Fiscal and Monetary Policy Mix

Fiscal and Monetary Policy Mix

How does the government stabilize the economy? The government has two different tool boxes it can use: 1. Fiscal Policy- Actions by Congress and the president to adjust to the G in aggregate demand. 2. Monetary Policy- Actions by the Federal Reserve Bank (our central bank) to adjust the money supply (M1).

Review Objective for AD MONETARY POLICY RequiredReserve Discount Rate Open Market Operations FISCAL POLICY Taxes Transfer Payments Spending EXPANSIONARY Increase AD to fix a recessionary gap Decrease Decrease Buy bonds Decrease Increase Increase CONTRACTIONARY Decrease AD to fix an inflationary gap Increase Increase Sell bonds Increase Decrease Decrease

Problems With Fiscal Policy 65

Problems with Fiscal Policy 1. Problems of Timing Recognition Lag-the government has to realize that the recessionary gap exists; economic data takes time to collect and analyze, and recessions are often recognized only months after they have begun. Administrative Lag-the government has to develop a spending plan, which can itself take months, particularly if politicians take time debating how the money should be spent and passing legislation. Operational/Implementation Lag-Spending takes time to organize and execute

Problems with Fiscal Policy Given these lags, by the time the full impact of the policy is felt, the economic problem it was designed to solve May no longer exist May not exist to the degree it once did May have changed all together

2. Politically Motivated Policies Politicians may use economically inappropriate policies to get reelected. QUESTION: Do you think there s a risk of a recession? How do you rate that? https://www.youtube.com/watch?v=sdd5tdz NDwo&list=PL97DE22B52CA9791D&index=2 1 BUSH: You know, you need to talk to economists. I think I got a B in Econ 101. I got an A, however, in keeping taxes low and being fiscally responsible with the people s money.

3. Crowding-Out Effect A decrease in private expenditures that occurs as a consequence of increased government spending or the financing needs of a budget deficit. Examples: 1. The gov t spends more on public libraries so individuals buy fewer books at bookstores. 2. An increased deficit forces the gov t to borrow, which increases the demand for credit, which leads to higher interest rates, which decreases investment. AD as a result of crowding out Goal for AD Expansionary fiscal policy will have less impact on AD and real GDP than Keynesian theory predicts.

What if the U.S. borrows from China, does crowding out still occur? Before foreigner can buy U.S. Treasury bonds, they must exchange their currency for U.S. dollars. This increases the demand for U.S. currency, causing the dollar to appreciate. This makes American goods. More expensive What happens to the demand of U.S. exports?

4. Net Export Effect International trade reduces the effectiveness of fiscal policies. Example: We have a recessionary gap so the government spends to increase AD. The increase in AD causes an increase in price level and interest rates. U.S. goods are now more expensive and the US dollar appreciates Foreign countries buy less. (Exports fall) Net Exports (Exports-Imports) falls, decreasing AD.

5.Deficit Spending!!!! A budget deficitis when the government s expenditures exceeds its revenue. The national debtis the accumulation of all the budget deficits over time. If the Government increases spending without increasing taxes they will increase the annual deficit and the national debt. Most economists agree that budget deficits are a necessary evil because forcing a balanced budget would not allow Congress to stimulate the economy.

Budget deficits almost always rise when the unemployment rate rises and falls when the unemployment rate falls. Driven mainly by automatic stabilizers as tax revenues fall and transfer payments increase during recessions. Effects are only felt temporally

Bush Deficits FY 2009 : $1,413 billion FY 2008: $458 billion FY 2007: $161 billion FY 2006: $248.18 billion FY 2005: $318.35 billion Obama Deficits FY2014: $744 billion FY 2013: $973 billion FY 2012: $1,087 billion FY 2011: $1,300 billion FY 2010: $1,294 billion

Strengths of Monetary Policy The Fed functions independently from the government and thus is not subject to political pressures. More flexible and less likely to get caught up in legislation

Problems with Monetary Policy Inside Lags it takes time to identify a problem. it takes additional time to enact policies. The Federal Open Market Committee meets 8 times a year to discuss monetary policy more often if necessary. Once it has decided on the changes are called for, the FOMC can make open market policy or discount changes immediately. Outside Lags once policy is determined, it takes time to be effective. Outside lags can be much longer for monetary policy because firms may require months or even years to make large investment plans, especially those involving new physical capital, such as a new factory.