14. Fiscal Polic Review
View Entire Chapter 14).
A. Economic goals of the
Employment Act of 1946
was a reaction to a five-year economic growth plan of the Soviet Union.
a. Set four economic goals
1. Economic growth 2. Price
stability 3. Low unemployment 4.
Positive balance of payments
b. Created the President's Council of Economic Advisor
2. Humphrey-Hawkins Act of
was a reaction to stagflation of the 1970's and it set five-year goals for
a. 4% unemployment
b. 3% inflation by 1985, 0% by 1988 c. Reduce balance of
d. Increase economic growth and investment e. Reduce the size
of the public sector
3. Government methods of affecting the
economy to achieve economic goals
a. Fiscal policy, the focal point of
Keynesian economics, will be explored in this chapter.
b. Monetary Policy will be covered in chapter 15.
B. Discretionary fiscal policy
1. Discretionary fiscal
policy is the deliberate manipulation of government taxing and spending to
control AD and the business cycle.
2. AD = C + I + G + XN
Expansionary fiscal policy consists of reversing an economic downturn by
increasing AD with deficit spending.
Lower taxes to increase Consumption (C) and Investment (I)
1. Personal income taxes
2. Capital gains taxes paid on the profit from the sale of commercial
real estate, a company, and financial assets (stocks and bonds)
3 Investment tax creditis a direct lowering of the tax liability of
companies investing in certain approved types of plant and equipment
Increase government spending (G)
c. The result will be a fiscal stimulus through
d. The impact of a fiscal stimulus,
once implemented, will affect AD.
Contractionary fiscal policy: Decreasing inflationary pressure by decreasing
a. Increase taxes
b. Decrease government spending
result will be a fiscal drag with smaller deficits or a surplus.
5. The multiplier effect described
in chapter 12 applies to fiscal policy measures.
1. Cause the economy to expand
without government action during recession by increasing AD.
2. Cause the economy to contract without government action during
inflation by lowering AD.
Transfer payments (unemployment compensation, food stamps, and other social
programs) increase during recession to increase AD.
Progressive taxes (income tax) increase during inflation to lower AD.
D. Fiscal policy effectiveness is questionable
Determining when recessions begin is difficult.
1. Disagreement over whether the U.S. was in a recession from 1989-1991 resulted
in little fiscal action being taken.
2. The 2001 slowdown happened so fast there was not time for preemptive action.
Fiscal policy takes time to implement
c. There will be a delay because
it takes business time to expand capital investment.
2. Political considerations
a. Some spending
programs are difficult to cut (social security).
b. Expansionary bias:
people vote to spend but not to tax.
Political business cycle: it is difficult to accomplish anything
economically constructive during an election year
3. Until recently, many felt
the federal debt is too big and has rendered fiscal policy ineffective. Its
success in ending
2001 recession has yet to be determined although the Federal budget surplus
certainly makes it easier to increase
spending and decrease taxes although the expense of fighting three wars has
again increased the deficit.
E. Monetary affects of fiscal policy
1. Until recently, government borrowing increased the demand for
loanable funds causing higher long-term interest rates.
a. Crowding out is the term used to describe how high rates due to
government borrowing lower private investment.
feel high economic growth of the late 1990's resulted because of low interest
rates caused by federal fiscal responsibility.
2. Now, people are concerned about the fiscal drag caused by a federal
15. Monetary Policy
Entire Chapter 15
A. The Demand for Money is Dm= Dt + Da
1. Transaction Dt results because people hold money, often in a money market account, to use as a medium of exchange.
2. Asset Demand, Da results because people
accumulate money, often held in an investment account, to buy assets.
B. Monetary policy is the regulation of the money supply to
affect interest rates, economic activity, with the objective
of noninflationary full employment.
1. It is part of, but not the focal point of Keynesian economics.
2.Affecting interest rates and to change investment
thus affecting economic activity is one goal of the Fed.
a. Controlling reserve requirement may affect the money supply which may affect interest
1. Reserve requirement is the amount of demand deposits that must be kept in cash with the Federal
Reserve or in the bank.
2. Often expressed as a percent called the reserve ratio.
3. Excess reserve can be loaned as demand deposits.
4. Excess reserves determine the potential money supply (M1).
Changes interest rates change investment
causing a change in AD which changes economic
the money supply may lower interest rates.
investment which increases AD which causes an increase in Real
2) Decreasing the money supply
may increase interest rates lowering investment which
increses AD which causes an increase in Real
c. Dollar values on this page are representative of amounts
prevalent during the late 1990's (billions of dollars).
C. Types of monetary policy
1. Quantitative controls affect the money supply.
a. Required Reserve Ratio
1. Lowering the reserve ratio creates excess reserves which banks
may loan as newly created money. This is expansionary.
2. Raising the reserve ratio eliminates excess reserve so banks
can not renew loans removing money and causing a contraction.
b. Open-market operations
1. Buying and selling of U.S. government bonds by the
banks or in the open market to change excess reserves affecting M1 supply and interest rates is
the primary tool.
2. Buying bonds is expansionary.
a) When buying from banks, the Federal Reserve pays with reserves providing
excess reserves banks can loan as demand deposits.
b) When buying in the open market, increased demand
from the Federal Reserve pushes up prices sellers
receive, lowering the effective
interest sellers pay.
3. Selling bonds contracts the economy.
4. Review of
a) Suppose you buy a twenty year, $10,000 bond paying 5% per year at face value
of $10,000. Face value is called par value.
1) A few years go by and you need money and one choice is to sell the bond.
2) If interest rates on this type bond have gone down, people will be very
anxious to buy, demand, will be high pushing price up and your will receive more
3) If rate shave gone down, no one will give you $10,000, demand will be low, so
if you need the money, you will sell for less, below par.
4) You can hold for twenty years and get par and get the money some where else.
b) Therefore, interest rates and bond values (prices) go in the opposite
direction, if interest rates down, old bond price up because they are at the old
c) This is called the interest rate risk for bonds. Other risks have to do with
issuer default and monetary inflation.
5. It is the most powerful of the four tools.
C. Discount rate
1. This is the rate charged by the Federal Reserve for loans to member banks.
2. It strongly affects the prime
interest rate paid by a bank's best customers.
a) Lower the rate to expand economy as interest rates decrease.
b) Raise the rate to contract economy as interest rates increase.
c) Another important interest rate is the federal
funds rate which is the rate
at which banks loan funds to each other.
D. Term Auction
1. Initiated in 2007, it allows banks to add to their reserves at low rates.
2. Done to increase bank liquidity which was low because of a loss in reserve
caused by a housing crisis.
2. Other controls affect the actions of market participants.
A. Moral suasion or jawboning
is social pressure by influential people to encourage specific people to
act in the public interest.
B. Margin requirements,
the down payment required on stocks which is now 50%, is seldom changed.
C. Consumer credit controls, on items such as credit
cards, work so well it is seldom used.
D. The Federal Funds Rate
is the overnight rate banks with
excess fed reserve charge each banks short of fed reserve to keep the system in
Most controllable interest rate 2. Targeted by monetary policy
3. Controlling reserves, controls this
rate. 4. Allows some control over short-term
D. Effectiveness of
Speedy, flexible b.
Somewhat isolated from political pressure c.
Hard money, restrictive policy by the Federal Reserve, has worked well recently.
Easy money has not worked well because low business profit expectations , fears over employment loss
by workers make low interest rates ineffective.
Bank deregulation has made commercial banks a less important supplier of
investment funds thus diminishing the effectiveness of monetary policy.
Changes in the velocity of money may negate some of the effects of monetary