Expansionary Monetary and Fiscal Policies

Introduction

Expansionary fiscal policy is a more favorable tool for inducing consumption during a recession. As observed in the Great Recession, the monetary policy failed to provide the required level of aggregate demand that can stimulate production. The Fed has been able to rule out crowding out effects by keeping interest rates at the zero lower bound level. Expansionary fiscal policy is applied through increased government spending and lower taxes. An expansionary monetary policy targets the interest rate and money supply through the reserve ratio, discount rate, and open market operations.

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Expansionary fiscal policy

Lowering taxes

Expansionary fiscal policy can be accomplished by lowering taxes. When the federal government lowers taxes, households, and businesses end up with a higher disposable income (Amacher & Pate, 2012). Higher disposable income increases the purchasing power of households and businesses. It increases the consumption of goods and services. An increase in aggregate expenditure results in an increase in demand, which stimulates increased production and investment in capital goods. The GDP grows when there is increased production.

The effect of lower taxes may lower when people are pessimistic about future growth. Carvalho, Eusepi, & Grisse (2012) discuss that the U.S. government reduced taxes by about 45 percent during the 2008-recession. Lowering taxes is more effective when the economy is not in a recession. Carvalho et al. (2012) explain that households are likely to save increases in disposable income during a recession. Workers will prefer to keep more money aside with a precautionary motive when they are uncertain about job security (Amacher & Pate, 2012). It results in less demand than expected and a lower—33333 GDP growth rate than targeted.

The target in lowering taxes is to increase spending and aggregate demand. In the Obama Administration, the tax relief programs that were started in Bush’s Administration were extended by two years in response to the Great Recession (Amacher & Pate, 2012). According to Amacher & Pate (2012), it is better to increase government spending than to lower taxes during a recession. In addition to increasing savings, tax cuts have a lower multiplier than increased government spending.

In a situation like the current economic condition, where the interest rate is at a zero lower bound, tax policy can be a favorable alternative. The monetary policy is less effective when the interest rates are almost zero. Correia, Farhi, Nicolini, & Teles (2012) suggest that using taxes to target employment and investment can be more effective than an expansionary monetary policy. First, the effect occurs in a timely manner. Second, it is less costly and lacks long-term side effects. The government can target relief in labor taxes and investment in new capital goods (Correia et al., 2012). When the government targets specific areas with tax reduction, it can encourage employment and production in a timely manner than waiting for the effects of expansionary monetary policy.

Increasing government spending

Increasing government spending creates a demand for final goods and services, as well as inputs. The main target in increasing government expenditure is increased aggregate demand (Amacher & Pate, 2012). High aggregate demand will stimulate investment and employment. In classical theory, money received as salaries and profit is used to create a second level demand for goods and services (Amacher & Pate, 2012). Part of the increase in government spending is expected to create and improve infrastructure, which attracts investment. The government also increases expenditure on health care and education because they increase productivity.

Transfer payments are another area that can be increased in government expenditure. In the Great Recession, which occurred in 2008, the federal government increased transfer payments. All spending expansions stimulate an increase in aggregate demand, which will stimulate production. An increase in production and productivity increases the GDP growth rate.

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Increasing government expenditure can be a favorable tool during a recession. One of the reasons is that there are deflationary pressures during recessions. Carvalho et al. (2012) explain that increasing government spending may cause inflation when the economy is operating near full employment. During a recession, the deflationary pressure offsets the inflationary effect of expansionary fiscal policy. In the Great Recession, the deflationary pressures helped to maintain inflation below the 2-percent target (Labonte, 2015).

Ball, DeLong & Summers (2014) discuss that expansionary fiscal policy is the most effective tool remaining for the government when the interest rate is at the zero bound level, and the unemployment level is still high. An increase in government expenditure directly increases aggregate demand and creates employment.

One of the concerns of expansionary fiscal policy is how the funds are raised to increase expenditure. When the government raises funds by selling bonds, it raises the market interest rates. Amacher & Pate (2012) explain that it creates a crowding-out effect. High market interest rates may reduce private investments. Fishback (2010) also raises the issue of a possible crowding out effect in the economic situation after the Great Recession. However, the Fed has kept interest rates at the zero lower bound level, which may rule out the possibility of crowding-out effect. DeLong & Tyson (2013) explain that the crowding-out effect occurs when increased government borrowing causes a rise in short-term and long-term interest rates. Crowding out effect would reduce the effect of increased government spending by increasing the capital cost of private investment. In such a case, it would reduce aggregate demand by some fraction and lower the multiplier effect of government spending.

