Fiscal and Monetary Policy Term Paper

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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.

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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.....

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