Level I – Economics

Monetary and Fiscal Policy

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Graphs, charts, tables, examples, and figures are copyright 2020, CFA Institute.
itute

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Reproduced and republished with permission from CFA Institute. All rights
s reserved.
reserved

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 Contents
1. Introduction Government decisions and actions can
have a large impact on the economy
2. Monetary Policy
Governments are generally the largest
employers and the largest borrowers
3. Fiscal Policy
Two types of government policy

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4. The Relationship between

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Monetary and Fiscal Policy tio
on
Goal: stable growth and low inflation

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 2. Monetary Policy
Monetary policy attempts to have an impact on the economy by influencing the
quantity of money and interest rates

In this section we will cover:

1. Money
2. The Role of Central Banks
3. The Objectives of Monetary Policy

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4. Contractionary and Expansionary Monetary Policies and the Neutral Rate

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5. Limitations of Monetary Policy

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Example 1

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 2.1 Money
Money is generally defined a medium of exchange. For money to be a medium of
exchange, it must:
i. be readily acceptable
ii. have a known value
iii. be easily divisible
iv. have a high value relative to its weight
v. be difficult to counterfeit

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Money fulfills three important functions, it:

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1. acts as a medium of exchange

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2. provides individuals with a way of storing wealth

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3. provides society with a convenient measure of value and unit of account

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Paper Money and the Money Creation Process

Fractional reserve system

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Money Created =

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New deposit / Reserve requirement
quireement

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Money Multiplier =
1 / Reserve requirement
uirem
ment

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 Example
Given a reserve requirement of 8 percent, how much money can be created by
depositing an additional $500?
A. $ 800
B. $ 5,000
C. $ 6,250

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Answer: C

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The expression used to calculate the amount of money created is New Deposit/Reserve Requirement.

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Therefore, 500/0.08 = $ 6,250.

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 Definitions of Money
What is money?

Broad Money versus Narrow Money

Excerpt from Exhibit 3

The U.S. Federal Reserve produces two measures of money. The first is M1, which comprises notes and coins in
circulation, travelers’ cheques of non-bank issuers, demand deposits at commercial banks, plus other deposits

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on which cheques can be written. M2 is the broadest measure of money currently produced by the Federal

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Reserve and includes M1, plus savings and money market deposits, time deposit accounts of less than

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$100,000, plus other balances in retail money market and mutual funds.

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 Quantity Theory of Money
Quantity theory of money: total spending (in money terms) is proportional to the quantity of money

Quantity equation of exchange: M x V = P x Y

Where M = quantity of money

V = velocity of circulation of money
P = average price level
Y = real output

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Money neutrality

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 Demand for Money
Demand for money: The amount of wealth that the citizens of an economy choose to
hold in the form of money rather than in bonds or equities

Motives for holding money:

• Transaction-related
• Precautionary

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• Speculative

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Example 3

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 The Supply and Demand for Money
MS
Nominal
What is the short-run impact
Interest of an increase in money supply?
Rate

I1
What is the long-run impact
of an increase in money supply?
I0

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I2
MD

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M1 M0 M2

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Quantity of Money

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 The Fisher Effect
Fischer effect: Rnom = Rreal + ∏e

Fisher effect is directly related to money neutrality

When we consider uncertainty, nominal interest rates have three components:

1) Required real return
2) Expected inflation

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3) Risk premium

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Example
e4

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Example
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 2.2 The Roles of Central Banks
• Monopoly supplier of the currency

• Banker to the government and the bankers’ bank

• Lender of last resort

• Regulator and supervisor of the payments system

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• Conductor of monetary policy

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• Supervisor of the banking system

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 2.3 Objectives of the Monetary Policy
Primary objective: maintain price stability

In this sub-section we will cover:

1. The Costs of Inflation
2. Monetary Policy Tools
3. Targeting Inflation

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4. Exchange Rate Targeting

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Example
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 Costs of Inflation
Expected inflation can give rise to:
• Menu costs and
• Shoe leather costs

Unanticipated (unexpected) inflation can, in addition:

• Lead to inequitable transfers of wealth between borrowers and lenders
• Give rise to risk premia in borrowing rates and the prices of other assets

