Characteristics and barriers of coherent financial reporting frameworks

Characteristics of coherent financial reporting frameworks

• Transparency – full disclosure and fair presentation
• Comprehensiveness – encompass the full spectrum of transactions that have financial consequences.
• Consistency – similar accounting across companies, geographic areas, and time periods for similar transaction

Barriers to create a coherent financial reporting framework

• Effective standards can have conflicting approaches on valuation, the bases for standard setting, and resolution of conflicts between balance sheet and income statement focus.

Barriers to developing one universally accepted set of financial reporting standards

• Different standard-setting bodies and regulatory authorities have different opinion
  Political pressures faced by regualatory bodies from business groups and others
  
  

Automatic stabilizers

Automatic stabilizers refer to the built-in fiscal devices ensuring deficit in recession and suplus during booms. Automatic stabilizers can minimize the timing problem.

Progressive income taxes

• Drop out from tax rolls during downturn and add to it during booms

Corporate taxes

• Taxes on corporate profits go up substantially during boom times, and decline rapidly during times of recession.

Unemployment benefits (need- tested spending)

• More money is paid out when more people is unemployed.

Discretionary fiscal policy

During recession, government increase spending and/or reduce taxes to stimulate aggregate demand.

During inflation, government reduce spending and/or increase taxes to restrain aggregate demand.

Limitations of discretionary fiscal policy

• Recognition lag - the time difference between the need for a fiscal policy shift and when policy makers recognize it
• Administrative lag - the time difference between recognition of the need and when the policy shift is implemented
• Impact lag - the time difference between implementation of the policy shift and its impact on the economy

Expenditure multiplier, Tax multiplier, Balanced budget multiplier

Expenditure (Government Purchase) Multiplier
Increase in government expenditure => workers and captial owners receive wages or payments => increase in aggregate expenditures

Tax Multiplier
Increase in taxes => decrease in income => decrease in consumpton expenditures

Balanced budget multiplier
As expenditure multiplier is stronger than tax multiplier, equal increase in expenditure an tax will lead to increase in GDP.

The generational effects of fiscal policy

Current fiscal policy impacts the amount of taxes that future citizens will pay. This situation is referred to as generational imbalance.

In case of long-term budget deficits, future generations will need to pay higher taxes in order to pay the interest.

In case of budget surpluses, future generations will pay lower taxes.

Generational accounting
Economists have created systems which examine the lifetime taxes and benefits associated with generations or age groups. Those systems are referred to as generational accounting.

Crowding-out effect and other Influences

Crowding-out effect
It occurs when budget deficits caused by expansionary fiscal policy lead to higher interest rate and lower private investment.

Government borrowing => increase demand for loanable funds => increase real interest rate => reduce profitability of investment projects => lower private investment => reduce the impact of expansionary fiscal policy on aggregate demand => inefficient public sector crowding out efficient private sector without any gain in GDP

Government spending =>shift aggregate demand =>budget decficit =>increase demand for loan =>increase interest rate, lower private investment =>adjust AD back

Note:
Unlike Keynesian model, prices are flexible Under classical economist’s view.

Keynesian model
It recommends that fiscal policy should be used (countercyclical policy) to smooth the business cycle. Expansionary fiscal policy to help the economy out of recessions and boost employment. Restrictive fiscal policies to rein in aggregate demand when the economy is growing too fast.

Some economist’s view
Deficit spending =>increase interest rate =>attract foreign investment =>increase loanable fund =>reduce interest rate =>offset crowding out effect

Increase saving =>increase loanable fund => interest rate unchanged

Increase foreign investment=>appreciate dollars=>increase imports decrease exportàtrade deficit and budget deficit

New classical model
Expansionary fiscal policy => budget deficits and debt => private individuals realize that taxes will eventually increase and so increase saving => fall in private consumption =>negates the rise in government spending and hold AD constant

Summary: If tax cut, no change in output, price, interest rate, unemployment => ineffective

Note:
Tax cut increase saving but no spending, opposite to Keynesian view that tax cut cause increase in disposable income =>increase consumption

Supply side model:
Governments should fuel economic growth by promoting supply rather than demand. Lower marginal tax rates => increase in efficient private sector investment => higher incomes => increased tax receipts despite lower tax rates.

Emprical evidence
Fiscal policy:
Countercyclical due to automatic stabilizer rather than actively change fiscal policy.

Budget deficits and real interest rates:
According to the crowding out model, deficits leads to higher demand for loanable funds and thus higher real interest rates. However, any rise in real interest rates increases the supply of capital from home and abroad. Empirical evidence suggests that the link between the two is very weak and crowding out effect is mixed.

Budget deficits and trade deficits:
Deficit leads to inflow of foreign capital flows and thus appreciate domestic currency and causes influx of imports, higher trade deficit is resulted at last.

Inflation:
Little support budget deficit cause inflation

Sources of investment finance

Sources of investment finance includes:

• Private saving
• Government saving
• Borrowing from foreigners

Capital markets are influenced by fiscal policy in two ways:

• Government spending and tax policy will generate either a budget surplus or a deficit, which will in turn contribute towards financing investment or "crowd out" private investment.
• Tax policy will affect the amount saved. Taxes on interest earned will decrease the incentive to save.
  

