Topic 6 Using Monetary and Fiscal Policy to Fight Unemployment and Inflation

Inflation Cause: too much economic activity Fix: slow down spending 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 Unemployment, as of April 1st, is 8.5% Inflation is down, currently at about 0% Inflation, ignoring food and energy costs is down slightly to 1.8% (it was 2.3% in 2007 and 2008) See graphs on next slides (from BLS and inflationdata.com)

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 0.000 03/26/2009 0.06 6-Month 0.000 06/25/2009 0.22 12-Month 0.000 12/17/2009 0.36 2-Year 0.875 12/31/2010 0.88 3-Year 1.125 12/15/2011 1.06 5-Year 1.500 12/31/2013 1.51 10-Year 3.750 11/15/2018 2.13 30-Year 4.500 05/15/2038 2.61

US Treasury Bill Rate

Reserve Requirements Requirement Type of liability Percentage of liabilities Effective date Net transaction accounts $0 to $10.3M 0% 1-01-09 $10.3M to $44.4M 3% 1-01-09 > $44.4M 10% 1-01-09

Federal Funds Rate

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

Projected Deficit (Wash Post)

Keynesian Economics Unemployment is caused by insufficient aggregate demand for goods and services Expansionary monetary and fiscal policy increase aggregate demand, thereby decreasing unemployment

Alternatives to Keynes Unemployment is caused by bad policies or an inflexible economy Economies must be able to adjust to government or market induced shocks to employment Along these lines are current government policies to encourage bank lending and “fix” the banking system Structure of tax system and quality of government spending are important Make it easier for producers and consumers to respond to shocks—transparency, incentives, etc. In recession, govt spending might help speed up turn around, but will not be long term solution