Hello tom123!!!
I came back from a mini-vacation trip directly to work.
The modern public authority has a responsibility of promoting public
welfare.
It cannot play a passive role during such major economic crises. In
this way
fiscal and monetary policies are the two important instruments in the
hands of
the modern public authority.
Keynes was the first one to recognize the need of regulating private
enterprise economy, he asserted that large-scale public expenditure is
to be made from time to time to avoid cyclical fluctuations in
economic activities and to maintain high levels of employment and
income.
-Fiscal Policy:
"The second tool available to government (and one that is used by all
levels of government) is fiscal policy. The term fiscal policy refers
to the expenditure a government undertakes to provide goods and
services and to the way in which the government finances these
expenditures."
From "Fiscal Policy" at The Financial Pipeline site:
http://www.finpipe.com/fiscpol.htm
Fiscal policy is carried out by the executive and legislative branches
of government that make policy regarding government spending programs
and taxation. Fiscal policy is part of the process of making laws and
government budgeting, although emergency expenditures can be
undertaken.
We can rewritte the equation of the Gross Domestic Product, that sums
up consumption, investment, government spending and net exports (GDP =
C + I + G + NX) as follows:
GDP = C(Y - T) + I(r) + G + NX = AD
Where
AD = Aggregate Demand
Y = income
T = taxes paid
Y - T = disposable (after-tax) income
r = the rate of interest
I(r) means Investment (I) is a function of the interest rate (r): As r
increases, I will decrease and as r decreases, investment will rise.
Using this equation we can see that fiscal policy can be split in two:
·Changes in taxes or the tax rate (T), that in turn affects total
consumption.
·Directly alter the growth rate of GDP and aggregate demand by
changing the level of government spending (G).
Keynes and his followers have popularized expansionary and
contractionary policies. However, the Keynesians emphasize
expansionary policies. It is only in exceptional situations of running
away conditions of inflation or others that the contractionary policy
may be called in.
Expansionary fiscal policy would be used to speed up the rate of GDP
growth or during a recession when GDP growth is negative. A tax cut
and/or an increase in government spending would be implemented to
stimulate economic growth and lower unemployment rates. These policies
will lead to higher federal budget deficits.
A restrictive fiscal policy involves raising taxes or cutting
government spending in an attempt to dampen GDP (aggregate demand)
growth and lower inflationary pressures.
Fiscal policy impacts the growth rate of aggregate demand, given a
constant growth in aggregate supply:
- A contraction of aggregate demand due to higher taxes or a
reduction in total government expenditures results in a shift of the
aggregate demand from a point of full employment to a point with a
higher unemployment rate. This is the impact of a restrictive fiscal
policy that reduces the growth rate of aggregate demand in proportion
to aggregate supply. Inflationary pressures are dampened, but higher
unemployment rates will result.
- The government enacts expansionary fiscal policies such as an
income tax cut and/or an increase in government spending when the
economy is in a recession. The aggregate demand curve intersects
aggregate supply to the left of full employment, in order to raise the
level of aggregate demand and GDP growth an expansionary fiscal policy
is taken. This will boost aggregate demand in relation to the
aggregate supply curve by the shift of the aggregate demand curve. A
greater level of output and increased demand for labor is reached.
- Monetary Policy:
"Monetary policy is one of the tools that a national Government uses
to
influence its economy. Using its monetary authority to control the
supply and
availablity of money, a government attempts to influence the overall
level of
economic activity in line with its political objectives. Usually this
goal is
"macroeconomic stability" - low unemployment, low inflation, economic
growth,
and a balance of external payments. Monetary policy is usually
administered by
a Government appointed "Central Bank", the Bank of Canada and the
Federal
Reserve Bank in the United States....
...
Operations of a Modern Central Bank
The Central Bank attempts to achieve economic stability by varying the
quantity of money in circulation, the cost and availability of credit,
and the composition of a country's national debt. The Central Bank has
three instruments available to it in order to implement monetary
policy:
·Open market operations
·Reserve requirements
·The 'Discount Window'
-Open market operations are just that, the buying or selling of
Government bonds by the Central Bank in the open market. If the
Central Bank were to buy bonds, the effect would be to expand the
money supply and hence lower interest rates, the opposite is true if
bonds are sold. This is the most widely used instrument in the day to
day control of the money supply due to its ease of use, and the
relatively smooth interaction it has with the economy as a whole.
-Reserve requirements are a percentage of commercial banks', and other
depository institutions', demand deposit liabilities (i.e. chequing
accounts) that must be kept on deposit at the Central Bank as a
requirement of Banking Regulations. Though seldom used, this
percentage may be changed by the Central Bank at any time, thereby
affecting the money supply and credit conditions. If the reserve
requirement percentage is increased, this would reduce the money
supply by requiring a larger percentage of the banks, and depository
institutions, demand deposits to be held by the Central Bank, thus
taking them out of supply. As a result, an increase in reserve
requirements would increase interest rates, as less currency is
available to borrowers. This type of action is only performed
occasionally as it affects money supply in a major way.
-Altering reserve requirements is not merely a short-term corrective
measure, but a long-term shift in the money supply. ial banks, and
other depository institutions, are able to borrow reserves from the
Central Bank at a discount rate. This rate is usually set below short
term market rates (T-bills). This enables the institutions to vary
credit conditions (i.e., the amount of money they have to loan out),
there by affecting the money supply. It is of note that the Discount
Window is the only instrument which the Central Banks do not have
total control over.
By affecting the money supply, it is theorized, that monetary policy
can establish ranges for inflation, unemployment, interest rates ,and
economic growth. A stable financial environment is created in which
savings and investment can occur, allowing for the growth of the
economy as a whole."
