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Go Global !
Global Economic Environment :
The Effect of Government
Macroeconomic Policy on Business

                             By

                          Stephen Ong
          Edinburgh Napier University Business School
                    chong@mail.tarc.edu.my
     Visiting Professor, College of Management, Shenzhen
                            University
                          4 August 2012
Learning Objectives

 To identify the fiscal policy instruments of
  Government to manage the economy
 To critically assess the effectiveness of
  fiscal policy
 To identify the principal instruments of
  monetary policy
 To evaluate the nature and effectiveness
  of monetary policy
Agenda

1. Fiscal Policy
2. Monetary
   Policy
Fiscal Policy

 Government Policy
 Dilemma
Aggregate Demand
Fiscal Policy
Issues
1. Impact of Government Economic Policy
2. Aggregate Demand
2.1 Movements vs Shifts
2.2 Economic Downturn
2.3 National Income & Consumption
2.4 National Output (GDP)
2.5 GDP=C+I
2.6 Multiplier Model
2.7 Taxes (-T)
2.8 Government Spending (+G)
2.9 GDP=C+I+G
2.9.1 GDP=C+I+G
2.10 Economic Boom & Defence Spending
3. Fiscal Policy
     • Council of Economic Advisers
       (CEA)
     • Discretionary fiscal policy
      • Eliminate recessionary or
        inflationary gap
      • Countercyclical
     • Nondiscretionary fiscal policy
18    • Passive or automatic
3.1 Fiscal Policy

     • Expansionary fiscal policy
      • Increased spending and/or
        lower taxes
      • Budget deficit
     • Contractionary fiscal policy
      • Lower spending and/or higher
        taxes
19
      • Budget surplus
     • Policy options?
3.2 Expansionary Fiscal Policy
                                                          Recessions
                                                           Decrease
        $5 Billion                                        Aggregate
        Additional                                         Demand
        Spending
                                                     AS
          Price Level




                                                      Full $20 Billion
                        P1                              Increase in
                                                     Aggregate Demand


                                                       AD1
                                               AD2

20                            $490      $510
                             Real Domestic Output, GDP
3.3 Contractionary Fiscal Policy
          Reduce
        Demand Pull                      $5 Billion
          Inflation                  Initial Decrease
                                       In Spending
                                                     AS
          Price Level




                                                      Full $20 Billion
                        P1                              Decrease in
                                                     Aggregate Demand


                                                      AD4
                                               AD3

21                            $510      $522
                             Real Domestic Output, GDP
3.4 Built-In Stability

     • Automatic stabilizers
      • Taxes and transfers
     • Economic importance
     • Tax progressivity
      • Progressive tax system
      • Proportional tax system
22    • Regressive tax system
3.5 Built-In Stability

                                                                    T
     Government Expenses, G
       and Tax Revenues, T




                                                          Surplus
                                                                        G
                                Deficit




23                                     GDP1   GDP2     GDP3
                                     Real Domestic Output, GDP
3.6 Evaluating Fiscal Policy

 • Standardized budget
   • Full-employment budget
   • Cyclical deficit
   • Recent U.S. fiscal policy
   • Budget deficits and
     projections
24 • Social security considerations
3.6.1 Evaluating Fiscal Policy
                                                                       T
                                       Cyclical deficit
                                       Fiscal policy
       Government Expenses, G
                                       neutral
         and Tax Revenues, T




                                               b          a
                                $500                                   G

                                $450
                                                   c




25                                            GDP2       GDP1
                                              (Year 2)   (Year 1)
                                           Real Domestic Output, GDP
3.6.2 Evaluating Fiscal Policy
                                       Standardized deficit             T1
                                       Expansionary fiscal              T2
                                       policy
       Government Expenses, G
         and Tax Revenues, T




                                                e         d
                                $500                                     G
                                $475
                                                              h
                                $450
                                                    f
                                $425                g




26                                             GDP4      GDP3
                                              (Year 4)   (Year 3)
                                            Real Domestic Output, GDP
4. Fiscal Policy Issues
      Problems, Criticisms, and Complications
• Problems of timing
   • Recognition lag
   • Administrative lag
   • Operational lag
• Political considerations
• Future policy reversals
• Offsetting state and local finance
• Crowding-out effect
• Current thinking on fiscal policy
  27
4.1 Budget Balances as % of GDP
                    (2)                      (3)
                 Actual                Standardized
         (1)   Deficit (-) or           Deficit (-) or
        Year   Surplus (+)              Surplus (+)
        1992      -4.5%                      -2.9%
        1993      -3.8%                      -2.9%
        1994      -2.9%                      -2.1%
        1995      -2.2%                      -2.0%
        1996      -1.4%                      -1.2%
        1997      -0.3%                      -1.0%
        1998      +0.8%                      -0.4%
        1999      +1.4%                      +0.1%
        2000      +2.5%                      +1.1%
        2001      +1.3%                      +1.0%
        2002      -1.5%                      -1.2%
        2003      -3.4%                      -2.5%
        2004      -3.5%                      -2.4%
        2005      -2.6%                      -1.9%
        2006      -1.9%                      -1.8%
28      2007      -1.3%                      -1.4%
                                Source: Congressional Budget Office
4.2 Standardized Budget Balance
     Percentage of Potential GDP, 2007
                              Deficits                           Surpluses
                       -6      -4      -2               0         2    4               6
           Denmark
       New Zealand
             Ireland
            Canada
            Norway
             France
       United States
     United Kingdom
29            Japan
                            Source: Organization for Economic Cooperation and Development
4.3 Federal Budget Balance
     Actual and Projected, Fiscal 1994-2014
                                                            Actual        Projected       (as of March 2008)
                                                 $300
       Budget Deficit (-) or Surplus, Billions


                                                 200

                                                 100

                                                   0

                                                 -100

                                                 -200

                                                 -300

                                                 -400

                                                 -500
30                                                      1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

                                                                                           Source: Congressional Budget Office
4.4 The Public Debt
• National or public debt $9.01
  trillion
• Ownership
 • U.S. securities
 • 53% owned by federal
   government and Federal Reserve
 • 47% held outside the federal
   government and Federal Reserve
 31
4.5 The Public Debt
     Debt Held Outside
       The Federal                                    Debt Held by the
                                 Other, Including
       Government                State and Local    Federal Government
       and Federal                Governments           and Federal
      Reserve (47%)                                    Reserve (53%)

     U.S. Banks
      And other                     8%    7%
      Financial
                                                9%
     Institutions
                                                                Federal
                           25%                                  Reserve
      Foreign
     Ownership
                                            44%
                             7%
                                                             U.S.
                                                          Government
               U.S.
32          Individuals
                                                           Agencies

                                                           Source: U.S. Treasury
                          Total Debt: $9.01 trillion
4.6 Debt and GDP
     Federal debt held by the public, percentage of GDP
                           50
                           45
                           40
                           35
          Percent of GDP




                           30
                           25
                           20
                           15
                           10
                            5
                           0
                           1970   1975   1980   1985    1990      1995        2000         2005
                                                   Year
33
                                                         Source: Economic Report of the President, 2006
4.7 Debt and GDP
     Publicly Held Debt: International Comparisons