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• Reduce the information content of market prices

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 Monetary Policy Tools
• Open Market Operations

• The Central Bank’s Policy Rate

ƒ Official interest rate
ƒ Repo rates
ƒ Base rates

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Federal funds rate

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• Reserve Requirements

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 The Transmission Mechanism

Market Rates

Domestic
Asset Prices Demand
Official Domestic
Total
Rate Inflationary
Demand
Expectations/ Pressure
Confidence Net External

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Demand Inflation
n

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Exchange

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Import
Rate

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Prices

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Example 8

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 Inflation Targeting
Target a certain level of inflation and then ensure this level is met by monitoring a
range of monetary and real economic indicators

The success of inflation targeting depends on:

1. Central Bank Independence (free from political interference)

2. Credibility (follows through on its stated policy intentions)

3. Transparency (clear policy on economic indicators)

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Other features of an inflation targeting framework:

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• A decision-making framework that considers a wide range of economic and financial market ket

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indicators

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• A clear, symmetric and forward-looking medium-term inflation target, sufficiently abov
above 0 pe percent

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to avoid the risk of deflation but low enough to ensure a significant degree of price
rice stability
sttabilit

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Example 9

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 Exchange Rate Targeting

Set a fixed level or band of values for the exchange rate against a major currency

• Central bank supports the target by buying and selling the national currency in
foreign exchange markets

• “Import” the inflation experience of the low inflation economy

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• Interest rates and conditions in the domestic economy must adapt to

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accommodate this target and domestic interest rates and money supply can

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become more volatile

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Dollarization is where a country adopts the US dollar as its functional currency. This is stronger
nger tthan
an pe
pegging

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because the US dollar effectively replaces the previous national currency.

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Example 10

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 2.4 Contractionary and Expansionary Monetary
Policies and the Neutral Rate
Contractionary monetary policy: increase official policy rate Æ growth rate of money
supply and real economy contract

Expansionary monetary policy: decrease official policy rate Æ growth rate of money
supply and real economy increase

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High and low policy rate is with respect to the neutral rate of interest

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ƒ Rate that neither spurs nor slows the economy

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ƒ Trend growth rate + inflation target

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 2.5 Limitations of Monetary Policy
The will of the monetary authority does not necessarily transmit seamlessly
through the economy

Central banks can not control:

1) the amount of money households and corporations put in banks on deposit
2) the willingness of banks to create money by expanding credit.

It is relatively easy for central banks to influence short-term rates but long term

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rates depend on expectations of interest rates

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Example 11 Example 12
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 3. Fiscal Policy
Fiscal policy refers to the taxing and spending policies of the government

A government can influence the following aspects of the economy:

• Overall level of aggregate demand in an economy and hence the level of economic activity
• Distribution of income and wealth among different segments of the population
• Allocation of resources between different sectors and economic agents

In this section we will cover

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1. Roles and Objectives of Fiscal Policy

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2. Fiscal Policy Tools and the Macroeconomy

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3. Fiscal Policy Implementation: Active and Discretionary Fiscal Policy

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 3.1 Roles and Objectives of Fiscal Policy
Primary objective: Help manage the economy through its influence on
aggregate national output (real GDP)

• Fiscal Policy and Aggregate Demand

• Government Receipts and Expenditures in Major Economies

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• Deficits and National Debt

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 Fiscal Policy and Aggregate Demand
An expansionary fiscal policy can take several forms
• Lower taxes
ƒ Cuts in personal income tax
ƒ Cuts in sales taxes
ƒ Cuts in corporate taxes
• Higher government spending

What is a contractionary fiscal policy?

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oliccy??
What are the Keynesian and Monetarist views on the effectiveness of fiscal policy?

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 Government Receipts and Expenditures in Major
Economies
• Exhibits 13 and 14 and show government revenues and expenditures as a
percentage of GDP

• Fiscal policy can influence output Æ can be used for economic stabilization

• Budget deficit

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• Automatic stabilizers

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 Deficits and the National Debt
Government deficit = Revenue – Expenses; government deficits add to national debt
Should we worry about national debt?

