Download Economics for Educators, Revised

Economics for Educators
Lesson 17 and 5E Model
Revised Edition
Robert F. Hodgin, Ph.D.
Texas Council on Economic Education
ii
Economics for Educators, Revised
Copyright © 2012
Texas Council on Economic Education
All Rights Reserved
Texas Council on Economic Education
94
Economics for Educators, Revised
Lesson 17: Fiscal and Monetary Policy
Laissez-faire versus Government Intervention
Does the public truly believe in free enterprise and the workings of private markets? Why not let markets lift all businesses in good
times and purge weak firms in slow times. Or should government intervene in a market society during an economic crisis?
Understanding that there is no economic action without consequences, what are the costs and benefits of government attempts to
moderate economic swings? Do government economists and political leaders see the future so much more clearly than the rest of
society? These and other compelling questions spur the debate on if, how and when government should manifest its presence in a
free enterprise economy.
The fact is that individual actions today are based on perceptions of the future. Policies intended to benefit collective behavior
toward a desired economic goal, however well intentioned could misjudge the economy’s needs as well as the collective economic
response.
The Demand for Money
Knowing how much money individuals and businesses demand to hold is important because that is how many federal economic
policies most often show up—as checks or as the inducement to write checks to spend or invest. First government economists and
policy makers must predict how the average household will respond when they receive new money from the government.
Each individual and business has a certain demand to hold money for transactions, uncertainty and speculation. If they possess
more money than they wish to hold, citizens attempt to spend or invest the difference. If they currently hold less than the desired
amount, citizens will curtail spending or liquidate investments until they achieve desired money balance. Incorrect estimates by
government economists on how the public will react, given their demand for money, can erode a policy’s intended economic effect.
Why can the economy not easily absorb unexpected or unwanted increases in the money supply? From the view of the total
economy, one individual can shed “excess” money by buying more goods or investing in additional assets. But when all individuals
attempt to do so, higher demand for the goods or investments sought with the excess money drives up their price. The reason is that
the output levels simply cannot respond quickly, because of industry rigidities, uncertainty, misperceptions or even fear. So inflation
shows up—as a means to “absorb” the “excess” money.
Monetary Policy Tools
Monetary policy operates through Fed tools, by altering commercial bank reserves to affect the money supply and achieve
macroeconomic goals. The Fed’s seven-member Board of Governors and the Federal Open Market Committee jointly determine
Texas Council on Economic Education
95
Economics for Educators, Revised
monetary policy actions for the economy. The tools used to conduct monetary policy are well-defined and, in a mechanical way, do
work. Yet the full effect of a monetary policy shift may take as long as 18 to 24 months to work through the system. That places
much pressure on the Fed to correctly anticipate future conditions and then be correct in their policy move.
Monetary Policy—influencing the economy’s money supply, by central bank policy makers to achieve national goals.
Monetary Policies with Effects on Aggregate Demand and Interest Rate
“Loose” Monetary Policy
Aggregate Demand
Fed lowers reserve requirement
Fed buys government bonds
Fed lowers discount rate
“Tight” Monetary Policy
Aggregate Demand
Fed raises reserve requirement
Increase; Shift to the Right
Interest rate tends to fall
Fed sells government bonds
Fed raises discount rate
Decrease; Shift to the Left
Interest rate tends to rise
For the Fed to achieve its stated targets without making other economic measures worse they must accurately read both the current
condition and mood of the economy. The Fed must then correctly anticipate how each major economic sector is likely to respond to
their monetary policy change. For example, should the Fed pursue a policy of stabilizing interest rates or stabilizing growth in the
money supply, M1—cash and demand deposits? If the Fed attempts to keep interest rates low by increasing bank’s excess reserves
and expanding the money supply, short-term interest rates will fall. But over time, interest rates and prices could rise if there is more
money than the economy needs to purchase current production.
The inflation arises because people want to hold only so much money, so they shed any “excess” money balances by purchasing
other goods or making investments. While one person can lower his or her money holdings, all people in the economy cannot do so
without consequences. So, general prices rise from “excess dollars chasing too few goods”. Banks enter the picture again as they
try to preserve the purchasing power of future loan payments by bumping up their loan rates as protection against future inflation.
With interest rates now starting to rise, the Fed finds itself having to increase the money supply again to temporarily lower interest
rates. This sequence of actions is the beginning of a monetary policy-induced inflationary spiral.
So what is the best proscription for the Fed regarding monetary policy? Perhaps to match the growth of the money supply to the long
run real growth rate of the US economy—about 3.5% per year. If the Fed were able to control the money supply that closely, at least
some relative sense of stability could be achieved. Yet steadfast reliance on this policy can be criticized from two positions. First, it
tends to inhibit economic growth above 3.5% per year. Second, it ignores the economy’s liquidity needs during unexpected
economic downturns.
Texas Council on Economic Education
96
Economics for Educators, Revised
Fiscal Policy Tools
Fiscal policy influences aggregate demand through Congressional legislation that alters federal spending and tax rates to achieve
macroeconomic goals. America’s discretionary fiscal policy debut occurred during the Great Depression. Prior to that time, incurring
federal debt was unthinkable for a capitalist-based economy and politically supported only as a last resort to finance foreign wars.
