks use monetary policy to stabilize the economy; during periods of economic slowing central banks initiate expansionary policy, whereby the bank increases the money supply in order to lower prevailing interest rates. As the cost of money falls the demand for funds increases, thereby expanding consumer and investment spending and promoting economic growth.

Expansionary policy

An active expansionary policy increases the size of the money supply, decreasing the interest rate. Central banks can increase the money supply through open market operations and changes in the reserve requirement.

Bank reserves

Banks and other depository institutions are required to keep a certain amount of funds in reserve in order to maintain enough liquidity to meet unexpected demand for deposits. Banks can keep these reserves as cash in their vaults or as deposits with the Federal Reserve (the Fed). By adjusting the reserve requirement, the Fed can effectively change the availability of loanable funds.

In an expansionary policy regime, the Fed would reduce the reserve requirement. Banks would be able to issue more loans with the same reserves, thereby increasing the supply of money and the level of economic activity and investment.

Federal Funds market

From day to day, the amount of reserves a bank wants to hold may change as its deposits and transactions change. When a bank needs additional reserves on a short-term basis, it can borrow them from other banks that happen to have more reserves than they need. These loans take place in a private financial market called the federal funds market.

The interest rate on the overnight borrowing of reserves is called the Federal Funds rate or simply the “fed funds rate.” It adjusts to balance the supply of and demand for reserves. For example, if the supply of reserves in the fed funds market is greater than the demand, then the funds rate falls, and if the supply of reserves is less than the demand, the funds rate rises.

At a lower fed funds rate, banks are more likely to increase loans, thereby expanding investment activity (in factories, for example, not financial instruments) and promoting economic growth.

Expansionary monetary policy will seek to reduce the fed funds target rate (a range). The Fed does not control this rate directly but does control the interest rate indirectly through open market operations.

Open market operations

The major tool the Fed uses to affect the supply of reserves in the banking system is open market operations—that is, the Fed buys and sells government securities on the open market. These operations are conducted by the Federal Reserve Bank of New York.

In an expansionary policy regime, the Fed purchases government securities from a bank in exchange for cash. Payment for the bonds increases the bank’s reserves. As a result, the bank may have more reserves than required. The bank can lend these unneeded reserves to another bank in the federal funds market. Thus, the Fed’s open market purchase increased the supply of reserves (money) to the banking system, and the federal funds rate (interest rate) falls.

28.2.7: Executing Restrictive Monetary Policy

Learning Objective

Explain common restrictive monetary policy tools

Key Points

• In a contractionary policy regime, the Fed may increase the reserve requirement, thereby effectively restricting the funds that banks have available for loans.
• Restrictive monetary policy will seek to increase the fed funds rate, which is the interest banks charge on loans to other banks.
• In a contractionary policy regime, the Fed uses open market operations to sell government securities from a bank in exchange for cash and thereby reduce the money supply and increase interest rates.

Key Term

full employment

A state when an economy has no cyclical or deficient-demand unemployment.

Monetary policy is based on the relationship between money supply and interest rates, where the interest rate is the price of money. The interest rate, therefore, has an inverse relationship with the money supply. As a result, as the money supply in an economy is decreased, the interest rate is assumed to increase and if the money supply is increased, interest rates are typically assumed to decrease .

The money supply is a monetary policy mechanism available to a central bank as part of its initiatives to promote economic growth and maintain full employment. Central banks use monetary policy to stabilize the economy; during periods of economic slowing central banks initiate expansionary policy, whereby the bank increases the money supply in order to lower prevailing interest rates. As the cost of money falls, economic theory assumes that the demand for funds will increase, thereby expanding consumer and investment spending and promoting economic growth. During periods where the economy is showing signs of growing too quickly or operating above full employment, the central bank may initiate a contractionary or restrictive monetary policy by reducing the money supply and allowing interest rates to increase and economic growth to slow.

Restrictive policy

An active contractionary policy restricts the size of the money supply, increasing the interest rate. Central banks can decrease the money supply through open market operations and changes in the reserve requirement.

Bank reserves

Banks and other depository institutions keep a certain amount of funds in reserve to meet unexpected outflows. Banks can keep these reserves as cash in their vaults or as deposits with the Fed. By adjusting the reserve requirement, the Fed can effectively change the availability of loanable funds.

In a contractionary policy regime, the Fed would increase the reserve requirement, thereby effectively restricting the funds that banks have available for loans.

Federal funds market

From day to day, the amount of reserves a bank wants to hold may change as its deposits and transactions change. When a bank needs additional reserves on a short-term basis, it can borrow them from other banks that happen to have more reserves than they need. These loans take place in a private financial market called the federal funds market.

The interest rate on the overnight borrowing of reserves is called the federal funds rate or simply the “funds rate.” It adjusts to balance the supply of and demand for reserves. For example, if the supply of reserves in the fed funds market is lower than the demand, then the funds rate increases.

At higher fed funds rates, banks are more likely to limit borrowing and their provision of loanable funds, thereby decreasing access to loanable funds and reducing economic growth.

Restrictive monetary policy will seek to increase the fed funds target rate. The Fed does not control this rate directly but does control the interest rate indirectly through open market operations.

Open market operations

The major tool the Fed uses to affect the supply of reserves in the banking system is open market operations—that is, the Fed buys and sells government securities on the open market. These operations are conducted by the Federal Reserve Bank of New York.

In a contractionary policy regime, the Fed sells government securities from a bank in exchange for cash. Payment for the bonds decreases the bank’s reserves, reducing the supply of funds that the bank has for loans. The Fed’s open market purchase decreases the supply of reserves (money) to the banking system, and the federal funds rate (interest rate) increases. In net, this reduces the financial resources available to stimulate growth and leads to a contraction in the economy.

28.2.8: The Taylor Rule

Learning Objective

Explain the Taylor Rule and its use by central banks

Key Points

• The rule states that the real short-term interest rate (that is, the interest rate adjusted for inflation) should be determined according to three factors.
• The rule recommends a relatively high interest rate (contractionary monetary policy) when inflation is above its target or when the economy is above its full employment level.
• The rule recommends a relatively low interest rate (expansionary monetary policy) when inflation is below its target or when the economy is below its full employment level.

Key Term

Taylor Rule

A way of determining the appropriate change in interest rates for a given change in inflation.

The Taylor rule is a formula developed by Stanford economist John Taylor. It was designed to provide monetary policy guidance for the Federal Reserve. The formula suggests short-term interest rates depending on changing economic conditions, in order to keep the economy stable in the short term, and minimize inflation over the long term.

The rule stipulates how much a central bank should change the nominal interest rate (real rate plus inflation) in response to changes in inflation, output, or other economic conditions. In particular, the rule stipulates that for each one-percent increase in inflation, the central bank should raise the nominal interest rate by more than one percentage point.

