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)

 Unemployment & slow growth? expansionary policies to increase output  Inflation? contractionary policies to slow output

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 = “Demand Side Economics”  Gov’t. should use its power to tax and to spend to affect AGGREGATE DEMAND Problem: Inflation  gov’t. should raise taxes to decrease the amount of money individuals and businesses have available to spend (recall the 2 nd of the 3 criteria of “demand”…that you have the $ available)

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

Keynesian Economics (“demand-side economics”)  We have talked about inflation only…what about Problem: Unemployment  During recessions, gov’t. 1. spends to create jobs + income - income gets spent which stimulates the economy. 2. Decreases taxes to make more $ available to biz and individuals

Fiscal Policy When the Economy is Healthy & Expanding  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 (with moderate inflation)

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

Quick Summary so far:  Keynesian economics = “Demand side economics”  Gov’t. uses authority to tax & spend to influence aggregate demand: 1. When demand is weak, GDP growth is slow, … reduce taxes and/or increase spending 2. When demand too strong GDP grows too fast, … raise taxes and/or cut spending

A VERY important thing to add…  A “balanced budget” means that you only spend what you have…what if increasing fed’l. spending will cost more than what is collected in taxes?  That is called “deficit spending”… an important pillar of Keynesian economics  He argued that gov’t. MUST borrow the $ if necessary!

A political football ?  As we have seen so clearly during the Obama presidency, 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 course of action did the Obama administration push? How did Republicans respond?

Economics & Politics As a VERY general statement, Democrats accept Keynesian economics…that government intervention is needed to cure an ailing economy… Lawrence O’Donnell: host of The Last Word (MSNBC)

Economics & Politics And generally speaking, Tea Party supporters disagree w/Keynesian economics…that an economy free of gov’t. intervention is the answer… Rep. Steve King (R-Iowa) at the 2010 Virginia Tea Party Convention

Supply - Side Economics  Stresses influence taxes have on the economy  The concept: lower tax rates will lead to higher output (supply will increase)…how?  Will lead to higher employment Popularized by Pres. Ronald Reagan in 1980s AKA: “trickle-down” economics OR “Reaganomics”

A different strategy: Ch. 16 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

What does the Fed do ? The Federal Reserve has 3 primary goals  Maintain long term economic growth  Maintain stable price levels  Maintain full employment

Main Functions of the Fed 1. Set the Capital Reserves requirement  the % of deposits banks must maintain in cash 2. Set the “discount rate”  the interest rate banks pay to the Fed to borrow money (int. rate on consumer loans are tiered above this!)

Fed Functions (con’t.) 3.Open Market Operations *  Controlling the money supply… 1. Expansionary policy: Fed buys U.S. bonds to increase money supply which stimulates the economy 2. Contractionary policy: Fed sells U.S. bonds to decrease money supply which slows the economy * Most used, most important “tool”

The Fed buys securities when it wants to increase the supply of money and credit, and sells securities when it wants to reduce the flow

Applying Monetary Policy Slow growth? (and unemployment is a problem), the Fed should adopt: (choose one) (A) expansionary policy (B) contractionary policy

Applying Monetary Policy (con’t.) To expand (stimulate growth) the economy the Fed could/should: 1. Reserve Reqs: LOWER them 2. Discount Rate: LOWER it 3. Open Mkt Ops: BUY BONDS

Applying Monetary Policy When inflation is a problem, the Fed should adopt: (choose one) (A) expansionary policy (B) contractionary policy

Applying Monetary Policy (con’t.) To slow growth of the economy the Fed could/should: 1. Reserve Reqs: RAISE them 2. Discount Rate: RAISE it 3. Open Mkt Ops: SELL BONDS

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 discount rate: what banks pay to borrow from the Fed)  The Prime Rate (what consumer loans are based on) is tiered above the Fed Funds rate  All interest rates (mortgages, car loans, credit cards, etc.) will move up or down as the Fed raises or lowers the Discount rate)

3 Names to know:  Monetary Policy = Milton Friedman  Fiscal Policy = John Maynard Keynes  New Chairman of he Federal Reserve: Janet Yellen

Quick Review:  Monetary Policy is about the Fed controlling money supply…how much money is circulating through the system  Fed does this thru Open Market Operations (buying or selling gov’t. bonds)  Also does this by adjusting interest rates  Low int. rates (“easy money”) encourages borrowing…high rates (“tight money”) does not  Int. rates ultimately affect aggregate demand

Classical Economics What makes both fiscal policy and monetary policy significant is that they each mark a huge departure from “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, aggregate demand plummeted…and prices followed  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 argument that gov’t. MUST act to “steer the economy” v. “free market” argument that favor less gov’t. action and allowing S+ D to work naturally

Unemployment?  Gov’t: 1. Lower int. rate 2. Reduce capital reserve req 3. Buy gov’t. bonds 4. Increase spending 5. Reduce taxes

Inflation?  Gov’t: 1. Raise int. rate 2. Increase capital reserve req 3. Sell gov’t. bonds 4. Decrease spending 5. Raise taxes

 Chap. 15/16 Quiz Monday, April 27th  Do the reading (including the “supplemental readings”)  Do the Study guide  You can use the note card (no extra credit for creating one)