Transcript Monetary policies

Ch. 15/16
Fed. Gov’t uses
2 strategies to fight inflation
and/or unemployment to promote a healthy,
growing economy:
Fiscal
policies (Ch. 15)
Monetary policies (Ch. 16)
Policies
that try to increase output
(stimulate the economy) are called
expansionary policies
Policies
intended to decrease output
are called
contractionary policies
Ch. 15 Fiscal Policy
Fiscal Policy defined:
The use of gov’t spending
and
taxing to influence the economy
To understand FP
economics, one must know
the 20th century’s most brilliant economic
theorist…
John Maynard Keynes
Cambridge Univ. professor…world’s leading
econ thinker in the 1930’s
Keynesian Economics:
Gov’t. should use
its power to tax and to
spend to affect the economy.
In periods of
inflation, gov’t. should raise
taxes to decrease the amount of money
individuals and businesses have available to
spend.
Similarly, gov’t. should lower its
spending to
decrease available income.
Less income =
individuals
less spending by business and
lower demand
 We
Fiscal Policy
have talked about inflation only…what about
unemployment?
 During
recessions, gov’t.
1. spends to creating jobs … jobs = income and
income gets spent which stimulates the
economy.
2. Decreases taxes to make more $
available to businesses and individuals
Fiscal Policy
During
booming economic cycles,
gov’t. cuts back on its spending and
raises taxes
This
puts the brakes on consumer
spending and helps to keep growing
GDP under control
Limits of Fiscal Policy
Increasing gov’t. spending is
not so simple:
1. 60% of fed’l. budget goes to entitlement
programs which are fixed by law (programs like
Social Security, Medicare, veteran’s
benefits)…gov’t cannot alter these payments.
So…any change in fed’l spending must come from
only ~ 40% of what is in the fed’l budget
A political football?
As
we have seen so clearly in the past 2
years, gov’t. spending is viewed differently by
Democrats and Republicans (generally)
A 2nd Problem:
Predicting
future GDP isn’t easy…the
wrong decision now could spell disaster
down the road
Keynesian econ applied:
During our recent recession, what did
the Obama administration push?
How have the Republicans responded?
A different strategy:
Monetary policy
Monetary Policy
Gov’t uses the Federal Reserve to
affect the economy…
The Federal Reserve
“the Fed”
Federal Reserve System created 1913
- USA divided into 12 districts…each has a
federal reserve bank
- all US banks belong to the system
Main Functions of the Fed
lend to member banks
Set interest rates on what banks charge one
another for loans
- consumer int. rates are “pegged” to that
rate
Adjust money supply

Monetary Policy
If
prices are being pulled higher by increased
demand, one solution would be to lessen
demand.
Any
ideas how to discourage demand? How
could the Fed make people less willing to
spend??
Monetary Policy
Make
it harder to borrow money to buy things on
credit by making the cost of money more
expensive. In other words…
RAISE INTEREST RATES!
Higher interest rates would:
1
make paying
back loans
more costly
2
Discourage
people from
borrowing
(and buying on credit
IS borrowing)
3
4
Less borrowing = lower demand (recall 3 conditions of
demand)
And as we already know from studying supply
and demand, less demand will
Bring
Prices
Down
Is
this a logical tactic to tame
inflation?
Say “Yes”, little Power Rangers
A few last thoughts on
Monetary Policy
As
we already discussed, the Federal Reserve is
the key player
It sets a key interest rate (called the Federal
Funds Rate: the rate banks charge each other
for overnight loans)
The Prime Rate (what consumers pay) is tiered
above the Fed Funds rate
2 Names to know:
Monetary Policy =
Milton Friedman
(recently deceased)
Fiscal Policy =
John Maynard Keynes
Quick Review:
Monetary Policy is about the
Fed controlling
money supply…how much money is
circulating through the system
Fed does this partly by adjusting interest rates
as needed
Low int. rates (“easy money”) encourages
borrowing…high rates (“tight money”) does
not
Int. rates ultimately affect overall demand
Classical Economics
What
makes both fiscal policy and monetary
policy significant is that they each mark a
huge departure from what is called
“classical economics”

The heart of classical economic theory
is that:
1. free markets will regulate
themselves thru the natural interaction
between supply and demand…markets
will naturally seek equilibrium
2. gov’t. intervention is not needed
Adam
Smith…David Ricardo…Thomas
Malthus were the major architects of this
theory that dominated economic theory
and gov’t policies for more than a century
The
Great Depression challenged this line
of thinking because…
Connecting the dots…
During
the Great Depression, prices
plummeted
Classic econ says that demand should
rise with low prices which should cause
producers to produce more, creating a
need for higher employment…but it
didn’t
Keynes
argued that neither business nor
consumers had the ability or desire to spend
Government MUST be the catalyst…it was the
only entity that had the ability to spend to
stimulate the economy
So…gov’t. can intervene with either fiscal
policy, monetary policy, or both….
Tying it all together
Keynes’ belief that gov’t HAD
to act has guided
our gov’ts actions for 75 years:
When inflation is
the problem:
contractionary policies are needed
When unemployment is
the problem:
expansionary policies are needed