There are legitimate economic and political reasons why the public should pay for social assets like highways, public education and
national defense. As long as tax revenues are raised in a relatively equitable fashion and do not outstrip government expenditures,
citizens usually raise little protest.
Fiscal policy—actions altering federal spending levels via Congressional policy on government programs and taxation.
Fiscal Policies and Effects on Aggregate Demand and Interest Rates
Policy Direction
Aggregate Demand
Government spending increase
Government transfer increase
Government tax decrease
Policy Direction
Aggregate Demand
Government spending decrease
Increase; Shift to the Right
Interest rate tends to fall
Government transfer decrease
Government tax increase
Decrease; Shift to the Left
Interest rate tends to rise
The role of government as “business cycle steward” raises more difficult questions. How much federal government presence in the
market is desirable and necessary to stabilize the economy? Does active government spending during times of rapid growth or
decline do more good than harm on balance? Fiscal policy management is an inherently political process. Federal legislation to
alter spending or taxes is subject to the voting and procedural rules of every congressional bill. The new policy must be crafted,
debated, voted on and signed into law. No matter the urgency of the economic need, partisanship is part of the process. Once the
legislation is signed into law it may take some time to implement, then more time to have its desired effect. By that point, the
economy may have already “healed” or may be too “ill” for the legislated remedy to “cure” the problem. While the US track record on
fiscal remedies achieving desired targets is mixed, the logically anticipated effects of fiscal policies on the economy are mechanically
direct.
National Debt and Fiscal Policy
When the federal government spends more than it receives in tax collections, it borrows the difference from society. To authorize the
bond sale, Congress must pass legislation approving an increase in the statutory federal debt ceiling. Then, on instructions from
Congress, the Treasury prepares new financial instruments—US Government Bonds—and offers them for sale in domestic financial
Texas Council on Economic Education
97
Economics for Educators, Revised
markets in an amount sufficient to cover the anticipated annual debt increase. These US government bond debt instruments have a
face value, fixed duration and interest rate stated as a percentage of the face value, as do most bonds. The Federal Reserve
System then acts as the Treasury’s agent to conduct the initial bond sale in US financial markets. Individuals, companies and banks
can buy US government financial instruments to hold in their investment portfolios. Even though their interest yields are lower than
other financial assets of similar size and duration, they are backed by the full faith and credit of the US government.
Crowding Out Effect of Deficit Financing
The US government borrows money from the same pool of net savings from which the private sector draws. Two opposite in
direction effects occur on the money supply when increasing the federal debt. First, some part of the public willingly trades money in
exchange for US bonds, so the money supply temporarily shrinks, causing private market interest rates to rise. Second, and
sometime later, the Treasury spends the newly acquired money on federal programs. Now the money supply increases and interest
rates tend to fall, though not necessarily to their prior level.
So deficit financed fiscal policy contains an inherent monetary dimension. When the government enters the money market as a
borrower, the possibility, and often the actuality, exists that business investment, sensitive to interest rate as an investment cost,
might fall as a result. By the time the Treasury spends the money acquired from its deficit-financing, some business investment may
have been postponed and some consumer spending may have been curtailed. This occurrence is what economists label “crowding
out”. The result is that public sector program spending partially substitutes for precious private sector activity.
Texas Council on Economic Education
98
Economics for Educators, Revised
In Sum
9 The demand to hold money as a liquid asset has direct bearing on the effectiveness of government economic policies.
9 Monetary policy aims to influence aggregate demand using Federal Reserve System tools to alter bank reserves and the money
supply to achieve desired macroeconomic goals
o Raising the Fed discount rate discourages member bank borrowing while discount rate decreases encourage borrowing
o The Fed raising member bank reserve requirements discourages borrowing and reductions encourage borrowing
o The Fed buying US government bonds encourages borrowing and selling them discourages borrowing
9 Fiscal policy aims to influence aggregate demand using Congressional processes to alter government and private sector
spending, then via tax rates and deficit spending, toward desired economic goals.
o Lowering tax rates encourages private sector spending, raising taxes reduces private sector spending
o Increasing government spending encourages economic activity and decreasing government spending reduces economic
activity
o Decreasing tax rates encourages, but does not guarantee, more private sector spending; increasing tax rates reduces private
sector spending.
o Increasing (decreasing) transfers and subsidies increases (decreases) spending
9 National Debt increases occur when government spending is greater than government tax revenues
9 Crowding Out occurs when the government deficit finances new spending, then increased demand for money from the
government’s bond sale increases interest rates and discourages some level of private business investment.
Texas Council on Economic Education
1801 Allen Parkway * Houston, TX 77019 * (713)655-1650 * Fax: (713)655-1655
Email: [email protected] * www.economicstexas.org
Having automatic deductions is a relatively painless way to save since
they do not even see the money.
Take this opportunity to stress that savings must be PLANNED in
advance or it will rarely occur.
Many students will assume that savings should come at the end of the
month IF there is anything left over.
Ask the students to share their sources of income and expenditures.