                            As a Percentage of GDP, 2007
                        0   20         40          60            80          100

                    Italy
                  Japan
                Belgium
               Hungary
               Germany
          United States
        United Kingdom
                 France
            Netherlands
                Canada
                  Spain
34               Poland
                                 Source: Organization for Economic Cooperation and Development
4.8 Debt and GDP
• Interest charges
 • Primary burden
 • 1.7% of GDP 2007
• False concerns
 • Bankruptcy
 • Refinancing
 • Taxation
 •35Burdening future
    generations
4.9 Debt and GDP
• Substantive issues
     • Income distribution
     • Incentives
     • Foreign-owned public debt
• Crowding-out effect revisited
     • Burden on future generations
     • Public investment as an offset
36
     • Graphically
4.10 Crowding Out

     A Large Public Debt to Finance Public Investment Will Cause…
                                         16
                                                                        If Public Spending
                                         14                             Spurs More Private
                                                                          Investment Will
          Real Interest Rate (Percent)


                                         12
                                                                           Increase to ID2
                                                              b             c
                                         10

                                         8
                                                                              a
                                         6
                                           Interest Rate      Crowding-
                                         4   Rise Will        Out Effect
                                             Decrease
                                                                                                  ID 2
                                         2 Investment
                                               a to b                                     ID 1
                                              0   5   10   15     20     25       30      35     40
37
                                                       Investment (Billions of Dollars)
4.11 The Leading Indicators
     1. Average workweek
     2. Initial claims for
        unemployment insurance
     3. New orders for consumer
        goods
     4. Vendor performance
     5. New orders for capital goods
     6. Building permits for houses
     7. Stock prices
     8. Money supply
38   9. Interest-rate spread
     10.Consumer expectations  Source: The Conference Board
Monetary Policy
 Money
 The Central Banker : FRS
 The Banking System
 Monetary Policy
 The US Subprime Crisis
1. Functions of Money

• Medium of exchange
 • Used to buy/sell goods
• Unit of account
 • Goods valued in dollars
• Store of value
 • Hold some wealth in money
   form
• Money is liquid
                               31-40
1.1 Money Defined
• M1
 • Currency
 • Checkable deposits
• Institutions offering checkable
  deposits
 • Commercial banks
 • Savings and loan associations
 • Mutual savings banks
 • Credit unions
                               31-41
1.2 Money Defined
• M2
 • M1 plus near-monies
 • Savings deposits including
   money market deposit
   accounts (MMDA)
 • Small time deposits
 • Money market mutual funds
   (MMMF)

                                31-42
1.3 Money Defined
                                                    M1        M2
January 2008                       Currency +        56%
                                                              M1
                          Checkable Deposits +       44%      18%

                         Small Time Deposits +                16%

                Money Market Mutual                           14%
             Funds Held By Individuals         +

                        Savings Deposits,                     52%
                  Including Money Market +
                        Deposit Accounts

                                      Totals       $1,365    $7,499
Source: Federal Reserve System                     Billion   Billion
                                                                       31-43
1.4 Money Supply

• Are credit cards money?
• What “backs” the money
  supply?
 • Nothing!
• Why is money valuable?
 • Acceptability
 • Legal tender
 • Relative scarcity        31-44
1.5 Money and Prices
• Prices affect purchasing power
  of money
• Hyperinflation renders money
  unacceptable
• Stabilizing money’s purchasing
  power
 • Intelligent management of the
   money supply – monetary policy
 • Appropriate fiscal policy    31-45
2. Federal Reserve System
• Historical background
• Board of Governors
• 12 Federal Reserve Banks
 • Serve as the central bank
 • Quasi-public banks
 • Banker’s bank
                               31-46
2.1 Federal Reserve System

                        Board of Governors

Federal Open Market Committee


                    12 Federal Reserve Banks


                                          Thrift Institutions
                                   (Savings and Loan Associations,
     Commercial Banks                  Mutual Savings Banks,
                                            Credit Unions)



                            The Public
                         (Households and
                           Businesses)

                                                                31-47
2.2 Federal Reserve System
 The 12 Federal Reserve Banks




                    Source: Federal Reserve Bulletin

                                                       31-48
2.3 Federal Reserve System
• Federal Open Market Committee
 • Aids Board of Governors in setting
   monetary policy
 • Conducts open market operations
• Commercial banks and thrifts
 • 7,300 commercial banks
 • 11,000 thrifts
                                  31-49
2.4 Federal Reserve Functions
•   Issue currency
•   Set reserve requirements
•   Lend money to banks
•   Set discount rate
•   Check collection
•   Fiscal agent for U.S. government
•   Supervise banks
•   Control the money supply
                                 31-50
2.5 Federal Reserve System
• Federal Reserve independence
• Recent developments
   • Relative decline of banks and
     thrifts
   • Consolidation
   • Convergence of services provided
     by financial institutions
   • Globalization of financial markets
   • Electronic payments
                                     31-51
2.6 Financial Institutions

  World’s 12 Largest Financial Institutions, 2007
                                   Assets (Billions of U.S. Dollars)
                         0    1,300,000     1,600,000        1,900,000

              Barclays (UK)
       BNP Paribas (France
            Citigroup (USA)
          HSBC Group (UK)
          UBS (Switzerland)
Royal Bank of Scotland (UK)
   ING Group (Netherlands)
     Mitsubishi UFJ (Japan)
 Deutsche Bank Group (Ger)
       Bank of America (US)
    Allianz Worldwide (Ger)
     JPMorgan Chase (USA)
                              Source: Organization for Economic Cooperation and Development
                                                                                       31-52
2.7 U.S. Financial Institutions

•   Commercial banks
•   Thrifts
•   Insurance companies
•   Mutual fund companies
•   Pension funds
•   Securities firms
•   Investment banks          31-53
2.8 The Global Greenback
• U.S. currency circulating abroad
  • Russia $80 billion
  • Argentina $50 billion
  • $450 billion total
  • 60% of total US currency
• U.S. profits from dollars leaving
• Black markets and illegal activities
• Dollar offers stable purchasing power
• Exchange rate risk
                                    31-54
3. Fractional Reserve Banking

• The Goldsmiths
 • Stored gold and gave a receipt
 • Receipts used as money by public
 • Made loans by issuing receipts
• Characteristics
 • Banks create money through
   lending
 • Banks are subject to “panics”
                                   32-55
3.1 Fractional Reserve System
• Balance sheet
 • Assets = Liabilities + Net
   Worth
 • Both sides balance
• Necessary transactions
 • Create a bank
 • Accept deposits
 • Lend excess reserves
                                32-56
3.2 Creating a Bank

• Transaction #1
• Vault cash: cash held by the
  bank
                 Creating a Bank
            Balance Sheet 1: Wahoo Bank
   Assets                  Liabilities and Net Worth
   Cash          $250,000 Stock Shares         $250,000




                                                          32-57
3.2.1 Creating a Bank
• Transaction #2
• Acquiring property & equipment

            Acquiring Property and Equipment
                  Balance Sheet 2: Wahoo Bank
       Assets                    Liabilities and Net Worth
       Cash             $10,000 Stock Shares         $250,000
       Property         240,000




