CFA Level 1 (2009) - 2

Srudy Session 6

Cross-Reference to CFA Institute Assigned Reading #26 - Fiscal Policy

delay both the implementation and resulting effect on the economy of changes in fiscal policy.

Recognition deLay. Discretionary fiscal policy decisions are made by the President and voted on by Congress. The state of the economy is complex and it may rake rhe Adminisrrarion rime to recognize rhe ex rent of the economic problems. Administrative or Law-making deLay. The Adminisrrarion and Congress cannor vore and enacr decisions overnighr. Legal changes are delayed while elecred officials debare rhe issues.

•Impact deLay. Time passes before rhe effecrs of the fiscal policy changes are felr. Delays occur in implementing increases and decreases in government spending and raxing. Moreover, ir rakes rime for corporarions and individuals to acr on rhe fiscal policy changes.

In conrrasr to discrerionary fiscal policy srabilizers, automatic stabilizers are builr-in fiscal devices rriggered by rhe srare of rhe economy. Auromaric fiscal srabilizers minimize riming problems encountered hy discrerionary fiscal policy srahilizers, Automaric fiscal srahilizers fall into rwo main caregories: induced raxes and needs-resred spending,

refer to the amounl of t.1XCS collecred .1,' a perl-enragc (i,e .. incomc [ax rare) of income, Incoml's arc posirivel:-' relared to (;DP Incomes risc during 3n economic boom, As incomes rise. rhe toral amount of raxes collecred automarically increases, The increase in raxes paid bv corporarions and individuals slows do\\'n the economy, Converseh" incomes fall during a recession. As incomes fall. the

wtal amount of raxes collecred automaticalh' falls, The decline in raxes paid by corporations and individuals stimulares the econom\',

•Need,-tested spending refers to government expenditures for programs rhar pass a 'needs" test, such as unemploymenr. During a recession, unemplovment is high.

The governmenr automatically pays our more in unemployment compensarion. The increase in unemploymenr compensation stimulates the economy. During an expansion, unemployment payments automatically drop. The decline in unemployment compensation dampens the economy.

Together, induced taxes and needs-tested spending offer automatic stability to the econom\'. Both actions are countercyclical: raxes rise and needs-hased spending falls during expansions. Jnd raxes fall Jnd needs-based spending rises during recessions.

Because of these automatic fiscal policy effects, the government budget deficit or surplus is affected by the stage of the business cycle. We can think of any budget surplus or deficir as consisting of a srructural component and a cyclical componenr. The structural surplus or deficit would srill exist if rhe economy were ar full employmenr. The

cyclical surplus or deficit exists because the economy is producing above or below full employment GOP. The cyclical surplus or deficir is zero when real CDP equals porential GOP. The actual surplus or deficit at any point in rime eguals rhe sum of any srructural surplus or deficit and any cyclicJl surplus or deficir. Over the lasr few decades, the lJ.S. government has had a persistent srructural deficir.

Professor's Note: The automatic stabilizers mentioned here are based 017 the u.s. tax Law and entitlement programs.

5rudy Session 6

~ross-Reference to CFA Institute Assigned Reading #26 - Fiscal Policy

KEy CONCEPTS

LOS 26.a

An increase in taxes, whether they are imposed on income or on expenditures, reduces the incentive to work, which decreases the quantity of labor supplied and thereby reduces potential GOP from the supply side.

The Laffer curve illustrates the idea that at some tax rate, the disincentive to work from higher tax rates outweighs the revenue-raising effects of higher tax rates, so that total tax revenue will acmally fall in response to a further increase in the tax rate.

LOS 26.b

The sources of investment in an economy are national savings, foreign borrowing, and government savings. Government budget surpluses increase total investment funds, hut g0\,nnll1cnt budget deficits reduce total sal'ings and t()(~li investl11ent in the l'COllOI11V. which Ivill dCU"l\lSl' the growth Llrl' of pClIClHia! CD!' ()I'nriml". Incrclscd l.1:\n on capital inUll11C make saving less attractive. which decreases investment and rhl' long-run growth rate of rl'al GOP

LOS 26.c

Generational efkcts of fiscal policl' refer to the effects of postponing the ta:\c> necessan to pal" for currently enacted federal programs. shifting the burden of paying for unfunded r·,·og:nms to a future gener:ltion of taxpayers.