Another concern for the increase in government expenditure is an increase in the budget deficit. The budget deficit increased from 3.3 percent in 2008 to 9.9 percent in 2009 (Fishback 2010). The increased government expenditure has also seen national debt increase from 36 percent in 2007 to 64 percent in 2010 (Fishback, 2010). In the Great Depression, it took about ten years for the national debt to rise by a similar proportion. DeLong & Tyson (2013) elaborate that the country will have slower growth in GDP per capita when it has a high public debt to GDP ratio. However, the effect is small for a large increase in public debt.

Expansionary monetary policy

The required reserve ratio is decreased

In an expansionary monetary policy, the Fed acts by reducing the reserve ratio. When the reserves ratio is reduced, it enhances the ability of banks to create money (Amacher & Pate, 2012). It increases the upper limit by which banks can extend loans, increasing the availability of credit.

The Fed has kept the reserve ratio low for a long time. During the Great Recession, banks increased their reserves to $3 trillion, as a result of the Fed purchasing financial assets (Cochrane, 2014). Only $80 billion was required as reserves out of the $3 trillion, giving a reserve ratio of about 2.5% (Cochran, 2014). It shows that banks can lend about 40 times the amount they have in reserves. According to Amacher & Pate (2012), the deposit multiplier is 1/rr, where RR is the reserve ratio (1/0.025 = 40).

However, during the recession, the Fed paid interest on reserves held by banks (Cochrane, 2014). Cochrane (2014) explains that the interest policy on reserves helped to keep inflation low because banks are not compelled to issue loans in the search for profits. There is the perception that the high risk during the recession limited the ability of banks to issue loans. Assets that could be used as collateral had unstable prices (Carvalho et al., 2012).

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A lower reserve ratio is supposed to increase the ability of banks to create money. The availability of credit is intended to increase investment, which increases employment and demand for capital goods and raw materials. It creates a higher level of aggregate demand and GDP. However, increased availability of credit has not achieved the expected level of investment after the Great Recession. One of the reasons is that banks are only willing to lend to customers with a lower level of risk. Businesses were also unwilling to borrow more because of the increased uncertainty of aggregate demand.

The discount rate is decreased

In an expansionary monetary policy, the Fed decreases the discount rate, which allows banks to borrow short-term loans from the central banks at a lower cost. A lower discount rate encourages banks to keep their reserves at a minimum level. It discourages banks from holding excess reserves. Banks charge their customers lower interest rates when the discount rate is low. Amacher & Pate (2012) discuss that the Fed uses the discount rate as a signal for the level of interest rate that banks should charge their customers. The Fed has held the discount rate close to zero percent since the Great Recession in what is known as the zero lower bound. It was about 0.25% in Dec 2008, from about 5.25% in September 2007 (Labonte, 2015). The Fed also decided to offer loans to both banks and non-banks during the recession.

The Fed targets a reduction in the federal funds rate (Labonte, 2015). It can reduce the federal funds rate by setting a lower discount rate. Financial institutions see the discount rate as an alternative to the federal funds rate, which is the rate at which banks lend to each other (Amacher & Pate, 2012). Banks will be more willing to offer loans at a lower discount rate because they can obtain emergency cash at a lower cost.

Labonte (2015) explains that a low-interest rate may boost spending in consumer durables, housing, and business investment, which are sensitive to lower interest rates. Lower interest has the effect of increasing the money supply, which has the effect of increasing aggregate demand. One of the concerns is that sometimes households and businesses become insensitive to lower interest rates, such as in a recession (Amacher & Pate, 2012). Lower discount rates stimulated demand and GDP growth after the recession. However, it is at a lower level than expected because households and businesses were less sensitive to low-interest rates.

Buying securities

Buying securities has an effect of increasing money available for borrowing and spending. When the government purchases assets from banks, it increases the money available for lending. When it purchases from households, it increases the money available for spending. Amacher & Pate (2012) explain that in both ways, the government increases the number of bank reserves. As an expansionary monetary policy, the Fed increased its balance sheet to $4.5 trillion by purchasing assets from banks worth over $2.8 trillion between 2009 and 2014 (Labonte, 2015). The direct impact of the policy was an increase in reserves held by banks and other financial institutions.