Laffer curve

The Laffer curve shows the relationship between tax rates and tax revenue.

As the tax rate increases from zero, the amount of tax revenue collected will increase. But after a point where potential GDP is maximized, increases in the tax rate lead to decreases in the tax revenue collected. High tax rates also produce a loss to society in the sense that productive economic activity is being discouraged.

Fiscal Policy and Potential GDP

Fiscal policy
Fiscal policy refers to the use of government taxation, spending and borrowing to satisfy macroeconomic goals.

Three major ways that fiscal policy to increase aggregate demand:
Lower business tax - can change the profitability of businesses and the amount of business investment.
Increase government spending
Lower tax for individuals - increase disposable personal income and increase consumption spending.

Fiscal policy has an advantage over monetary policy as increase in government spending leads to an immediate increase in aggregate demand. However, the effects of a tax cut may be more moderate and have more of a time lag because individuals may not immediately spend their increases in disposable income that resulted from the tax cut.

Potential GDP
The GDP resulted from an economy operating at full employment with full utilization of capital is called potential GDP.

Supply-side effect
The effects of the changes in fiscal policy on aggregate supply is called supply-side effect.

Increase in taxes on expenditures and/or income => less labour supplied => supply curve shift up to the left=> reduce aggregate supply of labor, real GDP and potential real GDP.

Stabilizing Aggregate Supply Shocks

Two types of shock occur to bring fluctuations in aggregate supply.

Productivity growth fluctuations.
The growth rate of productivity changes from time to time and therefore potential GDP (and the LAS curve) fluctuates.

Monetarist fixed rule with a productivity shock
A productivity growth slowdown decreases long-run aggregate supply. With a fixed rule, aggregate demand is unchanged. Real GDP decreases and the price level rises.

Feedback rules with productivity shock.

Real GDP stability conflicts with price stability in the face of a productivity shock. So there are two possible feedback rules.

1. Rule to stabilize real GDP. Suppose that the Fed's feedback rule is: when real GDP decreases, cut the interest rate to increase aggregate demand. This policy brings a rise in the price level but does not prevent the decrease in real GDP.
2. Rule to stabilize the price level. Suppose that the Fed's feedback rule is: when the price level rises, raise the interest rate to decrease aggregate demand. In this case, the price level is stable and real GDP is unaffected by the monetary policy.

When a productivity shock occurs, a feedback rule that targets the price level delivers a more stable price level and has no adverse effects on real GDP.

Fluctuations in cost-push pressure.
Cost-push pressures fluctuate and bring changes in short-run aggregate supply.

Monetarist fixed rule with a cost-push inflation shock

• If the Fed follows a monetarist fixed rule, it holds aggregate demand constant when a cost-push inflation shock occurs. Real GDP decreases and the price level rises - stagflation.
• There is a recessionary gap that eventually lowers the money wage rate and returns the economy to full employment. But this adjustment takes a long time.

Feedback Rules with Cost-Push Inflation Shock.
Again, there are two feedback rules.

1. Rule to stabilize real GDP. When a cost-push inflation shock occurs, the Fed cuts the interest rate and increases aggregate demand. The price level rises and real GDP returns to potential GDP. If the Fed keeps responding to repeated cost-push shocks in this way, a cost-push inflation takes hold.
   
2. Rule to stabilize the price level. A cost-push inflation shock leads the Fed to raise the interest rate and decreases aggregate demand. The Fed avoids cost-push inflation but at the cost of deep recession.
   

Fixed-rule, Feedback-rule and Discretionary Monetary Policies

Fixed-rule policies
To keep the quantity of money growing at a constant rate regardless of business cycle, independent of the state of the economy

Feedback-rule policies
Push the interest rate ever higher in response to rising inflation and strong real GDP growth and ever lower in response to falling inflation and recession, i.e. in response to changes in the state of the economy.

Discretionary policies.
A discretionary policy responds to the state of the economy by using all the information available, including perceived lessons from past "mistakes." Most macroeconomic policy actions have an element of discretion because every situation is to some degree unique.

Policy Lags
The effects of policy actions taken today are spread out over the next two years or even more. The Fed cannot forecast that far ahead.

Restrictive and Expanionary Monetary Policy

Restrictive monetary policy:

• Sell Treasuries
• Raise discount rate
• Raise required reservation.

In short-run

• If the economy is overheating, the Fed decreases money supply by selling securities => higher interest rates => lower investment, consumer spending and exports => lower output and rise in unemployment.

In long-run

• If beyond full employment => decrease inflation
• At or below full employment => recession
  
  

Expansionary monetary policy

• Buy Treasuries
• Lower discount rate
• Lower required reserve ratio

In short-run

• In a recession, Fed increases money supply by buying securities => lower interest rates => less expensive current consumption and investment, depreciate dollars, higher assets price eg. stocks bonds house higher => higher wealth => higher investment, consumer spending and exports => higher output and fall in unemployment.