                                                                32-58
3.2.2 Creating a Bank
• Transaction #3
• Commercial bank
  functions
 • Accepting deposits
 • Making loans Deposits
           Accepting
              Balance Sheet 3: Wahoo Bank
   Assets                     Liabilities and Net Worth

   Cash            $110,000     Checkable
                                   Deposits        $100,000
   Property         240,000
                                Stock Shares        250,000


                                                              32-59
3.2.3 Creating a Bank
•   Transaction #4
•   Depositing reserves in a
    Federal Reserve bank
    • Required reserves
    • Reserve ratio
                      Commercial bank’s
     Reserve          Required reserves
      ratio    =
                      Commercial bank’s
                   Checkable-deposit liabilities
                                               32-60
3.2.4 Reserve Requirements
                                   Current     Statutory
     Type of Deposit             Requirement    Limits
     Checkable deposits:
       $0-$9.8 Million                0%            3%
       $9.3-$43.9 Million             3             3
       Over $43.9 Million            10          8-14
     Noncheckable nonpersonal
     savings and time deposits        0           0-9


• Fed can establish and vary reserve
  ratio within limits set by Congress
• Required reserves help Fed control
  lending abilities of commercial banks
                                                           32-61
3.2.5 Creating a Bank

• Transaction #4
• Assume the bank deposits all
  cash on reserve at the Fed
             Depositing Reserves at the Fed
                Balance Sheet 4: Wahoo Bank
    Assets                     Liabilities and Net Worth
    Cash                   $0 Checkable
    Reserves          110,000   Deposits           $100,000
    Property          240,000 Stock Shares          250,000



                                                              32-62
3.2.6 Reserve Requirements
• Excess reserves
 • Actual reserves - required
  reserves
• Required reserves
 • Checkable deposits x reserve ratio
• Example:
 • Checkable deposits $100,000
 • Reserve ratio 20%              32-63
3.2.7 Creating a Bank
• Transaction #5
• Clearing a check
 • $50,000 check reduces reserves
   and checkable deposits
                     Clearing a Check
                 Balance Sheet 5: Wahoo Bank
      Assets                    Liabilities and Net Worth
                                Checkable
      Reserves          $60,000    Deposits          $50,000
      Property          240,000 Stock Shares         250,000


                                                               32-64
3.3 Money Creating Transactions

  • Transaction #6a
  • Granting a loan
   • $50,000 loan deposited to
     checking a Loan is Negotiated
            When
                 Balance Sheet 6a: Wahoo Bank
      Assets                    Liabilities and Net Worth
      Reserves         $60,000 Checkable
      Loans             50,000   Deposits           $100,000
      Property         240,000 Stock Shares          250,000


                                                               32-65
3.3.1 Money Creating Transactions
   • Transaction #6b
   • Using the loan
     • $50,000 loan cashed
           After a Check is Drawn on the Loan
                  Balance Sheet 6b: Wahoo Bank
       Assets                    Liabilities and Net Worth
       Reserves         $10,000 Checkable
       Loans             50,000   Deposits            $50,000
       Property         240,000 Stock Shares          250,000

        A single bank can only lend an amount
        equal to their preloan excess reserves                  32-66
3.3.2 Money Creating Transactions
   • Transaction #7
   • Bank buys government
     securities from dealer
    • Deposits payment into
      checking Government Securities
           Buying
             Balance Sheet 7: Wahoo Bank
       Assets               Liabilities and Net Worth
       Reserves     $60,000 Checkable
       Securities    50,000   Deposits          $100,000
       Property     240,000 Stock Shares         250,000



       New money is created                                32-67
3.4 Commercial Banks

•   Conflicting goals
•   Earn profit
    • Make loans to earn interest
    • Buy securities to earn interest
• Maintain liquidity
• Alternative?
    • Overnight bank loans
    • Federal funds rate
                                   32-68
3.5 The Banking System
•   Multiple-deposit expansion
•   Assumptions:
    • 20% required reserves
    • All banks “loaned up”
    • Banks lend all of excess reserves
• A $100 bill is found and
  deposited
• Multiple deposits can be created        32-69
3.6 The Banking System
              (1)                   (3)          (4)
           Acquired        (2)    Excess Amount Bank Can
           Reserves     Required Reserves Lend; New Money
 Bank    and Deposits   Reserves  (1)-(2)   Created = (3)

Bank A      $100         $20      $80         $80
Bank B      $80          $16      $64         $64
Bank C      $64         $12.80    $51.20      $51.20
Bank D      $51.20       $10.24   $40.96      $40.96


 The process will continue…

                                                       32-70
3.6.1 The Banking System
                              (2)
                (1)       Required          (3)            (4)
             Acquired     Reserves       Excess     Amount Bank Can
             Reserves     (Reserve      Reserves    Lend; New Money
  Bank     and Deposits   Ratio = .2)     (1)-(2)     Created = (3)

 Bank A     $100.00        $20.00       $80.00           $80.00
 Bank B       80.00         16.00        64.00            64.00
 Bank C       64.00         12.80        51.20            51.20
 Bank D       51.20         10.24        40.96            40.96
 Bank E       40.96          8.19        32.77            32.77
 Bank F       32.77          6.55        26.21            26.21
 Bank G       26.21          5.24        20.97            20.97
 Bank H       20.97          4.20        16.78            16.78
 Bank I       16.78          3.36        13.42            13.42
 Bank J       13.42          2.68        10.74            10.74
 Bank K       10.74          2.15         8.59             8.59
 Bank L        8.59          1.72         6.87             6.87
 Bank M        6.87          1.37         5.50             5.50
 Bank N        5.50          1.10         4.40             4.40
 Other Banks 21.99           4.40        17.59            17.59
                                                        $400.00       32-71
3.7 The Monetary Multiplier
Monetary                         1                         1
multiplier   =        required reserve ratio
                                                      =
                                                           R



   Graphic                  New Reserves
                               $100
   Example         $80                       $20
                  Excess                   Required
                 Reserves                  Reserves




                                                  $100
                        $400
                                                 Initial
                 Bank System Lending
                                                Deposit

                      Money Created
                                                               32-72
3.7.1 The Monetary Multiplier
• Maximum amount of new
  money created by single
  dollar of excess reserves
• Higher R, lower m
• Reversibility
 • Making loans creates money
 • Loan repayment destroys
   money                        32-73
3.8 Bank Panics of 1930-1933
• Before deposit insurance
• Bank failure led to mass withdrawals
• Forced loan reduction
• 25-33% decline in money supply
• 1933 national bank holiday to
  evaluate all banks
• Contributed to the Great Depression
• Regulation protects the system today
                                   32-74
4. Interest Rates

• Price paid for the use of
  money
• Many different interest rates
• Speak as if only one interest
  rate
• Determined by money supply
  and money demand
                             33-75
4.1 Demand for Money
• Why hold money?
• Transactions demand, D1
 • Determined by nominal GDP
 • Independent of the interest rate
• Asset demand, D2
 • Money as a store of value
 • Varies inversely with the interest
   rate
• Total money demand, Dm                33-76
4.1.1Demand for Money
                                                                                                           (c)
                                         (a)                           (b)                               Total
                                    Transactions                      Asset                            demand for
                                     demand for                     demand for                         money, Dm
                                      money, Dt                      money, Da                         and supply
Rate of interest, i percent