The factors that the Taylor rule suggests taking into account when setting inflation-adjusted short-term interest rates are:

1. the level of actual inflation relative to the target,
2. how far economic activity is above or below its “full employment” level, and
3. what the level of the short-term interest rate is that would be consistent with full employment.

The Taylor rule advocates setting interest rates relatively high (contractionary policy) when inflation is high or when the employment rate exceeds the economy’s full employment level. Expansionary policies with low interest rates are recommended by the Taylor rule in times when the economy is slow (i.e. unemployment is high, or inflation is low). 

The Taylor rule doesn’t always provide an easy answer. For example, in times of stagflation, inflation may be high while unemployment is also high. However, the Taylor rule can still provide a handy “rule of thumb” to policy makers on how to balance these conflicting issues when setting the interest rates.

The Taylor rule fairly accurately demonstrates how monetary policy has been conducted under recent leaders of the Federal Reserve, such as Volker and Greenspan. However, the Federal Reserve does not follow the Taylor rule as an explicit policy.

27.2: Introducing the Federal Reserve

27.2.1: Introduction to Monetary Policy

Learning Objective

Justify expansionary and contractionary monetary policy.

Key Points

• Monetary policy is referred to as either being expansionary or contractionary, where an expansionary policy increases the money supply more rapidly than usual, and contractionary policy expands the money supply more slowly than usual.
• Expansionary policy is traditionally used to try to combat unemployment by lowering interest rates. A monetary authority will typically pursue expansionary monetary policy when there is an output gap.
• Contractionary policy is intended to slow inflation in order to avoid the resulting distortions and deterioration of asset values.

Key Terms

inflation

An increase in the general level of prices or in the cost of living.

output gap

The difference between an economy’s actual GDP and its long-run potential GDP

Monetary policy is the process by which the monetary authority of a country, which could be a government agency or a central bank, controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment.

Monetary policy is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by easing credit to entice businesses into expanding. Contractionary policy is intended to slow inflation in order to avoid the resulting distortions and deterioration of asset values, or to cool an overheating economy. Monetary policy differs from fiscal policy, which refers to taxation, government spending, and associated borrowing.

Expansionary Monetary Policy

A monetary authority will typically pursue expansionary monetary policy when there is an output gap – that is, a country is producing output at a lower level than its potential output. Without a policy intervention the output gap may correct itself, if falling wages and prices shift the short-run aggregate supply curve to the right until the economy returns to the long-run equilibrium. Alternatively, the monetary authority could intervene in order to increase aggregate demand and close the output gap. Expansionary monetary policy consists of the tools that a central bank uses to achieve this increase in aggregate demand.

In practice, this means that a monetary authority will use the tools at its disposal in order to increase the money supply and decrease interest rates. Since interest rates represent the price of money, lower interest rates will cause the quantity of money demanded to increase, stimulating investment and spending. In addition, lower interest rates make a currency worth less in the currency exchange market. This reduces the demand for and increases the supply of dollars in the currency market, reducing the exchange rate (in foreign currency per dollar). A lower exchange rate makes a country’s goods relatively more affordable for the rest of the world, stimulating exports and further increasing output.

Contractionary Monetary Policy

By contrast, a monetary authority will pursue a contractionary monetary policy when it considers inflation a threat. Suppose, for example, that high short-run aggregate demand creates an equilibrium in which prices are higher than in the long-run equilibrium. This will cause high levels of inflation. In response, the monetary authority may reduce the money supply and thereby raise the interest rate. Investment falls as the interest rate rises. The higher interest rate also increases the demand for dollars as foreign investors shift their investments to the United States. Likewise, the supply of dollars declines. Consumers in the United States purchase domestic interest-bearing assets rather than purchasing assets abroad, taking advantage of the higher domestic interest rate. Increased demand and decreased supply cause an increase in the exchange rate, which boots imports while reducing exports. Thus, contractionary monetary policy causes aggregate demand to fall, thereby reducing the rate of inflation. .

27.2.2: The Creation of the Federal Reserve

Learning Objective

Explain monetary policy as the main function of a central bank

Key Points

• The Federal Reserve (the Fed) was originally created in response to a series of bank panics. While its policy goals were originally unclear, today the Fed has a dual mandate: to achieve maximum employment and stable prices.
• The Fed has three main policy tools: setting reserve requirements, operating the discount window and other credit facilities, and conducting open-market operations.
• The Fed sets the required ratio of reserves that banks must hold relative to their deposit liabilities.
• The discount rate is the interest rate charged by the Fed when it lends reserves to banks.
• The buying and selling of federal government bonds by the Fed are called open-market operations.

Key Terms

central bank

The principal monetary authority of a country or monetary union; it normally regulates the supply of money, issues currency and controls interest rates.

reserve requirement

The minimum amount of deposits each commercial bank must hold (rather than lend out).

The Federal Reserve Act of 1913

Until 1913, the United States did not have a true central bank. The US suffered through a number of financial crises that eventually drove Congress to create the US central bank, the Federal Reserve (the Fed), through the Federal Reserve Act of 1913.

The Act established three key objectives for monetary policy: maximum employment, stable prices, and moderate long-term interest rates. The first two objectives are sometimes referred to as the Federal Reserve’s dual mandate and are the most emphasized of the three.

Over the years, the Fed has expanded its duties to include conducting monetary policy, supervising and regulating banking institutions, maintaining the stability of the financial system, and providing financial services.

How the Fed Conducts Monetary Policy

The Fed has three main policy tools: setting reserve requirements, operating the discount window and other credit facilities, and conducting open-market operations.

Reserve Requirements

Commercial banks are required to hold a certain proportion of their deposits in reserves and not lend them out. This proportion is called the reserve requirement and is controlled by the Fed. By changing the reserve requirement, the Fed can impact the amount of money available for lending, and by extension, spending and investment.

Discount Window

Commercial banks are required to have a certain amount of reserves on hand at the end of each day. If they are going to come up short, they must borrow from other banks or the Fed. The Fed extends these loans through the discount window and charges what is called the discount rate. The discount rate is set by the Fed, and is important because it radiates throughout the economy: if it becomes more expensive to borrow at the discount window, interest rates will rise and borrowing will become more expensive economy-wide. In this way, the Fed can use the discount window to affect interest rates and the money supply .

Open-Market Operations

The government borrows by issuing bonds. Recall that the interest rate that the government pays is determined by the price of the bond: the higher the price of the bond, the lower the interest rate. The Fed can affect the interest rate by conducting open-market operations (OMOs) in which it buys or sells bonds. Buying or selling bonds changes the demand or supply of the bonds, and therefore their price. By extension, OMOs change the interest rate, hopefully to achieve one of the Fed’s monetary goals.

