Unit 7

Fiscal & Monetary Policy

The Federal Reserve System

• The central bank of the US which sets the monetary policy of the USA

• Monetary policy-control over the money supply and interest rates to dampen inflation or to stimulate growth

• The Fed holds reserves of all other banks in its vaults• Reserve requirement- the regulation that banks must keep a

certain percentage of deposits on hand to repay depositers• Provides loans to banks when they need it• Provides check clearing between different banks• Manages the banking system using the 12 regional Federal

Reserve Banks

Fiscal Policy

• The federal government uses fiscal policy to regulate the economy

• Fiscal policy- the government’s ability to tax and spend to get a stagnant economy going or to fight inflation

Great Depression

• Classical economists believed in the ideas of Adam Smith; that the government should stay out of the economy and keep taxes low

• Because of this idea prior to the Great Depression, government rarely got involved in the economy in a substantial way

• The Great Depression caused such widespread misery that people in America wanted their government to get involved to stabilize the economy

Keynes

• Keynesian economics- the idea of British economist John Maynard Keynes

• This idea is that recessions and depressions are caused by a lack of buying power; put simply, people did not have money to buy stuff which leads to a downward cycle

• Keynes believed that the government should stimulate the economy by lowering taxes and by the government spending money to put more money in the economy

• He felt that the government should borrow money to do this spending; not raise taxes to get it- this is called deficit spending

The New Deal

• FDR used deficit spending to increase demand and promote economic growth; these policies were called the New Deal

• 1939-1945 the federal deficit went from 3 Billion to 47 Billion

• Unemployment dropped from 17 to 2 percent and our GDP almost doubled

Friedman

• Milton Friedman believed that our monetary policy was the reason for the depression

• Monetarism-the idea that the money supply is the primary reason for ups and downs in the economy

• Too much money too fast results in inflation as consumers with more money demand goods and services faster than producers can provide them driving prices up

• If the money supply grows too slowly, deflation occurs and spending and investment slows down

• The goal of monetary policy should be to keep up with economic growth-but no faster

Stagflation• Monetarism as a policy device was put to the test in the 1970’s• The oil embargo drove gas prices up which caused businesses

to slow their activity while inflation soared• Stagflation- when the economy is stagnant, there is high

unemployment and there is high inflation at the same time• Paul Volker (Fed Chairman and Friedman follower) decided to

use a tight-money policy to help slow inflation. • Tight-money policy- a slowing of the growth of the money

supply (contractionary fiscal policy)• Inflation dropped but the resulting high interest rates caused

an even bigger drop in business activity and unemployment hit 11%

• Many economists now believe that the government should use both monetary and fiscal policy to help keep the economy stable

Demand Side Economics

• Keynesian idea that the best way to stimulate the economy is to cut taxes across the board to put more money in everyone’s pocket & increase government spending

• This is expansionary fiscal policy • Demand side economists believe in the

multiplier effect- dollars spent will eventually multiply and benefit others in the economy

Supply Side Economics

• Supply side economists believe that the best way to deal with an economic slowdown is to stimulate overall supply by cutting taxes on businesses and high-income taxpayers

• The idea is that businesses and investors will use the money from their tax savings to expand production, the supply of goods and services will increase, spurring economic growth

• “Trickle down economics”-Ronald Reagan used Supply Side economics to cut taxes on businesses and the wealthy in the early 80’s to try to grow the economy

National Debt

• The national debt is the debt accumulated when our yearly budgets run a deficit

• Yearly is called a budget deficit or budget surplus

• Overall it is the national debt• There are many people concerned about the

current size of our national debt

Concerns about the Debt

• Fear of Government bankruptcy• Concern about the burden on future

generations• Unease about foreign owned debt• Crowding out effect- happens when

government borrowing drives interest rates up so high that people are no longer willing to borrow money to invest in businesses