Monetary and Fiscal Policy

Monetary Policy

• Why the need for Regulation of the money supply?• U.S. experienced bad recessions and inflation in the

late 1800’s early 1900’s.• Attempts were made to stabilize money supply, but

unsuccessful• Who controls our money supply now?• The Gov’t established a true long lasting Nation’s

Bank in 1913= Federal Reserve System• All money printed is circulated through the Federal

Reserve Banks – all gov’t and bank spending is done through the Federal Reserve Banks

• How is the Fed set up?• It has 12 regional locations – each

location has a board of directors to oversee their region (

• It consists of 7 Board of Governors members – appointed by Pres and approved by Senate – they oversee operations of the Fed – (one 14yr term)

• a Chairperson is appointed to oversee all members - current Dr. Janet Yellen (4yr terms)

• How does the Fed help stabilize the economy?

• Through increasing the money supply or decreasing the money supply (expansionary or contractionary)

What role does the Fed play?

• The Federal Reserve monitors MONETARY policy

• They can increase or decrease the money supply to either fight inflation or boost economic growth.

• Two policies• Expansionary or Contractionary

Expansionary v. Contractionary

• Expansionary -Increase money supply to boost economic growth (GDP)

• Contractionary – decrease money supply to help curve inflation

Tools used by the Fed

• What THREE tools do the Fed use to control money supply?

• Federal Discount Rates – the rates the Fed uses when lending to member banks (not common)

• Required Reserve Ratio– the amount of money member banks are required to have on hand (not common)

• Open Market Operations – buying and selling of government securities – maintained by the Federal Open Market Committee – This step is often called FOMC (most used tool of the Federal Reserve)

Federal Discount Rates

• If the economy was experiencing high inflation, what option could the Fed use with Federal Discount Rates?

• They would increase the rate they charge banks to borrow money- remember that banks are required to keep reserves on hand – if it cost them too much get money, then they will hold on to the money instead of lending it out to customers or increase rates to their customers, who won’t want to take loans at that point – leaving less money circulating.

• Contractionary!

Federal Discount Rates

• If the economy is experiencing slow growth due to a recession, what option could the Fed use with Discount Rates?

• They would lower the discount rate for member banks – allowing the banks to borrow money from the Fed at a lower cost – this would give them the opportunity to have more money on to hand to lend out in the forms of loans because they can afford to get more money – they can offer better rates to consumers – more loans means more spending – more spending means economic growth

• Expansionary!

What happens to Aggregate Demand?

• Scenario 1 - • What happened to GDP?• What happened to Price

Level?• What can we assume

happened to unemployment?

• Which Phase of the Business Cycle are we most likely in?

What happens to Aggregate Demand?

• Scenario 2 • What happened to GDP?• What happened to Price

Level?• What can we assume

happened to unemployment?

• Which Phase of the Business Cycle are we most likely in?

Required Reserve Ratio

• If the economy was experiencing high inflation, what might be an option for the Fed to do with the reserve requirements?

• They could increase the RRR for member banks – leaving the banks with less money to loan out (since they now have to hold on to more) – if the banks are lending less money, then the money supply has been reduced.

• Contractionary

Required Reserve Ratio

• If the economy is suffering from a recession and banks are not lending, what might the Fed do to the reserve requirements

• They could lower the RRR – freeing up more money for the member banks to loan out to customers – More money allows more loans, more loans increases spending- more spending leads to GROWTH

• Expansionary

What would happen to Aggregate Demand?

• Scenario 1• What happened to GDP?• What happened to Price

Level?• What can we assume

happened to unemployment?

• Which Phase of the Business Cycle are we most likely in?

What happened to AD

• Scenario 2• What happened to GDP?• What happened to Price

Level?• What can we assume

happened to unemployment?

• Which Phase of the Business Cycle are we most likely in?

