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fiscal and monetary policy It’s just like math; no one likes it, but we need it... What is Fiscal Policy? It all begins with our Federal Budget and the idea that decides what amount of money we are going to spend on programs and services for a given fiscal year (Oct 1st - Sept 30th). The budget is created by the President, but it has to be approved by Congress due to checks and balances. It takes a long time (usually 18 months) to create and is a very complex process. Fiscal Policy is essentially the use of SPENDING and TAXES by the government to control the economy. We use it once we have diagnosed the country using the macroeconomic indicators. There are two types of Fiscal Policy Under Expansionary Policy, the government will do two things: Under Contractionary Policy, the government will do two things: 1. Increase Spending 2. Decrease Taxes 1. Decrease Spending 2. Increase Taxes The idea is that the economy will grow because people will find more jobs from increased spending and because people are spending more of their own money. The idea is that the economy will slow down because less activity is occuring. This could help to prevent things like inflation. I still don’t get how this fixes things... Fiscal policy relies on what we call the multiplier effect; this is the idea that every dollar spent becomes one more dollar in the economy (since money is not destroyed when spent, rather recycled). If one guy spends money, then part of what he spends become income for someone else (since prices reflect inputs like workers). Then, if that guy spends his income, part of what he spends will become income for a third guy (though the amount will be smaller). This process repeats over and over and over again, so that initial injection by the first guy “multiplies” over time to have a larger impact. Seems simple, is it? Yes and no. The general principal of fiscal policy is easy to understand; we use spending and taxes to speed up or slow the economy as we see necessary. However, it is actually a complex process and there are some issues with the process: Entitlements - benefits to people who meet eligibility requirements; cannot be easily changed. Prediction - we never know what might happen next week with the economy. Delay - once we set fiscal policy in motion, it takes time to get through the system. Coordination - there are many pieces to the puzzle and getting everyone to work together is hard. Political Pressure - no politician has complete control of their efforts; they often have to appease others. This is only half of the story, though. Fiscal Policy is a great tool, but it is far from perfect and it is simply not enough to make sure that everything goes well in our economy. What about Monetary Policy, yo? What is Monetary Policy? Historically, even though they served the same purpose, banks were privately owned and controlled companies (like Target or Microsoft today). This created some issues during bad times (like the stock market crash) because banks had no one to back them up if things went south. Monetary policy was created to address consumer confidence in banks and to help our banking system become what it is today with the backing of the Federal Reserve (the “Fed”). Monetary Policy utilizes INTEREST RATES and the MONEY SUPPLY to control the economy. We also use it once we have diagnosed the country using the macroeconomic indicators. So, what is “The FED?” It is ran by a board of seven members that serve staggered, 14-year terms and are appointed by Congress. The meet and decide all monetary policy in the United States. Their chair (currently, Ben Bernanke) is the spokesperson for the group to the public. It is a banking system that is headed by 12 major district banks meant to serve the nation and act as a failsafe. Virtually every bank in America is part of the system. What does the FED do? The FED has three main functions, but only two that comprise monetary policy. 1. Serving the Government: Acts as the checking account for the Federal Government. 2. Regulating the Money Supply: When the government wants to speed up the economy (make it grow), it buys securities from banks. Because the banks now have the money from selling the securities, it can now loan that money to people and businesses and so the supply of money in the economy increases. Conversely, to slow down the economy, the FED will sell securities to banks. The banks buy them because they are guaranteed money in the long run, but because they buy them, they don’t have as much money to lend out to people and businesses and the money supply shrinks. lol.omg.wtf.bbq What does the FED do? 3. Bank Regulation: In addition to working with banks, the FED also directly controls some aspects of the bank. The FED is in direct control of INTEREST RATES, which means it can control how much people choose to put in the economy. If interest rates are set low, people are more willing to take out loans and inject money in the economy, which speeds up the economy and helps it grow. At the same time, if interest rates are raised, then people don’t take out as many loans and there is less money circulating, which slows the economy. Do you know what I’m doing to your mind right now? What does the FED do? The FED also controls the REQUIRED RESERVE RATIO (RRR). It’s generally around 10% Banks make money by loaning money and earning interest. Therefore, to make as much money as possible, it would make sense to loan out all their money. This is problematic because if it loans out all its money, then you could never get your money from the bank. Thus, the Required Reserve Ratio is the amount of money the bank is required to keep in cash, on hand at all times (it is usually represented as a percentage). If the FED wants to slow the economy, it raises the RRR and then banks have to hold more cash and things slow down. Conversely, the FED can speed things up by lowering the RRR and allowing the banks to loan money. Sounds complicated...anything else? Along with all of this, there is the entirely unique issue around the different types of interest rates: First, there is the Discount Rate. It is the interest rate that the FED charges banks that borrow money from the U.S. treasury. Then, there is the Federal Funds Rate. This is the interest rate the banks charge each other to borrow money, usually short-term. There is also the Prime Rate. This is the interest rate that banks charge to their best customers (usually companies). Currently 0.75% Currently 0 - 0.25% Currently 3.25% None of these are rates that you get to look forward to when you get a loan for school or a car or a house. So what do I need to remember? Essentially, there are two types of Monetary Policy: Under Tight Money Policy, the government will do three things: Under Easy Money Policy, the government will do three things: 1. Sell Securities to Banks 2. Raise Interest Rates 3. Raise Reserve Ratios 1. Buy Securities from Banks 2. Lower Interest Rates 3. Lower Reserve Ratios The idea is that the economy will slow because these things shrink the money supply. The idea is that the economy will grow because these things will increase the money supply. What about young money? Any problems with this one? Just like fiscal policy, there are some similar issues with monetary policy: Timing -sometimes the window for adjusting the economy is tiny and we miss it. Prediction - we never know what might happen next week with the economy. Lagging - once we set fiscal policy in motion, it takes time to get through the system.