Applying Monetary & Fiscal Policy

Overview Both policies are used to stabilize the economy by: 1. Reducing a recession 2. Controlling inflation. Tools that they use to stabilize: Fiscal Policy: 1. gov’t spending 2. taxation Monetary Policy: 1. open market operations (bonds) 2. the discount rate 3. reserve requirements Both policies have limitations: Policy lags: the time it takes to ID the problem and for policy actions to take effect Political constraints: may limit the gov’t’s ability to do what is best for the Econ. Timing: to be effective, gov’t actions must be timed well with the business cycle.

II. Expansionary Monetary & Fiscal Policy Situation: The economy is in a recession. Goal: to stimulate the economy by reducing unemployment and increasing investment. (Put $ into ppl’s hands) Fiscal: increasing gov’t spending or tax cuts Monetary: you cash in your gov’t bonds or reduce the discount rate or the reserve requirement

c. Example: Unemployment rate is 9 c. Example: Unemployment rate is 9.5% and CPI is 2%--the economy is in a recession and inflation is a minimal concern. d. How to fix it? Monetary: The Fed buys bonds (you cash them in) and lowers the discount rate to increase the money supply Fiscal: Increased gov’t spending and have tax cuts to increase aggregate demand Effect: Real GDP increases and prices rise. Unemployment falls. e. Conflict: fiscal is likely to raise the interest rates while monetary should decrease interest rates. The actual change in interest rates will depend on the relative strength of the two policies.

III. Contractionary Monetary & Fiscal Policy Situation: The economy’s prices are rising too quickly– they are facing inflation. Goal: decreasing inflation and increasing interest rates (take $ out of ppl’s hands) Fiscal: decrease gov’t spending or increase taxes Monetary: The Fed sells bonds (you buy them) on the open market or raise the discount rate or the reserve requirement

c. Example: unemployment rate is 4 c. Example: unemployment rate is 4.5% and CPI is running in excess of 10%--the economy is operating at or above a sustainable level of output and inflation is very high. d. How to fix it? Monetary: Fed sells bonds (you buy them) and raises the discount rate to cut money supply Fiscal: decrease gov’t spending and increase taxes to decrease aggregate demand. Effect: Real GDP and prices fall. Unemployment increases. e. Conflict: fiscal is likely to lower interest rates b/c decreased gov’t spending will decrease demand for loans. Monetary should raise interest rates. The change will depend on the relative strength of the two policies.