27.2.3: Structure of the Federal Reserve

Learning Objective

Recall the structure of the Federal Reserve System of the United States

Key Points

• The Fed is a system of 12 regional banks, each of which has its own board of directors and rotating representative to the Federal Open Market Committee (FOMC).
• The Fed is run by a Board of Governors, the head of which is the Chairperson.
• The Federal Open Market Committee (FOMC) consists of the seven members of the Board of Governors and five rotating regional bank presidents. It is primarily responsible for buying and selling federal government bonds in order to conduct monetary policy.

Key Terms

monetary policy

The process by which the central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets.

open market operations

An activity by a central bank to buy or sell government bonds on the open market. A central bank uses them as the primary means of implementing monetary policy.

The Federal Reserve (the Fed) was designed to be independent of the Congress and the government. The idea justification for independence is that it allows the Fed to operate without being put under political pressure to take actions that may not be in the best long-term economic interest of the country.

The Federal Reserve System is composed of five parts :

1. The presidentially appointed Board of Governors (or Federal Reserve Board), an independent federal government agency located in Washington, D.C. Each governor serves a 14 year term. As of February 2014, the Chair of the Board of Governors is Janet Yellen, who succeeded Ben Bernanke.
2. The Federal Open Market Committee (FOMC), composed of the seven members of the Federal Reserve Board and five of the 12 Federal Reserve Bank presidents, which oversees open market operations, the principal tool of U.S. monetary policy.
3. Twelve regional Federal Reserve Banks located in major cities throughout the nation, which divide the nation into twelve Federal Reserve districts. The Federal Reserve Banks act as fiscal agents for the U.S. Treasury, and each has its own nine-member board of directors.
4. Numerous other private U.S. member banks, which own required amounts of non-transferable stock in their regional Federal Reserve Banks.
5. Various advisory councils.

The Fed can be thought of as having both private and public organization characteristics, though it considers itself to be private. On one hand, the Fed works toward achieving public goals such as moderate inflation and low unemployment. It does not exist to make money. On the other hand, it is, by design, separate from the government. It operates independently, and is not subject to political pressures directly as is Congress or the President.

27.2.4: The Federal Open Market Committee and the Role of the Fed

Learning Objective

Describe the structure and operations of the Federal Open Market Committee (FOMC)

Key Points

• Open market operations are the buying and selling of federal government bonds in order to influence the money supply and interest rate.
• The Fed sets targets for the federal funds rate and then conducts operations to maintain that rate. To achieve a lower federal funds rate, for example, the Fed goes into the open market to buy securities and thus increase the money supply.
• The FOMC decides on a target federal funds rate by looking at monetary targets such as inflation, interest rates, or exchange rates.

Key Terms

reserve

Banks’ holdings of deposits in accounts with their central bank.

federal funds rate

The interest rate at which depository institutions actively trade balances held at the Federal Reserve with each other.

One of the primary tools used by the Federal Reserve (the Fed) to conduct monetary policy is open market operations: the buying and selling of federal government bonds in order to influence the money supply and interest rate. These operations are the primary responsibility of the Federal Open Market Committee (FOMC). The FOMC is a twelve-person committee composed of the seven members of the Board of Governors, plus a rotating combination of five presidents of the Federal Reserve Regional Banks. The president of the New York regional bank is always a member of the FOMC; the other four seats are filled by four of the other eleven bank presidents.

When conducting monetary policy the Fed sets a target for the federal funds rate, which it attempts to achieve using open market operations. To lower the federal funds rate, for example, the Fed buys securities on the open market, increasing the money supply. In order to raise the federal funds rate, on the other hand, the Fed sells securities and thereby reduces the money supply.

Open Market Operations

As mentioned previously, the aim of open market operations is to manipulate the short term interest rate and the total money supply. This involves meeting the demand for money at the target interest rate by buying and selling government securities or other financial instruments. Monetary targets, such as inflation, interest rates, or exchange rates, are used to guide this implementation.

Imagine the Fed is targeting a federal funds rate of 3%. If there is an increased demand for money and the Fed takes no action, interest rates will rise. This may produce unintended contractionary effects in the economy. Instead, the FOMC responds to an increase in the demand for money by going to the open market to buy a financial asset, such as government bonds, foreign currency, or gold. To pay for these assets, the Fed transfers bank reserves to the seller’s bank and the seller’s account is credited. Since the bank now has more reserves than it had before, it can lend out more money and the money supply increases. Thus, the increase in demand for money is met with an increase in supply, and the interest rate remains unchanged.

Conversely, if the central bank sells its financial assets on the open market, reserves are transferred from the buyer’s bank back to the Fed. This reduces the amount of money that a bank may loan out and the total money supply falls. The process works because the central bank has the authority to bring money in and out of existence. They are the only point in the whole system with the unlimited ability to produce money.

27.2.5: The Federal Reserve and the Financial Crisis of 2008

Learning Objective

Summarize the monetary policy tools used by the Federal Reserve in response to the financial crisis of 2008.

Key Points

• In late 2007, the bursting of the U.S. housing bubble triggered the worst financial crisis since the Great Depression of the 1930s.
• The Fed cut the target federal funds rate and the discount lending rate seven times. Normally, a low federal funds rate would encourage banks to make loans, stimulating the economy, but this failed to work following the crisis.
• Unable to rely on conventional tools, the Fed created a variety of credit facilities to provide liquidity to the economy.
• The Fed also provided emergency funds to support financial institutions deemed “too big to fail”.

Key Terms

liquidity

The degree to which an asset can be easily converted into cash.

discount rate

An interest rate that a central bank charges to depository institutions that borrow reserves from it.

open market operations

An activity by a central bank to buy or sell government bonds on the open market. A central bank uses them as the primary means of implementing monetary policy.

In late 2007, the bursting of the U.S. housing bubble triggered the worst financial crisis since the Great Depression of the 1930s. It resulted in the threat of total collapse of large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world. The crisis caused the failure of businesses, huge declines in consumer wealth, and a downturn in economic activity that lead to the 2008-2012 global recession.

The Federal Reserve’s response to the 2008 crisis saw the use of both conventional and new monetary tools in order to stabilize the economy, support market liquidity, and encourage economic activity. Conventional monetary policy suggests that in an economic downturn, a central bank should conduct open market operations in order to increase the money supply and lower interest rates. Lower interest rates stimulate loans, spending, and investment and help an economy escape from recession. Further, this type of financial crisis meant that banks’ assets were suddenly worth far less; open market operations can ensure that these banks have the liquidity they need to carry out their financial activities.

Conventional Monetary Tools

The Federal Reserve (the Fed) did engage in these types of conventional operations in 2007 and 2008, cutting the target federal funds rate and the discount rate seven times. Normally, a low federal funds rate would encourage banks to borrow money in order to lend it out to firms and individuals, stimulating the economy, but in the aftermath of the financial crisis the Fed was unable to lower interest rates enough to successfully induce banks to make loans. One reason why traditional monetary policies failed is due to the zero lower bound and the low levels of inflation that accompanied the crisis.