From "Monetary Policy" at The Financial Pipeline:
http://www.finpipe.com/monpol.htm
"Remember the definition of the monetary base and the determination of
the money supply:
-the monetary base equals all reserves held by banks and all currency
in circulation.
-Money supply = (Monetary base) x (Money multiplier)
-Change in Money supply = (Change in Monetary base) x (Money
multiplier)
The Fed uses monetary policy to influence the economic activity by
altering the monetary base and in consequence change the money supply,
but it does not have direct control over the pace of economic growth.
Rather, it uses policy tools to accomplish this task.
Monetary policies works as follows:
a- The Fed uses one (or more) of its policy tools:
Open market operations, changes in the reserve requirement and/or
changes in the discount rate.
b- Open market operations and changes in the reserve requirement
change bank reserves and the monetary base.
c- Changes in the monetary base interact with the money multiplier to
change the money supply.
d- With changes in the money supply (along with Fed changes in the
discount rate), the Fed targets interest rates.
e- Changes in interest rates influence borrowing by businesses and
consumers and thus change aggregate demand.
f- As borrowing activity responds to changing interest rates, the
Fed's goal is to influence economic activity (the growth rate of GDP).
-Open market operations:
The Fed's most important and widely used policy tool is open market
operations. Remember the reserve requirement, which necessitates that
banks keep 10% of the value of existing deposits on reserve with the
Fed. This gives the Fed tremendous amounts of money with which to
engage in financial transactions. Open market operations involve the
buying and selling of government debt by the Fed (Treasury Bills,
Notes, and Bonds). The Fed makes these debt transactions with banks in
order to alter total reserves in the banking system.
An expansive open market monetary policy tries to increase bank
reserves, this will increase the money supply and the growth rate of
the GDP.
How does this work?
1- The Fed buys bonds from banks.
2- Bank reserves and the monetary base increase.
3- Banks don't want money sitting in their vaults, earning zero
return, so they attempt to loan out the money.
4- To attract borrowers, banks lower the interest rates that they
charge.
5- The businesses and individuals who borrow the money from the banks
spend it on goods and services.
6- These expenditures create incomes that are deposited into the
banking system.
7- The money supply increases by a greater amount than the original
Fed purchase of bonds because of the money multiplier.
8- Increases in investment activity by businesses will increase
aggregate demand and the growth rate of GDP.
In the other hand a restrictive monetary policy is a decision by the
Fed to raise interest rates in order to slow the growth rate of GDP.
When open market operations are used to implement a restrictive
monetary policy, the Fed sells bonds to banks. By purchasing bonds
from the Fed, banks have less money to loan out and the monetary base
shrinks. The result is a reduction in the money supply by a factor of
the money multiplier. The reduction in the money supply and bank
reserves raises the Fed funds rate using the opposite of the process
described above. As long-term interest rates increase along with the
Fed funds rate, business investment and consumer borrowing both
decrease, resulting in slower GDP growth.
-Changes in the Reserve Requirement and the Discount Rate:
On occasion, the Fed will change the percentage of deposits that banks
must keep on reserve with the Fed (the reserve requirement). If the
Fed lowers the reserve requirement as part of an expansionary monetary
policy, banks will have additional money that can be lent out to
businesses and consumers. The value of the money multiplier will also
increase. The net effect is to increase the money supply, lower
interest rates, and increase the GDP growth rate.
A restrictive monetary policy by the Fed involves increasing the
reserve requirement to reduce bank lending and decrease the value of
the money multiplier. The money supply contracts, raising interest
rates and reducing GDP growth as investment and consumption decline
due to the higher interest rates.
Due to the dramatic effects on the money multiplier, the Fed seldom
changes the reserve requirement. The Fed will only use this policy in
circumstances of severe recession or inflation.
-Changes in the discount rate:
The discount rate is the interest rate that the Fed charges banks to
borrow directly from the Fed. The discount rate is usually changed
after the fact of a policy decision involving open market operations.
If the Fed is using open market operations to carry out an
expansionary monetary policy, it may follow up on changes in the Fed
funds rate with a change in the discount rate. In this way, changes in
the discount rate are used to confirm (to the public) the direction of
Fed policy."
Summarized from "Unit 11 - The Federal Reserve and Monetary Policy" at
Department of Economics at the University of Colorado at Boulder
website:
http://www.colorado.edu/Economics/courses/econ2020/section11/section11-main.html
Sources: You can improve this answer by consulting the following
sources.
ECONOMICS by Paul A. Samuelson, Ed. McGraw Hill, chapter 26 "Central
Banking and Monetary Policy".
To see the curves and graphics related to this topics please visit:
http://www.mhhe.com/economics/samuelson17/students/Ch26.mhtml
ECONOMICS by Paul A. Samuelson, Ed. McGraw Hill, chapter 34 "Policies
for Growth and Stability".
To see the curves and graphics related to this topics please visit:
http://www.mhhe.com/economics/samuelson17/students/Ch34.mhtml
OUTLINE OF MICROECONOMIC THEORY by Dominick Salvatore, Ed. McGraw
Hill, chapter 8 "Fiscal Policy", chater 10 "The Federal Reserve and
the Money Supply" and chapter 11 "Monetary and Fiscal Policy".
"Intro to U.S. Money and Fiscal Policies" at Economics department at
Iowa State University website:
http://www.econ.iastate.edu/classes/econ302/tesfatsion/bht5.htm
Visit the page "Unit 11 - The Federal Reserve and Monetary Policy" at
Department of Economics at the University of Colorado at Boulder
website:
http://www.colorado.edu/Economics/courses/econ2020/section11/section11-main.html
Also you can take a look to this page at Salem-Keizer Public Schools
website:
http://skonline.salkeiz.k12.or.us/senrecon/visual15.htm
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