Fiscal and Monetary Policy Effects

2. 31 Fiscal and Monetary Policy Effects CHAPTER

3. 1 2 C H A P T E R C H E C K L I S T • When you have completed your study of this chapter, you will be able to • Describe the federal budget process and explain the effects of fiscal policy. Describe the Federal Reserve’s monetary policy process and explain the effects of monetary policy.

4. THE BUDGET AND FISCAL POLICY • The government’s surplus or deficit is equal to tax receipts minus expenditures. • The government has a budget surplus if tax receipts exceed expenditures. • The government has a budget deficit if expenditures exceeds tax receipts. • The government has a balanced budget if tax receipts equal expenditures. • Budget surplus (+)/deficit (–) = Tax receipts – Expenditures

5. THE BUDGET AND FISCAL POLICY Fiscal Policy: Changes in government spending Changes in Taxes To influence the real GDP (AD = C + I+ G+ XN) in the economy. • Types of Fiscal Policy • Fiscal policy can be 4 TYPES: • Discretionary fiscal policy • A fiscal policy action that is initiated by an act of Congress. • Automatic fiscal policy • A fiscal policy action that is triggered by the state of the economy such as an increase in payments to the unemployed and a decrease in tax receipts triggered by recession. • • Demand Side effect • • Supply Side effect

6. Automatic fiscal policy • A fiscal policy action that is triggered by the state of the economy such as an increase in payments to the unemployed and a decrease in tax receipts triggered by recession. Does not require congressional approval. • Welfare • Unemployment insurance • Transfer payment (social security and disability) • Fed G spending increases and decreases based on business cycle • Needs-tested spending is spending on programs that entitle suitably qualified people and businesses to receive benefits— that vary with need and with the state of the economy.

7. Fiscal Policy: • Discretionary fiscal policy • A fiscal policy action that is initiated by an act of Congress. (G T) • Changes in government spending • Changes in Taxes • Why? • To influence the real GDP in the economy. • Recession • Reduce taxes  C = AD shift to the right • Increase Government spending  G = AD shift to the right • Inflation • Increase taxes  C = AD shift to the LEFT • Decrease Government spending  G  = AD shift to the LEFT F

8. Expansionary Fiscal Policy(402) AS G T 250 C 110 A 105 AD2 100 AD1 Price 11 0 6 9 12 Real GDP

9. Contractionary Fiscal Policy(403) AS A T G 110 C 100 AD1 90 AD2 Price 11 0 6 9 12 Real GDP

10. THE BUDGET AND FISCAL POLICY • Discretionary Fiscal Policy: Supply-Side Effects (TRICKLE DOWN ECONOMICS) • Tax policies that  output • Tax policies that  resource prices • Tax policies that favor businesses • Tax policies that favor investments rather then consumption • Training workers (tax cuts on training/education) • technological advances (tax cuts of R&D) • reduce government regulations on business (environment and labor) • Tax cuts (incentive to work, save, and invest) • capital gains cut (reward risk)

11. Combined demand and supply side Fiscal Policy AD2 AS1 A AD1 AS2 250 C 200 Economic Expansion Increase in Long run Aggregate supply and Demand (C) 150 Recession (A) 100 Full employment (B) Price 8 0 4 6 10 12 14 Real GDP

12. THE BUDGET AND FISCAL POLICY • Limitations of Discretionary Fiscal Policy • The use of discretionary fiscal policy is seriously hampered by three factors: • Law-making time lag • Estimating potential GDP • Economic forecasting

13. THE FED AND MONETARY POLICY • The Monetary Policy Process • The Fed makes monetary policy in a process that has three main elements: • Monitoring economic conditions • Making policy decisions • Reporting to Congress • Twice a year, in February and July, the Fed prepares a Monetary Policy Report to Congress, and the Fed chairman testifies before the House of Representatives Committee on Financial Services.

14. THE FED AND MONETARY POLICY • Monitoring Economic Conditions • Beige Book • A report that summarizes current economic conditions in each Federal Reserve district and each sector of the economy. • The Beige Book is a good source of current information about the state of the economy.

15. THE FED AND MONETARY POLICY • Meetings of the Federal Open Market Committee (FOMC) • The FOMC, which meets eight times a year, makes the monetary policy decisions. • After each meeting, the FOMC announces its decisions and describes its view of the likelihood that its goals of price stability and sustainable economic growth will be achieved.

16. Monetary Policy: • Changes in money supply and interest rates • Why? • To influence the real GDP in the economy. • Recession • Increase M  AD shift to the right • Decrease interest rated  = AD shift to the right • Inflation • Decrease M  AD shift to the left • Increase interest rated  = AD shift to the left • Fed Buy bonds = money supply  • Fed Sell bonds = money supply  F

17. THE FED AND MONETARY POLICY • Limitations of Monetary Stabilization Policy • Monetary policy has an advantage over fiscal policy because it cuts out the law-making time lags. • But monetary policy shares the other two limitations of fiscal policy: • Estimating potential GDP is hard. • Economic forecasting is error-prone. Advantages of monetary policy are: • Quick (no time lag, every six weeks) • less politics (professional economics and bankers) • Tough decisions (control inflation)

18. THE FED AND MONETARY POLICY • The Fed Lowers the Interest Rate • If the Fed fears recession, it acts to increase aggregate demand. • The FOMC announces that it will lower the short-term interest rates. • To achieve this goal, the FOMC instructs the New York Fed to buy securities in the open market as a result Increases money supply. • This action increases bank reserves. • Flush with reserves, banks now seek to lend reserves to other banks. • The federal funds rate falls. • With more reserves, the banks increase their lending and the quantity of money increases. • Figure 31.6(b) on the next slide illustrates these events.

19. THE FED AND MONETARY POLICY 1. The current interest rate is 5 percent a year. 2. The FOMC’s interest rate target is 4 percent a year. 3. To lower the interest rate to the target, the Fed must buy securities in the open market and increase the quantity of money to $1.1 trillion.

20. THE FED AND MONETARY POLICY • The Fed INCREASES the Interest Rate • If the Fed fears INFLATION, it acts to increase aggregate demand. • The FOMC announces that it will INCREASES the short-term interest rates. • To achieve this goal, the FOMC instructs the New York Fed to sell securities in the open market as a result decrease money supply. • This action decreases bank reserves. • Shortage with reserves, banks now reduces lending to other banks. • The federal funds rates increases. • With less reserves, the banks decrease their lending and the quantity of money decreases.

21. THE FED AND MONETARY POLICY 1. The current interest rate is 5 percent a year. 2. The FOMC target interest rate is 6 percent a year. 3.To raise the interest rate to the target, the Fed must sell securities in the open market anddecrease the quantity of money to $0.9 trillion.

22. Fiscal Policy and Monetary Policy in YOUR Life Consider the U.S. economy right now. Is the U.S. economy at full employment or is there a recessionary gap or an inflationary gap? What type of fiscal policy or monetary policy would you recommend? What do recent changes in policy say about the government’s and the Fed’s view of the state of the economy? How do you think recent changes in fiscal policy and monetary policy will affect you?