FISCAL AND FISCAL AND MONETARY POLICYMONETARY POLICY

How do policymakers use How do policymakers use fiscal and monetary policy to fiscal and monetary policy to

stabilize the US economy?stabilize the US economy?

What are the Origins of Modern What are the Origins of Modern Fiscal and Monetary Policy?Fiscal and Monetary Policy?

Objective: keep the economy running Objective: keep the economy running smoothlysmoothly– Fiscal policyFiscal policy: the government’s power to tax : the government’s power to tax

and spendand spend– Monetary policyMonetary policy: the Federal Reserve’s power : the Federal Reserve’s power

to regulate the money supply and interest ratesto regulate the money supply and interest rates– Impact of John Maynard KeynesImpact of John Maynard Keynes

Prior to Great Depression – Laissez FairePrior to Great Depression – Laissez Faire Deficit spending – fight Depression/RecessionDeficit spending – fight Depression/Recession Milton Friedman: control money supply key to Milton Friedman: control money supply key to

stabilizing economystabilizing economy– Monetarism:Monetarism: money policy to contract or expand money policy to contract or expand

money supplymoney supply

Tools of Fiscal Policy to Tools of Fiscal Policy to Stabilize the EconomyStabilize the Economy

Expansionary fiscal policy toolsExpansionary fiscal policy tools– Increased government spendingIncreased government spending– Tax cutsTax cuts

Contractionary fiscal policy toolsContractionary fiscal policy tools– Decreased government spendingDecreased government spending– Tax increasesTax increases

* Role of automatic stabilizers* Role of automatic stabilizers

Tools for Monetary Policy to Tools for Monetary Policy to Stabilize the EconomyStabilize the Economy

The Federal Reserve uses monetary policy by The Federal Reserve uses monetary policy by managing the money supply and interest ratesmanaging the money supply and interest rates– Easy-money policyEasy-money policy

Expansionary policy that speeds the growth of the money Expansionary policy that speeds the growth of the money supply to prevent recession (decline in the GDP)supply to prevent recession (decline in the GDP)

– Tight-money policyTight-money policy Contractionary policy that slows the growth of the money Contractionary policy that slows the growth of the money

supply to prevent inflationsupply to prevent inflation

*Most common tool of Federal Reserve is open-market *Most common tool of Federal Reserve is open-market operations (buying and selling of government securities).operations (buying and selling of government securities).

The “Feds” Open-Market The “Feds” Open-Market Operations: the most used Operations: the most used

tool tool Buying and selling of government Buying and selling of government

“securities” in the bond market“securities” in the bond market– Treasury bonds, notes, bills, or other Treasury bonds, notes, bills, or other

government bonds (guaranteed by US government bonds (guaranteed by US gov. and tax exempt)gov. and tax exempt)

– Recommendation by FOMC (Federal Recommendation by FOMC (Federal Open Market Committee), component of Open Market Committee), component of the Fedthe Fed Foreign exchange rates, interest rates, and Foreign exchange rates, interest rates, and

growth of the money supplygrowth of the money supply

Other Tools of the FedOther Tools of the Fed Least used tool: The Reserve RequirementLeast used tool: The Reserve Requirement

– Reserve requirement for banks –”required reserve ratio”Reserve requirement for banks –”required reserve ratio” Minimum percent of deposit keep in reserve at all timesMinimum percent of deposit keep in reserve at all times

– Lowering the ratio allows for more loans and thus more money in Lowering the ratio allows for more loans and thus more money in circulation vs. raising, which tightens money supplycirculation vs. raising, which tightens money supply

– Average reserve requirement, 3-10%Average reserve requirement, 3-10%

The Discount Rate:The Discount Rate:– Banks borrowing money from Fed to maintain their reserve Banks borrowing money from Fed to maintain their reserve

requirementrequirement Interest rate is set by Fed at a discount for BanksInterest rate is set by Fed at a discount for Banks

– Low interest rate means more money to loan = more money in Low interest rate means more money to loan = more money in circulationcirculation

– High interest rate = less money to loan, less money in circulationHigh interest rate = less money to loan, less money in circulation– Between 1990-2008, from 7% to 0.75%Between 1990-2008, from 7% to 0.75%– Borrowing from the Fed can signal problems with the bank, last Borrowing from the Fed can signal problems with the bank, last

resortresort

Federal Funds RateFederal Funds Rate

Rate that banks change each other for Rate that banks change each other for very short – as in overnight – loansvery short – as in overnight – loans– Loans common between banks to Loans common between banks to

maintain the reserve requirementmaintain the reserve requirement– NOT a monetary policy tool because NOT a monetary policy tool because

between private banks, not governmentbetween private banks, not government– FOMC sets “federal fund rate” as ceiling FOMC sets “federal fund rate” as ceiling

for interest ratesfor interest rates Affects rate for credit cards, saving accounts, Affects rate for credit cards, saving accounts,

mortgages mortgages

Factors that Limit Effectiveness Factors that Limit Effectiveness of Fiscal and Monetary Policyof Fiscal and Monetary Policy

Time LagsTime Lags– Compilation of dataCompilation of data– ““Multiplier Effect”Multiplier Effect”

Inaccurate ForecastsInaccurate Forecasts– Economic models: PPF and Supply and Economic models: PPF and Supply and

Demand GraphsDemand Graphs– CBO (Congressional Budget Office)CBO (Congressional Budget Office)

Largest Concern: The National Largest Concern: The National DebtDebt

John Maynard Keynes = Deficit SpendingJohn Maynard Keynes = Deficit Spending– Emergencies onlyEmergencies only

Fear of Government BankruptcyFear of Government Bankruptcy– Increase taxes, refinance debtIncrease taxes, refinance debt

Sell new bonds to pay off old bondsSell new bonds to pay off old bonds Burden on Future GenerationsBurden on Future Generations

– Individuals and Institutions pay interestIndividuals and Institutions pay interest Holders of government bonds benefitHolders of government bonds benefit

Foreign-owned DebtForeign-owned Debt– Japan and ChinaJapan and China

Interest paid to foreign countries but they buy US goods with itInterest paid to foreign countries but they buy US goods with it Offset by Americans buying foreign bondsOffset by Americans buying foreign bonds

Crowding-out EffectCrowding-out Effect– Crowding private borrowers out of the lending marketCrowding private borrowers out of the lending market

Interest rate so high, no one can afford a loanInterest rate so high, no one can afford a loan Government borrowing raises interest rates but spend the money on Government borrowing raises interest rates but spend the money on

creating jobscreating jobs