Fiscal and Monetary Policy
- Regulating the economy
- We want slow growth
- If the economy is not doing good we can fall into a recession (right now) and people can lose their jobs
- If the economy is growing too fast we can have rapid inflation; where prices rise faster than wages
- Both are bad – Two ways to make sure our economy is growing slowly
- Fiscal Policy – Government
- Government spending = Tax Revenue (G=T) = Neutral
- Government spending > Tax Revenue (G>T) = Budget Deficit
- Higher G spending, lower taxes, or combination of both
- Government spending < Tax Revenue (G<T) = Budget Surplus
- Lower G spending, higher taxes, or combination of both
- Slow to work and situation changes
- Monetary Policy – Federal Reserve
- Controlling the money supply
- Availability of money
- Cost of money (interest rates)
The Federal Reserve (FED)
- Independent Agency: part of the government but unattached to Congress & the President
- Allows them to make economic decisions free from political pressure
- Roles of the FED
- Regulates foreign banks that do business in the U.S.
- Our Government’s bank
- Holds government’s money
- Buys and Sells Bonds for Government
- Issues our currency
- Conducts Monetary policy
- Board of Governors (7 member board)
- Chairman – Ben Bernake
- Advisory Council (12 members – 1 from each district)
- Federal Open Market Committee (FOMC) – major policy making group
- 12 Federal Reserve Banks & Branch banks
Fractional Reserve Banking
- The tools the FED has to create money
- Discount rate – prime rate which banks borrow money from the FED
- Reserve Requirements – Percentage of deposits that banks must hold
- Open Market Operations – buying and selling of government bonds
- Federal Funds Rate – interest rate that banks lend to other banks usually overnight
- Ex. Suppose a bank issues a loan which takes money out of the bank and lowers its reserves. If it falls below the reserve requirement, it must borrow money from another bank that has a surplus of funds. The rate the other banks charge is the federal funds rate.
Monetary Policy
- Quicker response than fiscal policy
- Regulates the amount of money in circulation
- Tight Money Policy
- Goal is to stall growth to stop inflation
- Taking money out of circulation
- Can lead to a recession
- Raising interest rates
- Raising the reserve requirements
- Selling bonds
- Loose Money Policy
- Goal is to start growth of the economy to combat a recession
- Increasing the money supply
- Can lead to inflation
- Lowering of interest rates
- Lowing reserve requirements
- Buying bonds
Fiscal Policy
- Government (politicians) use taxing and spending to regulate the economy
- Tools:
- Tax: can be raised or lowered
- Spending: can be increased or decreased. Ex. Cutting back on public works projects
- Tight Fiscal Policy
- Combat inflation
- Raise taxes
- Cut spending
- Take money out of economy – slow economy
- Loose Fiscal Policy
- Combat a decline
- Cut taxes
- Increase spending
- Put money into Economy – grow economy
Fiscal and Monetary Policy
- ______
- ______
- If the economy is not doing good we can fall into a recession (right now) and people can lose their jobs
- If the economy is growing too fast we can have ______; where prices rise faster than wages
- Both are bad – Two ways to make sure our economy is growing ______
- Fiscal Policy – ______
- Government spending = ______(G=T) = Neutral
- Government spending > Tax Revenue (G>T) = ______
- Higher G spending, ______, or combination of both
- Government spending < Tax Revenue (G<T) = Budget ______
- Lower G spending, higher taxes, or combination of both
- ______and situation changes
- ______
- Controlling the ______
- Availability of money
- Cost of money (______)
______(FED)
- Independent Agency: part of the government but unattached to ______
- Allows them to make economic decisions free from political pressure
- Roles of the FED
- Regulates ______that do business in the U.S.
- Our Government’s bank
- Holds government’s money
- ______
- Issues our currency
- Conducts Monetary policy
- Board of Governors (7 member board)
- Chairman – ______
- Advisory Council (12 members – 1 from each district)
- Federal Open Market Committee (______) - ______
______
- ______& Branch banks
Fractional Reserve Banking
- The tools the FED has ______
- ______– prime rate which banks borrow money from the FED
- Reserve Requirements – ______
- Open Market Operations – ______
- ______– interest rate that banks lend to other banks usually overnight
Monetary Policy
- ______
- Regulates the amount of ______
- Tight Money Policy
- ______
- Taking money out of circulation
- ______
- ______
- Raising the reserve requirements
- ______
- Loose Money Policy
- ______
- Increasing the money supply
- Can lead to ______
- Lowering of interest rates
- ______
- ______
Fiscal Policy
- Government (politicians) use ______
- Tools:
- Tax: can be ______
- Spending: can be increased or decreased. Ex. Cutting back on public works projects
- Tight Fiscal Policy
- ______
- ______
- Cut spending
- Take money out of economy – slow economy
- ______
- ______
- ______
- ______
- Put money into Economy – grow economy
Monetary Policy Tools of the Federal Reserve
Banks earn profits by accepting deposits and lending part of those deposits to someone else. They sometimes charge fees for establishing and maintaining accounts and always charge borrowers an interest rate. However, banks do not lend all of their deposits. Banks are required by the Federal Reserve System to hold a portion of their deposits as reserves in the form of currency in their vaults or deposits with Federal Reserve System.
