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Topic 5

Topic 5. Using Monetary and Fiscal Policy to Fight Unemployment and Inflation. Inflation. Cause: too much economic activity There are too few factors or production to support the demand for production, prices rise Fix: slow down spending

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Topic 5

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  1. Topic 5 Using Monetary and Fiscal Policy to Fight Unemployment and Inflation

  2. Inflation • Cause: too much economic activity • There are too few factors or production to support the demand for production, prices rise • Fix: slow down spending • Contractionary fiscal and monetary policy (decrease G, increase Tx, increase RRR, sell bonds, increase federal funds rate)

  3. Unemployment • Cause: not enough economic activity • The economy’s factors of production could support more output • Fix: increase economic output • Expansionary monetary and fiscal policy (increase G, decrease Tx, lower RRR, buy bonds, lower federal funds rate)

  4. Some schools of thought • Supply side economics – tax breaks and incentives for producers are the most effective way to stimulate the economy • Demand side economics – tax breaks and incentives for consumers, plus government spending, is the best way to stimulate the economy

  5. Trade off – The Philips Curve • Graph the Philips Curve – In class • Vertical axis for inflation, horizontal axis for unemployment • How to incorporate Natural Rate of Unemployment? • How to incorporate Inflationary Expectations? • As the labor market becomes tighter, what happens to prices?

  6. Changes in Philips Curve • Changes in the Natural Rate of Unemployment? • Monster.com? Minimum wage? Culture of changing jobs? • Changes in inflationary expectations? • People expect higher or lower inflation • Changes in worker bargaining power? • Ability to move production over seas

  7. Current Unemployment & Inflation http://www.google.com/publicdata/home

  8. Current Unemployment & Inflation • Unemployment is around 10% • Inflation is low, about 2.0% per year Links: http://www.wolframalpha.com/input/?i=usa+unemployment+rate http://www.wolframalpha.com/input/?i=usa+inflation+rate

  9. So, where are we on the Philips Curve?What policies help?

  10. Monetary Policy • Open Market Operations (to alter the interest rate) • Required Reserve Ratio (RRR) • Federal Funds Rate

  11. 12/08 Rates for US Treasury Bonds COUPON MATURITY YEILD 3-Month 0.000 03/26/2009 0.06 6-Month 0.000 06/25/2009 0.22 12-Month 0.000 12/17/2009 0.36 2-Year 0.875 12/31/2010 0.88 3-Year 1.125 12/15/2011 1.06 5-Year 1.500 12/31/2013 1.51 10-Year 3.750 11/15/2018 2.13 30-Year 4.500 05/15/2038 2.61

  12. US Treasury Bill Rate

  13. Reserve Requirements Total Deposits RRR $0 to $10.3M 0% $10.3M to $44.4M 3% > $44.4M 10%

  14. Fiscal Policy • Government spending • Taxes • Without much room to play with monetary policy, the government is relying heavily on fiscal policy What does the government spend money on? http://www.federalbudget.com/

  15. Projected Deficit (Wash Post)

  16. Keynesian Economics • The fiscal policies we focus on in class are key tools in Keynesian Economics. • John Maynard Keynes (1883-1946) advocated using government spending to smooth out the business cycle. • The key policy recommendation of Keynesian theory is to use deficit spending to pull an economy out of a recession.

  17. Downsides of Keynesian Spending • Expensive • The wrong type of spending? • Spending chosen by politicians and bureaucrats • Short term projects, not long term solutions • Real world multiplier may be less than 1 • Encourages irresponsible or inefficient behavior • Politically infeasible • Avoids benefits of a recession (!?!?!?)

  18. Similar issues with monetary policies: • Artificially low interest rates encourage the wrong type of investment • Lower return projects • More risky projects • Less focus on innovation • Artificially low interest rates make it “too easy” to borrow money for consumption • Might pull us out of the recession more quickly, but result in a lower long-run growth rate

  19. Politically infeasible? • Supporters of Keynesian motivated government spending wanted a bigger bailout • Opponents thought the spending was already too high • Quickly passed laws allow for more favors, waste, and other bad policies • The outcome of the policy was/is uncertain • Any way around this? • Dictator • Automatic spending that kicks in: i.e., unemployment insurance

  20. Upsides to a recession? • Survival of the fittest • Struggling businesses go under, resources redirected • People get retraining, better education • Political pressure to fix or change bad policy • Market bubbles burst, prices adjust • Others?

  21. Alternatives to Keynesian Spending • Hands off. Let the economy fix itself. • Implement better policy to help employers adjust to changing markets, and investors make better decisions • Economies must be able to adjust to government or market induced shocks to employment • Better quality regulation, taxes, government spending • transparency • incentives

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