LOS 26.d

The government expendirurc multiplier and tax multiplier are measures of the magnified effects of changes in government spending and changes in taxes on aggregate demand. The government expenditure multiplier is greater than the tax multiplier. so that an increase in government spending, together with an equal increase in taxes, tends to increase aggregate demand. This effect is termed the balanced budget multiplier and it is poslttve.

LOS 26.e

Discretionary fiscal policy changes are intended to smooth economic cycles but are difficult to time correctly hecause of a recognition lag while the government identifies the appropriate policy change, a law-making lag during which fiscal policy changes are enacted, and an impact lag, the time it takes for policy changes to take effect and inf-luence economic activity.

Induced taxes and needs-tested spending are automatic fiscal stabilizers which reduce timing problems because they tend to increase spending and reduce taxes (increase the deficit) during recessions and to decrease spending and increase taxes (reduce the deficit) during economic expansions.

Study Session 6

C~oss-Reference to CFA Institute Assigned Reading #26 - Fiscal Policy

CONCEPT CHECKERS

1.Which of the following sratemenrs regarding the economic effects of taxes is most Like~y correct?

A.An increase in income taxes creates an incenrive ro work more hours.

B.Decreasing the income tax rate increases the long-term growth rate of the economy.

C.Taxing consumption instead of income would eliminate the negative effect of taxes on economic growth.

2.The Laffer curve shows that an increase in the laX rate:

A.will increase wral tax revenue.

B.will decrease (Otal tax revenue.

C.can cither increase or decrease wtal tax revenue.

,1. \X!hich of the Idlowing (aewr, i, i£'Ii.l{ /;/.:(1, to reduu: [he level of in\'l:'SlmCn[;

A.L.ower sa\'il1g, rarn.

B.h:,der~t1 hudget surplll,es.

C.Increased [axes Oil capital income.

4..Sales in the rt'(~lil sector h;l\'<:' heen sluggish and consumCf confidence' has recently declined. indicating fewer planlled purchases. In response. the President sends an cxpansionan' government spending plan (0 Congress. The plan is

submitted on March 30 and Congress rdines and approves the terms of the spending plan on June 30. \X!hat tvpe of fiscal plan is being considered, and what type of delay did the plan experience between March 30 and June .10?

S.Congress is concerned about delays in the effects of fiscal polic~" and is considering requiring the compilation and reporting of economic statistics weekly, rather than quarterly. The new reporting period is intended to decrease the:

A.impact delay.

B.law making dela;',

C.recognition dela\'.

Study Session 6

Cross-Reference to CFA Institute Assigned Reading #26 - Fiscal Policy

7.Congress enacts a program to subsidiz.e farmers in the Midwest with an

expansive spending program of $10 billion. At the same time, Congress enacts a $10 billion tax increase. Which of the following best describes the impact on the

economy?

A.Lower growth due to the negative tax multiplier.

R.Highcr growth due to the nct positive balanced budget multiplier.

C. No cffect on growth because the tax and spending multiplier effects offset.

Srudy Session 6

Cross-Reference to CFA Institute Assigned Reading #26 - Fiscal Policy

ANSWERS - CONCEPT CHECKERS

I.B Income taxes reduce the incentive w work. Decreasing income taxes encourages workers ro work more hours, which increases potential COP. Consumption taxes also create a disincentive w work because they reduce the amount of goods and services an hour of labor is wonh.

2.C The Laffer curve shows that at low tax rates an increase in rates will increase [Otal tax revenue, but beyond some rate, funher increases will acrually decrease [Otal tax revenue.

3.B Federal budget surpluses represent government savings, a source from which investment can Il1crease.

4.C The expansionary plan initiated by the President and approved by Congress is an

example of discretionary fiscal policy. The lag from the time of the submission (March 30) through time of the vote (june ,10) is known as law-making delay, It took Congrl's" thr,'C month, to \\Titc ,uld pa;,s tllC nl'(l"SSan' I,\w"

". C ~lorc ftTtlucnt anJ ([[rrent l'cUlwmic dar.1 \\oul,l nuk,· it ,:a"ici (or 'ludlOritll" I" l11011it\)J Ih" CnlllOm\' '1I1d ro rcco!'ni/.e probl,ms. The rnllldiull II: Ih" rim,' economic report;, would reduce rhe rec()~nition del,!\".