                              10
                                                                                                                     Sm
                              7.5

                               5                               +                             =5
                              2.5

                               0
                                              Dt                                        Da                                     Dm
                                       50   100    150   200         50   100   150   200         50   100   150   200   250   300

                                     Amount of money                Amount of money                  Amount of money
                                          demanded                       demanded                 demanded and supplied
                                    (billions of dollars)          (billions of dollars)            (billions of dollars)

                                                                                                                               33-77
4.2 Interest Rates
• Equilibrium interest rate
 • Changes with shifts in money
   supply and money demand
• Interest rates and bond
  prices
 • Inversely related
 • Bond pays fixed annual
   interest payment
 • Lower bond price will raise the
   interest rate                33-78
4.3 Federal Reserve Balance Sheet
   • Assets
     • Securities
     • Loans to commercial banks
   • Liabilities
     • Reserves of commercial banks
     • Treasury deposits
     • Federal Reserve Notes
       outstanding
                                   33-79
4.3.1 Federal Reserve Balance Sheet

                  February 14, 2008 (in Millions)


         Assets                              Liabilities and Net Worth
      Securities            $713,369      Reserves of Commercial
      Loans to Commercial                     Banks                                   $ 11,312
          Banks               60,039      Treasury Deposits                              4,979
      All Other Assets       111,689      Federal Reserve Notes
                                              (Outstanding)                           778,937
                                          All Other Liabilities and                    89,869
                                              Net Worth
      Total                 $885,097      Total                                      $885,097




                               Source: Federal Reserve Statistical Release, H.4.1, February 14, 2008

                                                                                               33-80
4.4 Central Banks

   Selected Nations
       Australia:   Reserve Bank of Australia (RBA)
        Canada:     Bank of Canada
     Euro Zone:     European Central Bank (ECB)
          Japan:    Bank of Japan (BOJ)
         Mexico:    Banco de Mexico (Mex Bank)
          Russia    Central Bank of Russia
        Sweden:     Sveriges Riksbank
United Kingdom:     Bank of England
  United States:    Federal Reserve System (the “Fed”)
                     (12 Regional Federal Reserve Banks)
      Malaysia :    Bank Negara Malaysia
                                                      33-81
4.5 Tools of Monetary Policy
• Open market operations
 • Buying and selling of government
   securities (or bonds)
 • Commercial banks and the
   general public
 • Used to influence the money
   supply
• When the Fed sells securities,
  commercial bank reserves are
  reduced
                                   33-82
4.5.1 Open Market Operations
Fed buys $1,000 bond from a commercial
bank
                      New Reserves
                           $1000


                           $1000
                           Excess
                          Reserves




                          $5000
                   Bank System Lending

        Total Increase in the Money Supply, ($5,000)
                                                       33-83
4.5.2 Open Market Operations
Fed buys $1,000 bond from the public
                      Check is Deposited
                        New Reserves
                            $1000


                  $800                   $200
                 Excess                Required
                Reserves               Reserves




                                             $1000
                       $4000                 Initial
                Bank System Lending        Checkable
                                            Deposit


         Total Increase in the Money Supply, ($5000)
                                                       33-84
4.6 Tools of Monetary Policy
• The reserve ratio
 • Changes the money multiplier
• The discount rate
 • The Fed as lender of last resort
 • Short term loans
• Term auction facility
 • Introduced December 2007
 • Banks bid for the right to borrow
   reserves                            33-85
4.6.1 Tools of Monetary Policy

• Open market operations most
  important
• Reserve ratio last changed 1992
• Discount rate was a passive tool
• Term auction facility is new
 • Guaranteed amount lent by the
   Fed
 • Anonymous                       33-86
4.7 The Federal Funds Rate

• Rate charged by banks on
  overnight loans
• Targeted by the Federal Reserve
• FOMC conducts open market
  operations to achieve the target
• Demand curve for Federal funds
• Supply curve for Federal funds
                                  33-87
4.7.1 The Federal Funds Rate
                          Using Open Market Operations

   Federal Funds Rate, Percent
                                 4.5                                 Sf3


                                 4.0                                 Sf1


                                 3.5                                 Sf2


                                                                Df


                                       Qf3   Qf1   Qf2
                                         Quantity of Reserves
                                                                           33-88
4.8 Monetary Policy

• Expansionary monetary
  policy
 • Economy faces a recession
 • Lower target for federal funds rate
 • Fed buys securities
 • Expanded money supply
 • Downward pressure on other interest rates

• Contractionary monetary
  policy                                  33-89
4.9 Taylor Rule

• Rule of thumb for tracking actual
  monetary policy
• Fed has 2% target inflation rate
• If real GDP = potential GDP and
  inflation is 2% then target
  federal funds rate is 4%
• Target varies as inflation and
  real GDP vary                  33-90
4.10 Monetary Policy
• Affect on real GDP and price
  level
• Cause-effect chain
 • Market for money
 • Investment and the interest rate
 • Investment and aggregate demand
 • Real GDP and prices

• Expansionary monetary policy
• Restrictive monetary policy         33-91
4.11 Monetary Policy and GDP
                                                                                                              (c)
                                              (a)                     (b)                              Equilibrium real
                                          The market              Investment                            GDP and the
                                          for money                 demand                               Price level
 Rate of Interest, i (Percent)




                                          Sm1   Sm2    Sm3                                                              AS
                                 10                                                               P3




                                                                                        Price Level
                                                                                                                               AD3
                                  8                                                               P2                          I=$25
                                                         Dm                                                                   AD2
                                  6                                                ID                                        I=$20
                                                                                                                               AD1
                                  0                                                                                           I=$15
                                         $125   $150   $175      $15   $20   $25                          Q1    Qf Q3

                                       Amount of money        Amount of investment                           Real GDP
                                        demanded and           (billions of dollars)                   (billions of dollars)
                                             supplied
                                      (billions of dollars)


                                                                                                                                33-92
4.12 Expansionary Monetary Policy
                   Problem: unemployment and recession
                 Fed buys bonds, lowers reserve ratio, lowers the
                   discount rate, or increases reserve auctions
                            Excess reserves increase
                             Federal funds rate falls
                               Money supply rises

                                Interest rate falls
                         Investment spending increases
    E E S UA C




                          Aggregate demand increases
                                 Real GDP rises
                                                                33-93
     -
4.13 Restrictive Monetary Policy
                             Problem: inflation

              Fed sells bonds, increases reserve ratio, increases
               the discount rate, or decreases reserve auctions
                          Excess reserves decrease
                           Federal funds rate rises
                              Money supply falls

                              Interest rate rises
                       Investment spending decreases
 E E S UA C




                        Aggregate demand decreases
                              Inflation declines
                                                               33-94
  -
4.14 Monetary Policy
• Advantages over fiscal policy
 • Speed and flexibility
 • Isolation from political pressure
• Recent U.S. monetary policy
• Problems and complications
 • Recognition lag
 • Operational lag
 • Cyclical asymmetry                  33-95
4.15 The Big Picture
   Input                                              Consumption
Resources                                                 (C a )
With Prices




