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In the past, when America embraced a philosophy of Laissez Faire, the government did little to monitor and control the economy. After the depression, however, that philosophy changed radically. Today we all have come to understand that one of the federal governments most important roles is regulating and ensuring the stability of the economy.
The government has two major ways of doing this. The government can enact fiscal policy changes or they can enact monetary policy changes.
Fiscal Policy- The power of the federal government to tax and spend in order to achieve its goals for the economy.
Monetary Policy - Programs that try to increase or decrease the nations level of business by regulating the supply of money and credit.
What both of these policy options have as a goal is increasing or decreasing the level of business activity. It is most always preferable to have a productive growing economy but an economy can also be too productive. In that case the government may enact policies to slow down the economy.
In order to understand the functioning of these two policies we must again revisit the concept of inflation. Remember, inflation is when the value of money goes down. This means that it costs more money to buy products. Think of the economy in terms of supply and demand; the more money there is out there being spent, the less the money is worth. The supply is high, thus the value is comparatively lower. What this also means is that people are spending, and this is good. So what we have to do is find the proper balance between a healthy amount of spending and money in circulation and an acceptable level of inflation. Economists have placed "healthy" inflation ant 2 - 3%. This shows spending growth and expansion, any more and we begin to worry.
Fiscal Policies include raising or lowering of taxes. If we raise taxes we are taking money out of circulation. When one considers the impact of taxes one must look at the sector of society being impacted by the tax hike. Does it impact on the middle class, working class or upper class. There are differing philosophies on who should shoulder the tax burden. Some feel it should be the wealthy while other look to the middle class. The reality is that the middle class pay the largest amount of taxes overall. Raising taxes to the middle class will limit consumer spending so if you are going to do that you had better have a good reason. Clearly raising taxes will slow down spending, economic growth as well as inflation.
The question then comes to tax cuts. You must again ask the same questions. Who do you want to cut taxes too? Who do you want to encourage to spend? Again, recent economic history proves that cutting taxes to the middle class is the only effective way to encourage growth and spending.
The grand daddy of all fiscal policy spending programs was FDR's new deal. Knowledge of the New Deal is essential to understand the importance of government spending, as well as its shortfalls. As any student of American History knows, the New Deal did not end the Depression, W.Wdid. It did, however, help to move the economy along and did help millions of people. Spending programs pump money into an economy and increase spending and growth. They also have the potential impact of increasing inflation as more money circulates in the economy.
Again, when determining what spending programs to initiate depends on where you want the impact to be. If you build highways you will create jobs for the working class, same with housing projects, etc. These types of jobs employ many workers. If you build B2 bombers, however, less workers are employed at a much higher cost. Who gets the money here? The large corporation that builds it does, that's who. So you see, how you spend the money means as much as how much money you spend.
Spending cuts have the same impact. If you cut homeless shelter there are people out on the streets. From en economic impact perspective that may not seem like much but now you have a human interest issue. If you close military bases you may well shut down the town that thrives off of the existence of the base. Some bases employ up to an over 20,000 townspeople with no other viable means of support. You have to consider the impact and the location of the base. When the federal government cut funding for the F-14 Tomcat Fighter built by Grumman on Long Island it had a terrible impact on the Long Island economy as those highly technical workers sought to find jobs. Since Long Island is a wealthy suburb of New York City, however, those workers were more likely to find work then if the factory had been located in a more rural area.
You can find information about the Fed's structure on this site or at the link above.
The Fed has several policies they can take through the Board of Governors and the Open Market Committee. Most often they are led in their actions by the Chairman of the Federal Reserve Board, a post currently held by Alan Greenspan. The powers of monetary policy often have immediate and forceful impact so what it does is closely watched. Every word that comes out of Greenspan's mouth is seen as a sign for what he thinks of the economy. Entire businesses exist just to watch the fed and Mr. Greenspan. I wouldn't be surprised is some economists and investors consulted psychics to try to gain an advantage.
Each policy has one basic goal, impact the money supply. All of these policy actions work using the laws of supply and demand. The more money in circulation, the more spending there is and the higher inflation is. The less money there is in circulation, the less spending there is, inflation decreases. Those policies that restrict the money supply are known as "tight" and those that put more money into circulation are known as "loose." Lets examine each of the policy actions and their possible results.
The Federal Reserve System has the power to set an amount, or percentage, of deposits that its member banks must keep in reserve at the Fed. If the fed raises its reserve requirements then banks have less money on hand and thus have less to lend. This lowers the amount of money in circulation and could have the impact of slowing the economy and inflation. Conversely if the fed lowers the reserve requirement. banks have more money on hand, more to lend and more money goes into circulation, thus increasing spending and possibly inflation.
One of the most important and publicly watched Fed actions, the discount rate is interest rate that the Fed charges banks on money the banks borrow from the Fed. Member banks borrow money from the Fed to pay out loans and other investments but they must pay a fee, the discount rate. The reason this can be done is because the Fed acts as the central bank and makes loans to other depository institutions. These institutions may borrow money from the Fed because they either have an unexpected drop in their member bank reserves or because they are faced with seasonal demands for loans. The discount window is a teller's window at the Fed that depository institutions use to borrow member bank reserves. For a bank to obtain a loan, it must agree on the terms of the loan in advance. Next, the depository institution delivers collateral to the window. Then the loan is granted and appears as an increase in the institution's member account. Currently the Fed charges 5.3% and the banks charge 8.5%-10%. The Prime Lending Rate is lowest rates banks are allowed to charge their customers. The Prime, as of December 31 is 8.5%. You can check the figures for the discount rate and Prime here.
If the Fed lowers the discount rate, banks are charged less for the money they borrow and thus more people borrow. This increases the amount of money in circulation, speeds up the economy and increases inflation. Conversely, if the Fed raises the discount rate this lowers the amount of money in circulation because fewer loans are expended as the Prime goes up. This slows the economy and lowers inflation.
Open Market Operations are the Fed's power to buy and sell government securities like T-Bills. The Fed uses Open Market Operations more than any other tool to regulate the economy. Most people do not pay attention to this less public action but it is very effective.
If the Fed buys back bonds it is putting money into circulation because the money is going from the government to the people. So if the government buys bonds it increases inflation. Selling bonds restricts the money supply. If we do this we can lower inflation rates.
The simplest and most clear of all the Fed's operations. The government does not, as a matter of sound economic policy, print money or destroy money in order to effect changes in the economy. The power, however to do so, does exist. If the government prints money it increases the amount in circulation and if it destroys money it restricts the amount in circulation. This has a corresponding effect on inflation. To illustrate the possible negative effects of just printing more money to counter deflation consider the case of the Weimar Republic in Germany during the Depression. To counter deflation and pay off reparations debts owed to France, Germany began to overprint money. This action caused hyperinflation. Germans saw the value of the Mark plummet as prices skyrocketed. Shoppers literally carried money in wheelbarrows. It was worthless.
It is 1974. The economy is suffering from a situation economists have referred to as "stagflation." The GNP is showing a slower than normal rate of increase, an indication of a sluggish economy. Housing starts are low and unemployment is on the rise. To make matters worse inflation is quite high.
This problem presents a bit of a conundrum for economists. Stagflation is a two headed monster. You have inflation AND a sluggish economy. This is rare but it has happened, as recently as the mid 70's. The problem is that any action you take has the reverse effect on the other half of the problem. The answer to the problem was to deal with inflation first as this is considered more problematic and eventually leads to less spending. Then we turned our attention to the recession.