1>. C TIlt" increase in income t'lXC," shi~'ts rhe labor ;,upplv curVl' 10 thc left. re."ulting in '1 lowel equilibriunl qu.l:Hin· of l;lbor. Llbor is oneof the input betor;, o( producrion for thl' econom\". Therefore. the lower ljuanrit\· of labor eluse, potential GDP to LII,

BThe amoun r uf the spendin~ program exactl)' offsets the amount of the tax increase. leaving the budget unaffected. The multiplier effect is stronger for government spending than For the t;lX incre;lSC. Therefore. the multiplier will he positive. All of the government spending enters the economv as increased expenditure, whereas only a portion 01' the tax increase results in lessened expenditure.

The following is a review of the Economics principles designed to address the learning outcome statements sel forth by CFA Institutel'll. This topic is also covered in:

MONETARY POLICY

Study Session 6

EXAM FocUS

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LOS 2~.~i: niscLlS~, till' gOJj~ of t 1.-':. 1110nl'tJr~' polic~ ;lnd the fed(c"~"i l~(:sc:-"'_'

(Fed'sl means for achieving the goals, including how the Fed operarion:dize' those goals.

The goals of the U.S. Federal Reserve Bank (the Fed) arc three-fold: (I) m.lXll11l1l11 cmplo)ll1el1l. i,e.. maximum sustainable growth of the econODlV; (2) srablt prices: and

(3) moderate Ions-term interest rates.

According to rhe most recent version of the law establishing the mandate of the Fed (2000 amendments), these goals arc to be achieved by rnaimaining "... Iong-run growth of the monetary and credit aggregates commensurate with the economy's long-run potential [0 increase production." Note that the viewpoint here is based on the quantit:, theory of money and represents a monetarist view of macroeconomics. If money, defined as the money supply and available credit, grows annually at a rate just 1% or 2% higher tban the annual growth rate of real output. inflation should average I% or 2% over the long term.

The goal of moderate long-term interest rates is closely tied to the goal of stable prices. since nominal interest rates are real rates plus expected inflation. Over the long term, most macroeconomists believe that stable prices (which translate typically to inflation of 1% to 2%) and the stability and predictability they bring arc an important means of promoting maximum sustainable long-term growth of economic rroduction and employment.

To operationalize its goals, the Fed focuses primarily on two things. core inBation and the difference between actual and potential (full-employment) economic output. Core inflation is calculated as (he rate of increase in the Consumer Price Index (CPO with the effect of its most voJatile components (food and energy prices) removed. An adjustment is typically also made for the upward bias that many believe is a result of the way in which the CPI is calculated. While the calculation of the potential or full-employment rate of growth of real GOP is beyond the scope of this review, we do know that the output gap between the actual growth rate and the potential growth rate of real GOP is an important consideration in setting monetary policy.

Srudy Session 6

Cross-Reference to CFA Institute Assigned Reading #27 - Monetary Policy

When the output gap is positive (actual> potential), there are inflationary pressures and a reduction in the money credit aggregates is indicated. When the output gap is negative (actual < potential), we have a recessiollary gap and an expansion of money and credit aggregates is indicated,

LOS 27.b: Describe how the Fed conducts monetary policy, and explain the Fed's decision-making strategy including an instrument rule, a targeting rule, open-market operations, and the market for reserves.

The primary way that the Fed conducts monetary policy is through their influence on the federal funds rate, the interest rate that banks charge each other for overnight loans of reserves. As wirh most other central banks. this shorr-term rate is the Fed's choice of a policy instrument. When the Fed wants to increase the money supply, they decrease their target value for the federal funds rate. When they want to decrease the money supplY (or the rate of growth of the 1110ne" supply), the Fed increases their target vallie for the federal funds Lire.

In de'crmining ho\', [0 adjusr the fednal funds ratL', rhe Fed I11USt decide berween two types of rules. insrrument rules and targeting rules. \0;'hell following an insrrument rule. the monetary authorities base their target federal funds rare on the CUHClH perforn13nce of th,_ eCOIlO!1l\·. The Taylor rule is an insrrumenr rule hased on the ratC' of inflation and

OUI pur gap. Created lw Prof. .John Tavlor of Stanford University. one version of the Tl\'lor rule. with an inflation target of 2%. sets the federal funds rate as:

FR = 2% + actual inflation + 0,5 (actual inflation - 2(Joo) + 0.5 (outpur gap).1

Nare that when there is no output gap and inflation is at its target rate of 2%, the ffR is set at 4°/h, When inflation is above 2% and/or there is a positive (inflationary) output gap, the FFR is increased. and when inflation is below 2% and/or there is a negative (recessionary) omput gap, the FFR is decreased. While the Fed does not explicitly follow this rule. ir has proven to be a fair approximation of the Fed's policy over the laSt 20 years.

