Understanding Fiscal and Monetary Policy for Economic Growth

1. Fiscal & Monetary Policy

2. Fiscal Policy • Annual Economic Issues • GDP change about 2-3 % • Unemployment about 4-5% • Fiscal Policy – Federal Govt use of taxation & spending • Increased government spending or decreased net taxes stimulates the economy • Consumers spend more money • Firms sell more goods and hire more workers • Employment and output increase • Decreased government spending or increased net taxes contracts the economy

3. Critics • Fiscal policy is ineffective: can’t change output, employment or total spending • To increase spending government must get $ • Taxes • Loanable funds to borrow • Using loanable funds increases interest rates • Government spending crowds out spending by households and firms • Taxes on households means less money to spend • Taxes on firms means costs up and production falls

4. Expansionary Fiscal Policy • To stimulate a sluggish economy • Increase government spending • Reduce taxation • Government spending or reduced taxes, increases spending and demand for goods • Production increases with increased demand • Tax cuts for business stimulate production by reducing production costs • If budget is balanced, increased government spending or reduced taxes creates a budget deficit

5. Contractionary Fiscal Policy • To slow down an over stimulated economy • Decrease government spending • Increase taxation • If budget balanced, decreased government spending or increased taxes creates budget surplus • Surplus slows economic growth by reducing spending, which slows production and demand for workers = potential inflation • If cost-push inflation and the economy is sluggish, contractionary fiscal policies increase sluggishness with little affect on prices

6. Monetary Policy • Federal Reserve Act of 1913 • “The Fed” provides the U.S. banking system with the stabilizing influence of a central bank • 1977 amendment: to “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates” • The Fed conducts monetary policy • Three Functions to Stabilize: • Open Market • Reserve Ratio • Discount Rate

7. Open Market Operations • Primary tool to manage money supply • Currency/Deposits—dollar bills and coins • Buy and sell government securities (Treasury bonds and bills) to commercial banks and general public • Example: When you buy a bond from the Fed for $10,000, you write a check and take money out of the economy

8. Reserve Ratio • Used infrequently • Banks hold $ for emergencies • Current reserve requirement: about 10% • Banks hold at least $10 for every $100 • Decrease required reserves increases money • Increase required reserves decreases money • some banks sell securities or call in loans

9. Discount Rate • Discount Rate = interest rate the Fed loans money to banks • Discount rate changes money supply • Increases in discount rate decrease money supply by decreasing borrowing (interest rates rise) • Decreases in discount rate increase money supply by increasing borrowing (interest rates fall) • Changes in discount rates foreshadow the Fed’s policy intentions

10. Expansionary Monetary Policy • Increase money supply • Buy securities (open market operations) • Reduce reserve ratios (not likely) • Lower the discount rate • Lower Discount/Interest Rates • Plant and equipment (by firms) • New housing • Consumer durables (especially autos) • Increased spending stimulates production, which reduces unemployment and increases GDP, which increases income, stimulation 

11. Contractionary Monetary Policy • Decrease money supply • Sell securities (open market operations) • Increase reserve ratio (not likely) • Raise discount rate • Increase Discount/Interest rates • Contractionary monetary policy effective with rapidly increasing GDP and inflation • Decreases investment and slows economic expansion