Fiscal and Monetary Policy

Fiscal and Monetary Policy in a Fictitious Economic Scenario

Recently, all of Wall Street waited with bated breath for Allen Greenspan to announce what would be the shift in the Federal Reserve's upcoming policy regarding interest rates, given that our national economy was apparently recovering at a much stronger than expected pace. Dismayed at the news that the Fed was likely to raise rates, thus encouraging saving and tempering consumer spending, the stock market temporarily took a nosedive. It was speculated that this information might have been leaked, to assess Wall Street's reaction to a possible rate hike. The Fed retracted its position, slightly.

This recent dialogue of public relations and monetary policy highlights the impact even suggestions by the federal government and the Federal Reserve chairman regarding national fiscal and monetary policy respectively can have upon the nation. Fiscal policy is the use of government spending and taxes to stabilize the economy. Monetary policy is the use of the money supply and credit to stabilize the economy.

Now consider the following fictitious scenario. The United States economy's GDP or Gross National Product growth is at approximate 1.5% and has been at approximately this level for two years. As a means of comparison, during the 2001 recession, GDP hovered at 1%. (Herman-Elkin 2003) The inflation rate, as measured by both the CPI and the GDP deflator has been at approximately 1-2% for the last two years. Again, as a means of comparison, during the 2001 recession, inflation also hovered at 1%(Herman-Elkin 2003) In the fictional scenario, unemployment has recently moved to 7.3% up from 7% one year ago, and 6.5% 2 years ago. The federal funds rate target is 3.5% and the discount rate is 3.25%. The government's budget has been operating at a deficit of approx $60 billion for the last year, up from $50 billion the year before.

Economists generally look to annual goals of GDP growth of 2.5-3%, an inflation rate of 3-4%, and an unemployment rate of approximately 5% for stable economic growth. (Herman-Ellison, 2003) Thus, the overall portrait of the economy in the given scenario is a two-year economic slump in the United States' GDP. The inflation rate, because of the sluggish rate of growth is also low, and in fact lags behind the rate of GDP growth, suggesting a potential problem of deflation looming on the horizon. Unemployment is likewise very high in the scenario. Yet it is not so easy for the government to spend itself out of this dip in economic fortunes, given that the budget deficit is growing, as might be suggested by the British economist so popular in the first half of the 20th century, John Maynard Keynes. Thus fiscal policy might not be the 'way to go.'

The Fed uses three monetary policy tools to influence the availability and cost of money and credit: open market operations, the discount rate, and reserve requirements. To tighten money and credit in the economy, the FOMC directs the New York trading desk to sell government securities, collecting payments from banks by reducing their reserve accounts. With less money in these reserve accounts, banks have less money to lend, interest rates will increase, consumer and business spending are likely to decrease, and economic activity thus slows down. (FRBSF, 2004) In the given economic scenario, however, the Fed would desire to do the opposite and desire to sell more government securities.

In the given scenario, the Fed must change the discount rate. "The discount rate is the interest rate a Reserve Bank charges eligible financial institutions to borrow funds on a short-term basis." (FRBSF, 2003) A higher discount rate can indicate a more restrictive policy, while a lower rate may be used to signal a more expansive policy. In this case, the discount rate, given sluggish economic growth, is far too high and should be immediately lowered by the Fed. In fact, the Fed's inexplicable decision not to lower the discount rate earlier seems to be one of the contributing factors to the slow-down in the economy. To stimulate growth as well, the Fed should lower the interest rates, making it easier for individuals to borrow and to spend money. If the Federal Reserve increases the money supply, interest rates will fall. This will make it less expensive to borrow money. Individuals desiring to borrow money will have an increased incentive to do so, and will be more likely to spend that money on goods and services to stimulate economic growth. (Herman-Ellison, 2003)

By law, financial institutions, whether or not they are members of the Federal Reserve System, must set aside a percentage of their deposits as reserves to be held either as cash on hand or as reserve account balances at a Reserve Bank." Although seldom used as a monetary tool in the modern economy of the United States, these reserve requirements could be lowered as well, given the dire state of the economy. (FRBSF, 2004) The bank's dissatisfaction with the lowered interest rates might be tempered by lowering the reserve requirements to some extent.

One problem because the Fed has not taken action earlier, and because the recession is so sustained, however, businesses may be unwilling to take advantage of the lowered discount rates and consumers may be unwilling to part with their dollars, despite a lowered interest rate, because the unemployment rate makes their economic futures so dicey. Thus, it may be necessary for the federal government to spend its way out of the recession, despite the growing budget deficit, to raise employment, consumer confidence in the future, and to create a more stable overall economy. The danger of deflation is a real one. Although at first it might seem salutary for consumers, when prices continue to spiral downward, the businesses that remain active have less of an incentive to produce goods and to hire more workers. Deflation also devalues the currency abroad, and creates the perception in the eyes of the world of a less stable economy.