Transcript fiscal and monetary policy

FISCAL AND MONETARY
POLICY
How do policymakers use fiscal
and monetary policy to stabilize
the US economy?
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
 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 government spending
– Tax 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
– 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
– 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)
Largest Concern: The National
Debt

John Maynard Keynes = Deficit Spending
– Emergencies only

Fear of Government Bankruptcy
– Increase taxes, refinance debt
 Sell new bonds to pay off old bonds

Burden on Future Generations
– Individuals and Institutions pay interest
 Holders of government bonds benefit

Foreign-owned Debt
– Japan and China
 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
 Interest rate so high, no one can afford a loan
 Government borrowing raises interest rates but spend the money on creating jobs