Topic 5 Using Monetary and Fiscal Policy to Fight Unemployment and Inflation

Inflation Cause: too much economic activity There are too few factors or production to support the demand for production, prices rise Fix: slow down spending Contractionary fiscal and monetary policy (decrease G, increase Tx, increase RRR, sell bonds, increase federal funds rate)

Unemployment Cause: not enough economic activity The economy’s factors of production could support more output Fix: increase economic output Expansionary monetary and fiscal policy (increase G, decrease Tx, lower RRR, buy bonds, lower federal funds rate)

Some schools of thought Supply side economics – tax breaks and incentives for producers are the most effective way to stimulate the economy Demand side economics – tax breaks and incentives for consumers, plus government spending, is the best way to stimulate the economy

Trade off – The Philips Curve Graph the Philips Curve – In class Vertical axis for inflation, horizontal axis for unemployment How to incorporate Natural Rate of Unemployment? How to incorporate Inflationary Expectations? As the labor market becomes tighter, what happens to prices?

Changes in Philips Curve Changes in the Natural Rate of Unemployment? Monster.com? Minimum wage? Culture of changing jobs? Changes in inflationary expectations? People expect higher or lower inflation Changes in worker bargaining power? Ability to move production over seas

Current Unemployment & Inflation

Current Unemployment & Inflation Unemployment is around 10% Inflation is low, about 2.0% per year Links:

So, where are we on the Philips Curve? What policies help?

Monetary Policy Open Market Operations (to alter the interest rate) Required Reserve Ratio (RRR) Federal Funds Rate

12/08 Rates for US Treasury Bonds COUPON MATURITY YEILD 3-Month /26/ Month /25/ Month /17/ Year /31/ Year /15/ Year /31/ Year /15/ Year /15/

US Treasury Bill Rate

Reserve Requirements Total Deposits RRR $0 to $10.3M0% $10.3M to $44.4M3% > $44.4M10%

Fiscal Policy Government spending Taxes Without much room to play with monetary policy, the government is relying heavily on fiscal policy What does the government spend money on?

Projected Deficit (Wash Post)

Keynesian Economics The fiscal policies we focus on in class are key tools in Keynesian Economics. John Maynard Keynes ( ) advocated using government spending to smooth out the business cycle. The key policy recommendation of Keynesian theory is to use deficit spending to pull an economy out of a recession.

Downsides of Keynesian Spending Expensive The wrong type of spending? Spending chosen by politicians and bureaucrats Short term projects, not long term solutions Real world multiplier may be less than 1 Encourages irresponsible or inefficient behavior Politically infeasible Avoids benefits of a recession (!?!?!?)

Similar issues with monetary policies: Artificially low interest rates encourage the wrong type of investment Lower return projects More risky projects Less focus on innovation Artificially low interest rates make it “too easy” to borrow money for consumption Might pull us out of the recession more quickly, but result in a lower long-run growth rate

Politically infeasible? Supporters of Keynesian motivated government spending wanted a bigger bailout Opponents thought the spending was already too high Quickly passed laws allow for more favors, waste, and other bad policies The outcome of the policy was/is uncertain Any way around this? Dictator Automatic spending that kicks in: i.e., unemployment insurance

Upsides to a recession? Survival of the fittest Struggling businesses go under, resources redirected People get retraining, better education Political pressure to fix or change bad policy Market bubbles burst, prices adjust Others?

Alternatives to Keynesian Spending 1. Hands off. Let the economy fix itself. 1. Implement better policy to help employers adjust to changing markets, and investors make better decisions Economies must be able to adjust to government or market induced shocks to employment Better quality regulation, taxes, government spending transparency incentives