Browsing Category: "Finance"
Fiscal and Monetary Policies
Fiscal policy is a government policy that looks to influence the economy through changes in government spending and/or taxes, and is contrasted with the other tool used by the government, called monetary policy, which attempts to stabilize economy by regulating interest rates and the supply of money. Fiscal policy deals with government expenditures, debt, and taxes, while monetary policy pertains to the availability, regulation, and cost of credit.
Fiscal Policy impacts aggregate demand, resource allocation, and distribution of income. It deals with the budget of economic activity. There are three possible stances of fiscal policy, which are expansionary, contractionary, and neutral. The neutral stance of the fiscal policy is when the government spending is equal to the tax revenue or (G=T), so the government spending is fully funded by taxes. When the stance of the fiscal policy is neutral, there is no affect on economic activity. The expansionary stance of the fiscal policy is when government spending is more than the tax revenue (or G>T). Expansionary stance is when there is an increase in government spending; this can be due to either a rise in government spending, or a decrease in tax revenue. The last stance of the fiscal policy is the contractionary stance, which is when government spending is less than the tax revenue brought in. This contractionary stance is possible when there is higher taxation revenue, lower government spending, or a combination of the two simultaneously.
The United States government spends money on a variety of different things, and the fiscal policy’s job is to fund these services. The fiscal policy has three ways of funding the government’s spending, which are taxation, seignorage, and borrowing money from the citizens. The government can receive extra money from higher taxes, benefit from printing money, and also from the population which does result in a fiscal deficit. The government can fund its fiscal deficit by issuing bonds such as treasury bills (T-bills) and consolidated stock (consols). These pay interest, whether it be a fixed time period or indefinitely.
Fiscal policy is used to influence the aggregate demand of the economy, which is the demand for gross domestic product, or the total demand for the final goods and services of the economy. The government tries to influence aggregate demand so that there is price stability, full employment, and economic growth. The idea behind stimulating aggregate demand by lowering government spending or raising taxes is that once it is done, the economy will grow from it.
Monetary policy is the process by which the central bank manages the supply of money. Monetary policy is typically referred to as being in an expansionary or contractionary, just as fiscal policy is. The expansionary policy increases the size of the money supply or lowers the interest rates. The contractionary policy decreases the size of the money supply, or makes the interest rates higher. The expansionary part of the monetary policy is usually used to fight unemployment during a recession by lowering interest rates. The contractionary part of the monetary policy targets to raise interest rates to combat inflation. The expansionary and contractionary policies must be meticulously used so that they do not go too far in either direction (expansionary or contractionary) or cause a big problem in the economy.
One of the primary tools of the monetary policy is open market operations. The open market operation used to manage money in circulation by buying and selling different credit instruments. The short term goals of open market operations are typically to achieve a certain target interest rate. The monetary policy is associated with the interest rate and credit. This did not used to be the case, as the only two parts of the policy were the decisions of coinage and decisions to print paper money to start credit. The monetary policy has grown so much since its start that there are many different factors of its success, including short term interest rates, long term interest rates, speed of money through the economy, exchange rates, quality of credit, corporate ownership and debt, government and private sector spending and savings, international capital flow, and financial derivatives. Since there are so many factors that must be accounted for, some people think that the economy should go back to how it used to be, which was called the gold standard.
The gold standard is basically the elimination of the Federal Reserve Bank and the dollar’s fiat currency status along with it. In a gold standard, the standard economic unit of account is the weight of gold. Under the gold standard, banks guarantee that the owner of the money can receive their money in gold at any time. The reason this is a large issue is because at certain points in time, there were a periods of time when some banks could not give the owner their money. If a person went to the bank with the intention of withdrawing money from their savings account, it was not possible for them to do so because the bank simply did not have the money. With the gold standard this is not a problem, because the banks are required to have the money physically at all times.
Monetary policy refers to the actions that the Federal Reserve Bank (Fed) takes to influence the financial conditions to achieve its goals. The Fed’s main job is to raise and lower interest rates, which is just one of many tasks that it must carry out. For example, if rates on interest are lowered, the borrowing of money then becomes less expensive to the consumer, making them more motivated to spend their money since there is a better deal on a loan. The reason that the Fed is so important is that it provides a stable currency that can be used throughout the whole country. Before the Fed was introduced to the U.S., there were over 30,000 currencies throughout the United States. Before the Fed, currency could be issued by anyone for a certain good. There were many problems with this, because some currencies were worth more than others, and there was no basis on how to tell which was worth more.
The original purpose for the Fed was to organize and stabilize the monetary system in the United States. It was made to set up a method that would create liquidity, which is the ability to take out money. The reason liquidity was coveted is so that the banks could honor every customer’s withdraw. The Fed also had to set up a method to create elastic currency, which means that they had to control inflation by making sure prices did not climb too fast. Elastic currency plays a major part in the impedance of inflation and recession.
