Topic 5

Using Monetary and Fiscal Policy to Fight Unemployment and Inflation

InflationCause: too much economic activity

There are too few factors or production to support the demand for production, prices rise

Fix: slow down spendingContractionary fiscal and monetary policy

(decrease G, increase Tx, increase RRR, sell bonds, increase federal funds rate)

UnemploymentCause: not enough economic activity

The economy’s factors of production could support more output

Fix: increase economic outputExpansionary monetary and fiscal policy

(increase G, decrease Tx, lower RRR, buy bonds, lower federal funds rate)

Some schools of thoughtSupply side economics – tax breaks and

incentives for producers are the most effective way to stimulate the economy

Demand side economics – tax breaks and incentives for consumers, plus government spending, is the best way to stimulate the economy

Trade off – The Philips CurveGraph the Philips Curve – In class

Vertical axis for inflation, horizontal axis for unemployment

How to incorporate Natural Rate of Unemployment?

How to incorporate Inflationary Expectations?

As the labor market becomes tighter, what happens to prices?

Changes in Philips CurveChanges in the Natural Rate of

Unemployment?Monster.com? Minimum wage? Culture of

changing jobs?

Changes in inflationary expectations? People expect higher or lower inflation

Changes in worker bargaining power?Ability to move production over seas

Current Unemployment & Inflationhttp://www.google.com/publicdata/home

Current Unemployment & InflationUnemployment is around 10%Inflation is low, about 2.0% per year

Links:http://www.wolframalpha.com/input/?i=usa+unemployment+rate

http://www.wolframalpha.com/input/?i=usa+inflation+rate

So, where are we on the Philips Curve?

What policies help?

Monetary PolicyOpen Market Operations (to alter the

interest rate) Required Reserve Ratio (RRR)Federal Funds Rate

12/08 Rates for US Treasury Bonds

COUPON MATURITY YEILD3-Month 0.000 03/26/2009 0.066-Month 0.000 06/25/2009 0.2212-Month 0.000 12/17/2009 0.362-Year 0.875 12/31/2010 0.883-Year 1.125 12/15/2011 1.065-Year 1.500 12/31/2013 1.5110-Year 3.750 11/15/2018 2.1330-Year 4.500 05/15/2038 2.61

US Treasury Bill Rate

Reserve RequirementsTotal Deposits RRR

$0 to $10.3M 0% $10.3M to $44.4M 3% > $44.4M 10%

Fiscal PolicyGovernment spendingTaxes

Without much room to play with monetary policy, the government is relying heavily on fiscal policy

What does the government spend money on?http://www.federalbudget.com/

Projected Deficit (Wash Post)

Keynesian EconomicsThe fiscal policies we focus on in class are

key tools in Keynesian Economics.

John Maynard Keynes (1883-1946) advocated using government spending to smooth out the business cycle.

The key policy recommendation of Keynesian theory is to use deficit spending to pull an economy out of a recession.

Downsides of Keynesian SpendingExpensiveThe wrong type of spending?

Spending chosen by politicians and bureaucrats

Short term projects, not long term solutions

Real world multiplier may be less than 1Encourages irresponsible or inefficient

behaviorPolitically infeasibleAvoids benefits of a recession (!?!?!?)

Similar issues with monetary policies:Artificially low interest rates encourage the

wrong type of investmentLower return projectsMore risky projectsLess focus on innovation

Artificially low interest rates make it “too easy” to borrow money for consumption

Might pull us out of the recession more quickly, but result in a lower long-run growth rate

Politically infeasible?Supporters of Keynesian motivated government

spending wanted a bigger bailoutOpponents thought the spending was already

too highQuickly passed laws allow for more favors, waste,

and other bad policiesThe outcome of the policy was/is uncertain

Any way around this? DictatorAutomatic spending that kicks in: i.e.,

unemployment insurance

Upsides to a recession?Survival of the fittestStruggling businesses go under, resources

redirectedPeople get retraining, better educationPolitical pressure to fix or change bad

policyMarket bubbles burst, prices adjustOthers?

Alternatives to Keynesian Spending1. Hands off. Let the economy fix itself.

1. Implement better policy to help employers adjust to changing markets, and investors make better decisions

Economies must be able to adjust to government or market induced shocks to employment

Better quality regulation, taxes, government spendingtransparencyincentives