Monetary and Fiscal Policy

What is ISLM economics?

➲ 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

➲ Taxation and revenue capture● Reduces demand, contracts economy, drives

down interest rates➲ Government expenditure

● 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

➲ Tax and spend● Spending more than counteracts equal tax● Surplus = taxes > expenditures

➲ Borrow and spend● Greater short term impact than tax and spend● Deficit = expenditures > taxes● Borrowing now = taxes in future

➲ Print money and spend● Does not increase interest rates● Threat of inflation● We could increase reserve requirements,

give government more control

Current Fiscal Policy➲ As Senate Passes Spending Measure,

Stark Budget Views Are on Display in House

● 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

➲ 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● Creates jobs, stimulates consumption

➲ Decrease interest, and people buy more on credit, save less

● 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)

● Allows private banks to create more or less money● Interest rates (discount window)

● Rate at which Fed loans money to banks● Open market operations: buying and selling

government securities (bonds)● Changes money supply. ● Goal typically is to increase or decrease overnight interest

rates for banks loaning to one another (Fed funds rate)

Monetary Policy

➲ Why might we want to decrease M?➲ Liquidity trap

Current Monetary Policy

● Discount window?● Open market operations?● Reserve requirements?

Who Controls the Fed?

➲ 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?➲ 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

➲ Bernanke’s remedies● 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?

➲ “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

➲ What should our goals be?● 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

➲ Only affects market goods directly● 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

➲ Taxes and ● 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

➲ Subsidies● Research and development● Activities that provide positive externalities:

'subsidize goods, not bads'

Fiscal Policy

➲ Government expenditures● 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