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. zz 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. zz 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.
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. zz 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. zz 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. zz
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. zz 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. zz 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: zz 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.
