Fiscal and Monetary Policy

What is Fiscal Policy? • Fiscal policy refers to

government policy regarding taxing and spending.

• In general, governments use fiscal policy to help stimulate the economy, esp. if it is in a recession. This often involves deficit spending.

• The goals of fiscal policy are economic growth, stable prices, and low unemployment.

What are the tools of fiscal policy?

•Tax cuts

•Tax hikes

• Increase in government spending

•Reduction in government spending

What is deficit spending?

• Deficit spending is the practice of spending more than one has in revenue.

• Governments must borrow in order to do this.

• Some government policymakers believe that the economic stimulus provided by deficit spending is worth the additional debt; not all agree.

What is stagflation?

• Stagflation is a combination of economic stagnation – or slowdown – and high inflation.

• Features of stagflation include slow or zero economic growth, high unemployment, and rising prices.

• This happened in the U.S. in the late 1970s.

Multiplier effect

• The multiplier effect is a ripple effect in which a change in spending by one person or business leads to additional changes in spending by another person or business.

• Deficit spending is sometimes supported by claims that it will have a multiplier effect on the economy, spurring economic growth much larger in size than the additional spending.

The Laffer Curve • Using dynamic scoring, some politicians and

economists have argued that tax cuts can benefit not only the economy but also the government’s fiscal position. They argue that lowering tax rates (say, from 40 to 25%) can actually increase government tax revenues. The increase in economic activity caused by the tax cuts would actually generate more tax revenue than if marginal tax rates were higher.

• Conversely, these supply-siders maintain that raising marginal tax rates beyond a certain point (e.g., 30%) reduces tax revenues. For one thing, people would have less of an incentive to work if a larger percentage of their income were to go the taxman.

Crowding-out effect

• The crowding-out effect refers to the possible effect of increased government borrowing on businesses and consumers.

• By driving interest rates up, high levels of government borrowing may crowd private borrowers out of the lending market.

• This decrease in aggregate demand would cause a contraction in the economy.

Summary of fiscal policy and its anticipated effects

What is Monetary Policy? • Monetary policy is a central bank

policy aimed at regulating the amount of money in circulation. Influencing interest rates is also part of monetary policy.

• In the U.S., the Federal Reserve bank is given responsibility for controlling monetary policy.

Expansionary monetary policy

Prime interest rate

• The prime interest rate refers to the rate of interest charged on loans to a bank’s preferred customers, i.e. those with excellent credit.

• It is the basis for loans to other customers, including those with not so good credit, as well as for credit card balances, mortgages, and the like. Typically these loans accrue interest charges at prime + some additional percentage (e.g., 3.25% (Prime Rate) + 9.99% (additional interest rate) =13.24%).

• Typically the prime rate is approx. 3% above the federal funds rate (=the interest rate that banks charge each other for overnight loans).

Taylor rule • This is a rule first put forth by Stanford

economist John Taylor.

• Its goal is to curb inflation without slowing economic growth.

• Taylor says that the central bank (the Fed Reserve) should increase the nominal interest rate by more than one percentage point (usually 1.5%) in response to each increase of inflation by one percent.

What are some important tools of monetary policy?

•Open-Market Operations

•The Reserve Requirement

•The Discount Rate

What are Open-Market Operations?

• These concern the purchase and sale of government bonds by the Federal Reserve for the purpose of regulating the money supply and controlling interest rates.

• This is the monetary tool the Federal Reserve uses the most frequently to stabilize the economy.

• When the Federal Open Market Committee (or FOMC) adopts more of an easy-money policy, its bond traders buy government securities in the bond market.

• When the FOMC adopts more of a tight-money policy, its bond traders sell government securities.

The purchase and sale of U.S. Treasury bills, bonds, and notes are esp. important

• Treasury bills mature in one year or less.

• Treasury notes mature in 2 to 10 years.

• Treasury bonds mature in 10 to 20 years.

• These securities are much safer than most securities; on the other hand, their yield could be considerably lower than other bonds.

• Bonds and notes typically pay dividends every 6 mos.

Reserve requirement

• The reserve requirement is the regulation that requires banks to keep a certain percentage of deposits on hand at all times to repay their depositors.

• The lower the reserve requirement, the more money that can lent out by banks.

• On the other hand, the lower the reserve requirement also means there is greater risk in the event of a run on banks or of problems with bank loans.

Discount rate • The discount rate is the interest rate that the

Federal Reserve charges on loans to private banks.

• A low rate makes it less costly for private banks to borrow from the Federal Reserve. A low discount rate tends to encourage private banks to lend more to their customers.

• A high rate makes it more expensive for private banks to borrow from the Federal Reserve. A high discount rate usually encourages private banks to lend less.

• The discount rate is a tool used by the Federal Reserve more frequently than the reserve requirement.

Federal funds rate

• The federal funds rate is the interest rate that banks charge each other for loans from their excess reserves.

• The Federal Reserve helps determine this rate -- also known as the overnight rate – by regulating the money supply through overnight operations.

Summary