ECO/372T Week 5 Fiscal and Monetary Policy Notes\
Fiscal Policy
The US Legislative Branch (Congress and Senate) define, implement, and govern US fiscal policy which is
the national expenditures and taxation employed to stabilize the economy
(https://www.britannica.com/topic/fiscal-policy)
Fiscal Policy Tools
Government expenditures (G) which are all Federal, State, and Local government purchases from paper
clips to aircraft carriers.
Taxation (T) which is imposition of compulsory levies on individuals or entities by governments. Taxes are
levied in almost every country of the world, primarily to raise revenue for government expenditures, as well
as to stabilize an economy (https://www.britannica.com/topic/taxation)
Expansionary Fiscal policy is implemented during a contraction on the business cycle.
Expansionary Fiscal policy includes increasing G and/or decreasing T.
This allows Aggregate Demand to shift to the right and move an economy toward growth.
Contractionary Fiscal policy is implemented during an expansion on the business cycle.
Contractionary Fiscal policy includes decreasing G and/or increasing T.
This allows Aggregate Demand to shift to the left and minimize the economy’s overheating.
Monetary Policy
The Federal Reserve (the Fed) defines monetary policy as its actions to influence the availability and cost
of money and credit. Because the expectations of market participants play an important role in determining
prices and economic growth, monetary policy can also be defined to include the directives, policies,
statements, and actions of the Fed that influence future perceptions. However, the Feds cannot control the
inflation directly; instead, indirectly by affecting the money supply, it is theorized that monetary policy can
establish ranges for inflation, unemployment, interest rates, and economic growth. The Fed’s primary
mission is to ensure that enough money and credit are available to sustain economic growth without
inflation. If there is an indication that inflation is threatening our purchasing power, the Fed may need to
slow the growth of the money supply. It does this by using three tools—the discount rate, reserve
requirements and, most important, open market operations.
Monetary Policy Tools
Open market operation: This is the tool that the Federal Reserve uses the most frequently (on a daily
basis) monetary policy tool to involves the buying and selling of government securities in order to influence
short-term interest rates and the growth of the money and credit aggregates. Whenever an increase in the
growth rate of the money supply and credit is needed, or if downward pressure on short-term interest rates
is desired, the Fed sends securities to brokers and dealers electronically and takes payment by debiting
the accounts of banks with which the brokers and dealers do business. These reserves leave the banking
system, thereby reducing the money supply and curtailing the expansion of credit.
To stimulate the economy that is experiencing a contraction, the Fed will increase the money supply by
buying securities.
To slow down an overheating economy that is experiencing an inflationary expansion, the Fed will
decrease the money supply by selling securities.
This is done on a daily basis and makes incremental changes to the money supply. i In a sense, open
market operations tweak the money supply.
Reserve Requirements: Are the requirements regarding the amount of funds that the bank must hold in
reserve against deposits made by their customers. This money must be in the bank's vaults or at the
closest Federal Reserve Bank. This tool is used to maintain the minimum amount of physical funds in their
reserve.
Reserve requirement changes are not made very often at all. i They are a policy used in an extreme
economic situation.
To stimulate the economy that is experiencing a contraction, the Fed will increase the money supply by
decreasing the reserve requirement allowing banks and other financial institutions to loan out a greater
fraction of the deposits.
To slow down an overheating economy that is experiencing an inflationary expansion, the Fed will
decrease the money supply by increasing the reserve requirement restricting even more the amount of
money banks and other financial institutions are allowed to loan out.
Discount Rate: interest rate charged commercial banks and other depository institutions for loans that are
received by the Federal Reserve Banks. This tool is important because it is a visible announcement of
change in the Fed's monetary policy and it will give insight to the Fed's plans.
Like the reserve requirement, the discount rate changes are not made very often at all. i This policy is not
used very often; however, the Fed is increasing the discount rate today.
To stimulate the economy that is experiencing a contraction, the Fed will decrease the discount rate which
makes borrowing for consumption and investment friendlier.
To slow down an overheating economy that is experiencing an inflationary expansion, the Fed will
increase the discount rate making savings more attractive than consumption and investment.
Most important of the Fed's responsibilities is monetary policy, the means by which the Fed influences the
growth of money and credit in the U.S. economy. i When the supply of money grows too rapidly in relation
to the economy's ability to produce goods and services, inflation may result. It is a case of too many dollars
in the hands of buyers chasing the same amount of goods. i On the other hand, too little growth in the
money supply can lead to such problems as recession and unemployment. As the money flow slows
down, people have fewer dollars to spend for various goods and services. Businesses, in turn, receive
less money for the goods and services they produce and have less to spend for the resources they use.
Through monetary policy, the Fed tries to avoid either of these extremes. To do so, the Fed analyzes the
national economy and seeks to influence growth in money and credit that will contribute to stable prices,
high employment, and growth in the economy. i i The Fed can put more money in the economy - actually
create money - by buying U.S. government securities on the open market. The Fed pays sellers for the
securities. They, in turn, deposit the money in various financial institutions. While these institutions are
required by law to keep a certain percentage of this money on reserve, they are free to loan out the
remainder.