The zero lower bound refers to the fact that the central bank cannot push nominal interest rates below 0%. This is because any creditor can do better by keeping their money in cash than by loaning it out at an interest rate below 0%. When inflation is high, however, central banks may be able to push the real interest rate below 0%. Recall that the nominal interest rate is the sum of the real interest rate and the expected inflation rate. If the nominal interest rate is 1% and inflation is 3%, the real interest rate is -2%. However, following the crisis, the U.S. experienced very low levels of inflation, and cutting the federal funds rate failed to provide enough economic stimulus to get the country out of the recession.

Unconventional Monetary Tools

Unable to create interest rates low enough to encourage banks to resume lending money, the Fed turned to other, untried policy tools to encourage economic activity. To deal with the shrinking credit markets, the Fed created a selection of new credit facilities. The Primary Dealer Credit Facility (PDCF) allows the banks that normally handle open market operations on behalf of the Fed to apply for overnight loans. The Term Asset-Backed Securities Loan Facility uses the primary dealers to give companies access to loans based on asset-backed securities, such as those related to credit card or small business debt. These new credit facilities were created based on the hope that increasing liquidity in the market would induce firms and consumers to borrow and spend.

The Fed also provided targeted assistance to bail out large financial institutions that would have otherwise collapsed. During the crisis, housing prices fell and the number of foreclosures increased dramatically. Investors, banks, and other financial institutions came under pressure as their mortgage-based assets lost value. The Fed provided credit to these institutions in an attempt to mitigate the effect of falling asset prices and stem the crisis. This included bailouts of two housing finance firms – Fannie Mae and Freddie Mac – which had been established by the government in order to encourage home ownership and stimulate the housing market.

The Fed also provided billions of dollars of assistance to AIG, an insurance firm that had invested heavily in mortgage loans . Without the assistance the firm would have collapsed, possibly causing a chain reaction of failing financial institutions. The Fed determined that these consequences were too severe to be allowed – that is, that AIG was “too big to fail. ” Many argue that when the Fed provided this type of emergency aid, it encouraged banks to take even more extreme risks, safe in the knowledge that they would be bailed out if their investments failed. Others praise the Fed for avoiding an even deeper financial crisis.

27.2.6: The Structure and Function of Other Banks

Learning Objective

Summarize the structure of the ECB, the Bank of England, and the People’s Bank of China

Key Points

• The European Central Bank controls interest rates through auctions rather than the bond market, and is responsible for maintaining price stability over all other goals.
• The Bank of England is the second-oldest central bank in the world. Monetary policy is dictated by the Monetary Policy Committee, and recently the Financial Policy Committee was formed in order to regulate the UK’s financial sector.
• The People’s Bank of China conducts monetary policy and is the largest central bank in the world.

Key Terms

monetary policy

The process by which the central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets.

Eurozone

Those European Union member states whose official currency is the euro.

price stability

A state of economy characterized by low inflation, and thus a stable value of money.

The primary function of a central bank is to manage the nation’s money supply (monetary policy), through active duties such as managing interest rates, setting the reserve requirement, and acting as a lender of last resort to the banking sector during times of bank insolvency or financial crisis. Central banks usually also have supervisory powers, intended to prevent bank runs and to reduce the risk that commercial banks and other financial institutions engage in reckless or fraudulent behavior. Central banks in most developed nations are institutionally designed to be independent from political interference. However, the structure, tools, and primary goals of these banks differ between countries.

European Central Bank

The European Central Bank (ECB) is the central bank for the euro and administers the monetary policy of the Eurozone, which consists of 17 EU member states and is one of the largest currency areas in the world. The bank was established by the Treaty of Amsterdam in 1998, and is headquartered in Frankfurt, Germany. In contrast with the Federal Reserve, the ECB has the primary objective of maintaining price stability within the Eurozone, but is not charged with regulating unemployment or economic output.

In the U.S., liquidity is furnished to the economy primarily through the purchase of Treasury bonds by the Federal Reserve (the Fed), but the European system uses a different method. Instead, there are about 1,500 eligible banks that can bid for short term repurchase contracts, or “repos”. The banks borrow cash, and when the repo notes come due the participating banks bid again. Because the loans have a short duration, the ECB can adjust interest rates and money supply by varying the quantity of notes offered at auction.

The ECB has three decision-making bodies: the Executive Board, the Governing Council, and the General Council. The Executive Board is responsible for implementing monetary policy and the day-to-day running of the bank. The Governing Council makes decisions about what monetary policies to implement. The General Council deals with the transitional issues that come about as new countries adopt the euro.

The Bank of England

The Bank of England is the central bank of the United Kingdom and the model on which most modern central banks have been based. Established in 1694, it is the second oldest central bank in the world . It was established to act as the English Government’s banker, and was privately owned from its foundation in 1694 until it was nationalized in 1946. In 1998, it became an independent public organization, owned by the Treasury Solicitor on behalf of the government, with independence in setting monetary policy. The primary goals of the Bank of England are to maintain price stability and support the economic policies of the government.

The Monetary Policy Committee is responsible for formulating monetary policy and for setting interest rates in order to maintain a given inflation target. The recently-established Financial Policy Committee is responsible for regulating the UK’s financial sector in order to maintain financial stability.

The People’s Bank of China

The People’s Bank of China (PBC) is the central bank of the People’s Republic of China with the power to control monetary policy and regulate financial institutions in mainland China. The People’s Bank of China has the most financial assets of any single public finance institution. It is responsible for making and implementing monetary policy for safeguarding the overall financial stability and provision of financial services.

The PBC has nine regional branches, as well as many sub-branches and six overseas representative offices. It is divided into 18 functional departments that oversee such issues as monetary policy, financial stability, anti-money laundering, and legal affairs. The top management of the PBC is composed of the governor and a certain number of deputy governors. The PBC adopts a governor responsibility system under which the governor supervises the overall work of the PBC while the deputy governors provide assistance to the governor to fulfill his or her responsibility.

26.2: Evaluating Fiscal Policy

26.2.1: Automatic Stabilizers

Learning Objective

Explain the role of automatic stabilizers in regulating economic fluctuations

Key Points

• During recessions, government spending automatically increases, which raises aggregate demand and offsets decreases in consumer demand. Government revenue automatically decreases.
• During economic booms, government spending automatically decreases, which prevents bubbles and the economy from overheating. Government revenue automatically increases.
• The fiscal multiplier is the ratio of a change in national income to the change in government spending that causes it. An initial change in aggregate demand may cause a change in aggregate output (and hence the aggregate income that it generates) that is a multiple of the initial change.

