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Factors in Fiscal and Monetary Policy Making

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  • Anthony Espinoza

 

Fiscal policy is the working of the government in the way they change government spending, which affects and controls how the economy is going to perform. The government, specifically the president and congress, look at how the economy is performing and how the government wants the economy to perform for the better of the nation. Failure to establish a budget is not only bad practice and can get the government in an extraordinary amount of debt, but by law considered unconstitutional.

When the president and congress approve a budget it’s considered a non-discretionary budget. This is the budget that falls into place and the government distributes funds to departments with their share of the budget. This is the most ideal way to proceed with budgeting because it gives the government on all levels strict guidelines on how much money they are authorized throughout the fiscal year, which is from October 1st to September 30th.

When the government makes changes to the budget when it’s already in place, it’s called a discretionary budget. Making changes to the budget can sometimes be unavoidable. When 9/11 happened, the president and congress made changes to the budget which gave the military war money, that wasn’t in the initial budget, and the city of New York relief money, thus making the budget discretionary. In this instance, changing the budget was a necessity with the original budget not being setup for a state of war. When the budget is set and there’s no dramatic changes in the economy or government, the budget needs to stay non-discretionary to prevent overspending and creating a deficit.

Government spending can be a useful tool to boost or slow down the economy in order to control and stabilize it. The economy can be manipulated by the government by either changing government spending or tax. When the economy is in a recession the government can implement an expansionary fiscal policy by increasing government spending, which will shift the aggregate demand curve to the right increasing the overall Gross Domestic Product (GDP) boosting the economy. When this happens, the government increases the flow of money by putting money into the building of new highways, hospitals and schools, putting people to work and decreasing unemployment. The money then goes into disposable income getting separated into consumption and savings by the percentage of the Marginal Propensity to Consume (MPC) and the Marginal Propensity to Save (MPS) which then determines the multiplier equaling how many times the money circulates the circular flow. After the money went around the circular flow the correct amount of times, it’ll give you the impact it had on the GPD. The government can also decide to reduce taxes to shift the demand curve to the right, this increases disposable income by giving its people extra money to consume and save. The problem with reducing tax is if the government wanted to increase GDP by $20 billion with the MPC ratio being 75% making the multiplier equal 4, the amount of tax that needs to be reduced would be $6.67 billion, compared to increasing government spending with the same MPC ratio and multiplier, the government would only need to spend $5 billion. This is why at the end of the fiscal year the departments of the government spend the extra money they didn’t use from the budget on new office furniture and computers, keeping the circular flow in motion.

The other aspect of fiscal policy is contractionary fiscal policy which could be done by increasing tax or decreasing government spending or a combination of both, when the economy is at a peak which causes an inflationary GDP gap. This shifts the demand curve to the left trying to avoid inflation. The debate in Washington is still going on to which is the best way to close the gap, but either way will work if done properly. The Fed can use these tools to either expand or contract the economy in times of need.

In contrast to fiscal policy is the working of monetary policy, being the changing of money supply by the Federal Reserve (Fed) influencing interest rates, price stability, full employment, and economic growth. The Fed uses four tools to control the reserves of commercial banks. The first tool, open-market operations, is the selling of government bonds called securities. Securities are bought and sold every day by banks, corporations, and the general public. The open-market operations is the most important tool used by the Fed in controlling the money supply.

The second tool the Fed uses is the reserve ratio, the percentage of checkable deposits required by a bank to hold in its vaults or in a Federal Reserve Bank. The Fed doesn’t like to change the reserve ratio because, it changes the banking system by increasing the banks required reserves which takes away the amount of money they can loan. This change happens overnight which is entirely too fast and dramatic. This forces the bank to deny loans and raise the interest rates on potential loans, which is too dramatic of a change to the banks and the economy. When the Fed wants to change the money supply they want it done slow enough it doesn’t shock the banking system or the economy.

The third tool is the discount rate. When a bank needs to borrow unexpected or immediate funds, the Federal Reserve Bank will give them a short term loan with an interest rate called a Fed Discount Rate. This can cover a shortage the bank may have meeting the required reserve ratio or allow the bank to loan more money to their clients which would make more money on the interest charges for that loan. If the Fed wants to restrict the money supply, they can raise the discount rate to make it unappealing for the banks to borrow money, decreasing the amount of reserves the bank has to loan causing the banks to raise their interest rates on loans, making it unappealing for their clients to borrow money. On the other hand, if the bank doesn’t want to borrow for the Fed they can borrow from another bank, which has a Fed Funds Rate. This rate acts the same as the Fed Discount Rate but can be slightly higher and does have corresponding changes with the Fed Discount Rate.

The fourth tool the Fed can use is the Term Auction Facility, holding auctions where banks can borrow money for either 28 days or 84 days. The banks will give the Fed the amount they would like to borrow and the interest rate they would like pay. The order of the banks is then listed from the highest interest rate bids and awarded to the top bidders until the amount the Fed is auctioning is gone. The interest rate is set by the lowest interest rate that got awarded money in the auction. This tool puts money into the banks reserves so they can offer more money for loans and lowering the interest rates making more money in return while helping boost the economy.

The best way to control the economy is through monetary policy. The government needs to set a budget for government spending and stick with those spending’s, letting the Federal Reserve control the money supply. Letting the Fed and the banks run like normal and keeping the government out of the economic situation would allow the economy to take its course and correct itself when needed. The government could then only spend money that is necessary for the government preventing them from overspending and going into debt with other countries. Government spending is not the answer to economic growth, especially when the government have a deficit of $17 trillion. The American economy doesn’t need Washington to control how Americans spend their money. The economy would be better off letting the Fed and the people contribute to the economy’s future and worry about the national debt and running the country politically, not economically. This world is getting bigger by the day and the US economy is now part of the world economy and America, along with the rest of the world, needs to change to accommodate that, and it’s by letting the financial institutions around the world get together and come up with a plan to work together for the better of the world, not each individual country.


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