Transcript fiscal and monetary policy

Principles of Macroeconomics
Lecture 8c
FISCAL AND MONETARY POLICY MIX
What are the Origins of Modern Fiscal and
Monetary Policy?

Objective: keep the economy running smoothly
Fiscal policy: the government’s power to tax and spend
 Monetary policy: the Federal Reserve’s power to regulate
the money supply and interest rates
 Impact of John Maynard Keynes

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Prior to Great Depression – Laissez Faire
Deficit spending – fight Depression/Recession
Milton Friedman: control money supply key to stabilizing economy

Monetarism: money policy to contract or expand money supply
Tools of Fiscal Policy to Stabilize the
Economy

Expansionary fiscal policy tools
 Increased
 Tax

government spending
cuts
Contractionary fiscal policy tools
 Decreased
government spending
 Tax increases
* Role of automatic stabilizers
Tools for Monetary Policy to Stabilize the
Economy

The Federal Reserve uses monetary policy by
managing the money supply and interest rates

Easy-money policy


Expansionary policy that speeds the growth of the money supply to
prevent recession (decline in the GDP)
Tight-money policy

Contractionary policy that slows the growth of the money supply to
prevent inflation
*Most common tool of Federal Reserve is open-market operations
(buying and selling of government securities).
The “Feds” Open-Market Operations: the
most used tool

Buying and selling of government “securities” in the
bond market
 Treasury
bonds, notes, bills, or other government bonds
(guaranteed by US gov. and tax exempt)
 Recommendation by FOMC (Federal Open Market
Committee), component of the Fed
 Foreign
exchange rates, interest rates, and growth of the
money supply
Other Tools of the Fed

Least used tool: The Reserve Requirement

Reserve requirement for banks –”required reserve ratio”

Minimum percent of deposit keep in reserve at all times

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
Lowering the ratio allows for more loans and thus more money in circulation vs.
raising, which tightens money supply
Average reserve requirement, 3-10%
The Discount Rate:

Banks borrowing money from Fed to maintain their reserve requirement

Interest rate is set by Fed at a discount for Banks
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Low interest rate means more money to loan = more money in circulation
High interest rate = less money to loan, less money in circulation
Between 1990-2008, from 7% to 0.75%
Borrowing from the Fed can signal problems with the bank, last resort
Federal Funds Rate

Rate that banks change each other for very short –
as in overnight – loans
 Loans
common between banks to maintain the reserve
requirement
 NOT a monetary policy tool because between private
banks, not government
 FOMC sets “federal fund rate” as ceiling for interest
rates
 Affects
rate for credit cards, saving accounts, mortgages
Factors that Limit Effectiveness of Fiscal and
Monetary Policy

Time Lags
 Compilation
of data
 “Multiplier Effect”

Inaccurate Forecasts
 Economic
models: PPF and Supply and Demand
Graphs
 CBO (Congressional Budget Office)
Factors that Limit Effectiveness of Fiscal and
Monetary Policy
Factors that Limit Effectiveness of Fiscal and
Monetary Policy
Largest Concern: The National Debt

John Maynard Keynes = Deficit Spending

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Emergencies only
Fear of Government Bankruptcy

Increase taxes, refinance debt

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Burden on Future Generations

Individuals and Institutions pay interest


Holders of government bonds benefit
Foreign-owned Debt

Japan and China
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Sell new bonds to pay off old bonds
Interest paid to foreign countries but they buy US goods with it
Offset by Americans buying foreign bonds
Crowding-out Effect

Crowding private borrowers out of the lending market
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Interest rate so high, no one can afford a loan
Government borrowing raises interest rates but spend the money on creating jobs