Key Terms

fiscal multiplier

The ratio of a change in national income to the change in government spending that causes it.

automatic stabilizer

A budget policy that automatically changes to stabilize fluctuations in GDP.

In macroeconomics, the concept of automatic stabilizers describes how modern government budget policies, particularly income taxes and welfare spending, act to dampen fluctuations in real GDP. The size of the government budget deficit tends to increase when a country enters a recession, which tends to keep national income higher by maintaining aggregate demand. This effect happens automatically depending on GDP and household income, without any explicit policy action by the government, and acts to reduce the severity of recessions.

Here is an example of how automatic stabilizers would work in a recession. When the country takes an economic downturn, more people become unemployed. As a result more people file for unemployment and other welfare measures, which increases government spending and aggregate demand. The unemployed also pay less in taxes because they are not earning a wage, which in turn decreases government revenue. The result is an increase in the federal deficit without Congress having to pass any specific law or act.

Similarly, the budget deficit tends to decrease during booms, which pulls back on aggregate demand. Because more people are earning wages during booms, the government can collect more taxes. Also, because fewer individuals need social services support during a boom, government spending also decreases. As spending decreases, aggregate demand decreases. Therefore, automatic stabilizers tend to reduce the size of the fluctuations in a country’s GDP.

Fiscal Multiplier Effect

What makes automatic stabilizers so effective in dampening economic fluctuations is the fiscal multiplier effect. The fiscal multiplier is the ratio of a change in national income to the change in government spending that causes it. When this multiplier exceeds one, the enhanced effect on national income is called the multiplier effect.

The multiplier effect occurs as a chain reaction. The increased funds received from the government by citizens allows them to increase their consumption. As a result, producers must increase their production, which requires firms to hire more workers. Because of the increased purchases and lower unemployment, people have more money to spend and increase their consumption. This consumption-production-consumption cycle leads to the multiplier effect, resulting in an overall increase in national income greater than the initial incremental amount of spending. In other words, an initial change in aggregate demand may cause a change in aggregate output (and hence the aggregate income that it generates) that is a multiple of the initial change.

26.2.2: Automatic Stabilizers Versus Discretionary Policy

Learning Objective

Describe the differences between automatic stabilizers and discretionary policy

Key Points

• Discretionary policy is a macroeconomic policy based on the judgment of policymakers in the moment as opposed to policy set by predetermined rules. Examples may include passing a new spending bill that promotes a certain cause, such as green technology, or the creation of a federal jobs program.
• When the economy begins to go through an economic fluctuation, automatic stabilizers immediately respond without any official or government body having to take action. With discretionary policy there is a significant time lag before action can be taken.
• Automatic stabilizers are limited in that they focus on managing the aggregate demand of a country. Discretionary policies can target other, specific areas of the economy.
• Automatic stabilizers exist prior to economic booms and busts. Discretionary policies are enacted in response to changes in the economy.

Key Terms

discretionary policy

Actions taken in response to changes in the economy. These acts do not follow a strict set of rules, rather, they use subjective judgment to treat each situation in unique manner.

automatic stabilizer

A budget policy that automatically changes to stabilize fluctuations in GDP.

In fiscal policy, there are two different approaches to stabilizing the economy: automatic stabilizers and discretionary policy. Both approaches focus on minimizing fluctuations in real GDP but have different means of doing so.

Discretionary Policy

Discretionary policy is a macroeconomic policy based on the judgment of policymakers in the moment, as opposed to a policy set by predetermined rules. Discretionary policies refer to actions taken in response to changes in the economy, but they do not follow a strict set of rules; rather, they use subjective judgment to treat each situation in unique manner. In practice, most policy changes are discretionary in nature. Examples may include passing a new spending bill that promotes a certain cause, such as green technology, or the creation of a federal jobs program .

Discretionary policies are generally laws enacted by Congress, which requires that any policy go through the same vetting and marking up process as any other law.

Automatic Stabilizers and Discretionary Policy

The key difference between these two types of financial policy approaches is timing of implementation. When the economy begins to go through an economic fluctuation, automatic stabilizers immediately respond without any official or government body having to take action. With discretionary policy there is a significant time lag. Before action can be taken, Congress must first determine that there is an issue and that action needs to be taken. Then Congress needs to design and implement a policy response. Then the law needs to be passed and the relevant agencies need to adjust and alter any necessary procedures so they can carry out the law. It is due to these significant lags that economists like Milton Friedman believed that discretionary fiscal policy could be destabilizing.

On the other hand, automatic stabilizers are limited in that they focus on managing the aggregate demand of a country. Discretionary policies can target other, specific areas of the economy. Discretionary policies can address failings of the economy that are not strictly tied to aggregate demand. For example, if an economy is going through a recession because its workers lack a certain set of skills, automatic stabilizers cannot address that problem. Government programs, such as retraining, can address this problem.

Finally, automatic stabilizers, such as the tax code and social service agencies, exist prior to an economic fluctuation. Discretionary policies are made in response to a fluctuation and only come into existence once a fluctuation starts to occur.

Of course, it is not possible to create an automatic stabilizer for every potential economic issue, so discretionary policy allows policymakers flexibility.

26.2.3: The Role of the Federal Budget

Learning Objective

Describe how the federal budget is created and its economic role

Key Points

• Congressional decisions are governed by rules and legislation regarding the federal budget process. Budget committees set spending limits for the House and Senate committees. Appropriations subcommittees then approve individual appropriations bills to allocate funding to various federal programs.
• If Congress fails to pass an annual budget, a series of appropriations bills must be passed as “stop gap” measures.
• The budget is a method of conducting fiscal policy and reflect government intervention in markets.

Key Term

appropriations bill

A legislative motion that authorizes the government to spend money.

The Federal Budget is the roadmap for how the national government plans to spend its money of the course of the upcoming year. It dictates which programs will receive funding and how much money the government will spend on each.

How the Federal Budget is Created

The Budget of the United States Government often begins as the president’s proposal to the U.S. Congress which recommends funding levels for the next fiscal year, beginning October 1. However, Congress is the body required by law to pass a budget annually and to submit the budget passed by both houses to the president for signature. To help Congress pass the best budget possible, several government agencies provide data and analysis. These include the Government Accountability Office (GAO), Congressional Budget Office (CBO), the Office of Management and Budget (OMB), and the U.S. Treasury Department.

Congressional decisions are governed by rules and legislation regarding the federal budget process. Budget committees set spending limits for the House and Senate committees. Appropriations subcommittees then approve individual appropriations bills to allocate funding to various federal programs.

