Chapter 14: Fiscal and Monetary Policy John Maynard Keynes Studied the economy as a whole Break the downward spiral by cutting taxes (more money to spend) or increasing government spending by borrowing money Keynesian economics – ensure economic stability Classical Economics Started by Adam Smith Decisions of the economy made by the consumers and producers Recessions were due to “outside events” such as war and droughts Fiscal policy – keep taxes low, keep government spending low and balance the budget

Fiscal and Monetary Policy Post World War II All Keynesian Economics Employment Act of 1946 passed to keep the US from having another depression 1960s – JFK asked Congress to cut taxes to help with the economy Using Fiscal Policy to end the great depression Deficit spending used for the first time 1939-1945 Deficit did jump from $3 billion to more than $47 billion Unemployment decreased from 17% to 2% The GDP doubled So did it work?

Friedman and Monetarism Using Monetary Policy to fight STAGFLATION 1970s: OPEC and the oil embargo Inflation increased, business activity decreased and unemployment increased Misery Index – inflation and unemployment went to 20% (Nixon, Ford and Carter) Paul Volcker- Federal Reserve Chair – slow money growth – inflation did decrease Great Depression was caused by a drop in the money supply not demand (decrease prices, increase unemployment and decrease incomes) Federal Reserve should have acted Too fast a growth in the money supply – leads to inflation Too slow a growth in the money supply leads to deflations

Fiscal Policy Expansionary Contractionary 2008 Stimulus Checks Increase government spending and/or cut taxes Supply Side Economics – cut business taxes – Reagan – Laffer Curve showed the relationship between Tax rates and revenue Demand side economics –cut taxes on individuals – they will spend money Contractionary How to slow down the economy Increase tax rates and/or cut government spending

Multiplier Effect Government spending has a greater impact on the economy than reducing income taxes Multiplier impact You give $1000 to an individual That person saves $300 and spends $700 The $700 spent goes to Person B Person B saves $200 and spends $500 Person C receives the $500 Person C spends $400 and saves $100 Total amount in the economy from that $1000 is now $2600

Automatic Stabilizers Budget Time: 1/3 of the budget is discretionary spending and 2/3 mandatory spending Congress can touch the discretionary but not the mandatory Automatic Stabilizers help smooth out the transitions between expansion and contraction If you decrease income, the taxes also decrease If you decrease income, you increase transfer payments

Tools for monetary policy Federal Reserve Bank 7 member Board of Governors Independent (more so than Congress) Appointed by the president for a term of 14 years – only one term – Chair is chosen from the 7 members 12 Districts Janet Yellen – President Appointee

Fighting Recession and Inflation Easy Money Policy Expansionary Help the economy to grow Decrease interest rates – borrowing of money increases--- spending increases---- demand increases – economic growth Tight Money Policy Contractionary policy Slow down the money supply growth Increase interest rates--- borrowing of money slows--- less spending--- demand decreases--- economy slows

The Fed’s Tools in dealing with money Most Important Role

Other tools Required Reserve Ratio Discount Rate How much must be left in the bank? Excess Reserves are loaned out and become part of the M1 Money supply Lower rates – more loans Higher rates – fewer loans Least used tool Discount Rate Loans to individual banks are given this interest rate Low rate – less costly to borrow High rate – more costly to borrow Changes frequently – Last Resort – borrow from each other first

Federal Funds Rate The rate charged between banks for short loans FOMC (Open Market Committee) – Affects our interest rate on mortgages, savings accounts, credit card limits, etc

What limits the effectiveness? National Debt Concerns Bankruptcy Burden to future generations Unease over foreign owned debt – Should others be the owners of the bonds? Crowding out effect If the government borrows then there is nothing left for the individual or the businesses? Time Lags Compiling the data takes time Actions into results lag Economic Forecasts Are predictions always 100 percent accurate?