Monetary and Fiscal Policy
What is ISLM economics?
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Discussed real sector of economy:
production and income
Discussed monetary sector
What policy tools do we have to affect
these?
Rough model. “Economics is a two-digit
science”
Idea is that economy is always moving
towards equilibrium
Equilibrium?
Chapter 7: Efficiency and Exchange
Slide 3
Macroequilibrium in Real Sector
Conventional Goals of Monetary and
Fiscal Policy
Inflation, Disinflation, Deflation
Fiscal Policy
Fiscal Policy
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Taxation and revenue capture
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Government expenditure
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Reduces demand, contracts economy, drives
down interest rates
Stimulates investment, expands economy
Drives up interest rates if competing with private
sector
Crowding out
3 ways for government to cover
expenditures
3 Ways for Government to Spend
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Tax and spend
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Borrow and spend
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Spending more than counteracts equal tax
Surplus = taxes > expenditures
Greater short term impact than tax and spend
Deficit = expenditures > taxes
Borrowing now = taxes in future
Print money and spend
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Does not increase interest rates
Threat of inflation
We could increase reserve requirements,
give government more control
Current Fiscal Policy
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As Senate Passes Spending Measure,
Stark Budget Views Are on Display in
House
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Congressional Progressive Caucus…would cut
Pentagon spending to 2006 levels, impose a
new tax on millionaires, eliminate tax subsidies
for oil and gas companies and bolster
unemployment insurance.
House’s most conservative members… would
open the Arctic National Wildlife Reserve to oil
drilling, raise the eligibility age for Social
Security and Medicare to 70 and balance the
budget in four short years [and lower taxes on
rich]
Gov’t Revenue as Share of GDP
Monetary Policy
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Based on supply and demand for money
Price of money = interest
Increase supply, price goes down, and vice
versa
Decrease interest, and more investments
become lucrative
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Decrease interest, and people buy more on
credit, save less
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Creates jobs, stimulates consumption
Creates demand for projects, stimulates
investment
What are the tools of monetary policy?
Monetary Policy Review:
3 tools Fed can use:
Reserve requirements (within bounds set by
congress)
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Allows private banks to create more or less money
Interest rates (discount window)
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Rate at which Fed loans money to banks
Open market operations: buying and selling
government securities (bonds)
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Changes money supply.
Goal typically is to increase or decrease overnight interest
rates for banks loaning to one another (Fed funds rate)
Monetary Policy
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Why might we want to decrease M?
Liquidity trap
Current Monetary Policy
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Discount window?
Open market operations?
Reserve requirements?
Who Controls the Fed?
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The governors appointed by the president,
approved by Congress
Chair appointed for 14 years
Regional bank presidents “selected by
leaders of their communities, particularly
bankers.” (NYT)
What is the goal of the Fed?
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Officially to target unemployment and
inflation
“Their main thrust has been to limit inflation,
even at the risk of a recession”
NYT 2005, calling Bernanke a safe choice:
“The lessons of the Depression sometimes
seem to hover behind much of his thinking.
Shortly after becoming a Fed governor in 2002,
for example, Mr. Bernanke argued forcefully for
tough action to head off a possible epidemic of
deflation, or downward spiraling prices.”
Fighting Deflation
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Bernanke’s remedies
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Buying treasury securities with longer maturities
Buy up private debt, e.g. corporate bonds
“In effect, the Federal Reserve would be printing
more money and injecting it into the economy —
a strategy of “quantitative easing,” in Fed
jargon.”
Why does Fed Target Inflation?
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“In settling on Mr. Bernanke, President
Bush ... chose a candidate who would
satisfy others -- investors on Wall Street,
lawmakers in Congress -- more than himself
or his Republican base.”
''They needed somebody that everybody,
including the financial markets, would react
positively to.''
“But Mr. Bernanke had what many
outsiders wanted: a world-class reputation
among economists; credibility on Wall
Street”
Ecological Monetary and Fiscal
Policy
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What should our goals be?
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Sustainable Scale
Just Distribution
Efficient allocation
Stability
How do we reduce consumption without
increasing unemployment, while making
poor better off?
What is appropriate balance between
market goods and public goods?
Monetary Policy
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Only affects market goods directly
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Difficult to simultaneously address scale and
distribution
Poor at dealing with public goods, including
ecosystem services
Changing reserve requirements
Blunt instrument
Institutional Change: The Monetary
System
From
To
Fractional reserve banking
100% reserve requirements
(window of opportunity)
Private sector seigniorage
Public sector seigniorage
Growing money supply for
growing economy
Constant money supply for
steady state economy
Pro-cyclical
Countercyclical
New money spent on
market goods
New money spent on public
goods or loaned for
essential market goods
Fiscal Policy
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Taxes and
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Can be targeted: 'tax bads, not goods'; 'tax what
we take, not what we make'
Reduces overall consumption
Stabilize economy
Can have important impact on scale
WWII 96% marginal tax rate
Fiscal Policy
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Subsidies
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Research and development
Activities that provide positive externalities:
'subsidize goods, not bads'
Fiscal Policy
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Government expenditures
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Can be targeted: welfare for corporations or for
the poor?
Public goods or private goods? What offers
highest marginal benefits?
Investments in human made vs. natural K
Crowding out in a full world