A targeting rule is based on a forecaSt of future inflation and reguires that the FfR be set so that the forecast of inflation is equal to the target inflation rate. typically 2%.

Since the FFR is dew'mined by supply and demand in rhe marker for interbank loans of reserves. the Fed influences the fFR by increasing or decreasing reserves, primarily. through open market operations. Open market operations are the buying or selling of Tre:lsury securities hy rhe Fed in the open market. When the Fed buys Treasury securities, cash replaces securities in invesror accoums, hanks have excess reserves, more funds arc available for lending, and the FFR decreases to a level where the quamit), of reserves demanded equals the new, larger supply of reserves. Sales of securities by the Fed have the opposite effect, reducing bank reserves available for lending, and increasing the FFR. This increase in the FFR decreases the quanti!)' of reserves demanded to match the decreased supply of reserves. This is the Fed's most commonly used rool and is most important in achieving the federal funds target rate.

Scudy Session 6

Cross-Reference to CFA Institute Assigned Reading #27 - Monetary Policy

LOS 27.c: Discuss monetary policy's transmission mechanism (chain of events) between changing the federal funds rate and achieving the ultimate monetary policy goal when fighting either inflation or recession, and explain loose links and time lags in the adjustment process.

We now turn our attention to how a change in the FFR affects the economy in such a way to achicve the Fed's policy goals regarding GOP growth, employment, and infhtion. Let's trace the effects of a decrease in the FFR to stimulate economic activity and growth.

1.The Fed engages in open market purchases of Treasury securities, which increases bank reserves.

2.Excess reserves lead to a decrease in the FFR as banks are more willing ro lend reserves to each other.

.:;, Orher shurl-term rares. such as rhe T-b>ill rate, decrclsl' as well since lcndin b IT'Vl'I'C, and hlll'inS T-bill, (lending 10 the L.S Tre~lslln'i ,He dose: suhsrilures Urhe"

rares ill the econOIl1\' decrease as well, as hanks luve morc reselTes and are !norl willing to make loans to consumers and businesses. W'e describe this as the

as the supply of loanahle funds increases, the equilibriun; rate (or

4.Longer-term interesr ratcs, which can he \'icwcd as shon-term rates plus a prcm;~lm for expected inflation. decrease as well.

S, The decrease in rates makes invcstmcl1l in other cOllntries relatively more altracrlVC, reducing the demand for U.S. dollars (for investment), which causes the dollar to depreciate relative to other currencies (more dollars per foreign currency unit)

6.The decrease in interest rates on business loans causes businesses to find borrowing to fund expansion more attractive and spend more on investment in plant and eqUIpment.

7.Consumers react to the reduction in the interest rates on consumer loans by increasing their purchases of goods that are typically financed, such as houses, automobiles, and appliances.

8.The depreciation of the dollar makes U.S. goods prices fall in terms of foreign currency, so foreigners increase their purchases of U.S. goods, i.e .. demand for exports Increases.

9.In sum, the increases in business investment, consumer purchases of durable goods, and exports all tend to increase aggregate demand.

10.The increase in aggregate demand putS upward pressure on both the price level (increasing inflation) and employment and real GDP.

Study Session 6

Cross-Reference to CFA Institute Assigned Reading #27 - Monetary Policy

This whole transmission mechanism, by which decreases in the federal funds rate stimulate aggregate demand and economic growth, is the same but in the opposite direction for an increase in the federal funds rare, which decreases aggregate demand, GOP growth, and inflationary pressure.

In practice, monetary policy acrions do nor always have rheir intended effecrs. There is only a loose link between shorr-rerm interesr rates, which the Fed can influence directly, and long-rerm rares, which affecr economic decisions by consumers and businesses. A decrease in rhe FFR will not reduce long-term rares as much if the policy change causes inflarion expectarions to increase.