The fiscal and monetary policies both play an important role in the survival of the economy in the United States. They both are required to regulate certain aspects of the economy in order to keep from going into a depression. The Federal Reserve Bank also plays an important role in economy, because it is in control of the monetary policies. As the economy grows and becomes more complex, there will only be more changes and additions to these policies, as it has come a long way from the gold standard in the early 1900s.
Fiscal and Monetary Policy
Imagine you are listening to the radio around the year 1900 and there is news that the economy is going to enter into a recession. Chances are that sooner or later you will not have a job, and there isn’t going to be nearly as many goods available because of lack of production. The only thing of any value will end up being the money in your checking and savings accounts, so the only choice you have it to run to the bank and get hold of that money. The problem: every other person who just heard that announcement is thinking the same thing, and now there’s going to be a run on the bank, or even worse, a bank panic. This was a serious dilemma prior to the year of 1913 – the year the Federal Reserve Bank was established – because there was no way to ensure the economy would remain stable. Although bank panics were not an everyday thing, it was something that citizens had to worry about more than they do today. When the Federal Reserve Act of 1913 was set in place, however, two policies were enabled to monitor and help control the stability of the economy: to this day they remain a very important part of our government and these courses of action are known as monetary policy and fiscal policy.
To fully understand the purpose of monetary and fiscal policy, it is important to look at the structure behind them. The basis of these policies comes from the Federal Reserve, more commonly known as the “Fed.” The “Fed” is a fairly simple system to understand: it is the central bank of the United States. This central bank is broken down into districts; the Board of Governors being the most recognized, but also included is the Federal Open Market Committee. Today the head chairman of the Board of Governors is Benjamin Bernanke, and he oversees all the actions that are taken.
The Federal Reserve is the only bank with the power to control a run on the banks or a bank panic. It holds the money available to lend to smaller banks as a last resort in bad economic times. Therefore, the Federal Reserve plays a huge part in controlling the money supply of the US. When the “Fed” was established, so was monetary policy. In the book Macroeconomics by R. Glenn Hubbard and Anthony Patrick O’Brien, monetary policy is defined as “the actions the Federal Reserve takes to manage the money supply and interest rates to pursue economic objectives.” These certain objectives include maintaining a stable economy, increasing economic growth, keeping unemployment at a satisfactory low, and keeping prices of goods and services stable in order to minimize the chances of inflation.
The Federal Reserve uses three separate tools of monetary policy to maintain the money supply. These tools include open market operations – controlled by the Federal Open Market Committee – and the discount rate and reserve requirements, which are controlled by the Board of Governors. Open market operations are a tool used by the FOMC to increase the money supply through the buying and selling of Treasury securities. The trading desk at the Federal Reserve Bank in New York is designated to buy these securities and the sellers deposit them into banks. These deposits increase the reserve of the bank which in turn increases the total money supply because there will also be an increase in loans and checking account deposits (Hubbard/O’Brien). The FOMC also has the power to decrease the money supply by reversing the operations of that same process.
The branch of the “Fed” which controls the other two tools of monetary policy is the Board of Governors. One tool, the discount rate, is defined as “the interest rate the Federal Reserve charges on discount loans (Hubbard/O’Brien). If a bank needs to increase the money available in their vault, otherwise known as their reserve, they turn to the “Fed” for the money and this loan is known as a discount loan. However, unless the Federal Reserve has become the last resort in the case of a recession, discount loans are not typically taken out by banks.
In certain instances, such as the case of Black Tuesday when the worst stock market crash hit the United States, discount loans did not save the economy. It was not until after the Great Depression when the run on the banks caused a severe bank panic that Congress established deposit insurance. In other words, prior to the Federal Deposit Insurance Corporation, a person was neither assured that the money they held in the bank was safe nor that they would be able to retrieve it if the economy were to fall into a recession.
The third tool of monetary policy which is also controlled by the Board of Governors to help manage the money supply is reserve requirements. It is a rare occasion for the Fed to change the reserve requirements though. In essence, changing the reserve requirements entails the banks to make “significant alterations in holdings of loans and securities” (Hubbard/O’Brien). Although it is not a common course of action, it is still purposeful. When the Fed decreases the reserve requirements, it allows the banks to use the excess money to loan out as opposed to holding in the vault. Conversely, if the Fed chooses to increase the reserve requirement, the banks will have less money to lend out. Either way, though, the Fed is makes the change based on the assumption that it will help the economy. All of these tools of monetary policy are followed through with the intention of meeting the objectives stated previously. On the other hand, fiscal policy also plays and important role in helping to maintain a stable economy.
Fiscal policy is defined as “the changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives” (Hubbard/O’Brien). Fiscal policy is similar to monetary policy in terms of what it attempts to achieve, but varies because of the way it tries to do so. Changes in taxes and spending are controlled solely through the federal government.