In long-run

• If at full employment, increase output and employment => higher price bring economy back=>inflation
• below full employment => Increase output and employment
  
  
  

Expectations of Monetary Policy
Expectations impact perceptions about inflation and the timing of those perceptions.
The effectiveness of expansionary monetary and fiscal policy with regards to increases in output and employment is reduced by expectations.

Monetarist’s view:
As change in Money supply will influence price and output, the best monetary plicy is one of steady, preditable money growth. and discretary monetary policy not be used to moderate the price & output fluctuation.
Time lag: 5-36 mths

Monetary Policy

Monetary policy is the control of the money supply (and sometimes credit conditions) to achieve or satisfy macroeconomic goals.

Fed’s monetary tools:
Open market operations

• buying Treasuries in the repo market injects money into markets and thus lowers Fed Funds rate

Buying Treasuries in the repo market => injects money => lowers Fed Funds rate

Discount rate

• lowering this rate makes it more attractive for banks to borrow money from Fed

Reserve requirements

• lower required reserve ratio make more funds available for lending, used rarely

Verbal persuasion

• used often, to persuade bank to tighten their credit policies
  

Note:

• Open market operations & discount rate methods are most commonly used

Fed’s goals

Fed’s primary goal of price stability
Unexpected swings in the inflation rate bring costs for borrowers and lenders and employers and workers. In general, an inflation rate between 0 - 3% a year is seen as being consistent with price level stability.

Price stability => real wages/ interest rate close to the expected value => reduce uncertainty => encourage to save and invest => strengthen economy

Fed’s secondary goal of sustainable GDP real growth close to potential GDP
Whether or not that growth is sustainable depends upon other factors such as:

• technological advances
• availability of natural resources
• the willingness of people to work
• the willingness of people to invest
• political stability.

Intermediate targets of monetary policy include:

• M1 growth rate
• M2 growth rate
• Growth rate of monetary base
• Federal funds rate

The Quantity Theory of Money

The quantity theory of money proposes that the quantity of money and price levels increase at the same rate in the long run. This concept is demonstrated by the equation of exchange.

The Equation of Exchange

M × V= P × Q = Total Spending or GDP

Where
M – Money supply
V – average no of times per year each dollar used to buy goods & services = GDP/money
P – Price level
Q –real output

As Q and V are constant and change slowly, incease in M (money supply) lead to increase in P (price) propotionally.

Demand and supply for money

Factors that influence the demand of money
Interest rate – most critical
Higher interest rate => higher opportunity cost of cash => people less willing to hold money=> lower demand for money

Inflation
Higher inflation => increase in demand for nominal money

Real GDP growth
Higher real GDP growth => increases the demand for money (nominal and real)

Demand curve for money
Graph of money demanded versus interest rates is downward sloping and depends on interest rate, inflation, GDP

Supply curve for money
Controlled by the Fed. Graph of money supply versus interest rate is a vertical line.

Actual and Potential Deposit Expansion Multipliers

Potential deposit expansion multiplier:
Increase in money supply due to one additional dollar of deposits.

Potential multiplier = 1 / Required reserve ratio.

Actual multiplier is lower due to currency leakages {some people may hold currency and not deposit it in a bank} and excess bank reserves {some banks are not able to loan out excess funds}.

Excess reserve: actual reserve – minimum required reserve

Marginal propensity to consume (MPC), Expenditure multiplier

Marginal propensity to consume (MPC)

MPC = Proportion of each additional dollar of income spent on personal consumption
= Marginal increase in consumption / Marginal increase in income.

Expenditure multiplier = 1/ (1 - MPC).

Keynesian or aggregate expenditure (AE) model:

Keynesian macroequilibrium:
Actual output (income) = the planned output given by the AE model (i.e demand or expenditure in next period)

Real GDP = C + I + G + NX

Planned consumption (C)

• Determined by disposable income, less than one to one basis

Planned investment (I) and Government Spending (G)

• Fixed constant, unrelated to income

Planed net exports (NX)

• Decreases as income increase

If the actual expenditure is lower, inventories will build up. If higher, inventories will be depleted.

SRAS is horizontal out to the full employment where it becomes vertical.
If below full employment, increase expenditures =>increase output, change in AE = change in output
If at full employment, increase expenditure=> increase prices

Classical economist, Monetarist, Keynesian economics

Classical economist:
Focuses on AS, markets will direct economy to full employment and equilibrium at full capacity by flexible wages and prices, similar to AS/AD model

Monetarist
Unpredictable changes in monetary policy are the primary cause of deviation from full employment GDP. Suggest steady predicatable increase in the money supply and low mariginal tax rates to keep prices stable and to maximize real GPD growth.

Keynesian economics:
Fluctuations in aggregate demand are the source of economic disturbance. Resource prices and wages are inflexible in the downward direction. Business cycle-driven by demand-side factors.

Unemployment is resulted from aggregage demand and spending. This causes friction and does not allow the economy to grow at its full potential. The government can help the economy by boosting demand. (fiscal policy – tax and spending, but NOT monetary policy)