LO 7.1.2: Assess the impact of a given monetary or physical policy on interest rates, security prices, and overall economic conditions. Flashcards
What type of policy is the federal government responsible for: fiscal or monetary?
The federal government is responsible for fiscal policy.
What type of policy is the Federal Reserve responsible for: fiscal or monetary?
The Federal Reserve is responsible for monetary policy.
How do the federal government and Federal Reserve use fiscal and monetary policy?
- When used properly, monetary and fiscal policies combine to maintain conditions that support:
- Full employment,
- Stabilize prices, and
- Encourage economic growth.
Fiscal Policy | Who is the responsible party?
Congress and the President
Fiscal Policy | How does the responsible party exercise authority?
Congress passes legislation; the president signs into law
Fiscal Policy | What are the tools available to implement policy changes?
- Makes changes in tax laws
* Increases and decreases government spending
Monetary Policy | Who is the responsible party?
Federal Reserve Board (Fed)
Monetary Policy | How does the responsible party exercise authority?
Fed independently makes and implements decisions
Monetary Policy | What are the tools available to implement policy changes?
- Changes reserves required for banks;
- Changes the discount rate that banks pay for short-term loans from the Fed;
- Conducts open-market operations.
Who makes fiscal policy decisions?
Both Congress and the president (the Administration)
Can the Executive or Legislative branches of government make a fiscal policy decision without involvement of the other?
- No.
- Example: The president may propose a certain fiscal policy action, such as raising income taxes for the wealthy; unless Congress passes legislation to raise tax rates for high-income individuals, no change will occur.
- Even if Congress does pass legislation, end result will be different from the president’s proposal.
What are the two tools used in exercising fiscal policy?
- The power to tax
* The power to spend.
What will changes in the rate of government taxation affect?
- Changes in the rate of government taxation will affect:
- the amount of corporate earnings;
- the amount of consumer disposable income; and
- the incentives for individual workers to produce.
What will changes in the rate of government spending affect?
- Changes in the rate of government spending will affect:
* corporate earnings as well as consumer demand.
What has happened in recent years with regard to government spending?
Congress has conducted a policy of deficit spending — government expenditures exceed revenues, which in turn, causes the government to sell securities to the public to finance these deficits.
What does the increase in issuance of government securities do to the overall bond market?
- Results in a crowding out affect with respect to other potential borrowers.
- Market interest rates must eventually rise to compete for the limited overall money supply that is made available by the Fed.
What are the two forms of fiscal policy?
- Expansionary policy
* Contractionary policy
What is expansionary policy?
An expansionary fiscal policy often involves increasing government spending or by reducing taxes for individuals and/or business.
What is contractionary policy?
A contractionary fiscal policy commonly incorporates decreases to government spending and/or increases to individual and/or business taxes.
What are the three major tools used by The Fed to enact monetary policy?
- reserve requirements;
- discount rate; and
- open-market operations.
How does The Fed’s use of its 3 monetary policy tools impact the economy?
Allows the Fed to influence and control the overall money supply, and thus, affect future economic behavior.
Which of the 3 monetary policy tools is the most important and most frequently practiced?
Open-market operations
How are open-market operations carried out by The Fed?
- Depending on the intended economic outcome, the Fed can either
- sell government securities to banks and market makers or
- buy back government securities in the open market.
What will the Fed do if it wants to expand economic activity?
Buy government securities in exchange for money, thereby increasing the money supply and driving down overall interest rates.
What will the Fed do if it wants to contract economic activity?
Sell government securities from its existing inventory, thereby decreasing the money supply, driving up overall interest rates, and reducing prices.
Discount rate
- The rate at which banks can borrow from any of the Federal Reserve Banks;
- The one and only interest rate that the Fed directly controls.
What happens when the Fed increases the discount rate?
It increases the cost of borrowing and discourages member banks from borrowing funds, resulting in a contraction of the money supply.
Why would the Fed lower the discount rate?
- The Fed will lower the discount rate when it wants to increase the money supply;
- When banks are able to borrow funds at lower rates and lend more money, they increase the supply of money in circulation and this stimulates demand.
What are the two interest rates that the Fed greatly influences/indirectly controls?
Federal funds rate and the prime rate.
Federal funds rate
- Is the interest rate charged on short-term borrowing (often to fulfill overnight reserve requirements) between banks;
- The Fed targets — but does not directly control — this rate in all of its interest rate decisions.
Prime rate
- Is the rate of interest charged by commercial banks to their best business and personal customers.
- This rate is set directly by commercial banks, but is normally about 3% higher than the federal funds rate.
