Stabilizing the Economy
There are two main ways that the government can influence employment, production, and prices, both of which we've already discussed. The first is fiscal policy, which is established by Congress and the president. Fiscal policy involves government spending and taxation. The second way the government can influence the economy is by managing the money supply through monetary policy, which is controlled by the Federal Reserve System.
Expansionary Fiscal Policy
During contractionary phases, the government can use expansionary fiscal policy to stimulate the economy. We've already talked about many aspects of expansionary fiscal policy, which consists of increased government spending and lowered taxes. Increasing government spending and reducing taxes can encourage additional production and increase employment. On the negative side, expansionary fiscal policy leads to inflation and higher interest rates. More significantly, increased spending and reduced taxes lead to increased government debt. We'll talk more about the problems of increased government spending and increased government debt over the next couple of lessons.
Contractionary Fiscal Policy
The opposite of expansionary fiscal policy is contractionary fiscal policy, which consists of decreased government spending and increased taxes. Contractionary fiscal policy is used to slow the economy down during periods of high inflation. Decreasing federal spending and raising taxes leads to lower prices and interest rates but can reduce production and employment in the short run.
Contractionary fiscal policy is beneficial when the economy is growing at a greater rate than two or three percent per year. This might sound odd—a quickly growing economy seems like it would always be a good thing. Unfortunately, this isn't necessarily the case. Below are three negative consequences of an economy that is growing too quickly.
HIGH INFLATION -
We've already discussed many of the consequences of high inflation. If an economy is growing at a high rate, prices will also grow at a high rate. The rate at which people's wages grow probably won't keep up with the rate at which the prices grow, which will eat into people's savings and lower their standard of living.
ASSET BUBBLES -
An asset bubble occurs when the prices of assets like housing, oil, or gold increase significantly, beyond their actual value.
An example of an asset bubble is the housing bubble that contributed to the Great Recession. The price of housing rose to incredibly high levels, which made it difficult for many people to become homeowners. Still driven by the desire to own a home, many borrowers took out mortgages they couldn't afford to pay back. Many of these borrowers knew they wouldn't be able to pay back the loan, but they expected that the value of houses would continue to soar. They believed they would be able to sell their home for a profit if they needed to.
When the housing bubble popped, the value of these homes collapsed, and many borrowers were stuck with loans that exceeded the value of their homes. (For example, a home buyer might have taken out a $300,000 mortgage to buy a $300,000 house in 2006. By 2008, the home was only worth $200,000, but the home buyer still owed $280,000 on the mortgage.) With the economy in free fall, these borrowers couldn't make enough money to make the payments on their homes, and they couldn't sell their homes for enough money to pay back the mortgage. In the end, the borrowers lost everything, and the banks that made the loans took big losses as well.
UNSUSTAINABILTY -
When the economy grows at four percent or more per year, it typically leads to a recession. Recessions are a natural part of the business cycle, but the ups and downs will be more violent and frequent if the economy experiences periods of fast growth. The faster the economy goes up, the faster it will come down.
Unlike expansionary fiscal policy, contractionary fiscal policy is rarely used. The reason is simple: voters like tax decreases. They don't like tax increases. Politicians who vote for contractionary fiscal policy—cutting government programs and increasing taxes—are likely to be voted out of office. Ideally, periods of expansionary fiscal policy would be offset by equally long periods of contractionary fiscal policy. This never comes close to happening, however, leading to higher inflation and ever-increasing government debt.
Monetary Policy
Just like fiscal policy, monetary policy can also be used to expand or contract economic growth. Monetary policy decisions by the Federal Reserve create changes in the money supply and the availability of credit. These changes influence the overall levels of spending, employment, and prices in the economy. Monetary policy also affects interest rates. Interest rates act as incentives that influence people's spending and saving decisions. When interest rates are high, people are encouraged to save more money, but they're not likely to borrow as much money. When interest rates are low, people are encouraged to borrow more money, but fewer people will want to save money.
To fight inflation, the Federal Reserve System can use monetary policy to create higher interest rates. Higher interest rates reduce inflation because they discourage borrowing and spending, reducing the upward pressure on prices. (Remember that less spending means less demand. Less demand means lower prices. Thus, higher interest rates would reduce demand-pull inflation.)
The Great Recession
To close out the lesson, let's look at how expansionary fiscal and monetary policy was used during the Great Recession. From December 2007 to March 2009, America's GDP fell by 4.3%, and the unemployment rate rose from 5% to 9.5%, eventually peaking at 10% in October of 2009. The average home price fell by 30%, the stock market dropped by 57%, and the total net worth of American households and nonprofits fell from about $69 trillion to $55 trillion.
The United States government decided it wasn't going to follow the approach of classical economists—it wouldn't wait for the economy to self-correct. Instead, it followed the Keynesian (i.e., John Maynard Keynes) philosophy of aggressive government intervention. Government leaders passed several laws that were designed to stimulate the economy by increasing demand, including the Economic Stimulus Act of 2008 and the American Recovery and Reinvestment Act of 2009. These laws were largely a combination of two fiscal policy solutions: increasing government spending and reducing taxes.
American Recovery and Reinvestment Act
Provided nearly $300 billion in tax incentives, including a tax credit of $800 for every family
Spent over $80 billion on infrastructure projects
Spent over $100 billion on education, including support for teacher salaries and special education
Spent over $155 billion on healthcare, including helping states cover Medicaid costs
The government didn't only use fiscal policy to fight the recession; the Federal Reserve also used monetary policy to try to stimulate the economy. The Fed lowered interest rates and signaled that interest rates would stay low for a considerable time. This was a very traditional way of responding to a recession. As the recession stretched over a longer period of time, however, the Fed looked for more ways to stimulate the economy. Interest rates were already at zero; they couldn't be lowered any further. The Fed's solution was a process called quantitative easing (QE), also known as large-scale asset purchases, in which a central bank buys government bonds or other financial assets from commercial banks and other financial institutions. These purchases inject more money into the economy, increasing demand.
The success of this fiscal and monetary policy is hotly debated. Economic recovery from the Great Recession was steady but very slow. Some economists argue that the government's policies prevented the economy from recovering more quickly. Another significant issue is that the Fed continued quantitative easing well after the economy had recovered. Since quantitative easing increases the overall money supply, continuing these asset purchases has increased the risk of inflation. Because QE is a non-traditional policy that hasn't been implemented before, it will take time to understand the overall impact it will have on the economy.
Review of Key Terms
expansionary fiscal policy: fiscal policy characterized by increased government spending and decreased taxes
contractionary fiscal policy: fiscal policy characterized by decreased government spending and increased taxes
asset bubble: occurs when assets like housing, oil, or gold increase significantly, beyond their actual value
quantitative easing: large-scale asset purchases in which a central bank buys government bonds or other financial assets from commercial banks and other financial institutions
The tendency of the American government to employ expansionary fiscal policy for long periods, yet rarely employ contractionary fiscal policy, has led to several long-term problems in the national economy, including an exponential rise in the national debt. Over the next couple of lessons, we'll further explore the problems created by long-term unrestrained government spending.