If Congress fails to pass an annual budget, a series of appropriations bills must be passed as “stop gap” measures. After Congress approves an appropriations bill, it is sent to the president, who may sign it into law, or may veto it (as he would a budget when passed by the Congress). A vetoed bill is sent back to Congress, which can pass it into law with a two-thirds majority in each chamber. Congress may also combine all or some appropriations bills into an omnibus reconciliation bill. In addition, the president may request and the Congress may pass supplemental appropriations bills or emergency supplemental appropriations bills.

Economic Role of the Federal Budget

The federal budget is meant to provide the larger American economy with a sense of direction regarding where the Federal government is going to go and what they are going to do. The Federal budget discloses how much the government plans to tax and how it plans to spend its money. Individuals and businesses can then adjust their actions to accommodate what they’ll have to pay in taxes and what resources will be available to them in the government.

The federal budget also is one mechanism for conducting fiscal policy. The government can choose to expand or contract the budget to conduct expansionary or fiscal policy.

The specific items in the budget also have important policy implications: social welfare, social insurance, and government intervention in markets may all be reflected in the budget.

26.2.4: Arguments for and Against Balancing the Budget

Learning Objective

Describe arguments against maintaining a balanced budget in the United States

Key Points

• A balanced budget is a budget where revenues equal expenditures. A balanced budget can also refer to a budget where revenues are greater than expenditures.
• Most economists have also agreed that a balanced budget would decrease interest rates, increase savings and investment, shrink trade deficits and help the economy grow faster over a longer period of time.
• Keynesians argue for balanced budgets over the course of the business cycle. If a country rigidly pursues a balanced budget regardless of the circumstances, critics argue that economic downturns would be needlessly painful.

Key Term

balanced budget

A (usually government) budget in which income and expenditure are equal over a set period of time.

A balanced budget, particularly a government budget, is a budget with revenues equal to expenditures. There is neither a budget deficit nor a budget surplus; in other words, “the accounts balance. ” More generally, it refers to a budget with no deficit, but possibly with a surplus. A cyclically balanced budget is a budget that is not necessarily balanced year-to-year, but is balanced over the economic cycle, running a surplus in boom years and running a deficit in lean years, with these offsetting over time .

Balanced budgets, and the associated topic of budget deficits, are a contentious point within academic economics and within politics.

Arguments for a Balanced Budget

Most economists agree that a balanced budget would:

• decrease interest rates, making it easier for businesses and individuals to invest;
• increase savings and investment, which would provide security to individuals;
• shrink trade deficits; and
• help the economy grow faster over a longer period of time.

In the US, every state other than Vermont has a version of a balanced budget amendment, which prohibits some deficits. The federal government does not have such an amendment.

Arguments Against a Balanced Budget

The mainstream economic view is that having a balanced budget in every year is not desirable. If a country rigidly pursues a balanced budget regardless of the circumstances, critics argue that economic downturns would be needlessly painful. If balanced budgets were required and if the budget was in deficit during a recession, critics argue that the required cuts would make the economy even worse off.

Keynesian economists argue that government budgets should be balanced over the business cycles. During recessions governments should run deficits. Keynesians argue that increasing government spending and decreasing taxes can minimize the painful effects of a recession. Once an economy moves into a growth cycle, Keynesians believe the government should shift its perspective and try to run a budget surplus by decreasing spending and increasing taxes. By balancing deficits in recessions and surpluses in growth, Keynesians believe that the government can obtain the benefits of a balanced budget without facing the risks of making recessions worse due to spending and revenue limitations.

26.2.5: Long-Run Implications of Fiscal Policy

Learning Objective

Identify the long-run consequences of fiscal policy

Key Points

• Fiscal policy is the use of government revenue collection (taxation) and expenditure (spending) to influence the economy.
• When government borrowing increases interest rates, it can attract foreign capital from foreign investors, which can increases demand for that country’s currency and raise it’s value. This increase in the currency’s value increases export the price of exports.
• When governments fund a deficit with the issuing of government bonds, interest rates can increase across the market, because government borrowing creates higher demand for credit in the financial markets. This causes a lower aggregate demand for goods and services.
• In theory, fiscal stimulus does not cause inflation when it uses resources that would have otherwise been idle.

Key Term

inflation

An increase in the general level of prices or in the cost of living.

Fiscal policy is the use of government revenue collection (taxation) and expenditure (spending) to influence the economy. The two main instruments of fiscal policy are changes in the level and composition of taxation and government spending in various sectors.

It is important to underline that fiscal policy is heavily debated, and that expected outcomes are not achieved with complete certainty. That being said, these changes in fiscal policy can affect the following macroeconomic variables in an economy:

• Aggregate demand and the level of economic activity;
• The distribution of income;
• The pattern of resource allocation within the government sector and relative to the private sector.

Decreased Private Investment

Economists still debate the effectiveness of fiscal policy to influence the economy, particularly when it comes to using expansionary fiscal policy to stimulate the economy. When the government runs a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing, or monetizing the debt. When governments fund a deficit with the issuing of government bonds, interest rates can increase across the market, because government borrowing creates higher demand for credit in the financial markets. This causes a lower aggregate demand for goods and services, contrary to the objective of a fiscal stimulus.

Decreased Net Exports

Some also believe that expansionary fiscal policy also decreases net exports, which has a mitigating effect on national output and income. When government borrowing increases interest rates it attracts foreign capital from foreign investors. This is because, all other things being equal, the bonds issued from a country executing expansionary fiscal policy now offer a higher rate of return. In other words, companies wanting to finance projects must compete with their government for capital so they offer higher rates of return. To purchase bonds originating from a certain country, foreign investors must obtain that country’s currency. Therefore, when foreign capital flows into the country undergoing fiscal expansion, demand for that country’s currency increases. The increased demand causes that country’s currency to appreciate. Once the currency appreciates, goods originating from that country now cost more to foreigners than they did before and foreign goods now cost less than they did before. Consequently, exports decrease and imports increase.

Increased Inflation

Other possible problems with fiscal stimulus include inflationary effects driven by increased demand. Simply put, increasing the capital in a given system will eventually devalue the currency itself if there is an increase in money supply in circulation. Similarly, if stimulus capital is invested in creating jobs, the overall spending in a given economy will increase (that is, if jobs are actually created). This spending increase will shift demand to potentially increase price points. Whenever fiscal policy decisions are made, modeling the likelihood of inflation is a critical consideration.

26.2.6: Problems of Long-Run Government Debt

Learning Objective

Evaluate the consequences of imbalances in the government budget

Key Points

• To raise the necessary funds to pay down debt, governments will ultimately have to lower costs and/or raise taxes. Because cutting spending and raising taxes is unpopular, Congressmen may be hesitant to take those actions because it might prevent them from being re-elected.
• To pay off the debt, the government must maintain a certain level of income. This could limit the government’s ability to pursue expansionary fiscal policies to address future recessions.
• If the government chooses to delay paying down the debt, the compounding interest will lead to more debt which will lead to a higher annual interest expense that future generations will have to pay.