Answer will vary but should include a job for income and all basic
expenses (rent, food, utilities, transportation, entertainment, etc).
Income and expenses
Ask for opinions on putting a savings amount in the budget.
Multiply weekly expenses by 4.3 weeks for items like food to count for a
month’s worth of expenses. (The average month has 4.3 weeks).
On your own paper, list what you will need to live for a month. Put income
in one column and expenditures in another.
Imagine that you are living on your own, You are going to set up a budget
for yourself. What are the two components you need to include?
Engage
Lesson 17 Fiscal and Monetary Policy, page 94
Page | 53
1801 Allen Parkway * Houston, TX 77019 * (713)655-1650 * Fax: (713)655-1655
Email: [email protected] * www.economicstexas.org
Unemployment leads to less consumption (less money to spend) and
inflation leads to more consumption (more money to spend). Both
cause a change to production which leads to more economic problems.
“Aggregate” means the sum total of all economic actions. When most
consumers are increasing their demand to buy goods & services, then
the aggregate demand increases and more goods and services are
produced. When most consumers are decreasing their demand to buy,
then AD decreases and production will be cut back.
Who is in charge of making the income/spending decisions in a free market
economy?
How does this budgeting process resemble that of the entire society?
Explain
Answers should logically reflect the changes that must be made in the
budget –more income = more spending/investing; higher prices =
tradeoffs on what to buy; less income = less spending.
If one spends more than he makes, the money must be borrowed
(credit cards) or he must make tradeoffs and decide what to eliminate.
If he spends less, he will have money to save or invest.
Discuss possible answers with a variety of students. Have them
speculate on why your income must be the same or greater than all
expenses.
What happens when you get a raise, prices go up, you get laid off from your
job, etc?
What are the consequences when there is not a balance?
Does your budget “balance” – income is the same or greater than expenses?
Why or why not?
Explore
Page | 54
1801 Allen Parkway * Houston, TX 77019 * (713)655-1650 * Fax: (713)655-1655
Email: [email protected] * www.economicstexas.org
Government Fiscal Polity tools = raise or lower taxes or
increase/decrease government spending.
FED Monetary Policy tools = change in the discount rate, change in the
reserve requirement, or change in the Open Market Operations.
The Federal Reserve Act of 1913 and the Employment Act of 1946 have
given them tools for assisting at times of economic crisis.
Recession leads to less spending, less production (unemployment) &
lower prices. Inflation leads to more spending, more production
(higher employment) & higher prices which eventually lead to demands
for higher wages. (wage-price spirals)
Accept student ideas for a few minutes, then follow up with a reminder
that the government is elected to act for the good of the entire nation
when individual actions are not working.
What are the “tools”?
What can the government and the Federal Reserve System do to help out?
Describe the problems in terms of spending, production of goods and
services and prices.
What can a free market system do to help fix the problems of
recession/unemployment or inflation?
Extend
The market system allows individual consumers and producers to make
the economic decisions. When the system is not balanced
(recession/unemployment or inflation), then the individual decisions
do not FIX the problems.
Page | 55
1801 Allen Parkway * Houston, TX 77019 * (713)655-1650 * Fax: (713)655-1655
Email: [email protected] * www.economicstexas.org
Monetary - raise the discount rate (more expensive for banks to
borrow from the FED, therefore they will make fewer loans); raise the
reserve ration so that more money must be kept in reserve and fewer
loans are made while interest rates rise; OR sell bonds in the Open
Market – money is taken out of circulation by the FED when they sell,
leading to higher interest rates.
Fiscal - Increase taxes – take money away from individuals &
businesses so spending is slowed & prices are not driving up quickly OR
decrease government spending so less money is available to encourage
spending & drive up prices
Decrease reserve ratio – banks keep less money in reserve so excess
reserves (loanable funds) increase & interest rate goes down; Buy
bonds in the Open Market – more money is put into circulation when
the FED buys the government bonds, leading to lower interest rates.
Monetary – decrease discount rate – allow banks to borrow from the
FED at a lower interest rate (will make bank loans less expensive for
individuals or businesses);
Fiscal - Decrease taxes – allow people & businesses to keep & spend
more of their income OR increase government spending by paying more
unemployment compensation, creating new government programs
(jobs), etc.
If the problem is inflation, what Fiscal Policy tools can be used? What
Monetary Policy tools?
If the problem is recession/unemployment, what Fiscal Policy tools can be
used? What Monetary Policy tools? This could be in the form of a quiz,
test or essay.
Evaluate
Page | 56
The Texas Council on Economic Education (TCEE) thanks the Council for Economic Education and the
Department of Education Office of Innovation and Improvement for awarding the Replication of Best Practices
Program grant that allowed Economics for Educators, Revised Edition to be written and published.
The Texas Council on Economic Education also thanks six of its major partners whose support allows TCEE to
provide the staff development that utilizes content and skills provided in Economics for Educators.
Helping young people learn to think & make better
economic & financial choices in a global economy.
economicstexas.org
1801 Allen Parkway Houston, Texas 77019 Telephone 713-655-1650 Fax 713-655-1655
Email: [email protected]