Fiscal and Monetary Policy Breakdown

Any given economy has two ways at its disposal to control the economic aspects of that economy. We insist on the economy since an economy is entirely a different entity from a government. Mankiw (2006) writes that control of the economic activity through monetary policy is implemented by a central bank (Federal Reserve Bank System), while the national government (Federal government) sets fiscal policy decisions. Nevertheless, in most cases, economies will tend to use both policies to influence the performance of the economy both in the short run and in the long run. Growth of the economy is measured best through the GDP while other key performance indicators or rather macroeconomic issues such as unemployment levels also indicate the direction taken by a given economy. In this paper, we discuss both the monetary and fiscal policies and how they have been used to influence the performance of the economy in the US in response to two articles on this subject. These articles are Why ‘Stimulus’ Will Mean Inflation by George Melloan (2009) and Fed Cuts Key Rate to a Record Low by Jackie Calmes & Edmund Andrews (2008)

The prevailing global recession and more specifically in the US is being attributed to:

  • Credit crunch
  • Housing bubble – related to the shortage of mortgages and credit crunch
  • Cost-push inflation squeezing incomes and reducing disposable income (the result of high energy prices)
  • The collapse in the confidence of the finance sector causing lower confidence amongst ‘real economy’

Therefore, the explained factors have influenced negatively on aggregate demand (AD) which is composed of consumption by households, government spending, and exports fewer imports and thus a change in any of its components means that it shifts (Mankiw 2006). In the current economic crisis, the curve has shifted to the left. Graphically, it is indicated by the shift of AD1 to AD2 in the figure below. GDP will consequently fall from Y1 to Y2 and the price level has failed from P1 to P2. This is however only applicable in the short run. From the viewpoint of the monetary policy, this decline of the GDP was reasoned by numerous factors, which influence the position of the AD line.

Aggregate demand curve
Fig. 1: Aggregate demand curve

From figure 2, we can draw a new graph to show an increase in the money supply from figure 3. From figure 3 it shows the supply curve shift to the right from S1 to S2, and the price level decreases from P1 to P2, so there is an increase in GDP fromY1 to Y2. Thus, it results in an increase in loans and an increase in borrowings.

In the offered stimulus plans, the money is being spent on bailing out falling corporations as well as tax decreases. This will increase the amount of disposable income available to the households and thus increase aggregate demand. However, the stimulus bills under former president Bush were not enough and hence the Obama’s idea of increasing money supply through stimulus bills further.

The slope of AS determines the change in Y. If there is a fall in AD represented by a shift to the left, GDP will increase from Y1to Y3 A vertical AS curve would mean that the economy is operating at full capacity and 100% utilization of all resources. In that case, a change in demand would only mean a slight change in real GDP. This is what would be theoretically expected of the US economy as a leading economic power that a change in AD would only mean a slight change in real GDP, but this has not been the case.

Goods and services market
Fig.2: Goods and services market

An increase in money supply through a stimulus is marked by a shift of the aggregate demand curve AD1 toAD3. The new equilibrium point after the increase in money supply will be E3. The GDP shall have increased from Y1 to Y3. Again, the stimulus will lead to inflation marked by the increase on the price level form P1 to P3.

In the money market, the above increase in money supply can be represented graphically as follows.

Money market
Fig. 3: Money market

The slope of AS determines the change in Y axis. If there is a fall in AD represented by a shift to the left, GDP will increase from Y1to Y3 A vertical AS curve would mean that the economy is operating at full capacity and 100% utilization of all resources. In that case, a change in demand would only mean a slight change in real GDP. This is what would be theoretically expected of the US economy as a leading economic power that a change in AD would only mean a slight change in real GDP, but this has not been the case.

Melloan (2009) on the other hand addresses the ever-increasing stimulus plans. He argues that by the end current financial crisis, the American government will have injected trillions of dollars into the economy which in this case qualifies as an expansionary fiscal policy as it increases money circulating in the economy. The government plays its role by influencing economic patterns expansionary monetary and fiscal policies. The action increases money circulating in the economy that in turn increases aggregate demand as households have more money at their disposal for spending. Unfortunately, the excessive money supply in the economy will lead to inflation. Mankiw (2006) informs us that there is no guarantee, however, that the money injected into the economy through the stimulus bill will directly be reflected in the GDP. This is because other factors will come into play such as speculation by households that will despite the increase in nominal income, lead households into saving for a rainy day.