Cochran (2014) elaborates that banks held about $3 trillion in reserves. In the 2011/2012 period, the Fed set out to purchase $85 billion worth of mortgage-backed securities (MBS) per month with the intention of lowering long-term interest rates and stabilizing mortgage markets (Leonard & Lazarus, 2013). Amacher & Pate (2012) explain that lower interest rates may make government debts more affordable, apart from encouraging private investments.

Open market operations target interest rates as well. Labonte (2015) explains that purchasing financial assets reduces the interest rates associated with financial assets. Low-interest rates cause an increase in the purchase of interest-sensitive commodities. Ball, DeLong & Summers (2014) argue that the rate of recovery from the Great Recession has been slow-paced. It could be that investment and household spending are less sensitive to lower interest rates. Ball et al. (2014) discuss that there could be a possible liquidity trap because lower interest rates have not been able to induce aggregate demand as expected.

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The increase in bank reserves and the Fed’s balance sheet may cause inflationary pressures (Labonte, 2015). However, as a result of globalization, it can result in an increased outflow of capital from the U.S. to other countries with higher interest rates (Amacher & Pate, 2012). The outflow of capital reduces the impact of low-interest rates in attracting investment. It also reduces inflationary pressures that may follow an increased supply of money. Bordo (2012) suggests that an expansionary monetary policy may cause an increase in asset prices and inflation. In the Great Recession, the Fed action was shielded by the fact that asset prices were falling.

Buying securities cause an increase in the money supply, which may create inflationary pressures. Romer & Romer (2013) discuss that the Fed has been cautious in using monetary policy because there is a trade-off between unemployment and inflation. In the Great Depression, the Fed was reluctant to use monetary tools to reduce the money supply because they wanted to avoid higher unemployment. In the Great Recession, people were pessimistic about inflation because of the Fed’s use of an expansionary monetary policy (Romer & Romer, 2013).

The Fed has postponed the quantitative ease tapering program a second time because it wants to avoid the possible rise of interest rates prematurely before the economy has fully recovered (Rehbock, 2013).

Conclusion

Directly, expansionary fiscal policy is supposed to create an increase in employment and aggregate demand. Indirectly, the jobs created by the government are supposed to increase aggregate demand, as described in the classical theory. The demand for goods by the government is intended to create an increase in investment from those contracted to supply goods. It creates an increase in aggregate demand and supply through the multiplier. Increased production increases GDP.

In the Great Recession, the expansionary fiscal policy proved more effective than an expansionary monetary policy. An increase in bank reserves, zero lower bound interest rates, and increased availability of credit did not give the expected growth in investment. Reducing taxes could be a more effective tool when it targets specific investment areas than the expansionary monetary policy.

References

Amacher, R., & Pate, J. (2012). Principles of macroeconomics. San Diego, CA: Bridgepoint Education. Web.

Ball, L., DeLong, B., & Summers, L. (2014). Fiscal policy and full employment. Web.

Bordo, M. (2012). Expansionary monetary policy can create asset price booms. Web.

Carvalho, C., Eusepi, S., & Grisse, C. (2012). Policy initiatives in the Global Recession: What did forecasters expect? Current Issues in Economics and Finance, 18(2), 1-11. Web.

Cochrane, J. (2014). Monetary policy with interest on reserves. Web.

Correia, I., Farhi, E., Nicolini, J., & Teles, P. (2012). Unconventional fiscal policy at the zero bound. Web.

DeLong, J., & Tyson, L. (2013). Discretionary fiscal policy as a stabilization policy tool: What do we think now that we did not think in 2007? Web.

Fishback, P. (2010). U.S. monetary and fiscal policy in the 1930s. Oxford Review of Economic Policy, 26(3), 385-413. Web.

Labonte, M. (2015). Monetary policy and the Federal Reserve: Current policy and conditions. Web.

Leonard, D., & Lazarus, E. (2013). Domestic open market operations during 2012. Web.

Rehbock, T. (2013). World of difference between Fed and ECB monetary policy. Web.

Romer, C., & Romer, D. (2013). The most dangerous idea in Federal Reserve history: Monetary policy doesn’t matter. American Economic Review, 103(3), 55-60. Web.

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