ECONOMICS FISCAL AND MONETARY POLICY Important Vocabulary Fiscal

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 Policy � Federal A Government----Uses Fiscal Policy to tax and spend Reserve----Uses Monetary Policy central bank; controls the money supply

Origins of Fiscal and Monetary Policy Prior to 1930 s, 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 � 2008 ---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 $1000 + $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