As said earlier, fiscal policies are implemented by the Federal Reserve System on behalf of the federal government. Calmes and Andrews (2008) write in the New York Times that the Federal reserve bank is cutting the funds rate to a record low as of December last year. Mankiw explains that these funds rates are interest rate charges that banks charge one another on overnight lending. The Federal Reserve Bank regulates this rate by acting as the lender of last resort to maintain the desired level of funds rate. As such, banks are forced to charge the interest rate that the Federal Reserve Bank charges on commercial banks as they strive to achieve the minimum reserve requirement regulation.

A low funds rate means that commercial banks have more deposits on which to lend out than in the case of high funds rate. As such, by the Federal Reserve Bank cutting funds rate to 0-0.25% as Calmes and Andews (2008) report, then there is more money to be lent out by the banks. As a result, more money will be circulating the economy as households and firms borrow the cash for spending and investing respectively.

Funds rate market: fall on the funds’ rate
Fig. 4: Funds rate market: fall on the funds’ rate

This graph shows the effect of a drop in funds rate that causes the aggregate demand curve to shift to the right from AD1 to AD2. As a result, GDP will increase from Y1 to Y2. Unfortunately, this has not been the case since the Federal Reserve System lowered the rates back in December last year. The increase in money supply in the economy has not translated directly to the GDP. Mankiw attributes this to inflation and unemployment relations.

Inflation means that the high increase in price levels results in higher production costs for firms. As a result, firms will hold back their production capacity as raw materials become more expensive. Consequently, firms will lay off employees to keep down their costs of production.

In the government securities/open market operations (OMO) market characterized by government bonds, the situation is as shown below.

Bonds Market
Fig.5: Bonds Market

When government bonds are in high supply, the government is reducing the amount of money in circulation in the economy. The Federal Reserve System accomplishes this, as the government itself is not directly involved in the trading. At S1, the supply of government bonds is high and the GDP is high at Y3. When the bond is fetching high-interest rates individuals and firms are more willing to invest their money in the bonds market than during the low rates. As such, when interest rates on bonds are high then the demand is high which applies when the demand is low. Unfortunately, high demand for bonds shrinks slows down the economy by limiting the growth of GDP. In the above graph, the high demand for bonds that fetches P3 leads to a smaller GDP value of Y3. When the bonds are fetching a smaller price of P1 hence lower demand, the economy grows as shown by a higher GDP of Y1.

An increase in the money supply in the economy leads to higher levels of GDP. However, the same leads to higher levels of inflation. Due to inflation, firms are limited in their production capacity as raw materials become more expensive. As such, they cut down on their production to ensure they remain profitable. This in turn leads to an increase in unemployment, as firms will lay off staff. Unemployment reduces aggregate demand as households have little disposable income. However, a new equilibrium point is reached though at a lower level of GDP. This is realized as employees become more desperate due to the high unemployment levels. They thus accept lower salaries and allow firms to increase production. With the lower salaries, firms’ households increase the aggregate demand and hence a new equilibrium point.

According to the lecture, we discuss the natural rate of unemployment is about 4%~6% unemployment, and I am going to apply this theory with Phillips Curve that we drew in the lecture, this is shown in figure 6.

Figure 6
Figure 6

In the long run, the Philips curve explains that the high inflation rates will force firms to lay off employees. The high rate of unemployment creates desperation among the unemployed for the firms to take advantage of. This takes the form of employees accepting lower wages and salaries. This is in line with the law of demand and supplies which states that the higher the supply the lower the price. In the long run, the economy will settle at an equilibrium point that might be lower than the previous point. As such, it is high time that the government reconsiders excessive money supply in the economy that will devaluate the dollar against other foreign currencies. Again this might also lead to stagflation which Mankiw (2006) says that history has shown that can prolong for over a decade completely destabilizing the economy and all industries.

If the situation would persist, then the low funds’ rate will have only added to the worsening of the economy through inflation. However, if inflation remains manageable, there will be a slight increase in GDP as shown below.

Figure 7
Figure 7

Y* would be the desired level of GDP if inflation would remain relatively low. Y0 would represent a point in which there is high inflation as shown by the change in the price level from P1 to P2. In favorable conditions prices will increase at a steady price at P* which would guarantee the highest level of GDP at Y*. As such, the government should also combat inflation while at the same time jumpstarting the economy through an increase in the money supply.

References

Calmes, J. & Andrews, E. (2008) Fed Cuts Key Rate to a Record Low, New York Times, Web.

Melloan, G. (2009). “Why ‘Stimulus’ Will Mean Inflation”, Wall Street Journal. Web. 

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