Economic Performance and real world politics How independent of each other are m

Question

Economic Performance and real world politics

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?

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Explanation / Answer

Fiscal policy is related to the government’s spending and revenue collection. Eg. , when the demand is very low, the government can increase its spending to stimulate demand. Similarly government can lower taxes that will leave more disposable income in the hands of people as well as corporations to spend.

Monetary policy is related to the supply of money, which is controlled by factors like interest rates and reserve requirements (CRR) for banks. Eg, to control high inflation, Central bank can raise interest rates thereby reducing money supply and vice versa.

B. 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.

In such a case, Due to tight monetary policies, the supply of money to the market will be restricted and thus the funds will be available at a very high rate of interest than usual.

C. Circumstances under which large increase in federal government borrowing would not produce higher interest rates is when supply of so much funds in the market does not trigger the increase in inflation rate.

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