                              Levels of
                                                      Investment
                Aggregate
                               Output,
                                          Aggregate
                                                          (I g )
                            Employment,
                 Supply                    Demand
Productivity                Income, and
                               Prices
  Sources
                                                       Net Export
                                                       Spending
                                                          (X n )
   Legal-
Institutional
Environment                                           Government
                                                       Spending
                                                         (G)
                                                                33-96
4.16 The Mortgage Debt Crisis
•   Home mortgage default 2007
•   Banks write off bad loans
•   Reserves reduced
•   Fed as lender of last resort
•   Term auction facility
•   Fed lowered federal funds rate
•   Mortgage backed securities as a
    new innovation
    • Bad incentives              33-97
5.   The US Subprime Crisis
 Video : Capitalism : A Love
 Story
“Over all history, money has
 oppressed people in one of
 two ways: either it has been
 abundant and very unreliable,
 or reliable and very scarce.”
John Kenneth Galbraith, The Age of Uncertainty
  (1977)
Conclusion

“Understanding the forces that affect
 aggregate     demand,     including
 government fiscal and monetary
 policies, can help economists and
 policymakers smooth out the cycle
 of boom and bust.”
 Paul Samuelson
Casestudy : IKEA

1. Read    and   prepare   the
   Casestudy      on     IKEA
   (Johnson, Whittington &
   Scholes     (2011))      for
   discussion and presentation
   next week.
2. Identify and evaluate the
   challenges    facing   IKEA
   during the global recession,
   by conducting       External
   Environment,       Industry,
   Competitor analysis and
   SWOT.
Core Reading

 Juleff, L, Chalmers, A.. and Harte, P. (2008) Business Economics in a Global
  Environment, Napier University Edinburgh
 Daniels, J.D., Radebaugh, L.H. and Sullivan, D.P. (2012) International
  Business: Environments and Operations. 14th edition, Pearson
 Samuelson, P.A. and Nordhaus, W. D. (2010)“Economics”
  Irwin/McGraw-Hill, 19th Edition
 Porter, Michael E. (2004)“Competitive Strategy – Techniques for Analyzing
  Industries and Competitors” Free Press
Questions?

