Finance - V
Policy Makers and the Money Supply
4 Jan 2025
Economic policy objectives
We can assume that the government has three main objectives when it comes to formulating economic policy:
Economic growth refers to the increase in the stock of productive resources (labour, capital) and the improvement in technology and skills that allow for the production of more goods and services. The goal here is to increase the rate of change of output, faster than the rate of change of the population. Since unemployment represents a loss of potential output, the government is also interested in maintaining high employment. Moreover, the government is interested in maintaining price stability, because it helps create an environment where other economic objectives can be achieved.
These goals often conflict with each other. For example, while economic growth generally leads to higher employment, a too rapid growth can lead to inflation, when the relative demand for labour and capital exceeds supply.
Policy maker groups
In the US, there are four main groups of policy makers that are responsible for achieving the nation's economic objectives:
Government influence on the economy
Every year, the president and the Council of Economic Advisers prepare a federal budget, which contains revenue and expenditure projections for the upcoming fiscal year. The budget is then submitted to Congress for approval. Congress can modify the budget, before passing it into law.
A budget deficit occurs when the government projects that it will spend more than it will receive in revenue. When this happens, the government must raise funds to cover the deficit, by:
A deficit can stimulate economic growth, since the government injects money into the economy, but it can also lead to higher interest rates (and consequently inflation), as the government competes with the private sector for funds.
Treasury cash and general management responsibilities
The US Treasury collects taxes, pays bills, and manages its cash balances to maintain reserves at a stable level. Moreover, the Treasury is responsible for managing the government's debt, by borrowing money to finance budget deficits. Although the Fed is primarily responsible for regulating the money supply, both parties work closely together to ensure that the government's financial needs do not disrupt the money supply of the economy. For example, a massive withdrawal of taxes from the economy, without any offsets, would lead to a decrease in the money supply, which in turn would cause a breakdown in the financial system's ability to serve the credit needs of the economy. Likewise, an influx of money into the economy due to the refunding of maturing Treasury securities would lead to an oversupply of money.
Since Treasury receipts and payments do not occur on a regular basis, the Treasury must hold a large cash balance (~ $3 trillion) to ensure that it can meet its obligations without disrupting the money supply. Treasury operations are typically conducted through dedicated accounts, held either at commercial banks or at the Federal Reserve. For example, taxes, such as individual income taxes, are deposited into these accounts.
The Treasury tries to balance its cash inflows and outflows to avoid large fluctuations in bank reserves. The funds shifted into the Treasury's account must closely correspond to the volume of Treasury securities that are maturing or being issued. This is possible if accurate forecasts can be made of the government's cash flows, which is not always the case. The Treasury's account frequently fluctuates by billions of dollars on a daily basis.
Since government expenditures and receipts often involve large sums of money, fiscal policies can play a significant role in determining the credit conditions of an economy. Fiscal policy significantly influences the aggregate demand for goods and services. Consumer demand is driven by disposable income, which is determined by the level of employment and the tax rate. Thus, the government can influence the level of economic activity by either increasing its spending to stimulate employment, or by reducing its spending to combat inflation. Tax rates can also be adjusted to control the level of disposable income. The difference between the two is that the effects of tax adjustments are mroe immediate (though not always, since consumers can choose to save the extra income), whereas the effects of spending adjustments are more gradual (the effects percolate outward from where the initial spending occurred).
The government also deploys various automatic stabilizers to help stabilize the level of disposable income. Unemployment insurance programs are payments made to individuals who lose their jobs, whereas welfare programs are payments made to individuals who are unable to work. Progressive tax systems are also a form of automatic stabilizer, as they reduce the tax burden on individuals with lower incomes.
Treasury deficit financing and debt management responsibilities
Deficit financing is the practice of borrowing money to finance budget deficits. In the US, the Treasury borrows money by issuing Treasury securities, which are sold to the public. When this happens, a competition for funds occurs between the government and the private sector.
The national debt is the total debt owed by the government. Debt management involves funding budget deficits and refinancing maturing Treasury securities previously issued to fund the national debt. The goal of the Treasury is thus:
The Treasury carries out its debt management operations in a predictable manner to avoid disrupting the financial markets. For example, the issuance and auctioning of Treasury securities are announced well in advance, so that investors can plan their investments accordingly. One key aspect of debt management is the determination of the optimal maturity structure of the national debt. The Treasury can issue short-term securities with lower interest rates, or long-term securities with higher interest rates.
Changing the money supply
The US banking system is based on a fractional reserve system. The money supply can be adjusted indirectly by changing the reserve requirements of banks.
For example, suppose that a bank is required to hold a reserve of 20% of its deposits. When it receives a deposit of, say, $10,000, it must hold $2,000 in reserve, and can do whatever it wants with the remaining $8,000, such as lending it out (banks don't usually lend out more because doing so would leave them at risk of not being able to meet their reserve requirements). A loan of $8,000 is made, and is immediately withdrawn by the borrower. At this point, no money has been created. The bank's assets currently consist of $2,000 in reserves and $8,000 in loans, and its liabilities consist of $10,000 created by the initial deposit.
Suppose now that the borrower deposits the $8,000 in another bank, which is also required to hold a reserve of 20%. This bank must hold $1,600 in reserve, and can lend out the remaining $6,400. Notice that the amount of checkable deposits has increased to $18,000: $10,000 in the first bank, and $8,000 in the second bank. The money supply has increased by $8,000, even though the initial deposit was only $10,000. This process can continue, but since the amount of money created diminishes with each deposit, the total amount of money created approaches a limit, called the money multiplier, which is determined by the amount of the primary deposit and the reserve requirement. In practice, the amount of money created is less than the money multiplier, because of other factors or leakages. For example, not all of the money lent out by the banks is deposited in another bank, and some of it is held as currency outside the banking system.
Factors affecting bank reserves
Currency flows into and out of the banking system can affect bank reserves. For example, when a bank receives a deposit of currency, and sends it to the Federal Reserve (instead of lending it out), the amount of currency in circulation decreases, and the amount of reserves in the banking system increases. Conversely, when a depositor cashes a check, the bank must pay out currency (it may withdraw from its reserves or borrow from the Federal Reserve), and the amount of currency in circulation increases, and the amount of reserves in the banking system decreases. Changes in the money supply have traditionally occurred during the holiday season, when currency is withdrawn from the banking system to pay for gifts and other expenses.
Fed transactions can also affect bank reserves. When the Fed conducts open market operations, all purchases of securities contribute to increasing bank reserves, and all sales of securities contribute to decreasing bank reserves. Treasury operations can also affect bank reserves.
The monetary base and the money multiplier