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 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 Expansionary fiscal policy tools –Increased government spending –Tax cuts Contractionary fiscal policy tools 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 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 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 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: 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 , 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 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 Time Lags –Compilation of data –“Multiplier Effect” Inaccurate Forecasts Inaccurate Forecasts –Economic models: PPF and Supply and Demand Graphs –CBO (Congressional Budget Office)

Largest Concern: The National Debt John Maynard Keynes = Deficit Spending John Maynard Keynes = Deficit Spending –Emergencies only Fear of Government Bankruptcy Fear of Government Bankruptcy –Increase taxes, refinance debt  Sell new bonds to pay off old bonds Burden on Future Generations Burden on Future Generations –Individuals and Institutions pay interest  Holders of government bonds benefit Foreign-owned Debt 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-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