A better understanding of fiscal policy can be explained through the ideas of John Maynard Keynes. His theory came about after the Great Depression and said if the governments were to spend more money in times of economic decline, then it would soon stimulate the economy. He argued that through the excessive government spending, incomes would rise and so would purchases of goods and services. Eventually, this would stabilize the economy and take the country out of decline and into a state of economic growth. His theory was proved when President Franklin D. Roosevelt took action during World War II and spent an excessive amount of money which ending up in economic growth, as Keynes had said it would (What is Fiscal Policy?).
More recently, as of the 1980s, the main goal of fiscal policy has focused on reducing the budget deficit that has skyrocketed since World War II. Because of such things as new technology and foreign trade opportunities economic growth has been happening automatically, and the deficit only continues to rise (What is Fiscal Policy?). The War in Iraq has also caused the deficit to steadily increase, and George W. Bush is currently under pressure to find a way to decrease it. Although the overall goal of fiscal policy is to achieve broad goals of the economy, it now focuses on smaller goals as well.
In conclusion, monetary and fiscal policies are extremely crucial in keeping the economy secure. Since the early nineteen hundreds the overall time period of economic growth has steadily exceeded the time of economic recession. The Great Depression was an occurrence that will hopefully not occur again, or at least not any time in the near future. With the knowledge the government now has, the economy will most likely get better, or at least keep a level of stability that is satisfactory.
Spotting the Next Economic Bubble
It’s difficult to predict what the next bubble will be, or when it will develop. But there are “early warning signs,” that, like the tiny crocus flowers that push through snow cover in early spring, point to changes ahead. One of the most important harbingers is an abundance of liquidity.
Markets are driven, in a very real way, by liquidity – a high-toned word for plain old cash. The song lyric from Cabaret, “Money makes the world go ’round,” has never been more true than in recent years. From the supply of money flows credit decisions that grease the wheels, not only in financial markets but economies in general.
In simple terms, central banks and governments control the supply of money and credit through two “spigots:” monetary and fiscal policy. Central banks control money supply by managing short-term interest rates. Governments do it using taxation and public spending.
To balance economic growth, one institution may work independent of the other. That is, one spigot may be open while the other is closed. For example, a government might increase taxes, while a central bank reduces interest rates to mitigate the impact of those taxes.
However, to slow down an overheated economy, both interest rates and taxes oft en move higher, to reduce the money supply. To stimulate growth, on the other hand, both spigots can be open. You will then see the government lower taxes and the central banks lowering interest rates.
Our objective here is not to turn you into an economist, of course, but to give you a simple way to see how the ebb and flow of money is controlled, as central banks and governments turn the taps on and off.
While banks and governments control the supply, in a free market economy the financial markets determine the direction. That means available liquidity (i.e., cash) will flow into investments that the market considers will benefit most from the economic environment.
Watch the needle on liquidity
Problems surface, though, when there is an excess of liquidity – it can spill over and drive the value of investments way beyond their fundamental values, to irrational levels. At the other end of the spectrum, too little liquidity can push investments well below their fundamental value.
The key to spotting potential bubbles, then, is to:
? Monitor central banks and government action to see how
tight or loose the two spigots are that control money supply.
? Try to foresee where the liquidity is flowing. Is it moving away from stocks to bonds, for example, or vice versa? Is all the money going into real estate, or into commodities (oil futures, for example, are at about $120 per barrel now).
An excess of liquidity creates excess demand for an asset, which pushes prices higher, reflecting lower return expectations among irrational participants (who think of themselves as investors, when they are really speculating).
Consumers fuel the liquidity fire, too
Ample availability of cheap and easy credit turns consumers into spendthrift s in record levels, enticing homeowners to tap into the available cash in their home equities and credit cards, and use it to sustain their way of life. Evidence: By the second half of 2005, financial obligations as a percentage of household income stood at 16 percent, nearly the highest on record. At the same time, savings as a percentage of disposable income sank to zero, the second lowest since the Great Depression.
High-octane liquidity sparks liberal and rapid credit creation, which in turn inflates asset values beyond rational norms. The result? An uncontrollable, global-scale liquidity flow that pushes asset values, particularly real estate, commodities and emerging market debt to over-rich levels.
It is liquidity overflow that fuels all of this activity, and turns everyday people into unsuspecting speculators, if not gamblers. People looking to “make a killing” often dive into risky assets like emerging countries’ stocks and bonds, real-estate backed debt, fine art, private equity funds – and sophisticated investment contracts even bankers can’t understand.
The difference is that experienced speculators will walk away when a miniscule risk premium signals low compensation for high risk. The Wall Street Journal explains it well: “…as the price of an asset rises, the income it throws off – a stock’s dividend, a bond’s coupon, a building’s rent – automatically declines as a percentage of the asset’s value. This means investors are demanding less compensation than usual for taking on the risk inherent in owning the assets.”
In plain language, the risk premium needs to be high enough to compensate for the possibility that you will not get the return you expect (and might even lose your principal). What happens in bubbles, as we have seen in evidence dating back to the 17th century, is that sky-high prices, like the mythical Icarus, fly too close to the sun and inevitably fall back to earth.
