Economics: Fiscal and Monetary policy

1. Economics: Fiscal and Monetary policy

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

3. 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

4. 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

5. 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”

6. 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.”

7. 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

8. 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 • 2008---Stimulus checks (Expansionary Policy) • Contractionary Policy---economy is overheated; increase taxes, cut spending to slow it down

9. 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

10. 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 • $1000 + $700 + $500 + $400 = $2,600 in economic activity generated by a $1000 cost

11. 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

12. 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

13. 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

14. 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

15. 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