Fiscal and Monetary Policy
Fiscal and Monetary Policy
FISCAL AND MONETARY POLICY
HOW DO POLICY MAKERS USE FISCAL AND MONETARY POLICY TO STABILIZE THE ECONOMY?
Objectives:
Design graphic organizers that show how policymakers use fiscal and monetary policy to respond to problems in the economy.
Interpret macroeconomic data to analyze fiscal and monetary policy options.
Summarize the limitations of using fiscal and monetary policy to help stabilize the economy.
Evaluate the effectiveness of current fiscal or monetary policy.
What are the origins of modern fiscal and monetary policy?
Policymakers use fiscal and monetary policy to keep the economy running smoothly. Fiscal policy uses the government’s power to tax and spend. Monetary policy uses the Federal Reserve’s power to regulate the money supply and interest rates.
Before the Great Depression, the government rarely intervened in the economy. Classical economists believed government’s role in the economy should be minimal.
British economist John Maynard Keynes believed that government spending could stimulate overall demand during recessions. He championed the use of fiscal policy to fight recession, including deficit spending.
American economist Milton Friedman believed controlling the money supply was key to stabilizing the economy. Called Monetarism, this idea promotes the use of monetary policy to expand and contract the money supply.
Monetarism was tested during the stagflation (the simultaneous increase of inflation & unemployment) of the 1970’s, when monetary policy was used to combat inflation.
The Federal Reserve uses monetary policy to stabilize the economy by managing the growth of the money supply and interest rates.
An easy-money policy is an expansionary monetary policy that speeds the growth of the money supply to prevent recession.
A tight-money policy is a contractionary monetary policy that slows the growth of the money supply to prevent inflation.
The Federal Reserve’s most common policy tool is open-market operations, or the buying and selling of government securities. Through open-market operations, the Fed can target the federal funds rate.
Acronyms to help remember the relationship between open market operations and interest rates:
FBIRD: Fed buys, interest rates decrease
FSIRI: Fed sells, interest rates increase
Other policy tools include the power to establish bank reserve requirements and the discount rate (the interest rate the Fed charges banks).
What tools does fiscal policy use to stabilize the economy?
The federal government and policymakers use fiscal policy to speed up or slow down the economy.
Expansionary fiscal policy tools: increased government spending, tax cuts.
Contractionary fiscal policy tools: decreased government spending, tax increases.
Automatic stabilizers can also serve to expand or contract the economy, because they increase or decrease overall demand.
**Multiplier effect
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What factors limit the effectiveness of fiscal and monetary policy?
Fiscal and monetary policy have both been useful in stabilizing the economy in the past. However, even during ordinary times several factors have limited their effectiveness. These factors include time lags, inaccurate forecasts, and concerns about the national debt.
Of course, these are extraordinary times we are living in, historic in proportion. The current economic crisis born out of the financial industry, has challenged all traditional tools of policymakers. The federal government has stepped in and taken unprecedented measures to stabilize the economy and save several companies deemed “too big to fail.” The outcome of the federal governments actions are yet to be determined. We shall all find out together…
The national debt has continued to rise as the federal government has continued to spend more than it receives in revenue. The size of the debt causes concern in several areas:
Foreign-owned debt
Burden on future generations
The crowding-out effect
Government bankruptcy