Download Topic 5: Using Monetary and Fiscal Policy

Topic 5
Using Monetary and Fiscal Policy to Fight Unemployment and
Inflation
Inflation
 Cause: too much economic activity
 There are too few factors or production to support the demand
for production, prices rise
 Fix: slow down spending
 Contractionary fiscal and monetary policy (decrease G, increase
Tx, increase RRR, sell bonds, increase federal funds rate)
Unemployment
 Cause: not enough economic activity
 The economy’s factors of production could support more
output
 Fix: increase economic output
 Expansionary monetary and fiscal policy (increase G, decrease
Tx, lower RRR, buy bonds, lower federal funds rate)
Some schools of thought
 Supply side economics – tax breaks and incentives for
producers are the most effective way to stimulate the
economy
 Demand side economics – tax breaks and incentives for
consumers, plus government spending, is the best way to
stimulate the economy
Trade off – The Philips Curve
 Graph the Philips Curve – In class
 Vertical axis for inflation, horizontal axis for unemployment
 How to incorporate Natural Rate of Unemployment?
 How to incorporate Inflationary Expectations?
 As the labor market becomes tighter, what happens to prices?
Changes in Philips Curve
 Changes in the Natural Rate of Unemployment?
 Monster.com? Minimum wage? Culture of changing jobs?
 Changes in inflationary expectations?
 People expect higher or lower inflation
 Changes in worker bargaining power?
 Ability to move production over seas
Current Unemployment & Inflation
http://www.google.com/publicdata/home
Current Unemployment & Inflation
 Unemployment is around 10%
 Inflation is low, about 2.0% per year
Links:
http://www.wolframalpha.com/input/?i=usa+unemployment+rate
http://www.wolframalpha.com/input/?i=usa+inflation+rate
So, where are we on the Philips
Curve?
What policies help?
Monetary Policy
 Open Market Operations (to alter the interest rate)
 Required Reserve Ratio (RRR)
 Federal Funds Rate
12/08 Rates for US Treasury Bonds
COUPON
3-Month
0.000
6-Month
0.000
12-Month
0.000
2-Year
0.875
3-Year
1.125
5-Year
1.500
10-Year
3.750
30-Year
4.500
MATURITY
03/26/2009
06/25/2009
12/17/2009
12/31/2010
12/15/2011
12/31/2013
11/15/2018
05/15/2038
YEILD
0.06
0.22
0.36
0.88
1.06
1.51
2.13
2.61
US Treasury Bill Rate
Reserve Requirements
Total Deposits
$0 to $10.3M
$10.3M to $44.4M
> $44.4M
RRR
0%
3%
10%
Fiscal Policy
 Government spending
 Taxes
 Without much room to play with monetary policy, the
government is relying heavily on fiscal policy
What does the government spend money on?
http://www.federalbudget.com/
Projected Deficit (Wash Post)
Keynesian Economics
 The fiscal policies we focus on in class are key tools in
Keynesian Economics.
 John Maynard Keynes (1883-1946) advocated using
government spending to smooth out the business cycle.
 The key policy recommendation of Keynesian theory is to
use deficit spending to pull an economy out of a recession.
Downsides of Keynesian Spending
 Expensive
 The wrong type of spending?
 Spending chosen by politicians and bureaucrats
 Short term projects, not long term solutions
 Real world multiplier may be less than 1
 Encourages irresponsible or inefficient behavior
 Politically infeasible
 Avoids benefits of a recession (!?!?!?)
Similar issues with monetary policies:
 Artificially low interest rates encourage the wrong type of
investment
 Lower return projects
 More risky projects
 Less focus on innovation
 Artificially low interest rates make it “too easy” to borrow
money for consumption
 Might pull us out of the recession more quickly, but result in
a lower long-run growth rate
Politically infeasible?
 Supporters of Keynesian motivated government spending
wanted a bigger bailout
 Opponents thought the spending was already too high
 Quickly passed laws allow for more favors, waste, and other bad
policies
 The outcome of the policy was/is uncertain
 Any way around this?
 Dictator
 Automatic spending that kicks in: i.e., unemployment insurance
Upsides to a recession?
 Survival of the fittest
 Struggling businesses go under, resources redirected
 People get retraining, better education
 Political pressure to fix or change bad policy
 Market bubbles burst, prices adjust
 Others?
Alternatives to Keynesian Spending
1.
Hands off. Let the economy fix itself.
1.
Implement better policy to help employers adjust to
changing markets, and investors make better decisions
 Economies must be able to adjust to government or market
induced shocks to employment
 Better quality regulation, taxes, government spending
 transparency
 incentives