Open Market Operations

• Buying and Selling of government securities• Securities come in the form of bonds or notes (Treasury

Notes)• These are government promise of repayment for money

loaned to them.• Ex: You give the gov’t $5K cash, and in ten years they will

give you $10K• They Federal Open Market Committee often BUYS and SELLS

these securities to increase or decrease the money supply• Buying = increase money supply• Selling = decrease money supply• See my drawing to understand and next examples

Open Market Operations (Most Common)

• If the economy is experiencing high inflation and needs to cool-off, what might the Federal Open Market Committee do?

• They would sell more securities (that they had previously purchased) – when the Fed receives the payment from the bank (leaving the bank with less money), they hold on to the money instead of putting back in circulation – lessening the money supply and forcing banks to change loan procedures

Open Market Operations

• If the economy is suffering from a recession and banks are not lending, what might the Federal Open Market Committee do?

• They Fed would buy more securities (from reputable source) - they then transfer the payment to the seller’s (customer they bought it from) bank – giving the banks more money on hand – freeing up some of their reserves and allowing them to give more loans – creating more money in circulation

What happens to Aggregate Demand?

• What happened to GDP?

• What happened to Price Level?

• What can we assume happened to unemployment?

• Which Phase of the Business Cycle are we most likely in?

What happens to Aggregate Demand?

• What happened to GDP?

• What happened to Price Level?

• What can we assume happened to unemployment?

• Which Phase of the Business Cycle are we most likely in?

Federal Reserve Review and New Info

• Recall• The Federal Reserve monitors and handles Monetary Policy

(money supply)• Created in 1913• The Chairmen of the Federal Reserve is currently Dr. Janet

Yellen• She was appointed by President (Obama), confirmed by Senate• There are SEVEN Board of Governors members that serve along

side with Yellen, the other five work on Discount and Reserves• They serve one 14yr term• There are 12 Regional Banks of the Federal Reserve

Federal Reserve

Tools of the Fed

• Federal Discount Rates• Required Reserve Ratios• Open Market Operations

Fiscal Policy

• Fiscal Policy = focuses on Government’s role.• Deals with how much money they spend and

collect.• Government Taxing • Government Spending

Fiscal Policy in action

• Expansionary Fiscal Policy – tries to increase output

• Contractionary Fiscal Policy – tries to decrease output

Expansionary Policy

• IF the economy is experiencing a slow-down and needs a boost the government might

• Spend more money on goods and services, which then triggers a chain of events that will lead to higher output and lower unemployment

• They could also cut taxes, leaving consumers with more money to spend, thus causing producers to increase their output and high new employees

Contractionary Policy

• Sometimes the economy needs to cool-down in order to prevent high rates of inflation – in this case the government would:

• Decrease spending on goods and services, causing a decrease in money for consumers (since the gov’t isn’t buying) – if the consumers aren’t spending money – if they aren’t spending the producers will be forced to lower their price – the law of supply tells us if they lower their price they will lower output

• They could also increase taxes – leaving consumers with less money to spend

Who controls government spending

• Once in Congress, the proposal is assigned to the Congressional Budget Office

• They research the proposal and then both houses work out changes to the proposal – the budget should be completed by May 15 and sent to the Appropriations Committee, who must work out all changes by September

• Once the proposal passes, it is sent to the President for approval• If he agrees, the proposed budget will be set in action that

January.• If he vetoes, they must rush to find an agreement before

September 30, if no agreement can be reached, the federal government could be shut down

Budget Deficit and National Debt

• Recall – if the government spends more in one fiscal year than it receives in revenue, they are running a budget deficit.

• The gov’t takes out loans to pay off the deficit• Our National Debt is the combined deficits

added up from year to year

Recall Theories

• What are the two different theories on government involvement in the economy?

• Keynesian Theory – Government is necessary in order to prevent nationwide depressions or severe recession

• Adam Smith – Government should be hands off (invisible hand) and allow the economy to work naturally

Limitations

• Spending sounds like the solution, but remember we have a limited money supply (in order to keep value), meaning that if the gov’t spends too much (deficit spending) it will increase the national debt