Ch. 15/16  Fed. Gov’t uses 2 strategies to fight inflation and/or unemployment to promote a healthy, growing economy:  Fiscal policies (Ch. 15)  Monetary policies (Ch. 16)

 Policies that try to increase output (stimulate the economy) are called expansionary policies

 Policies intended to decrease output are called contractionary policies

Ch. 15 Fiscal Policy  Fiscal Policy defined: The use of gov’t spending and taxing to influence the economy

 To understand FP economics, one must know the 20 th century’s most brilliant economic theorist… John Maynard Keynes  Cambridge Univ. professor…world’s leading econ thinker in the 1930’s

Keynesian Economics:  Gov’t. should use its power to tax and to spend to affect the economy.  In periods of inflation, gov’t. should raise taxes to decrease the amount of money individuals and businesses have available to spend.

 Similarly, gov’t. should lower its spending to decrease available income.  Less income = less spending by business and individuals lower demand

Fiscal Policy  We have talked about inflation only…what about unemployment?  During recessions, gov’t. 1. spends to creating jobs … jobs = income and income gets spent which stimulates the economy. 2. Decreases taxes to make more $ available to businesses and individuals

Fiscal Policy  During booming economic cycles, gov’t. cuts back on its spending and raises taxes  This puts the brakes on consumer spending and helps to keep growing GDP under control

Limits of Fiscal Policy  Increasing gov’t. spending is not so simple: 1. 60% of fed’l. budget goes to entitlement programs which are fixed by law (programs like Social Security, Medicare, veteran’s benefits)…gov’t cannot alter these payments. So…any change in fed’l spending must come from only ~ 40% of what is in the fed’l budget

A political football?  As we have seen so clearly in the past 2 years, gov’t. spending is viewed differently by Democrats and Republicans (generally)

A 2 nd Problem:  Predicting future GDP isn’t easy…the wrong decision now could spell disaster down the road

Keynesian econ applied: During our recent recession, what did the Obama administration push? How have the Republicans responded?

A different strategy: Monetary policy

Monetary Policy Gov’t uses the Federal Reserve to affect the economy…

The Federal Reserve  “the Fed”  Federal Reserve System created USA divided into 12 districts…each has a federal reserve bank - all US banks belong to the system

Main Functions of the Fed  lend to member banks  Set interest rates on what banks charge one another for loans - consumer int. rates are “pegged” to that rate  Adjust money supply

Monetary Policy  If prices are being pulled higher by increased demand, one solution would be to lessen demand.  Any ideas how to discourage demand? How could the Fed make people less willing to spend??

Monetary Policy  Make it harder to borrow money to buy things on credit by making the cost of money more expensive. In other words…  RAISE INTEREST RATES!

Higher interest rates would: make paying back loans more costly Discourage people from borrowing (and buying on credit IS borrowing) 1 2

Less borrowing = lower demand (recall 3 conditions of demand) And as we already know from studying supply and demand, less demand will 43

Bring Prices Down

 Is this a logical tactic to tame inflation?

Say “Yes”, little Power Rangers

A few last thoughts on Monetary Policy  As we already discussed, the Federal Reserve is the key player  It sets a key interest rate (called the Federal Funds Rate: the rate banks charge each other for overnight loans)  The Prime Rate (what consumers pay) is tiered above the Fed Funds rate

2 Names to know:  Monetary Policy = Milton Friedman (recently deceased)  Fiscal Policy = John Maynard Keynes

Quick Review:  Monetary Policy is about the Fed controlling money supply…how much money is circulating through the system  Fed does this partly by adjusting interest rates as needed  Low int. rates (“easy money”) encourages borrowing…high rates (“tight money”) does not  Int. rates ultimately affect overall demand

Classical Economics  What makes both fiscal policy and monetary policy significant is that they each mark a huge departure from what is called “classical economics”

 The heart of classical economic theory is that: 1. free markets will regulate themselves thru the natural interaction between supply and demand… markets will naturally seek equilibrium 2. gov’t. intervention is not needed

 Adam Smith…David Ricardo…Thomas Malthus were the major architects of this theory that dominated economic theory and gov’t policies for more than a century  The Great Depression challenged this line of thinking because…

Connecting the dots…  During the Great Depression, prices plummeted  Classic econ says that demand should rise with low prices which should cause producers to produce more, creating a need for higher employment…but it didn’t

 Keynes argued that neither business nor consumers had the ability or desire to spend  Government MUST be the catalyst…it was the only entity that had the ability to spend to stimulate the economy  So…gov’t. can intervene with either fiscal policy, monetary policy, or both….

Tying it all together  Keynes’ belief that gov’t HAD to act has guided our gov’ts actions for 75 years:  When inflation is the problem: contractionary policies are needed  When unemployment is the problem: expansionary policies are needed