Role of Federal Reserve in Monetary & Fiscal Policy for Economic Stabilization, Slides of Business

Download Role of Federal Reserve in Monetary & Fiscal Policy for Economic Stabilization and more Slides Business in PDF only on Docsity! Macroeconomics Topic 9: “Explain the strategy behind government policies to stabilize the economy and the specific role of the Federal Reserve.” Reference: Gregory Mankiw’s Principles of Microeconomics, 2nd edition, Chapter 20. Smoothing out the fluctuations: stabilization policy Real GDP in the United States has grown at about 3.3% per year since about 1875. Overtime this has led to the US becoming one of the richest countries in the world. Unfortunately, this growth in real GDP has not been smooth. In some years (expansions) GDP grows much faster than the long term trend, and inflation often increases. while in others (called recessions) real GDP falls. The pattern of recessions and expansion is called the business cycle by economists. Since the burden of poor economic performance during recessions falls principally on the unemployed, policy aimed at eliminating the fluctuations associated with the business cycle seems desirable to most people. Government policy designed to smooth out the business cycle are called stabilization policies. The two primary types of stabilization policy used in the United States are monetary and fiscal policy. Monetary policy Monetary policy attempts to reduce the fluctuations in nominal GDP and unemployment by manipulating the rate of growth in the money supply. Monetary policy is carried out by Federal Reserve Bank’s open market committee. The general strategy is to increase money growth during periods of higher unemployment (recession) and reduce money growth during periods of inflation (excess expansion) Why does increasing the money supply raise aggregate demand? Economists following the writings of John Maynard Keynes believe that recessions stem mostly from unusually low aggregate demand for final goods and services. To combat low aggregate demand a government policy must increase some component of aggregate demand without commensurately reducing some other component. Aggregate Demand = Consumer Spending + Investment Spending + Government Purchases + Net Exports Monetary policy attempts to increase aggregate demand during recession by increasing the growth of the money supply. The theory of liquidity preference suggests that increasing the money supply will cause interest rates to fall. Lower interest rates cause higher investment spending which increases aggregate demand. When the Federal Reserve Bank increases the money supply through an open market operation, it is buying government bonds from large banks with newly created reserves. The additional reserves allow the banks to create new money through loans to private citizens and companies. As banks compete to make new loans, they will offer loans at lower interest rates. The new lower interest rates attract new borrowers. Most borrowers are using the loans to purchase durable items such as cars, houses, or – in the case of companies – new factories and equipment. As a result, the lower interest rates increase investment spending, and aggregate demand increases. • Why does monetary policy involve slower money growth during expansions ? While most economists believe that increasing money growth can affect aggregate demand in the short run, in the long run a high rate of growth in the money supply leads to inflation. As a result, the average rate of growth in the money supply should be slowed if inflation develops in the expansionary phase. If growing the money supply more rapidly during the recessions lowers interest rates and increases investment spending, the slower growth of money during expansions raises interest rates an reduces investment spending and aggregate demand. When one combines the effects on both recessions and recoveries, monetary policy reduces the swings in economic activity – it stabilizes the economy. Rather than growing unusually rapidly during the recovery, with monetary policy GDP should rise at a rate closer to the long-term sustainable growth rate. • Interest rate targets and monetary policy at the Federal Reserve Bank When the Federal Reserve Bank describes its monetary policy actions in the newspaper, it does not typically discuss the rate at which it will be increasing the money supply. Instead, the Fed typically announces an interest rate target for the federal funds interest rate. The idea is that the Fed will keep increasing the money supply until that interest rate is reduced to its target level. In the newspaper, they often say something like “The Fed has lowered interest rates from 5% to 4%,” meaning that the Fed will increase bank reserves until this happens. Increasing reserves in most cases will lead to an increase in the money supply. Fiscal policy The word “fiscal” refers to “budget.” Since most Keynesian economists believe that recessions arise from low aggregate demand, the phrase “fiscal policy” amounts to a collection of strategies that manipulate the government’s budget to affect aggregate demand. In practice, fiscal policy involves using one of two strategies: Increasing Government Purchases: The government buys more goods and services during recessions (paying with borrowed money), and then pays back the loans during the recovery by buying fewer goods and services. Cutting Taxes: The government reduces the amount of tax collections during recessions (borrowing money to pay the bills), and then pays back the loans during the recovery by raising taxes.