How independent of each other are monetary policy and fiscal policy? a) Under wh

Question

How independent of each other are monetary policy and fiscal policy? a) Under what circumstances could the federal government run a large budget deficit without thereby producing an increase in the size of the money stock? b) Suppose the Fed determined to run a tight monetary policy, allowing no growth in commercial bank reserves, at a time when the federal government was trying to borrow to finance a large budget deficit. What would happen? c) Assuming that interest rates are set by the demand for and supply of loanable funds, under what circumstances could a large increase in federal government borrowing not produce higher interest rates? d) Suppose the Fed tries to prevent the increased government demand for loanable funds from raising interest rates by increasing the supply of loanable funds through and expansion of commercial bank loans. Will this Fed policy succeed in preventing interest rates from rising? At what point will the Fed's expansionary policy step up the inflation rate? How will the expectation of a higher rate of inflation cause interest rates to rise? e) Suppose that the federal government begins to run a large budget deficit at a time when many productive resources are idle - factories are operating far below capacity in most industries and there are surplus supplies of labor in almost every area of the economy. How might the existence of all these idle resources prevent even a very large increase in government borrowing from leading to an increase in interest rates?

Explanation / Answer

Monetary policyis a term used to refer to the actions of central banks to achieve macroeconomic policy objectives such as price stability, full employment, and stable economic growth. In the United States, the Congress established maximum employment and price stability as the macroeconomic objectives for the Federal Reserve; they are sometimes referred to as the Federal Reserve's dual mandate. Apart from these overarching objectives, the Congress determined that operational conduct of monetary policy should be free from political influence. As a result, the Federal Reserve is an independent agency of the federal government.Fiscal policyis a broad term used to refer to the tax and spending policies of the federal government. Fiscal policy decisions are determined by the Congress and the Administration; the Federal Reserve plays no role in determining fiscal policy.

1. Deficits can rise not only because policy makers raise spending or lower taxes, but also when the economy is in a recession. During recessions, unemployment benefits and welfare payments rise automatically while tax receipts drop. One way to separate the cyclical and structural components of the deficit is to estimate what the deficit would be if the economy were operating at full employment.

2. In the short run, deficits can have two potentially damaging effects on the economy. First, if the economy is at full employment, a government deficit is inflationary, because the excess of government spending over government revenues adds to aggregate demand pressures in the economy. Second, to the extent that federal deficits raise interest rates, they can retard growth in investment and housing activities, which are interest-sensitive.

The dollar's status as the world's reserve currency has become a facet of U.S. power, allowing the United States to borrow effortlessly and sustain an assertive foreign policy. But the capital inflows associated with the dollar's reserve-currency status have created a vulnerability, too, opening the door to a foreign sell-off of U.S. securities that could drive up U.S. interest rates. In thisCenter for Geoeconomic StudiesCapital Flows Quarterly, Francis E. Warnock argues that a sell-off came close to happening in 2009. How the United States uses this reprieve will affect the nation's ability to borrow for years to come, with broad implications for the sustainability of an active U.S. foreign policy

One reason why Republicans strenuously oppose the Obama administration's fiscal stimulus plan is because it repeats the errors of Franklin D. Roosevelt. To them, the New Deal was mainly about vastly expanding government spending and deficits, which Republicans believe made the Great Depression worse rather than better. Therefore, doing so again in the present downturn will also lead to failure.

The true New Deal legacy, however, is more complicated. Serious mistakes were indeed made. In particular, the National Industrial Recovery Act was fundamentally ill-conceived and retarded economic recovery. But in terms of fiscal policy, Roosevelt's error wasn't that he spent too much, but that he didn't spend nearly enough.

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