Introduction to Unit 3 - Fiscal Policy and Monetary Policy

Given an understanding of the business cycle, we can now expand our knowledge to better comprehend how economic policy makers deal with business cycles. In general, economic policy makers try to reduce the negative consequences of the business cycle without causing alternative problems as a result of their actions. For example, a reduction in the unemployment rate should not come at the expense of a boost in the inflation rate. As you may already have deduced, this is easier said than done. Our basic framework of analysis is the graph of aggregate demand and aggregate supply shown here.
As shown graphically, depending on the relation of aggregate demand to aggregate supply, a policy that encourages faster aggregate demand growth can have the undesired consequence of higher inflation rates.

In this section we will cover the basics of fiscal policy. Fiscal policy is carried out by the executive and legislative branches of government, and refers to tax policy and government spending on goods and services. Revisiting our equation for GDP that can be written as:

GDP = C(Y - T) + I(r) + G + NX

Consumption (C) is a part of our disposable income or, total income minus taxes (Y - T). Fiscal policy deals with changes in taxes or the tax rate (T), that in turn affects total consumption. Or, fiscal policy can directly alter the growth rate of GDP and aggregate demand by changing the level of government spending (G).

An expansionary fiscal policy would be used to speed up the rate of GDP growth or during a recession when GDP growth is negative. A tax cut and/or an increase in government spending would be implemented to stimulate economic growth and lower unemployment rates. These policies will lead to higher federal budget deficits.

A restrictive fiscal policy involves raising taxes or cutting government spending in an attempt to dampen GDP (aggregate demand) growth and lower inflationary pressures.

This section will begin with a bit of economic history and the development of what is known as Keynesian economics that emphasizes the use of discretionary fiscal policy to counteract the undesirable consequences of business cycles.

This section also covers potential impacts of the Internet on macroeconomic activity. A good argument can be made that as the Internet develops, the annual rate of increase in worker productivity will improve resulting in a higher rate of non-inflationary growth.

The Federal Reserve conducts monetary policy. Monetary policy is carried out by the Fed to counteract either actual or anticipated undesired changes in the economy. If inflation is rising or inflationary pressures are brewing, the Fed will attempt to slow economic growth by raising interest rates. Or if economic growth is stagnating then the Fed may try to give it a shot by lowering interest rates.

It is important to realize that the Fed only directly controls one out of many different interest rates. The Fed has direct leverage over what is known as the Federal Funds rate. The Fed Funds interest rate is directly linked to the amount of monetary reserves in the banking system. To increase the Fed Funds rate, the Fed will drain reserves from the banking system by selling some of its inventory of government debt to banks. To decrease the Fed Funds rate, the Fed will increase banking system reserves by purchasing some of the government debt present in the banks asset portfolio. By changing the Fed Funds rate we assume that all other financial interest rates change by a similar magnitude and in the same direction.

The assumption that the Fed has direct leverage over all other financial market interest rates simply by changing the Fed Funds rate may seem a bit grandiose. But in reality it isn't. Almost always, other interest rates respond immediately to changes in the Fed Funds rate. When they do fail to respond is when the Fed loses control over the economy.

In a nutshell, this is how Fed policy works. The Fed is always monitoring the economy for undesirable future changes. When the policy committee of the Fed, known as the Federal Open Market Committee (FOMC) decides that thinks look rough, they will initiate or continue either an expansionary or restrictive monetary policy. With the new policy, the New York branch of the Fed rapidly begins a net purchase or sale of government debt in exchange with various banks in order to change the level of banking reserves and the Fed Funds rate. Almost immediately, financial markets adjust other interest rates based on Fed policy.

The ultimate goal of the Fed is to alter the growth rate of aggregate demand and GDP. in order to change economic growth rates, the key is to alter the longer term interest rates that significantly affect business and consumer borrowing. We are talking about five, ten, up to thirty year interest rates. Focusing on the business sector, changes in longer term interest rates will alter the level of business investment or the I component of GDP that is written as:

GDP = C(Y - T) + I(r) + G + NX

Investment (I) and interest rates (r) have an inverse relationship. For example, an increase in r, will reduce I and also decrease GDP. Typically there is a lag of anywhere between six months to a year between changes in r and the subsequent effect on GDP. With this in mind we better understand the nature of Fed policy.

To be effective, the Fed can not base its policy decisions on current economic circumstances of inflation, unemployment and economic growth. instead, it must anticipate or forecast where those major economic indicators will be in six months or a year in the future.