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Enu macroecon policy 040812

  • 1. Go Global ! Global Economic Environment : The Effect of Government Macroeconomic Policy on Business By Stephen Ong Edinburgh Napier University Business School chong@mail.tarc.edu.my Visiting Professor, College of Management, Shenzhen University 4 August 2012
  • 2. Learning Objectives  To identify the fiscal policy instruments of Government to manage the economy  To critically assess the effectiveness of fiscal policy  To identify the principal instruments of monetary policy  To evaluate the nature and effectiveness of monetary policy
  • 3. Agenda 1. Fiscal Policy 2. Monetary Policy
  • 4. Fiscal Policy  Government Policy Dilemma Aggregate Demand Fiscal Policy Issues
  • 5. 1. Impact of Government Economic Policy
  • 9. 2.3 National Income & Consumption
  • 17. 2.10 Economic Boom & Defence Spending
  • 18. 3. Fiscal Policy • Council of Economic Advisers (CEA) • Discretionary fiscal policy • Eliminate recessionary or inflationary gap • Countercyclical • Nondiscretionary fiscal policy 18 • Passive or automatic
  • 19. 3.1 Fiscal Policy • Expansionary fiscal policy • Increased spending and/or lower taxes • Budget deficit • Contractionary fiscal policy • Lower spending and/or higher taxes 19 • Budget surplus • Policy options?
  • 20. 3.2 Expansionary Fiscal Policy Recessions Decrease $5 Billion Aggregate Additional Demand Spending AS Price Level Full $20 Billion P1 Increase in Aggregate Demand AD1 AD2 20 $490 $510 Real Domestic Output, GDP
  • 21. 3.3 Contractionary Fiscal Policy Reduce Demand Pull $5 Billion Inflation Initial Decrease In Spending AS Price Level Full $20 Billion P1 Decrease in Aggregate Demand AD4 AD3 21 $510 $522 Real Domestic Output, GDP
  • 22. 3.4 Built-In Stability • Automatic stabilizers • Taxes and transfers • Economic importance • Tax progressivity • Progressive tax system • Proportional tax system 22 • Regressive tax system
  • 23. 3.5 Built-In Stability T Government Expenses, G and Tax Revenues, T Surplus G Deficit 23 GDP1 GDP2 GDP3 Real Domestic Output, GDP
  • 24. 3.6 Evaluating Fiscal Policy • Standardized budget • Full-employment budget • Cyclical deficit • Recent U.S. fiscal policy • Budget deficits and projections 24 • Social security considerations
  • 25. 3.6.1 Evaluating Fiscal Policy T Cyclical deficit Fiscal policy Government Expenses, G neutral and Tax Revenues, T b a $500 G $450 c 25 GDP2 GDP1 (Year 2) (Year 1) Real Domestic Output, GDP
  • 26. 3.6.2 Evaluating Fiscal Policy Standardized deficit T1 Expansionary fiscal T2 policy Government Expenses, G and Tax Revenues, T e d $500 G $475 h $450 f $425 g 26 GDP4 GDP3 (Year 4) (Year 3) Real Domestic Output, GDP
  • 27. 4. Fiscal Policy Issues Problems, Criticisms, and Complications • Problems of timing • Recognition lag • Administrative lag • Operational lag • Political considerations • Future policy reversals • Offsetting state and local finance • Crowding-out effect • Current thinking on fiscal policy 27
  • 28. 4.1 Budget Balances as % of GDP (2) (3) Actual Standardized (1) Deficit (-) or Deficit (-) or Year Surplus (+) Surplus (+) 1992 -4.5% -2.9% 1993 -3.8% -2.9% 1994 -2.9% -2.1% 1995 -2.2% -2.0% 1996 -1.4% -1.2% 1997 -0.3% -1.0% 1998 +0.8% -0.4% 1999 +1.4% +0.1% 2000 +2.5% +1.1% 2001 +1.3% +1.0% 2002 -1.5% -1.2% 2003 -3.4% -2.5% 2004 -3.5% -2.4% 2005 -2.6% -1.9% 2006 -1.9% -1.8% 28 2007 -1.3% -1.4% Source: Congressional Budget Office
  • 29. 4.2 Standardized Budget Balance Percentage of Potential GDP, 2007 Deficits Surpluses -6 -4 -2 0 2 4 6 Denmark New Zealand Ireland Canada Norway France United States United Kingdom 29 Japan Source: Organization for Economic Cooperation and Development
  • 30. 4.3 Federal Budget Balance Actual and Projected, Fiscal 1994-2014 Actual Projected (as of March 2008) $300 Budget Deficit (-) or Surplus, Billions 200 100 0 -100 -200 -300 -400 -500 30 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Source: Congressional Budget Office
  • 31. 4.4 The Public Debt • National or public debt $9.01 trillion • Ownership • U.S. securities • 53% owned by federal government and Federal Reserve • 47% held outside the federal government and Federal Reserve 31
  • 32. 4.5 The Public Debt Debt Held Outside The Federal Debt Held by the Other, Including Government State and Local Federal Government and Federal Governments and Federal Reserve (47%) Reserve (53%) U.S. Banks And other 8% 7% Financial 9% Institutions Federal 25% Reserve Foreign Ownership 44% 7% U.S. Government U.S. 32 Individuals Agencies Source: U.S. Treasury Total Debt: $9.01 trillion
  • 33. 4.6 Debt and GDP Federal debt held by the public, percentage of GDP 50 45 40 35 Percent of GDP 30 25 20 15 10 5 0 1970 1975 1980 1985 1990 1995 2000 2005 Year 33 Source: Economic Report of the President, 2006
  • 34. 4.7 Debt and GDP Publicly Held Debt: International Comparisons As a Percentage of GDP, 2007 0 20 40 60 80 100 Italy Japan Belgium Hungary Germany United States United Kingdom France Netherlands Canada Spain 34 Poland Source: Organization for Economic Cooperation and Development
  • 35. 4.8 Debt and GDP • Interest charges • Primary burden • 1.7% of GDP 2007 • False concerns • Bankruptcy • Refinancing • Taxation •35Burdening future generations
  • 36. 4.9 Debt and GDP • Substantive issues • Income distribution • Incentives • Foreign-owned public debt • Crowding-out effect revisited • Burden on future generations • Public investment as an offset 36 • Graphically
  • 37. 4.10 Crowding Out A Large Public Debt to Finance Public Investment Will Cause… 16 If Public Spending 14 Spurs More Private Investment Will Real Interest Rate (Percent) 12 Increase to ID2 b c 10 8 a 6 Interest Rate Crowding- 4 Rise Will Out Effect Decrease ID 2 2 Investment a to b ID 1 0 5 10 15 20 25 30 35 40 37 Investment (Billions of Dollars)
  • 38. 4.11 The Leading Indicators 1. Average workweek 2. Initial claims for unemployment insurance 3. New orders for consumer goods 4. Vendor performance 5. New orders for capital goods 6. Building permits for houses 7. Stock prices 8. Money supply 38 9. Interest-rate spread 10.Consumer expectations Source: The Conference Board
  • 39. Monetary Policy  Money  The Central Banker : FRS  The Banking System  Monetary Policy  The US Subprime Crisis
  • 40. 1. Functions of Money • Medium of exchange • Used to buy/sell goods • Unit of account • Goods valued in dollars • Store of value • Hold some wealth in money form • Money is liquid 31-40
  • 41. 1.1 Money Defined • M1 • Currency • Checkable deposits • Institutions offering checkable deposits • Commercial banks • Savings and loan associations • Mutual savings banks • Credit unions 31-41
  • 42. 1.2 Money Defined • M2 • M1 plus near-monies • Savings deposits including money market deposit accounts (MMDA) • Small time deposits • Money market mutual funds (MMMF) 31-42
  • 43. 1.3 Money Defined M1 M2 January 2008 Currency + 56% M1 Checkable Deposits + 44% 18% Small Time Deposits + 16% Money Market Mutual 14% Funds Held By Individuals + Savings Deposits, 52% Including Money Market + Deposit Accounts Totals $1,365 $7,499 Source: Federal Reserve System Billion Billion 31-43
  • 44. 1.4 Money Supply • Are credit cards money? • What “backs” the money supply? • Nothing! • Why is money valuable? • Acceptability • Legal tender • Relative scarcity 31-44
  • 45. 1.5 Money and Prices • Prices affect purchasing power of money • Hyperinflation renders money unacceptable • Stabilizing money’s purchasing power • Intelligent management of the money supply – monetary policy • Appropriate fiscal policy 31-45
  • 46. 2. Federal Reserve System • Historical background • Board of Governors • 12 Federal Reserve Banks • Serve as the central bank • Quasi-public banks • Banker’s bank 31-46
  • 47. 2.1 Federal Reserve System Board of Governors Federal Open Market Committee 12 Federal Reserve Banks Thrift Institutions (Savings and Loan Associations, Commercial Banks Mutual Savings Banks, Credit Unions) The Public (Households and Businesses) 31-47