Don’t worry because… Worry because…

• Scale of the problem may be overstated because the debt is
owed internally to fellow citizens
• A proportion of the money borrowed may have been used
for capital investment projects or enhancing human capital
• Large fiscal deficits require tax changes which may actually
• High levels of debt to GDP may lead to higher
tax rates in the search for higher tax
revenues. This may lead to disincentives to
economic activity.
• If markets lose confidence in a government,

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then the central bank may have to print

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reduce distortions caused by existing tax structures

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• money to finance a government deficit.

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Deficits may have no net impact because the private sector
•

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may act to offset fiscal deficits by increasing saving in Government borrowing may divert privat
private
e
anticipation of future increased taxes sector investment from taking place.
ace.

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• If there is unemployment in an economy, then the debt is
not diverting activity away from productive uses

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 3.2 Fiscal Policy Tools and the Macroeconomy
• Government spending can take different forms
ƒ Transfer payments
ƒ Current government spending
ƒ Capital expenditure
• Economic and social justification for government spending
• Government revenue can take different forms
ƒ Direct taxes
ƒ Indirect taxes

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• Desirable attributes of tax policy

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Simplicity
ƒ Efficiency

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ƒ Fairness

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Revenue Sufficiency

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Advantages and Disadvantages of Using Different Tools of
Fiscal Policy

Advantages
• Indirect taxes can be adjusted almost
immediately after they are announced and
can influence spending behaviour instantly
and generate revenue for the government at
little or no cost to the government.
• Social policies, such as discouraging alcohol or
Disadvantages
• Direct taxes are more difficult to change
without considerable notice, often many
months, because payroll computer systems
will have to be adjusted.
• The same may be said for welfare and other

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social transfers.

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tobacco use, can be adjusted almost instantly • Capital spending plans take longer to

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by raising such taxes.

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formulate and implement, typically overer a
period of years.

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Modeling the Impact of Taxes and Government Spending:
The Fiscal Multiplier
• The objective of fiscal policy is to influence output though changes in government
spending and/or taxes
• The fiscal multiplier tells us about changes in output when there are changes in
spending and taxes
• Fiscal multiplier = 1/[1 – c(1 – t)]

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What is value of the fiscal multiplier if the tax rate is 20%, and the marginal propensity to spend is 90%?
90%

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What is the increase in total income if government spending increases by 1 billion?

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 The Balanced Budget Multiplier
Government expenditure and taxes go up by same amount Æ GDP up

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Example 14

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Example 15 Exam ple 16
Example Example 17

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 3.3 Fiscal Policy Implementation: Active and
Discretionary Fiscal Policy
• Deficit might not be an indication of government’s fiscal stance
• Structural or cyclically adjusted budget deficit
• Automatic vs. discretionary fiscal adjustments

• Executing fiscal policy can be difficult

ƒ Recognition lag

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ƒ Action lag

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ƒ Impact lag

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Example 18

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4. Relationship between Monetary Policy and Fiscal Policy

Easy/Expansionary Fiscal Policy Tight Fiscal Policy

Easy/Expansionary

AD up AD down
Monetary Policy

Low rates Æ private sector demand up Low rates Æ private sector stimulated

Growing private and public sector Public sector will become a smaller
percentage of economy

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AD up AD down

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Tight Monetary

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High interest rates Æ private sector down High interest rates Æ private sectorr

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demand down

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Policy

Public spending will become a higher

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percentage of GDP ic sec
Shrinking private and public tors
sectors

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Example 19

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 Summary
• Monetary Policy • Fiscal Policy
ƒ Functions of Money ƒ Roles and Objectives
ƒ Money Creation Process ƒ Policy Tools
ƒ Demand and Supply of Money ƒ National Debt/GDP
ƒ Central Banks ƒ Implementation Issues
ƒ Growth, Inflation, Interest and ƒ Expansionary versus Contractionary
Exchange Rates Policy

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ƒ Expansionary versus Contractionary

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Policy • Interaction of Monetary and Fiscal
Fisscal

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ƒ Limitations Policy

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 Conclusion
• Read summary

• Review learning objectives

• Examples

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• Practice problems

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• Practice questions from other sources

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