Key Term

cyclically balanced budget

Occurs when the government runs a deficit during recessions and lean years but a surplus during periods of significant growth.

Deficit spending during times of recession widely seen as a beneficial policy that can mitigate the effects of an economic downturn. However, even Keynesians that support deficit spending during recessions advise that governments balance this deficit spending with surpluses during the eventual economic boom. This means generating a government surplus by cutting expenses and raising taxes. This is known as a cyclically balanced budget; the government runs a deficit during recessions and lean years but a surplus during periods of significant growth.

Paying Down Debt

During periods of expansionary fiscal policy, the government will often fund programs by issuing debt . The problem with debt is that it must be paid off with future revenues.

To pay off the debt, the government must maintain a certain level of income. This could limit the government’s ability to pursue expansionary fiscal policies to address future recessions. On the other hand, if the government chooses to delay paying down the debt, the compounding interest will lead to more debt which will lead to a higher annual interest expense that future generations will have to pay.

Cutting Expenses and Raising Taxes

To offset the budgetary deficits and raise the necessary funds to pay down debt, governments will ultimately have to lower costs and raise taxes. In any democracy, especially in the U.S., doing those two things are incredibly difficult because both options are unpopular with voters. Since Congress is responsible for making budgetary, spending and taxation decisions, and because these elected officials may be disinclined to do anything that would hurt their chances to be re-elected, taking the necessary steps to balance out the periods of deficit spending during economic boom is difficult.

Credit Rating

A credit rating is an evaluation of the creditworthiness of a government, but not individual consumers. The evaluation is made by a credit rating agency of the country’s ability to pay back the debt and the likelihood of default. A sovereign credit rating is the credit rating of a sovereign entity (i.e., a national government). The sovereign credit rating indicates the risk level of the investing environment of a country and is used by investors looking to invest abroad. It takes political risk into account, as well as the amount of debt the country has outstanding.

If a country has a bad credit rating, it generally must have a higher interest rate on the debt it issues. This means it will be more expensive for that country to raise funds by issuing debt.

26.2.7: Limits of Fiscal Policy

Learning Objective

Identify the political and economic limits of fiscal policy

Key Points

• Conservatives are more likely to reject Keynesianism and argue that government should always run a balanced budget (and a surplus to pay down any outstanding debt) than Democrats.
• Liberals are more likely to be Keynesian and Post-Keynesians than Republicans; they are more likely to argue that deficit spending is necessary, either to create the money supply (Chartalism) or to satisfy demand for savings in excess of what can be satisfied by private investment.
• There is a dilemma as to whether these monetary and fiscal policies are complementary, or act as substitutes to each other for achieving macroeconomic goals.

Key Term

monetary policy

The process by which the central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets.

While fiscal policy can be a powerful tool for influencing the economy, there are limits in how effective these policies are.

Coordination with Monetary Policy

Fiscal policy and monetary policy are the two primary tools used by the State to achieve its macroeconomic objectives. While the main objective of fiscal policy is to influence the aggregate output of the economy, the main objective of the monetary policies is to control the interest and inflation rates. Fiscal policies have an impact on the goods market and monetary policies have an impact on the asset markets and since the two markets are connected to each other via the two macrovariables — output and interest rates – the policies interact while influencing the output or the interest rates.

There is controversy regarding whether these two policies are complementary or act as substitutes to each other for achieving macroeconomic goals. Policy makers are viewed to interact as strategic substitutes when one policy maker’s expansionary (contractionary) policies are countered by another policy maker’s contractionary (expansionary) policies. For example: if the fiscal authority raises taxes or cuts spending, then the monetary authority reacts to it by lowering the policy rates and vice versa. If they behave as strategic complements,then an expansionary (contractionary) policy of one authority is met by expansionary (contractionary) policies of other.

The issue of interaction and the policies being complement or substitute to each other arises only when the authorities are independent of each other. But when, the goals of one authority is made subservient to that of others, then the dominant authority solely dominates the policy making and no interaction worthy of analysis would arise. Also, it is worthy to note that fiscal and monetary policies interact only to the extent of influencing the final objective. So long as the objectives of one policy is not influenced by the other, there is no direct interaction between them.

Political Conflict

Fiscal policy is also a source of significant political conflict along party lines. Conservatives are more likely to reject Keynesianism and are more likely to argue that government should always run a balanced budget (and a surplus to pay down any outstanding debt), and that deficit spending is always bad policy .

Fiscal conservatism has academic support, predominantly associated with the neoclassical-inclined Chicago school of economics, and has significant political and institutional support, with all but one state of the United States (Vermont is the exception) having a balanced budget amendment to its state constitution. Fiscal conservatism was the dominant position until the Great Depression.

Liberals are more likely to be Keynesian and Post-Keynesians than Republican. They are more likely to argue that deficit spending is necessary, either to create the money supply (Chartalism) or to satisfy demand for savings in excess of what can be satisfied by private investment.

Chartalists argue that deficit spending is logically necessary because, in their view, fiat money is created by deficit spending: one cannot collect fiat money in taxes before one has issued it and spent it, and the amount of fiat money in circulation is exactly the government debt – money spent but not collected in taxes.

Fiscal Multiplier

The fiscal multiplier is the ratio of a change in national income to the change in government spending that causes it. When this multiplier exceeds one, the enhanced effect on national income is called the multiplier effect. The mechanism that can give rise to a multiplier effect is that an initial incremental amount of spending can lead to increased consumption spending, increasing income further and hence further increasing consumption, etc., resulting in an overall increase in national income greater than the initial incremental amount of spending. In other words, an initial change in aggregate demand may cause a change in aggregate output that is a multiple of the initial change.

How effective fiscal policy is depends on the multiplier. The greater the multiplier, the more effective the policy. If for some reason outside of the control of the government the multiplier remains low, the effectiveness of fiscal policy will remain limited at best.

26.2.8: Difficulty in Getting the Timing Right

Learning Objective

Explain the effect of timing on the use of fiscal policy tools

Key Points

• Automatic stabilizers are designed to respond to evolving economic conditions without anyone taking action; timing is not an issue.
• Good economic data are a precondition to effective macroeconomic management. The problem with this is that it could be weeks, or even months, before the necessary data is collected and organized in a way that would reveal there is a problem.
• Once a discretionary program is in place, the next step is to measure its effectiveness. Again, measurement becomes a problem. Because it takes so long to measure fluctuations in the economy, it may be months before the program’s effect on the economy can be seen.

Key Term

discretionary fiscal policy

A fiscal policy achieved through government intervention, as opposed to automatic stabilizers.

A nation can respond to economic fluctuations through automatic stabilizers or through discretionary policy. With regards to automatic stabilizers, timing is not an issue. Automatic stabilizers are designed to respond to evolving economic conditions without anyone taking action.

