FISCAL AND MONETARY POLICY MIX

Principles of MacroeconomicsLecture 8c

What are the Origins of Modern Fiscal and Monetary Policy?

Objective: keep the economy running smoothly Fiscal policy: the government’s power to tax

and spend Monetary policy: the Federal Reserve’s power

to regulate the money supply and interest rates Impact of John Maynard Keynes

Prior to Great Depression – Laissez Faire Deficit spending – fight Depression/Recession Milton Friedman: control money supply key to

stabilizing economy Monetarism: money policy to contract or expand

money supply

Tools of Fiscal Policy to Stabilize the Economy

Expansionary fiscal policy tools Increased government spending Tax cuts

Contractionary fiscal policy tools Decreased government spending Tax increases

* Role of automatic stabilizers

Tools for Monetary Policy to Stabilize the Economy

The Federal Reserve uses monetary policy by managing the money supply and interest rates Easy-money policy

Expansionary policy that speeds the growth of the money supply to prevent recession (decline in the GDP)

Tight-money policy Contractionary policy that slows the growth of the

money supply to prevent inflation

*Most common tool of Federal Reserve is open-market operations (buying and selling of government securities).

The “Feds” Open-Market Operations: the most used tool

Buying and selling of government “securities” in the bond market Treasury bonds, notes, bills, or other

government bonds (guaranteed by US gov. and tax exempt)

Recommendation by FOMC (Federal Open Market Committee), component of the Fed Foreign exchange rates, interest rates, and

growth of the money supply

Other Tools of the Fed

Least used tool: The Reserve Requirement Reserve requirement for banks –”required reserve ratio”

Minimum percent of deposit keep in reserve at all times Lowering the ratio allows for more loans and thus more money in

circulation vs. raising, which tightens money supply Average reserve requirement, 3-10%

The Discount Rate: Banks borrowing money from Fed to maintain their reserve

requirement Interest rate is set by Fed at a discount for Banks

Low interest rate means more money to loan = more money in circulation

High interest rate = less money to loan, less money in circulation Between 1990-2008, from 7% to 0.75% Borrowing from the Fed can signal problems with the bank, last

resort

Federal Funds Rate

Rate that banks change each other for very short – as in overnight – loans Loans common between banks to maintain

the reserve requirement NOT a monetary policy tool because

between private banks, not government FOMC sets “federal fund rate” as ceiling for

interest rates Affects rate for credit cards, saving accounts,

mortgages

Factors that Limit Effectiveness of Fiscal and Monetary Policy

Time Lags Compilation of data “Multiplier Effect”

Inaccurate Forecasts Economic models: PPF and Supply and

Demand Graphs CBO (Congressional Budget Office)

Factors that Limit Effectiveness of Fiscal and Monetary Policy

Factors that Limit Effectiveness of Fiscal and Monetary Policy

Largest Concern: The National Debt John Maynard Keynes = Deficit Spending

Emergencies only Fear of Government Bankruptcy

Increase taxes, refinance debt Sell new bonds to pay off old bonds

Burden on Future Generations Individuals and Institutions pay interest

Holders of government bonds benefit Foreign-owned Debt

Japan and China Interest paid to foreign countries but they buy US goods with it Offset by Americans buying foreign bonds

Crowding-out Effect Crowding private borrowers out of the lending market

Interest rate so high, no one can afford a loan Government borrowing raises interest rates but spend the money on creating

jobs