Question

1. What is the impact on GDP if consumer spending increases? Would the answer be different if the consumer spending were directed toward foreign goods?
2. What differentiates inflation and deflation?
3. What is the Fed? What are its economic goals?
4. How does the Fed pursue its economic goals? How may the tools of monetary policy affect securities prices?
5. What are M1 and M2? How does the Fed alter M1 and M2?
6. If the Fed finances the federal government’s deficit, what will happen to the supply of money?

Answer 1

Part 1)

The GDP is short form for Gross Domestic Product which refers to the total value of final goods and services which are produced in a country during an economic year.

In the question, a situation is given wherein the demand for goods and services in the country increases. If this happens, the country would experience increased production as well so as to fulfil this increase in demand which results in increased consumer spending. As this takes place more final goods get added in the economy and the GDP and the final value of goods and services also increases.

Now, this discussion is limited to domestic goods only. If the consumers begin spending more on foreign products than local ones, the demand for local products as a result would decrease, thus having a negative impact on the gross domestic product which would begin to fall as a result of increased international demand and reduced local spending. This is because people will substitute locally manufactured products with international ones respectively.

Part 2)

Inflation refers to an increase in prices of goods and services in the economy. Usually this happens as the demand for products and services in an economy is higher and the supply side is unable to catch up to the same. As scarcity is created in the economy, the prices of goods and services begin increasing.

For example, if the demand for goods and services is 500 while the supply capacity of the economy is 300 units only, in that case producers would see an opportunity to increase prices as it would allow them for additional profits. Inflation is usually a result of excessive money in the hand of the consumers which is controlled using techniques such as increased taxation or interest rates which help in lowering down the money which people have at present.

On the contrary, deflation is said to be negative inflation wherein prices of goods and services begin declining sharply. This is due to a lack of aggregate demand in the country which forces producers to produce goods in lesser quantity and sell the same at lower prices and profit margins to stay in business. The biggest example in the recent times is that of the Corona Virus Pandemic, which has resulted in a deep deflation cycle and prices of goods and services has been falling sharply as a result of the same.

Thus, the key difference between inflation and deflation are the fact that while inflation increases the price of goods and services, deflation decreases the same.

Part 3)

The Federal Reserve or the Fed is the Central Banking agency of the United States of America. It was created in the year 1913 and is the only agency which can control the supply of money in an economy as it is the sole authority that is granted the provision of printing notes in the economy. At the same time, it monitors the commercial banks in the country and helps the economy in tackling situations of inflation and recession by altering the supply of money.

The following are the main economic functions of the Federal Reserve: -

1) Helps in controlling the supply of money in the economy

2) Acts as a regulator of Commercial Banks in a country and overlooks how they are performing. It issues guidelines and controls the actions of commercial banks. It is also responsible for auditing the same and checking in case banks are adhering to the strict guidelines as issued by commercial banks or not.

3) It acts as the lender of the last resort to commercial banks which may require additional money in case the number of withdrawals in a country go unchecked and beyond a certain number.

4) It helps in deciding the minimum amount of money which commercial banks must hold at all given points of time with the Federal Reserve.

5) It helps in maintaining economic stability in a country and ensures that stable growth takes place with agreed levels of inflation. For example, during an inflation it reduces the flow of money and during a recession it increases the flow so as to bring in stability in the country using the following detailed tools: -

Part 4)

The Federal Reserve achieves its economic goals using monetary policy tools which are as follows. Now, talking about how they affect the stock prices, there are two main Federal Economic type of policies one refers to Monetary Expansion, wherein it increases the flow of money in the country as that happens the interest rates fall and business owners began expanding their operations thus leading to an appraisal in stock price. The exact opposite happens when the Federal Reserve begins conducting contraction policies wherein the flow of money in the economy is restricted and as that happens, the demand begins to fall and results in losses for companies which reduces stock value.

The following are the tools and methods used by the Federal Reserve in achieving the same.

1) Cash Reserve Ratio: -

Cash Reserve Ratio, represent "the minimum amount of money which the commercial banks as a mandate must hold with the Federal Reserve" at all given points of time.

During a recession, the flow of money in the economy is limited and the Federal Reserve wants to increase the same. This is done by decreasing the minimum requirements and allowing commercial banks to have sufficient funds which then extends loans to people and it helps in increasing demand as loans become cheaper. When banks have additional money available, they can easily give away more loans at a lower interest rate thus reducing the impact of recession. As explained above, this creates a positive impact on share prices since industries begin expanding.

The exact opposite happens in an inflation cycle when the cash reserve ratio is increased and the flow of money declines thus restricting loans and leading to lesser demand in the economy.

2) Discount Rate & Federal Funds Rate: -

Discount rate is the rate at which the Federal Reserve grants loans to private commercial banks. As this rate is altered, the rate at which private banks grant loans to people also changes. For an example, if the discount rate is increased during an inflation cycle, it limits the capacity of banks to give away loans thus having a negative impact on share prices as the cost of borrowing for companies increase. The exact opposite takes place during a recession cycle as Federal Reserve increases the flow of money in an economy.

Similarly, the Federal Funds rate is the rate at which one bank grants loans to another. Usually these are short term loans for a day or two to meet regulatory requirements. As the interest rate on this is hiked or reduced, the relative interest rates at which loans are granted to private players also changes having an equal response to stock prices as explained above.

3) Open Market Operations: -

Another, critical method through the help of which, the Federal Reserve controls the supply of money in any economy is via open market operations. This includes the concept of the Federal Reserve purchasing bonds from the market and supplying money to the economy or selling the same and withdrawing money from it.

We can conclude by saying, that through the tools mentioned above, the Federal Reserve increases or decreases the flow of money in any economy which further reflects on stock price in the same direction wherein an increase in flow reflects as an increase in demand and lesser interest rates while a decrease has the opposite effect.

Part 5)

M1 and M2 are measures of the supply of money which is in circulation within a country. How the Federal Reserve controls the supply of money has already been explained in the above sections, wherein it uses numerous tools of monetary policy to control aspects such as interest rates or minimum requirements which further have an impact on the flow of money in an economy. For example, when interest rates or the minimum requirements are lowered down, it helps in creating more money in the economy as banks are allowed to give away loans at a cheaper rate or generally have additional capital with them which can be given away as loans.

M1 represents hard cash which is also known as narrow money. It represents coins and notes which are in circulation and constitute the currency of a country.

M2 On the other hand includes M1 and short-term deposits which are made with banks example recurrent deposits or checking deposits which can be easily converted into cash. It may also include money market which are very short-term instruments which are used by big banks to give each other debt for a very short period of time and are as good as cash due to the credit worthiness of these companies.

Part 6)

A government deficit is said to have happened in an economy, when the overall expenses of the government go beyond their known sources of revenue. The government then has two choices to either avail debt or to print more currency via the Federal Reserve and finance the deficit as such.

The later has been discussed in the case study, wherein an increase in supply of money has been represented. As that happens, the flow of money in the economy increases as Federal Reserve begins pumping more money in the hands of the government which is used up to pay debt.

It is important to note however, that the debt payments through this mode lead to depreciation in the value of the local currency. This is because supply of currency increases and demand remains constant, thus leading to a reduction in price of the currency itself in relationship with other global currencies.

Please feel free to ask your doubts in the comments section if any.