ECONOMICS: FISCAL AND MONETARY POLICY

Important Vocabulary  Fiscal Policy  Monetary Policy  Deficit Spending  Stagflation  Multiplier Effect  Easy-Money Policy  Tight-Money Policy  Crowding-Out Effect

A Case Study: 2008  Where were you in 2008? What was going on?  Housing Market crisis  Homes devalued---sometimes less than owed in mortgage  Rise in oil prices--- gasoline goes from $3 to $4  Filling up cost some $100 or more  Food prices rose as well---People began packing lunch  Cafeteria prices rose by 32 cents on average  Job losses---cut back on spending

How could this happen?  Each recession or economic downturn is slightly different than the last one  We have two stop-gap institutions that try to stop these situations from happening, or at least minimize them  Federal Government----Uses Fiscal Policy Policy to tax and spend  Federal Reserve----Uses Monetary Policy A central bank; controls the money supply

Origins of Fiscal and Monetary Policy  Prior to 1930s, very little involvement  Great Depression changed that  Classical Economics  Give the market time; it would sort itself out  Low taxes, low spending, balanced budget  FDR originally believed in this until…  John Maynard Keynes  Economic problems caused by lack of spending  Thus, either reduce taxes or increase spending  At odds with Classical; “in the long run, we’re all dead”

Keynesian Economics  Deficit Spending:  Government spends more money than it collects in revenue  To finance spending, government borrows money by selling bonds  Eventually convinced FDR---he used it to moderate success  Eventually WWII helped get us out of Depression, but at a cost---budget deficit skyrocketed  Result: “We are all Keynesians now.”

Milton Friedman  Critic of Keynes  Argued Depression was result of lack of demand  Called for monetary policy, not fiscal  The Federal Reserve should have expanded the money supply  Monetarism—control money supply to manage economy  Money supply grows too fast---inflation  Money supply grows too slow---deflation; spending low

Tools of Fiscal Policy  Economic goals—low unemployment, stable prices, economic growth  How to achieve them?  How much to collect in taxes? How much to spend?  Examples of fiscal policy  Stimulus checks (Expansionary Policy)  Contractionary Policy---economy is overheated; increase taxes, cut spending to slow it down

Using Tax Cuts to Stimulate Growth  Demand side economics  Cutting individual income taxes  Supply side economics  Cutting taxes on businesses and high income tax payers  Sometimes called “Trickle Down Economics”  Reagan believed in this; cut corporate tax rate from 48 to 34%, and top income tax rate from 70 to 28%  Economy did grow, but at a cost---budget deficits grew

Why increase government spending?  Multiplier Effect  Theory that each dollar spent creates more spending, like a ripple effect throughout the economy  Example: Hire a teenager for $1000 a week Saves $300, spends $700 on a new bike Bike shop owner saves $200, spends $500 on car repairs Mechanic saves $100, spends $400 to hire a painter $ $700 + $500 + $400 = $2,600 in economic activity generated by a $1000 cost

Tools of Monetary Policy  Federal Reserve---Central Bank  Structure  Board of Governors---Washington, D.C.  Country divided into 12 districts  Regional banks oversee activities of national and state chartered banks in area  Elected to Board, one term of 14 years  All board members, plus presidents of 5 regional reserve banks sit on FOMC—dictate policy

Tools of Monetary Policy  Easy-Money Policy  Speed the growth of money supply  As money goes into economy, interest rates drop and borrowing becomes cheaper and easier  Loans are easier to get, so households and firms spend more; demand increases  Tight-Money Policy  Slow the growth of money supply  Opposite is true, but does lead to drop in inflation rate

Tools of Monetary Policy  Most used: Open Market Operations  Buying and selling of gov. securities in the bond market  Think: Buy-Big; Sell-Small---Fed bond traders buy gov. securities, every dollar Fed pays for bonds increases the money supply; opposite is true  Least used: The Reserve Requirement  Adjust the ratio of money banks must hold on reserve  Third tool: Discount Rate  Banks borrow money from Fed; interest rate on those loans is the discount rate  Board of Gov. controls this

The Federal Funds Rate  The Fed makes the news mostly over this  FFR is the rate banks charge one another for very short loans  NOT a monetary policy tool  FOMC sets a target for the FFR based on view of economy; then uses open market operations to move FFR toward the target  Interest rates on everything are affected by this  Savings accounts, bonds, mortgages, credit cards

What limits effectiveness?  Fiscal and monetary policies are weakened by certain factors  Time lags  Misleading economic forecasts E.g, 2001 budget surplus, CBO predicted continued surplus through 2011, and by 2009 would be large enough to pay off national debt…..oops  Concerns over national debt may limit gov. spending Foreign owned debt Burden on future generations  Crowding out effect: Gov. borrowing increases interest rates so high that people do not borrow to invest in business