Macroeconomic Policies Term Paper

Fiscal and Monetary Policy Changes in the United States

Principles of Macroeconomics

Pikes Peak Community College

Fiscal and Monetary Policies in the United States

Understanding macroeconomics is key to understanding the larger picture of the economy and plays an important role in keeping the economy balanced. With all the variables that are involved it can be hard for economists to know fully everything that will keep a good balance. Because there are so many variables, several economic policies have been put in place to help with times of change and uncertainty: Fiscal Policies and Monetary Policies. Fiscal policies show us the governments revenue collection and expenditures while monetary policies address the supply of money and short-term lending. Together, these policies are important and play a large role in sustaining a balanced economy because of the influences they have on economic parameters such as inflation, deflation, unemployment and the income and output of the country.

Fiscal policies laid out by the government are aimed to target the total level of spending, composition of spending, or both in an economy (Segal, 2019). The most common ways the government goes about affecting fiscal policy is through changing their spending policies or changing the current tax policies. When the government increases the amount of money that it spends it is usually because the government isn’t seeing enough business activity occurring. Decreased business activity can negatively impact the economy and as a solution the government proposes a fiscal policy typically referred to as a stimulus. Additionally, the government can change current tax policies to affect the economy. When the government increases taxes they are pulling money out of the economy and decreasing business activity and when they decrease taxes they are essentially putting more money into the economy and stimulating business activity.

Increases in spending are often referred to as expansionary fiscal policies. When taking a look at the larger picture, fiscal policies tend to impact consumers more over any other group. This impact is a positive one as it typically leads to lower unemployment rates and increased incomes. In addition to the impact on consumers, companies can also benefit because they will typically see an increase in their revenues. From these affects, it can be reasoned that fiscal policies essentially target aggregate demand, the total amount of money spent on goods and services (Kenton, 2019). While this may sound like a good thing, when the economy is operating at near full capacity there is an increased risk of inflation. When inflation occurs it creates an impact on businesses and consumers that often leads to higher unemployment rates and increased prices on goods and services. To combat this, the government can implement what is called a contractionary fiscal policy.

Contractionary fiscal policy is when the government reduces spending or when they reduce the rate of monetary expansion by a central bank (Bloomenthal, 2019). To do this, the government siphons money from the private economy with the intention of slowing production. More often than not, when this type of policy needs to be instituted it is done in the form of reducing government spending, typically only on specific sectors of the economy (Bloomenthal, 2019). Implementing higher taxes would not work as well as reducing spending because increased taxes take a harder hit on communities and individuals and the results from increased taxes are not the same as those that are seen from the government reducing their spending.

When the government makes theses kinds of fiscal policies they must decide where spending and taxes should be increased or decreased. By doing this the government can specifically target industries, commodities, communities and investments, influencing production levels. This may sound like a rather simple way to help keep the economy balanced, but not all actions that spur fiscal policy are based on economic considerations. This has made fiscal policies a widely debated topic by both economist and political stakeholders.

The concerns of monetary policy are primarily with the management of interest rates and the total supply of money that is in circulation. Monetary policies are used by central banks such as The Federal Reserve to either check economic growth or to stimulate it. These changes through policy are similar to fiscal policies made by the government. There are three main tools that are utilized to influence the economy: setting discount rates, open market operations and changing reserve requirements for banks (Segal, 2019).

The discount rate is interest rate on loans that have been extended by the central bank to commercial banks in order to reduce liquidity issues and help them keep to reserve requirements. This rate is one that has been set by The Federal Reserve and allows the Fed to control the supply of money (Kenton, 2018). This tool can be implemented to either stimulate or decrease the economy. If the Fed were to lower the discount rate it would allow for commercial banks to borrow money at a cheaper rate which increases the available credit and lending power of that bank. If the discount rate were to be increased, on the other hand, it would make it far more expensive for commercial banks to borrow from The Federal Reserve, which would result in decreased money supply (Kenton, 2018). Similarly, the Fed can also change money supply and interest rates by utilizing open market operations.

Open market operations, or OMO is how The Federal Reserve buys and sells government securities to expand or contract the amount of money in the banking system. It is the most common tool used by the Fed to control monetary policy. When the Fed buys and sells government bonds or securities, they are able to control reserve balances that are held by commercial banks. This allows the Fed to increase or decrease interest rates on short-term loans as needed, see image above (Open Market Operations, 2019). When securities are purchased from bond dealers, payments made to those dealers increase the amount of money commercial banks can lend. This would be a form of expansionary monetary policy. Conversely, when the Fed sells securities to financial institutions or individuals, the payments made by those parties decreases the amount that commercial banks are able to lend. This is a form of contractionary monetary policy.

In addition to these methods, The Federal Reserve also sets in place reserve requirements. A reserve requirement is the amount of cash that commercial banks must have, either in their own vaults or at their nearest Federal Reserve Bank (Chen, 2019). When the Fed reduces the reserve requirement, this results in an increase in money in circulation. This is referred to as a form of expansionary monetary policy. When the reserve requirement is raised, the Fed is reducing the liquidity of assets and results in slowed economic activity. This is known as a form of contractionary monetary policy. Of the three main tools used by The Federal Reserve this one is used the least as changes are expensive and create a negative impact on banks. When reserve requirements are changed, commercial banks have to completely modify their procedures which can result in loss of deposits and the increased risk that the bank will not meet reserve requirements (Amadeo, 2019).

When it comes to balancing the economy, there are many factors and variables that have to be considered in maintaining that balance. At times the government needs to step in with fiscal policies that can either stimulate or rein in changes in the economy. This is done through the government changing taxes or their spending. At other times, The Federal Reserve needs to make economic changes in the form of monetary policies. The Fed is able to do this by addressing what changes are needed regarding interest rates and the supply of money in circulation. Whether these policies are meant to expand or contract the money supply, combat inflation, increase unemployment or stimulate the economy in a positive way, they are incredibly important understanding economics. The influences that fiscal and monetary policies have on the parameters of the economy are many and both play a very essential role in creating stability in an always changing economy.

References

Amadeo, K. (2019, February 10). How Banks Lend $9 Out of Every $10 You Deposit. Retrieved July

20, 2019, from https://www.thebalance.com/reserve-requirement-3305883

Bloomenthal, A. (2019, May 01). Contractionary Policy Combats Economic Distortion During

Inflationary Times. Retrieved July 20, 2019, from https://www.investopedia.com/terms/c/contractionary-policy.asp

Chen, J. (2019, April 10). Reserve Requirements Definition. Retrieved July 20, 2019, from

https://www.investopedia.com/terms/r/requiredreserves.asp
Kenton, W. (2018, July 18). Federal Discount Rate. Retrieved July 20, 2019, from

https://www.investopedia.com/terms/f/federal_discount_rate.asp
Kenton, W. (2019, March 12). Aggregate Demand. Retrieved July 20, 2019, from

https://www.investopedia.com/terms/a/aggregatedemand.asp

Kenton, W. (2019, April 04). Open Market Operations (OMO). Retrieved from

https://www.investopedia.com/terms/o/openmarketoperations.asp

Segal, T. (2019, April 10). Monetary Policy vs. Fiscal Policy: What’s the Difference? Retrieved July

20, 2019, from https://www.investopedia.com/ask/answers/100314/whats-difference-between-

Photo

Federal Reserve. (2002, March). [Fed Policy Affects the Short-Term Interest Rates on Interbank

Federal Funds and the Fed’s Discount Rate]. Retrieved July 20, 2019, from https://www.frbsf.org/education/publications/doctor-econ/2002/march/fiscal-monetary-policy/