Let us see how this works. Suppose Jane Smith is holding a U.S. Treasury bond, one she can sell at any
time. Through a broker, she sells this bond to the Fed for $1,000. At this point the Fed, using power
granted to it by the U.S. Congress, pays Ms. Smith by creating $1,000 that did not exist before. If we were
to write a check for $1,000, that money would come out of our bank account. But the Fed's check creates
new money by adding to banking reserves. Ms. Smith deposits the $1,000 in Trustworthy Bank.
Trustworthy must keep a certain amount on reserve. i We'll suppose the bank's reserve requirement is 10
percent. Of the $1,000 deposit, then, Trustworthy can loan out $900, known as its excess reserves. Joe
Jones, an insurance salesman, needs to borrow $900 for new computer equipment for his office.
Trustworthy Bank credits Jones' bank account with $900, money he will later repay. In turn, Jones writes a
check to Computerwise Co. for $900. This company, in turn, deposits the check in Reliable Savings and
Loan. Reliable must hold back 10 percent on reserve and can loan out $810. This process goes on and
on, increasing the amount of money in the economy. While each financial institution can only lend an
amount equal to its excess reserves, the financial system as a whole can expand the amount of money in
the economy.
As you can see, money is created in our economy in two ways that are different but related. The Fed
begins the process by creating "raw money" when it buys a Treasury security on the open market. The
banking system can then expand this amount of money by lending it. i On the other hand, if the Fed sees
the nation is threatened with inflation, it may some of the securities in its portfolio. Buyers pay the Fed for
these securities out of their bank accounts. At this point, places like Trustworthy Bank and Reliable
Savings and Loan have less money to lend. In this way, the Fed removes money from the economy since
the money paid to the Fed does not go back into any sort of bank account.
A second way in which the Fed can influence the economy is by raising or lowering the discount rate, the
interest rate charged financial institutions when they borrow reserves from the Fed. Although seldom
used, discount rate changes can be powerful signals of the direction of monetary policy.
The Fed can also have a powerful impact on the flow of money and credit by either raising or lowering
reserve requirements, the percentage of their deposits that financial institutions must keep on reserve. If
the Fed lowers reserve requirements, this can lead to more money being injected into the economy since it
frees up funds that were previously set aside. On the other hand, if the Fed raises reserve requirements, it
reduces the amount of money that institutions are free to loan out or invest. However, the Fed is cautious
about changing reserve requirements and has done so only occasionally because of the dramatic impact it
can have on both financial institutions and the economy.
Lag times for Fiscal Policy and Monetary Policy
Economists must consider the concept of lag times with respect to economic behavior and policy
responses when developing and implementing economic policy.
Three Lag Times for Fiscal Policy and Monetary Policy
Recognition Lag – the lag time between a change on the business cycle and the time it takes for analysts
to see the change in the data.
Implementation Lag – the lag time between seeing a change on the business cycle and the time it takes
for fiscal policymakers and/or monetary policymakers to determine a resolution and to implement the
resolution. In the US, fiscal policy has a greater implementation lag time than monetary policy does.
Response Lag – the lag time between the policy implementation and the response by consumers and
firms to change behavior.
As a result, a downturn beginning in one administration or board of governors’ watch may not be fully
realized or resolved until the new policymakers take office.
Fiscal v. Monetary Policy Lag times
Fiscal Policy in the US economy involves the gathering of data, discussion of both Houses, deals, and
vote in the legislative branch which is both the House of Congress and the House of Senate.
Monetary Policy in the US economy involves the gathering of data, discussion of the Federal Reserve
Board of Governors, and determination of the policy by the Chair of the Federal Reserve.
On the business cycle, the lag times are not the same for Fiscal Policy and the Monetary Policy.
Fiscal policy has much longer recognition lag times because the legislative branch has many different
sources gathering data on quarterly and annual basis: Bureau of Labor Statistics (BLS), Bureau of
Economic Research (BER), Bureau of Economic Analysis, Federal Reserve, diverse lobbyists sources,
diverse private and public institutions of higher education, and internal research.
Monetary policy has much shorter recognition lag times because the Federal Reserve gathers data daily
with open market operations, as well as weekly, monthly, quarterly, semi-annually, and annually.
Fiscal policy has a very long implementation lag time because of the process involving both Houses of the
Legislative Branch, the deals that take place, and the discussion and vote intricacies.
Monetary policy has a very short implementation lag time because once the Federal Reserve Chair has
determined the necessary policy (whether democratically with significant input or autocratically without any
input), the policy can be implemented immediately.
Fiscal policy has an unpredictable response lag time because households and firms need to know about
the policy change, then they must accept that this change is a long run change, not a short run temporary
change, and that the change is beneficial for them personally.
Monetary policy has a relatively short response lag time because changes in interest rates and the money
supply can be observed and included in decision making daily by households and firms.
However, both fiscal policy and monetary policy must be implemented and responded to on the right
phase of the business cycle or risk exacerbating the inflation or recession.