  • 48. 2.2 Federal Reserve System The 12 Federal Reserve Banks Source: Federal Reserve Bulletin 31-48
  • 49. 2.3 Federal Reserve System • Federal Open Market Committee • Aids Board of Governors in setting monetary policy • Conducts open market operations • Commercial banks and thrifts • 7,300 commercial banks • 11,000 thrifts 31-49
  • 50. 2.4 Federal Reserve Functions • Issue currency • Set reserve requirements • Lend money to banks • Set discount rate • Check collection • Fiscal agent for U.S. government • Supervise banks • Control the money supply 31-50
  • 51. 2.5 Federal Reserve System • Federal Reserve independence • Recent developments • Relative decline of banks and thrifts • Consolidation • Convergence of services provided by financial institutions • Globalization of financial markets • Electronic payments 31-51
  • 52. 2.6 Financial Institutions World’s 12 Largest Financial Institutions, 2007 Assets (Billions of U.S. Dollars) 0 1,300,000 1,600,000 1,900,000 Barclays (UK) BNP Paribas (France Citigroup (USA) HSBC Group (UK) UBS (Switzerland) Royal Bank of Scotland (UK) ING Group (Netherlands) Mitsubishi UFJ (Japan) Deutsche Bank Group (Ger) Bank of America (US) Allianz Worldwide (Ger) JPMorgan Chase (USA) Source: Organization for Economic Cooperation and Development 31-52
  • 53. 2.7 U.S. Financial Institutions • Commercial banks • Thrifts • Insurance companies • Mutual fund companies • Pension funds • Securities firms • Investment banks 31-53
  • 54. 2.8 The Global Greenback • U.S. currency circulating abroad • Russia $80 billion • Argentina $50 billion • $450 billion total • 60% of total US currency • U.S. profits from dollars leaving • Black markets and illegal activities • Dollar offers stable purchasing power • Exchange rate risk 31-54
  • 55. 3. Fractional Reserve Banking • The Goldsmiths • Stored gold and gave a receipt • Receipts used as money by public • Made loans by issuing receipts • Characteristics • Banks create money through lending • Banks are subject to “panics” 32-55
  • 56. 3.1 Fractional Reserve System • Balance sheet • Assets = Liabilities + Net Worth • Both sides balance • Necessary transactions • Create a bank • Accept deposits • Lend excess reserves 32-56
  • 57. 3.2 Creating a Bank • Transaction #1 • Vault cash: cash held by the bank Creating a Bank Balance Sheet 1: Wahoo Bank Assets Liabilities and Net Worth Cash $250,000 Stock Shares $250,000 32-57
  • 58. 3.2.1 Creating a Bank • Transaction #2 • Acquiring property & equipment Acquiring Property and Equipment Balance Sheet 2: Wahoo Bank Assets Liabilities and Net Worth Cash $10,000 Stock Shares $250,000 Property 240,000 32-58
  • 59. 3.2.2 Creating a Bank • Transaction #3 • Commercial bank functions • Accepting deposits • Making loans Deposits Accepting Balance Sheet 3: Wahoo Bank Assets Liabilities and Net Worth Cash $110,000 Checkable Deposits $100,000 Property 240,000 Stock Shares 250,000 32-59
  • 60. 3.2.3 Creating a Bank • Transaction #4 • Depositing reserves in a Federal Reserve bank • Required reserves • Reserve ratio Commercial bank’s Reserve Required reserves ratio = Commercial bank’s Checkable-deposit liabilities 32-60
  • 61. 3.2.4 Reserve Requirements Current Statutory Type of Deposit Requirement Limits Checkable deposits: $0-$9.8 Million 0% 3% $9.3-$43.9 Million 3 3 Over $43.9 Million 10 8-14 Noncheckable nonpersonal savings and time deposits 0 0-9 • Fed can establish and vary reserve ratio within limits set by Congress • Required reserves help Fed control lending abilities of commercial banks 32-61
  • 62. 3.2.5 Creating a Bank • Transaction #4 • Assume the bank deposits all cash on reserve at the Fed Depositing Reserves at the Fed Balance Sheet 4: Wahoo Bank Assets Liabilities and Net Worth Cash $0 Checkable Reserves 110,000 Deposits $100,000 Property 240,000 Stock Shares 250,000 32-62
  • 63. 3.2.6 Reserve Requirements • Excess reserves • Actual reserves - required reserves • Required reserves • Checkable deposits x reserve ratio • Example: • Checkable deposits $100,000 • Reserve ratio 20% 32-63
  • 64. 3.2.7 Creating a Bank • Transaction #5 • Clearing a check • $50,000 check reduces reserves and checkable deposits Clearing a Check Balance Sheet 5: Wahoo Bank Assets Liabilities and Net Worth Checkable Reserves $60,000 Deposits $50,000 Property 240,000 Stock Shares 250,000 32-64
  • 65. 3.3 Money Creating Transactions • Transaction #6a • Granting a loan • $50,000 loan deposited to checking a Loan is Negotiated When Balance Sheet 6a: Wahoo Bank Assets Liabilities and Net Worth Reserves $60,000 Checkable Loans 50,000 Deposits $100,000 Property 240,000 Stock Shares 250,000 32-65
  • 66. 3.3.1 Money Creating Transactions • Transaction #6b • Using the loan • $50,000 loan cashed After a Check is Drawn on the Loan Balance Sheet 6b: Wahoo Bank Assets Liabilities and Net Worth Reserves $10,000 Checkable Loans 50,000 Deposits $50,000 Property 240,000 Stock Shares 250,000 A single bank can only lend an amount equal to their preloan excess reserves 32-66
  • 67. 3.3.2 Money Creating Transactions • Transaction #7 • Bank buys government securities from dealer • Deposits payment into checking Government Securities Buying Balance Sheet 7: Wahoo Bank Assets Liabilities and Net Worth Reserves $60,000 Checkable Securities 50,000 Deposits $100,000 Property 240,000 Stock Shares 250,000 New money is created 32-67
  • 68. 3.4 Commercial Banks • Conflicting goals • Earn profit • Make loans to earn interest • Buy securities to earn interest • Maintain liquidity • Alternative? • Overnight bank loans • Federal funds rate 32-68
  • 69. 3.5 The Banking System • Multiple-deposit expansion • Assumptions: • 20% required reserves • All banks “loaned up” • Banks lend all of excess reserves • A $100 bill is found and deposited • Multiple deposits can be created 32-69
  • 70. 3.6 The Banking System (1) (3) (4) Acquired (2) Excess Amount Bank Can Reserves Required Reserves Lend; New Money Bank and Deposits Reserves (1)-(2) Created = (3) Bank A $100 $20 $80 $80 Bank B $80 $16 $64 $64 Bank C $64 $12.80 $51.20 $51.20 Bank D $51.20 $10.24 $40.96 $40.96 The process will continue… 32-70
  • 71. 3.6.1 The Banking System (2) (1) Required (3) (4) Acquired Reserves Excess Amount Bank Can Reserves (Reserve Reserves Lend; New Money Bank and Deposits Ratio = .2) (1)-(2) Created = (3) Bank A $100.00 $20.00 $80.00 $80.00 Bank B 80.00 16.00 64.00 64.00 Bank C 64.00 12.80 51.20 51.20 Bank D 51.20 10.24 40.96 40.96 Bank E 40.96 8.19 32.77 32.77 Bank F 32.77 6.55 26.21 26.21 Bank G 26.21 5.24 20.97 20.97 Bank H 20.97 4.20 16.78 16.78 Bank I 16.78 3.36 13.42 13.42 Bank J 13.42 2.68 10.74 10.74 Bank K 10.74 2.15 8.59 8.59 Bank L 8.59 1.72 6.87 6.87 Bank M 6.87 1.37 5.50 5.50 Bank N 5.50 1.10 4.40 4.40 Other Banks 21.99 4.40 17.59 17.59 $400.00 32-71
  • 72. 3.7 The Monetary Multiplier Monetary 1 1 multiplier = required reserve ratio = R Graphic New Reserves $100 Example $80 $20 Excess Required Reserves Reserves $100 $400 Initial Bank System Lending Deposit Money Created 32-72
  • 73. 3.7.1 The Monetary Multiplier • Maximum amount of new money created by single dollar of excess reserves • Higher R, lower m • Reversibility • Making loans creates money • Loan repayment destroys money 32-73
  • 74. 3.8 Bank Panics of 1930-1933 • Before deposit insurance • Bank failure led to mass withdrawals • Forced loan reduction • 25-33% decline in money supply • 1933 national bank holiday to evaluate all banks • Contributed to the Great Depression • Regulation protects the system today 32-74
  • 75. 4. Interest Rates • Price paid for the use of money • Many different interest rates • Speak as if only one interest rate • Determined by money supply and money demand 33-75
  • 76. 4.1 Demand for Money • Why hold money? • Transactions demand, D1 • Determined by nominal GDP • Independent of the interest rate • Asset demand, D2 • Money as a store of value • Varies inversely with the interest rate • Total money demand, Dm 33-76
