Question

3. Critically and briefly describe the following conventional monetary policy tools and policy target and their relative effectiveness in controlling business cycle fluctuations such as state of recession and/or state of inflation. How do they operate during recession and inflation? Draw AD-AS diagram of macroeconomics model to illustrate your explanation in words.

• Reserve Requirements
• Discount Rate
• Open Market Operations
• Federal Fund Rate (Policy target)

5. Distinguish between budget deficit and public debt with an example from actual data from the US government budget office discussed in the beginning of this chapter. Give at least three reasons why the budget deficit and public debt has been continuously rising since 2001.
6. Give at least two reasons why balanced budget approach for the US economy is not a realistic approach in the short-run despite a political advocacy to bring the budget to balanced budget?

Answer 1

Reserve Requirements: During a recession, the Fed can stimulate growth by lowering the interest rate. People are more willing to make a major purchase when they can borrow money at 5%, rather than 7%. The Fed can also put more money into circulation by lowering the amount they require banks to keep on hand to cover daily transactions. By lowering these minimum reserve requirements, the Fed encourages banks to lend out more money to consumers and investors. To fight recession the monetary policy that can be taken is to lower the interest rate, lower reserve requirements and buy securities. On the other hand, in order to fight inflation, the Fed can increase the Interest rate which will lead to people keeping more money in banks and less money in hand leading to a fall in the aggregate demand which can help in curbing the price levels. It can also raise reserve requirements and buying securities.

Discount Rate- The federal discount rate is the interest rate set by central banks - in the U.S. by the Federal Reserve - on loans extended by the central bank and offered to eligible commercial banks or other depository institutions as a measure to reduce liquidity problems and the pressures of reserve requirements. The discount rate allows central banks such as the Federal Reserve to control the supply of money and is used to assure stability in the financial markets.

Open- market operations- Finally, the Fed can inject money by buying bonds in the bond market—through these “open market operations” the Fed uses Federal Reserve funds to buy up government securities. when the Fed buys bonds in open market operations it increases the money supply and expands aggregate demand. When the Fed sells government bonds it decreases the money supply and contracts the aggregate demand.

Federal Funds Rate- It is the interest rate that banks charge one another for short term loans, which is re-evaluated every six weeks. when the Fed sets a target for the interest rate, it commits itself to adjust the money supply to make the equilibrium in the money market hit that target. In order to increase the money supply, the Fed raises the target for the federal funds rate, by buying government bonds and this phenomenon lowers the equilibrium interest rate.

A budget deficit occurs when spending is greater than the revenue received in that year. When spending exceeds revenue, it's called deficit spending. Public debt is the accumulated deficits of a financial year. The U.S. Treasury must sell Treasury bonds to raise the money to cover the deficit. This type of financing is known as public debt since these bonds are sold to the general public.

Public debt is the stock of outstanding IOUs issued by the government at any time in the past and not yet repaid. Governments issue debt whenever they borrow from the public; the magnitude of the outstanding debt equals the cumulative amount of net borrowing that the government has done. The budget deficit is the addition in the current period (year, quarter, month, etc.) to the outstanding debt. The deficit is negative whenever the value of outstanding debt falls

The Public debt is a lifetime running tally, while the budget deficit is an amount calculated over a particular period. for example in early fiscal 2018, the U.S. federal debt was $20.805 trillion, the deficit $441 billion, and it’ll never be the other way around.

Debt need not indicate a weak economy. It’s important to understand that debt—money owed—is by definition negative, and can never be positive. While deficit is net money taken in (if negative).