With discretionary fiscal policy, timing plays a very significant role. Discretionary policy often requires that a set of laws must be passed through a legislature. This means that the problem has to be identified first, which means collecting macroeconomic data.

Good economic data are a precondition to effective macroeconomic management. With the complexity of modern economies and the lags inherent in macroeconomic policy instruments, a country must have the capacity to promptly identify any adverse trends in its economy and to apply the appropriate corrective measure. This cannot be done without economic data that is complete, accurate and timely. The problem with this is that it could be weeks, or even months, before the necessary data is collected and organized in a way that would reveal there is a problem.

Once the problem has been established, Congress must then arrive at a plan and hold debates. Any legislation must pass through committees in both chambers, and both chambers must approve. Then, it must be presented to the President for his signature. This entire process would take weeks at least, but would more likely take months .

Once the discretionary program is in place, the next step is to measure its effectiveness. Again, measurement becomes a problem. Because it takes so long to measure fluctuations in the economy, it may be months before the program’s effect on the economy can be seen.

26.2.9: Crowding-Out Effect

Learning Objective

Explain the crowding out effect

Key Points

• Some commentators and other economists use “crowding out” to refer to government providing a service or good that would otherwise be a business opportunity for private industry.
• An increase in the demand for loanable funds by the government shifts the loanable funds demand curve rightwards and upwards, increasing the real interest rate. A higher real interest rate increases the opportunity cost of borrowing money, decreasing investment and consumption.
• If the economy is at capacity or full employment, the government suddenly implementing a stimulus program could create competition with the private sector for scarce funds available for investment, resulting in reduced private investment.

Key Term

interest rate

The percentage of an amount of money charged for its use per some period of time (often a year).

Usually when economists use the term crowding out they are referring to the government using up financial and other resources that would otherwise be used by private enterprise. However, some commentators and other economists use crowding out to refer to government providing a service or good that would otherwise be a business opportunity for private industry.

The macroeconomic theory behind crowding out provides some useful intuition. What happens is that an increase in the demand for loanable funds by the government (e.g. due to a deficit) shifts the loanable funds demand curve rightwards and upwards, increasing the real interest rate. A higher real interest rate increases the opportunity cost of borrowing money, decreasing the amount of interest-sensitive expenditures such as investment and consumption. Thus, the government has crowded out investment .

Borrowing and Crowding Out

In economics, crowding-out occurs when increased government borrowing reduces investment spending. The increased borrowing crowds out private investing.

If an increase in government spending and/or a decrease in tax revenues leads to a deficit that is financed by increased borrowing, then the borrowing can increase interest rates, leading to a reduction in private investment. There is some controversy in modern macroeconomics on the subject, as different schools of economic thought differ on how households and financial markets would react to more government borrowing under various circumstances.

Crowding-Out and Stimulus Programs

The extent to which crowding out occurs depends on the economic situation. If the economy is at capacity or full employment, then the government suddenly increasing its budget deficit (e.g., via stimulus programs) could create competition with the private sector for scarce funds available for investment, resulting in an increase in interest rates and reduced private investment or consumption. Therefore, the effect of the stimulus is offset by the effect of crowding out.

26.2.10: Evaluating the Recent United States Stimulus Package

Learning Objective

Summarize the effects of the use of stimulus in the wake of the Great Recession

Key Points

• Secondary objectives of the ARRA were to provide temporary relief programs for those most impacted by the recession and invest in infrastructure, education, health, and renewable energy.
• Reports on the effectiveness of the ARRA’s ability to create jobs were mixed. One conservative estimate said that the ARRA saved or created 1.6 to 1.8 million jobs and forecast a total impact of 2.5 million jobs saved by the time the stimulus is completed.
• A sizeable number of projects funded by the stimulus could not be started right away, diminishing its immediate impact.

Key Terms

infrastructure

The basic facilities, services and installations needed for the functioning of a community or society

quarter

Related to a three-month term, a quarter of a year.

The American Recovery and Reinvestment Act of 2009 (ARRA), otherwise known as the Stimulus or The Recovery Act, was an economic stimulus package was signed into law on February 17, 2009.

The ARRA was drafted in response to the Great Recession. The primary objective for ARRA was to save and create jobs almost immediately. Secondary objectives were to provide temporary relief programs for those most impacted by the recession and invest in infrastructure, education, health, and renewable energy .

The approximate cost of the economic stimulus package was estimated to be $787 billion at the time of passage, later revised to $831 billion between 2009 and 2019. The Act included direct spending in infrastructure, education, health, and energy, federal tax incentives, and expansion of unemployment benefits and other social welfare provisions. The rationale for ARRA came from Keynesian macroeconomic theory, which argues that during recessions, the government should offset the decrease in private spending with an increase in public spending in order to save jobs and stop further economic deterioration.

The Stimulus’s Impact on Unemployment

The primary justification for the stimulus package was to minimize unemployment. The Obama administration and Democratic proponents presented a graph in January 2009 showing the projected unemployment rate with and without the ARRA. The graph showed that if ARRA was not enacted the unemployment rate would exceed 9%; but if ARRA was enacted it would never exceed 8%. After ARRA became law, the actual unemployment rate exceeded 8% in February 2009, exceeded 9% in May 2009, and exceeded 10% in October 2009. The actual unemployment rate was 9.2% in June 2011 when it was projected to be below 7% with the ARRA. However, supporters of ARRA claim that this can be accounted for by noting that the actual recession was subsequently revealed to be much worse than any projections at the time when the ARRA was drawn up.

One year after the stimulus, several independent firms, including Moody’s and IHS Global Insight, estimated that the stimulus saved or created 1.6 to 1.8 million jobs and forecast a total impact of 2.5 million jobs saved by the time the stimulus is completed. The Congressional Budget Office considered these estimates conservative. The CBO estimated that, according to its model, 2.1 million jobs were saved in the last quarter of 2009, boosting the country’s GDP by up to 3.5% and lowering the unemployment rate by up to 2.1%.

In 2013, the Reason Foundation conducted a study of the results of the ARRA. Only 23% of 8,381 sampled companies hired new workers and kept all of them when the project was completed. Only 41% of sampled companies hired workers at all. 30% of sampled companies laid off all workers once the government money stopped funding. These results cast doubt on previously stated estimates of job creation numbers, which do not take into account those companies that did not retain their workers.

Shovel-Ready Projects

One of the primary purposes and promises of the Act was to launch a large number projects to stimulate the economy. However, a sizable number of these projects, many of which pertained to infrastructure, took longer to implement than they had expected by most. Just because the money was there for the projects did not mean that the projects were “shovel-ready”: there was a delay between when the funding became available and when the project could actually begin. Since the stimulus only is impactful when the money is actually spent, delays could have reduced the overall effectiveness of the stimulus.