Also, monetary policy affects the economy wirh a significant rime lag. By the time an increase in money supply growth to stimulate a recessionary economy actually shows irs inrended effecrs, the economy may already be in an expansionary phase. The same holds true, of course, for decisions to reduce money supply growrh to slow an inflationary expansion. In either case, the resulr of rhe policy changes can actually make economic cvcles more severe.

Profi'ssor's Notc: j\1f1!:,c SlIr" ,l'OIi ,'1171 fma il,,, elli·cts ort/II ilil'}'('tlJI' iii ilh./i,tllTtil fiiIJrL mtr fi'olll thl' upen lliilr/.:el upcrllfiom r1'thc Fed through to II dNTca.ir iii aggrt'gllte demfwd and a slowillg of errJ/lomic groll'r!,.

Also /late that we ~)lpicaIlJ' describe the Fed as hauillg three policy tools: thr diJColillt rate at which the h:d loal1.' reserlles dirt'et~l' to member banks, 0PeJl market opera tio 1lS, and the bank reserve requirement, When there is a poliC)' change and the Fed increases or decreases the jederalfunds target rate, they typical0' change the discoullf rate similarly at the same time as they pursue the appr'opriate purchases or sales ill their open market operations. [he ban!{ minimum reserve requirement is seldom changed.

LOS 27.d: Describe alternative monetary policy strategies, and explain why they have been rejected by the Fed.

There are four alternarive rules ro the Taylor rule and rhe policy of targeting rhe federal funds rare as rhe key policy variable.

1.A rule called the McCallum rule focuses on rhe rare of growrh of rhe monerary base, based on rhe quanrity rheory of money (MV=PY), The rule essentially matches the growth rate of the monetar;' base ro the long-rerm growth rate of real GOP, adds the rarget inflation rate, and adjusts for changes in the velocity of money over rime. The main drawback of this policy is that fluctuations in the demand for money can cause variations in inreresr rares rhat lead to fluctuarions in aggregate demand.

2, A rule targeting the rare of growth of rhe money supply is closely associared with the work of Nobel Laureare Milton Friedman and the quanrity theory of money. Friedman's well-known prescriprion for monetary policy is to grow rhe money supply at the rate of increase of potenrial real GOP. The drawbacks of targeting monetary aggregates, which was followed to a large degree in the 1970s when the Fed rargeted the growth rates of M 1 and M2, are rhat fluctuations in both the

Study Session 6

Cross-~eference to CFA Institute Assigned Reading #27 - Monetary Policy

velocity of money and the demand for money can lead to iIHerest rate swings and consequent variability in aggregate demand for goods and services.

3. A rule targeting the exchange rate suggests that money supply growth should be adjusted so that the exchange rate between a country's currency and some basket or index of the currencies of other countries remains stable. In this case the resulting inflation rate would be that of the other countries in the long term and the monetary authorities would have little control over it.

4.The final alternative is inflation targeting and this is practiced by many cenrral

banks with the notable exceptions of Japan and the United States. Under this rule, the central bank makes its inflation expectations explicit and uses open market operations and manages the overnight rate in such a way as (0 bring expected inflation into line with the target rate, typically 2% with an acceptable range of 1ole> to 3%. The advantage of this policy rule is predictabilitv and transparency aJon[! with thc srable expecrations for future inAarion th~\l result from a central bank's credihle commitIlll'lIl ((l stahle prices (the tar~l't rare of inAarionl. \X'hclhn infbriol1 tJr[!cting \\'oLllci kl\'l f1roduccd berrn results in rcrl11~ ul'Sl~lbk prices and econoJ1lil growth lhan the targ.etin[! basl'J on S0111(' variant of lhl' Ta:'[or rule is srill an 0Pl'l1 question and subject to ongoing debate.

({,1ltml halll,s. Nof{' that l'l'ell ill the face o{t/;e sloU!dowli ill aonomic aetit'i~J' associated li'ith the colfapse ofthe U. S. housing market. the problems u'ith

sub-prime mortgage securities defaults in 2007-08 alld the consequent risk (l slowing economir growth and possible recession, ti'e European Central BanJ~ cOlltillued to milke monelflry pulic)l decisions hased on~l' un data on current lliU! expected inflation. Time will telf whether inflation targeting produces a better result thall the U. S. policy, zIJhich has leaned more toward econom ie stimlllw to redua the pruhabifi~J' and/or rnagnitude of a reccSi'ion,