Fiscal and Monetary Policy

Three Economic Goals of Government

1. Full Employment

  • between 3-5% unemployment

  • does not mean no unemployed people

2. Price Stability

  • don’t want prices to fluctuate up or down too much

  • general price stability

3. Economic Growth

Key Terms

Gross Domestic Product (GDP) - Total value of goods and services produced in a country

Inflation - increase in prices

Deflation - decrease in prices

Recession - absence of economic growth, economy shrinks (2 or more quarters)

Harmful Effects

Inflation - while prices go up, wages may stagnate causing a dollar to be worth less

  • Hurts consumers

Deflation - the price of goods goes down lowering the amount earned by selling it.

  • Hurts producers

Consumer Price Index (CPI)

The most common measure of inflation is the Bureau of Labor Statistics CPI.

  • A hypothetical collection of common spending items are compared month to month.

  • The change in price of this shopping basket gives an idea of inflation and deflation

Fiscal Policy

Power of government to tax and spend to influence the economy

Two types of fiscal policy

  • Expansionary Policy - stimulate the economy and create growth by increasing government spending and lowering taxes

  • Contractionary Policy - slows economic growth by reducing government spending and raising taxes

Consequences of Fiscal Policy decisions

Expansionary could lead to inflation.

Contractionary could lead to recession.

The Federal Reserved (The Fed)

Federal Reserve Act - created 12 regional federal reserve banks known as “banker’s banks.”

Monetary Policy

The Fed’s ability to regulate the money supply to influence interest rates and credit.

The Fed has three tools to use to do this.

  1. Open Market Operations - buying and selling of government securities

    • banks or rich people can do

    • give the gov $500,000 and the government pays that + interest back 10 years later

  2. Discount Rate - interest rate on loans the Fed makes to banks

    • only banks can do

  3. Reserve Requirement - fraction of deposits that banks must keep on reserve and not use to make loans

To foster economic expansion (growth) during a downturn the Fed will:

  • Reduce the discount rate

  • Reduce reserve requirement

  • Buy Treasury Securities

  • Result: encourage consumer + business spending

To foster an economic contraction during an upswing the Fed will…

  • Increase discount rate

  • Increase reserve requirement

  • Sell Treasury Securities

  • Result: depress consumer + business spending