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1. Unit 7 Macroeconomics: Taxes, Fiscal, and Monetary Policies Chapters 16.4 Economics Mr. Biggs
2. Monetary Policy and Macroeconomic Stabilization Monetarism - The belief that money supply is the most important factor in macroeconomic performance. How Monetary Policy Works Monetary policy alters the supply of money which then affects: Interest rates Level of investment and spending
3. The Money Supply and Interest Rates When the money supply is low, interest rates are high. When the money supply is high, interest rates are low. Interest Rates and Spending Easy money policy - Monetary policy that increases the money supply by decreasing the discount interest rate. It is used to encourage business investment. Tight money policy - Monetary policy that reduces the money supply by increasing the discount interest rate. It is used to discourage business investment, slow down the economy, and minimize inflation.
4. The Problem of Timing Monetary policy must be timed carefully because if they are enacted at the wrong time, they could actually intensify the business cycle, rather than smooth it out. Good Timing Good timing will lower the peaks and make the troughs less deep. This will minimize inflation in the peaks and the effects of recessions in the troughs. Bad Timing Poor data or policy lags can cause economists to not time monetary policy properly. This can actually make the business cycle worse.
5. Policy Lags There are a couple of problems in the timing of macroeconomic policy: Inside lags Outside lags Inside Lags Inside lags - Delay in implementing monetary policy. Inside lags occur for two reasons: It takes time to identify and recognize a problem Once a problem has been recognized, it can take time to politically enact appropriate policy Fiscal policy requires actions by Congress and the President and can take quite a while to enact. Monetary policy’s inside lag is streamlined because the FOMC meets 8 times a year and can make open market policy or discount rate changes almost immediately.
6. Outside lags Once a new policy is determined, it takes time to become effective. Outside lag - The time it takes for monetary policy to have an effect. For fiscal policy, the outside lag lasts as long as is required for the new government spending or tax policies to take effect. This can be a short amount of time. For example, tax rebates. Outside lags can be much longer for monetary policy since they primarily affect business investment plans. For example, firms may require months or even years to make large physical capital investment plans. Because of the political difficulties of implementing fiscal policy, we rely to a greater extent on the Fed to use monetary policy to soften the business cycle.
7. Predicting the Business Cycle The Federal Reserve must react to current trends as well as anticipate changes in the economy. Monetary Policy and Inflation Given the timing problems of monetary policy, in some cases it may be wiser to allow the business cycle to correct itself rather than run the risk of an ill-timed policy change (laissez-faire). On the other hand, if we expect a recession to last several years, then a more active policy is recommended. How Quickly Does the Economy Self-Correct Economists disagree, but they estimate that the US economy can self-correct in 2 to 6 years.
8. Approaches to Monetary Policy Laissez-faire economists who believe that the economy will self-adjust quickly will recommend against enacting new policies. Economists who believe that economies emerge slowly from recessions will usually recommend enacting fiscal and monetary policies to move the process along. The chart below shows how the federal government and the Federal Reserve can influence the nation’s economy.
9. The End