  • 77. 4.1.1Demand for Money (c) (a) (b) Total Transactions Asset demand for demand for demand for money, Dm money, Dt money, Da and supply Rate of interest, i percent 10 Sm 7.5 5 + =5 2.5 0 Dt Da Dm 50 100 150 200 50 100 150 200 50 100 150 200 250 300 Amount of money Amount of money Amount of money demanded demanded demanded and supplied (billions of dollars) (billions of dollars) (billions of dollars) 33-77
  • 78. 4.2 Interest Rates • Equilibrium interest rate • Changes with shifts in money supply and money demand • Interest rates and bond prices • Inversely related • Bond pays fixed annual interest payment • Lower bond price will raise the interest rate 33-78
  • 79. 4.3 Federal Reserve Balance Sheet • Assets • Securities • Loans to commercial banks • Liabilities • Reserves of commercial banks • Treasury deposits • Federal Reserve Notes outstanding 33-79
  • 80. 4.3.1 Federal Reserve Balance Sheet February 14, 2008 (in Millions) Assets Liabilities and Net Worth Securities $713,369 Reserves of Commercial Loans to Commercial Banks $ 11,312 Banks 60,039 Treasury Deposits 4,979 All Other Assets 111,689 Federal Reserve Notes (Outstanding) 778,937 All Other Liabilities and 89,869 Net Worth Total $885,097 Total $885,097 Source: Federal Reserve Statistical Release, H.4.1, February 14, 2008 33-80
  • 81. 4.4 Central Banks Selected Nations Australia: Reserve Bank of Australia (RBA) Canada: Bank of Canada Euro Zone: European Central Bank (ECB) Japan: Bank of Japan (BOJ) Mexico: Banco de Mexico (Mex Bank) Russia Central Bank of Russia Sweden: Sveriges Riksbank United Kingdom: Bank of England United States: Federal Reserve System (the “Fed”) (12 Regional Federal Reserve Banks) Malaysia : Bank Negara Malaysia 33-81
  • 82. 4.5 Tools of Monetary Policy • Open market operations • Buying and selling of government securities (or bonds) • Commercial banks and the general public • Used to influence the money supply • When the Fed sells securities, commercial bank reserves are reduced 33-82
  • 83. 4.5.1 Open Market Operations Fed buys $1,000 bond from a commercial bank New Reserves $1000 $1000 Excess Reserves $5000 Bank System Lending Total Increase in the Money Supply, ($5,000) 33-83
  • 84. 4.5.2 Open Market Operations Fed buys $1,000 bond from the public Check is Deposited New Reserves $1000 $800 $200 Excess Required Reserves Reserves $1000 $4000 Initial Bank System Lending Checkable Deposit Total Increase in the Money Supply, ($5000) 33-84
  • 85. 4.6 Tools of Monetary Policy • The reserve ratio • Changes the money multiplier • The discount rate • The Fed as lender of last resort • Short term loans • Term auction facility • Introduced December 2007 • Banks bid for the right to borrow reserves 33-85
  • 86. 4.6.1 Tools of Monetary Policy • Open market operations most important • Reserve ratio last changed 1992 • Discount rate was a passive tool • Term auction facility is new • Guaranteed amount lent by the Fed • Anonymous 33-86
  • 87. 4.7 The Federal Funds Rate • Rate charged by banks on overnight loans • Targeted by the Federal Reserve • FOMC conducts open market operations to achieve the target • Demand curve for Federal funds • Supply curve for Federal funds 33-87
  • 88. 4.7.1 The Federal Funds Rate Using Open Market Operations Federal Funds Rate, Percent 4.5 Sf3 4.0 Sf1 3.5 Sf2 Df Qf3 Qf1 Qf2 Quantity of Reserves 33-88
  • 89. 4.8 Monetary Policy • Expansionary monetary policy • Economy faces a recession • Lower target for federal funds rate • Fed buys securities • Expanded money supply • Downward pressure on other interest rates • Contractionary monetary policy 33-89
  • 90. 4.9 Taylor Rule • Rule of thumb for tracking actual monetary policy • Fed has 2% target inflation rate • If real GDP = potential GDP and inflation is 2% then target federal funds rate is 4% • Target varies as inflation and real GDP vary 33-90
  • 91. 4.10 Monetary Policy • Affect on real GDP and price level • Cause-effect chain • Market for money • Investment and the interest rate • Investment and aggregate demand • Real GDP and prices • Expansionary monetary policy • Restrictive monetary policy 33-91
  • 92. 4.11 Monetary Policy and GDP (c) (a) (b) Equilibrium real The market Investment GDP and the for money demand Price level Rate of Interest, i (Percent) Sm1 Sm2 Sm3 AS 10 P3 Price Level AD3 8 P2 I=$25 Dm AD2 6 ID I=$20 AD1 0 I=$15 $125 $150 $175 $15 $20 $25 Q1 Qf Q3 Amount of money Amount of investment Real GDP demanded and (billions of dollars) (billions of dollars) supplied (billions of dollars) 33-92
  • 93. 4.12 Expansionary Monetary Policy Problem: unemployment and recession Fed buys bonds, lowers reserve ratio, lowers the discount rate, or increases reserve auctions Excess reserves increase Federal funds rate falls Money supply rises Interest rate falls Investment spending increases E E S UA C Aggregate demand increases Real GDP rises 33-93 -
  • 94. 4.13 Restrictive Monetary Policy Problem: inflation Fed sells bonds, increases reserve ratio, increases the discount rate, or decreases reserve auctions Excess reserves decrease Federal funds rate rises Money supply falls Interest rate rises Investment spending decreases E E S UA C Aggregate demand decreases Inflation declines 33-94 -
  • 95. 4.14 Monetary Policy • Advantages over fiscal policy • Speed and flexibility • Isolation from political pressure • Recent U.S. monetary policy • Problems and complications • Recognition lag • Operational lag • Cyclical asymmetry 33-95
  • 96. 4.15 The Big Picture Input Consumption Resources (C a ) With Prices Levels of Investment Aggregate Output, Aggregate (I g ) Employment, Supply Demand Productivity Income, and Prices Sources Net Export Spending (X n ) Legal- Institutional Environment Government Spending (G) 33-96
  • 97. 4.16 The Mortgage Debt Crisis • Home mortgage default 2007 • Banks write off bad loans • Reserves reduced • Fed as lender of last resort • Term auction facility • Fed lowered federal funds rate • Mortgage backed securities as a new innovation • Bad incentives 33-97
  • 98. 5. The US Subprime Crisis  Video : Capitalism : A Love Story “Over all history, money has oppressed people in one of two ways: either it has been abundant and very unreliable, or reliable and very scarce.” John Kenneth Galbraith, The Age of Uncertainty (1977)
  • 99. Conclusion “Understanding the forces that affect aggregate demand, including government fiscal and monetary policies, can help economists and policymakers smooth out the cycle of boom and bust.” Paul Samuelson
  • 100. Casestudy : IKEA 1. Read and prepare the Casestudy on IKEA (Johnson, Whittington & Scholes (2011)) for discussion and presentation next week. 2. Identify and evaluate the challenges facing IKEA during the global recession, by conducting External Environment, Industry, Competitor analysis and SWOT.
  • 101. Core Reading  Juleff, L, Chalmers, A.. and Harte, P. (2008) Business Economics in a Global Environment, Napier University Edinburgh  Daniels, J.D., Radebaugh, L.H. and Sullivan, D.P. (2012) International Business: Environments and Operations. 14th edition, Pearson  Samuelson, P.A. and Nordhaus, W. D. (2010)“Economics” Irwin/McGraw-Hill, 19th Edition  Porter, Michael E. (2004)“Competitive Strategy – Techniques for Analyzing Industries and Competitors” Free Press

Editor's Notes

  1. The Learning Objectives for Chapter 1 are To define globalization and international business and show how they affect each other To understand why companies engage in international business and why international business growth has accelerated To discuss globalization’s future and the major criticisms of globalization To become familiar with different ways in which a company can accomplish its global objectives To apply social science disciplines to understanding the differences between international and domestic business