Deficits and Monetary Policy

Introduction The focus in this chapter is on the following questions: How do deficits and surpluses arise? What harm (good) do deficits (surpluses) cause? How are these monitored? Who will pay off the accumulated national debt?

Budget Effects of Fiscal Policy The federal budget is a key policy lever for controlling the economy. Fiscal Policy- use of government spending and revenue collection measures to influence the economy Use fiscal stimulus to eliminate unemployment. Use fiscal restraint to control inflation Taxes! Derived from Keynesian Economics

Budget Surpluses and Deficits Problem with Fiscal policy is that it has to go through the political process, which takes time Reducing tax revenues and increasing federal government spending throws the budget out of balance. Creates a budget deficit through deficit spending.

Budget Surpluses and Deficits Budget deficit is the amount by which government spending exceeds government revenue in a given time period. Deficit spending/financing is the use of borrowed funds to finance government expenditures that exceed tax revenues. Budget deficit = government spending – tax revenues > 0

Budget Surpluses and Deficits If the government spends less than its tax revenues, a budget surplus is created. Budget Surplus is an excess of government revenues over government expenditures in a given time period.

Federal Reserve & Monetary Policy The Federal Reserve, also called the “Fed,” as the nation’s privately owned, publicly controlled central bank. A central bank is a “banker’s Bank”- can lend to other banks Led by a 7-member board of governors selected by the President every 14 years Responsibilities Maintaining currency (paper and coin money) Maintaining payments (checks, online payments) Regulating and supervising banks Acting as the government’s bank

Monetary Policy Fractional reserve system- requires banks to keep a portion of their total deposits in the form of legal reserves (currency and deposits used to meet the requirements) Changing the reserve requirements can affect the money supply Monetary Policy- actions by the Fed to expand or contract the money supply to affect the cost and availability of credit Affects interest rates and the economy

Easy Money vs. Tight Money When the Fed conducts monetary policy, it changes the interest rates by changing the size of the money supply Tight Money Policy- Fed restricts the money supply, slows borrowing and economic growth due to higher interest rates Leads to higher unemployment Associated with contraction Easy Money Policy- the Fed expands the money supply, causing interest rates to fall. Stimulates the economy, higher inflation Associated with expansion

Problem with Monetary Policy No perfect solution, easy money policy causes issues like inflation, while tight money policy causes unemployment Like fiscal policy, time lags and slow changes, sometimes changes aren’t noticed for years or more