Open Market Operations
The Federal Reserve buys and sells government securities and by doing so, increases or decreases banks' reserves and the banks' abilities to make loans. As banks increase or decrease loans, the nation's money supply increases or decreases. That, in turn, decreases or increases interest rates. The purchase and sale of bonds by the Federal Reserve is called 'open market operations.' The Federal Reserve is 'operating' by buying or selling securities in the 'open market.'
When the Federal Reserve sells a bond, an individual or institution buys the bond with a debit on their account and transfers the funds to the Federal Reserve. The Federal Reserve removes an equal amount from the customer's bank's reserves. The bank, in turn, removes the same amount from the account of the customer who purchased the bond. Thus, the money supply decreases and interest rates increase.
The opposite occurs when the Federal Reserve buys a bond. The Federal Reserve gives funds to the seller of the bond. The seller deposits the funds in their account. Their bank adds the amount to deposits and thus the money supply increases. The bank also presents the funds back to the Federal Reserve, which in turn adds the amount to the bank's reserves. Because the bank has to keep only a portion of those reserves, the bank can make loans with the remainder. Thus the money supply expands even further. As banks make more loans, interest rates fall.
Open market operations are the primary tool of the Federal Reserve. It is a tool that is often used and is quite powerful. This is what the Federal Reserve actually does when it announces a new target for the federal funds rate. The federal funds rate is the interest rate banks charge one another in return for a loan of reserves. If the supply of reserves is reduced because the Federal Reserve has sold bonds, that interest rate is likely to increase. If the supply of reserves is increased because the Federal Reserve has purchased bonds, that interest rate is likely to decrease.
The Discount Rate
The Federal Reserve FOMC announcement refers initially to the change in the federal funds rate target. The announcement may also include a change in the Fed's discount rate.
The discount rate is the interest rate the Federal Reserve charges banks if banks borrow reserves from the Federal Reserve itself. Banks may need to borrow reserves if they have made too many loans, have experienced withdrawals of deposits or currency, or have had fewer deposits than they expected. Banks can borrow reserves from the Federal Reserve or from other banks.
In reality, banks seldom borrow reserves from the Federal Reserve and tend to rely more on borrowing reserves from other banks when they are needed. They will still pay an interest rate (the federal funds rate), but that is a rate determined in the market for reserves and influenced by the open market operations of the Federal Reserve.
From 2003 until mid-August 2007, the discount rate was almost always 1.0 percent above the federal funds rate. From August 17, 2007 until the current FOMC announcement rate, the discount rate has been ½ percent higher than the federal Funds rate.
Figure 2 shows the discount rate along with the federal funds rate. Notice that the discount rate typically changes along with the target for the federal funds rate.
Reserve Requirements
Banks are required by law to hold a portion of some of their deposits in what are called reserves. The portion varies depending upon the type of deposits and the size of the bank. Most are required to have either 3 or 10 percent of their deposits on reserve, depending on the size of the accounts. Reserves consist of the amount of currency that a bank holds in its vault and the bank's deposits at Federal Reserve banks. The required reserve is the portion of a bank's deposits that cannot be loaned to other customers.
If banks have more reserves than they are required to have, they can increase their lending. If they have insufficient reserves, that is, less than they are required to have, they have to curtail their lending or borrow reserves from the Federal Reserve or from another bank. If another bank has more reserves than they are required to maintain, those extra reserves are called excess reserves. The reserve requirement is seldom changed, but it has a potentially very large effect on the ability to make loans and thus on interest rates.
If the Federal Reserve were to increase the reserve requirements, banks would have to curtail loans and the money supply would shrink. If the reserve requirements were lowered, banks would have excess reserves and they could increase the amount and number of loans they make.