Ch. 15/16Ch. 15/16Ch. 15/16Ch. 15/16

Fed. Gov’t uses 2 strategies to fight inflation and/or unemployment to promote a healthy, growing economy:

Fiscal policies (Ch. 15)Monetary policies (Ch. 16)

Policies that try to increase output (stimulate the economy) are called

expansionary policies

Policies intended to decrease output are called

contractionary policies

Ch. 15 Fiscal Policy Ch. 15 Fiscal Policy Ch. 15 Fiscal Policy Ch. 15 Fiscal Policy

Fiscal Policy defined:

The use of gov’t spending and taxing to influence the economy

To understand FP economics, one must know the 20th century’s most brilliant economic theorist…

John Maynard KeynesCambridge Univ. professor…world’s leading

econ thinker in the 1930’s

Keynesian Economics:Keynesian Economics:Keynesian Economics:Keynesian Economics:

Gov’t. should use its power to tax and to spend to affect the economy.

Problem: Inflationgov’t. should raise taxes to decrease the

amount of money individuals and businesses have available to spend.

Similarly, gov’t. should lower its spending to decrease available income.

Less income = less spending by business and individuals lower demand prices

Fiscal PolicyFiscal PolicyFiscal PolicyFiscal PolicyWe have talked about inflation only…what about

Problem: UnemploymentDuring recessions, gov’t. 1. spends to create jobs + income - income gets spent which stimulates the economy.

2. Decreases taxes to make more $ available to biz and individuals

Fiscal Policy When the Fiscal Policy When the Economy is Healthy & Economy is Healthy &

ExpandingExpanding

Fiscal Policy When the Fiscal Policy When the Economy is Healthy & Economy is Healthy &

ExpandingExpandingDuring booming economic cycles, gov’t.

cuts back on its spending and raises taxes

This puts the brakes on consumer spending and helps to keep growing GDP under control

Limits of Fiscal PolicyLimits of Fiscal Policy

Increasing gov’t. spending is not so simple: 1. 60% of fed’l. budget goes to entitlement

programs which are fixed by law (programs like Social Security, Medicare, veteran’s benefits)…gov’t cannot alter these payments.

So…any change in fed’l spending must come from only ~ 40% of what is in the fed’l budget

A political football ?A political football ?

As we have seen so clearly in the past 2 years, gov’t. spending is viewed differently by Democrats and Republicans (generally)

Keynesian econ applied:Keynesian econ applied:

During our recent recession, what course of action did the Obama administration push?

How have the Republicans responded?

Economics & PoliticsEconomics & PoliticsAs a VERY general statement, Democrats accept Keynesian economics…that government intervention is needed to cure an ailing economy…

Lawrence O’Donnell: host of The Last Word (MSNBC)

Economics & PoliticsEconomics & PoliticsAnd generally speaking, Tea Party supporters disagree w/Keynesian economics…that an economy free of gov’t. intervention is the answer…

Rep. Steve King (R-Iowa) at the 2010 Virginia Tea Party Convention

Supply - Side EconomicsSupply - Side EconomicsStresses influence taxes have on the economyThe concept: lower tax rates on the wealthy and on

businesses will lead to higher output (supply will increase)

Will lead to higher employment

Popularized by Pres. Ronald Reagan in 1980s

AKA: “trickle-down” economics

A different strategy:

Ch. 16

Monetary policy

A different strategy:

Ch. 16

Monetary policy

Monetary PolicyMonetary PolicyMonetary PolicyMonetary Policy

Gov’t uses the Federal Reserve to affect the economy…

The Federal ReserveThe Federal Reserve

“the Fed”Federal Reserve System created 1913

- USA divided into 12 districts… each has a federal reserve bank

- all US banks belong to the system

What does the Fed do ?What does the Fed do ?

The Federal Reserve has 3 primary goalsMaintain long term economic growthMaintain stable price levels Maintain full employment

Main Functions of the FedMain Functions of the Fed

1. Set the Capital Reserves requirement the % of deposits banks must maintain in cash

2. Set the “discount rate” the interest rate banks pay to the Fed to borrow money

Fed Functions (con’t.)Fed Functions (con’t.)

3. Open Market Operations* Controlling the money supply…

1. Fed buys U.S. bonds to increase money supply and stimulates the economy (expansionary policy)

2. Fed sells U.S. bonds to decrease money supply and slows the economy (contractionary policy)

* Most used, most important used

The Fed buys securities when it wants to increase the supply of money and credit, and sells securities when it wants to reduce the flow

Applying Monetary PolicyApplying Monetary PolicyApplying Monetary PolicyApplying Monetary Policy

When unemployment is a problem, the Fed should adopt: (choose one)

(A) expansionary policy

(B) contractionary policy

Applying Monetary Policy Applying Monetary Policy (con’t.)(con’t.)

Applying Monetary Policy Applying Monetary Policy (con’t.)(con’t.)

To expand (stimulate growth) the economy the Fed could/should:

1.Reserve Reqs: LOWER them

2.Discount Rate: LOWER it

3.Open Mkt Ops: BUY BONDS

Applying Monetary PolicyApplying Monetary PolicyApplying Monetary PolicyApplying Monetary Policy

When inflation is a problem, the Fed should adopt: (choose one)

(A) expansionary policy

(B) contractionary policy

Applying Monetary Policy Applying Monetary Policy (con’t.)(con’t.)

Applying Monetary Policy Applying Monetary Policy (con’t.)(con’t.)

To slow growth of the economy the Fed could/should:

1.Reserve Reqs: RAISE them

2.Discount Rate: RAISE it

3.Open Mkt Ops: SELL BONDS

A few last thoughts on Monetary Policy

A few last thoughts on Monetary Policy

As we already discussed, the Federal Reserve is the key player

It sets a key interest rate (called the discount rate: what banks pay to borrow from the Fed)

The Prime Rate (what consumer loans are based on) is tiered above the Fed Funds rate

3 Names to know:3 Names to know:3 Names to know:3 Names to know:

Monetary Policy = Milton FriedmanFiscal Policy = John Maynard Keynes New Chairman of he Federal Reserve:

Janet Yellen

Classical EconomicsClassical Economics

What makes both fiscal policy and monetary policy significant is that they

each mark a huge departure from

“classical economics”

The heart of classical economic theory is that:

1. free markets will regulate themselves thru the natural interaction between supply and demand…markets will naturally seek equilibrium

2. gov’t. intervention is NOT needed

Adam Smith…David Ricardo…Thomas Malthus were the major architects of this theory that dominated economic theory and gov’t policies for more than a century

The Great Depression challenged this line of thinking because…

Connecting the dots…Connecting the dots…

During the Great Depression, prices plummeted

Classic econ says that demand should rise with low prices which should cause producers to produce more, creating a need for higher employment…but it didn’t

Keynes argued that neither business nor consumers had the ability or desire to spend

Government MUST be the catalyst…it was the only entity that had the ability to spend to stimulate the economy

So…gov’t. can intervene with either fiscal policy, monetary policy, or both….

Tying it all togetherTying it all together

Keynes’ belief that gov’t HAD to act has guided our gov’ts actions for 75 years:

When inflation is the problem: contractionary policies are needed

When unemployment is the problem: expansionary policies are needed

Chap. 15/16 Quiz

Thurs 4/24 and Fri 4/25Do the reading (including the “supplemental readings”)

Do the Study guideYou can use the “cheat sheet” handed out in class