Transcript Economics: Fiscal and Monetary policy

ECONOMICS: FISCAL AND
MONETARY POLICY
Important Vocabulary








Fiscal Policy
Monetary Policy
Deficit Spending
Stagflation
Multiplier Effect
Easy-Money Policy
Tight-Money Policy
Crowding-Out Effect
A Case Study: 2008


Where were you in 2008? What was going on?
Housing Market crisis
 Homes
devalued---sometimes less than owed in
mortgage

Rise in oil prices--- gasoline goes from $3 to $4
 Filling

up cost some $100 or more
Food prices rose as well---People began packing
lunch
 Cafeteria

prices rose by 32 cents on average
Job losses---cut back on spending
How could this happen?


Each recession or economic downturn is slightly
different than the last one
We have two stop-gap institutions that try to stop
these situations from happening, or at least minimize
them
 Federal
 Policy
to tax and spend
 Federal
A
Government----Uses Fiscal Policy
Reserve----Uses Monetary Policy
central bank; controls the money supply
Origins of Fiscal and Monetary Policy

Prior to 1930s, very little involvement
 Great

Depression changed that
Classical Economics
 Give
the market time; it would sort itself out
 Low taxes, low spending, balanced budget
 FDR originally believed in this until…

John Maynard Keynes
 Economic
problems caused by lack of spending
 Thus, either reduce taxes or increase spending
 At odds with Classical; “in the long run, we’re all dead”
Keynesian Economics

Deficit Spending:
 Government
spends more money than it collects in
revenue
 To finance spending, government borrows money by
selling bonds
 Eventually convinced FDR---he used it to moderate
success
 Eventually WWII helped get us out of Depression, but
at a cost---budget deficit skyrocketed

Result: “We are all Keynesians now.”
Milton Friedman




Critic of Keynes
Argued Depression was result of lack of demand
Called for monetary policy, not fiscal
The Federal Reserve should have expanded the
money supply
 Monetarism—control
money supply to manage
economy
 Money supply grows too fast---inflation
 Money supply grows too slow---deflation; spending low
Tools of Fiscal Policy




Economic goals—low unemployment, stable prices,
economic growth
How to achieve them?
How much to collect in taxes? How much to spend?
Examples of fiscal policy
 2008---Stimulus
checks (Expansionary Policy)
 Contractionary Policy---economy is overheated;
increase taxes, cut spending to slow it down
Using Tax Cuts to Stimulate Growth

Demand side economics
 Cutting

individual income taxes
Supply side economics
 Cutting
taxes on businesses and high income tax payers
 Sometimes called “Trickle Down Economics”
 Reagan believed in this; cut corporate tax rate from 48
to 34%, and top income tax rate from 70 to 28%
 Economy did grow, but at a cost---budget deficits grew
Why increase government spending?

Multiplier Effect
 Theory
that each dollar spent creates more spending,
like a ripple effect throughout the economy
 Example:
 Hire
a teenager for $1000 a week
 Saves $300, spends $700 on a new bike
 Bike shop owner saves $200, spends $500 on car repairs
 Mechanic saves $100, spends $400 to hire a painter
 $1000 + $700 + $500 + $400 = $2,600 in economic
activity generated by a $1000 cost
Tools of Monetary Policy


Federal Reserve---Central Bank
Structure
 Board
of Governors---Washington, D.C.
 Country divided into 12 districts
 Regional banks oversee activities of national and state
chartered banks in area
 Elected to Board, one term of 14 years
 All board members, plus presidents of 5 regional
reserve banks sit on FOMC—dictate policy
Tools of Monetary Policy

Easy-Money Policy
 Speed
the growth of money supply
 As money goes into economy, interest rates drop and
borrowing becomes cheaper and easier
 Loans are easier to get, so households and firms spend
more; demand increases

Tight-Money Policy
 Slow
the growth of money supply
 Opposite is true, but does lead to drop in inflation rate
Tools of Monetary Policy

Most used: Open Market Operations
Buying and selling of gov. securities in the bond market
 Think: Buy-Big; Sell-Small---Fed bond traders buy gov.
securities, every dollar Fed pays for bonds increases the
money supply; opposite is true


Least used: The Reserve Requirement


Adjust the ratio of money banks must hold on reserve
Third tool: Discount Rate
Banks borrow money from Fed; interest rate on those loans
is the discount rate
 Board of Gov. controls this

The Federal Funds Rate





The Fed makes the news mostly over this
FFR is the rate banks charge one another for very
short loans
NOT a monetary policy tool
FOMC sets a target for the FFR based on view of
economy; then uses open market operations to move
FFR toward the target
Interest rates on everything are affected by this
 Savings
accounts, bonds, mortgages, credit cards
What limits effectiveness?

Fiscal and monetary policies are weakened by certain
factors
Time lags
 Misleading economic forecasts



E.g, 2001 budget surplus, CBO predicted continued surplus
through 2011, and by 2009 would be large enough to pay off
national debt…..oops
Concerns over national debt may limit gov. spending
Foreign owned debt
 Burden on future generations


Crowding out effect: Gov. borrowing increases interest
rates so high that people do not borrow to invest in business