LO 7.1.2: Assess the impact of a given monetary or physical policy on interest rates, security prices, and overall economic conditions.

Question 1

What type of policy is the federal government responsible for: fiscal or monetary?

Answer 1

The federal government is responsible for fiscal policy.

Question 2

What type of policy is the Federal Reserve responsible for: fiscal or monetary?

Answer 2

The Federal Reserve is responsible for monetary policy.

Question 3

How do the federal government and Federal Reserve use fiscal and monetary policy?

Answer 3

• When used properly, monetary and fiscal policies combine to maintain conditions that support:
  
  • Full employment,
  • Stabilize prices, and
  • Encourage economic growth.

Question 4

Fiscal Policy | Who is the responsible party?

Answer 4

Congress and the President

Question 5

Fiscal Policy | How does the responsible party exercise authority?

Answer 5

Congress passes legislation; the president signs into law

Question 6

Fiscal Policy | What are the tools available to implement policy changes?

Answer 6

• Makes changes in tax laws

* Increases and decreases government spending

Question 7

Monetary Policy | Who is the responsible party?

Answer 7

Federal Reserve Board (Fed)

Question 8

Monetary Policy | How does the responsible party exercise authority?

Answer 8

Fed independently makes and implements decisions

Question 9

Monetary Policy | What are the tools available to implement policy changes?

Answer 9

• Changes reserves required for banks;
• Changes the discount rate that banks pay for short-term loans from the Fed;
• Conducts open-market operations.

Question 10

Who makes fiscal policy decisions?

Answer 10

Both Congress and the president (the Administration)

Question 11

Can the Executive or Legislative branches of government make a fiscal policy decision without involvement of the other?

Answer 11

• 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.

Question 12

What are the two tools used in exercising fiscal policy?

Answer 12

• The power to tax

* The power to spend.

Question 13

What will changes in the rate of government taxation affect?

Answer 13

• 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.

Question 14

What will changes in the rate of government spending affect?

Answer 14

• Changes in the rate of government spending will affect:

* corporate earnings as well as consumer demand.

Question 15

What has happened in recent years with regard to government spending?

Answer 15

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.

Question 16

What does the increase in issuance of government securities do to the overall bond market?

Answer 16

• 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.

Question 17

What are the two forms of fiscal policy?

Answer 17

• Expansionary policy

* Contractionary policy

Question 18

What is expansionary policy?

Answer 18

An expansionary fiscal policy often involves increasing government spending or by reducing taxes for individuals and/or business.

Question 19

What is contractionary policy?

Answer 19

A contractionary fiscal policy commonly incorporates decreases to government spending and/or increases to individual and/or business taxes.

Question 20

What are the three major tools used by The Fed to enact monetary policy?

Answer 20

• reserve requirements;
• discount rate; and
• open-market operations.

Question 21

How does The Fed’s use of its 3 monetary policy tools impact the economy?

Answer 21

Allows the Fed to influence and control the overall money supply, and thus, affect future economic behavior.

Question 22

Which of the 3 monetary policy tools is the most important and most frequently practiced?

Answer 22

Open-market operations

Question 23

How are open-market operations carried out by The Fed?

Answer 23

• 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.

Question 24

What will the Fed do if it wants to expand economic activity?

Answer 24

Buy government securities in exchange for money, thereby increasing the money supply and driving down overall interest rates.

Question 25

What will the Fed do if it wants to contract economic activity?

Answer 25

Sell government securities from its existing inventory, thereby decreasing the money supply, driving up overall interest rates, and reducing prices.

Question 26

Discount rate

Answer 26

• 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.

Question 27

What happens when the Fed increases the discount rate?

Answer 27

It increases the cost of borrowing and discourages member banks from borrowing funds, resulting in a contraction of the money supply.

Question 28

Why would the Fed lower the discount rate?

Answer 28

• 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.

Question 29

What are the two interest rates that the Fed greatly influences/indirectly controls?

Answer 29

Federal funds rate and the prime rate.

Question 30

Federal funds rate

Answer 30

• 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.

Question 31

Prime rate

Answer 31

• 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.