In economic terms, a recession is defined as a general slowdown in economic activity. In an effort to move the economy out of a recession, the government would implement expansionary economic policies. One action the government would take would include conducting expansionary fiscal policy. The other action taken would be conducting expansionary monetary policy. Both of these actions would have an effect on such things as money supply, interest rates, spending, aggregate demand, GDP, and employment.
Expansionary fiscal policy consists of change in government expenditures, or taxes, in order in influence the level of economic activity, inflation, and economic growth (Amacher & Pate, 2012). Expansionary fiscal policy is when taxes are cut and government spending is increased. Lower taxes will increase disposable income. The increase in disposable income will lead to higher levels of consumer spending. In theory the more money that consumers spend, the higher the chance for economic growth. Tax cuts will also lead to an increase in aggregate demand. Aggregate demand is the total demand for goods and services is the economy.
As stated earlier, a tax cut will increase people’s disposable income therefore increasing the amount of money available for consumption. The increase in consumption would increase the demand for goods and services. This in turn increases GDP (gross domestic product). GDP is the value of the total output that the economy produces in a given time period (Amacher & Pate, 2012). The higher the demand that there is for goods and services, the need for employees to produces these goods and services are needed. This increases employment. Lower tax cuts will also increase people’s incentive to work.
With lower taxes comes more money to spend from their paychecks. There are arguments, from economists and politicians, regarding the effect tax cuts in fiscal policy will have on the economy. Some economists argue that the effect of future tax cuts will lead consumers to change their saving (David, 2008). Some economists feel that people will save the value of the tax cut that they receive today in order to pay those future taxes (David, 2008). Some politicians feel that tax cuts will have no effect because changes in private saving will offset changes in government saving.
Tax cuts allow the government to increase spending on special programs and health care. The increased revenue allows a government to borrow less money or lower government debt. This will result in lower interest rates which are beneficial to everyone involved. What is important to look at though is what the increased spending by the government is going towards. Those against increased government spending say that the government spends foolishly. In order to stimulate the economy, the increased government spending needs to go towards those things that are beneficial to its citizens.
An example of this would be if the unemployment rate is high and the government spends on hiring workers to fix the roads, this would help to decrease the high unemployment rate. According to a global poll taken in 2009, an average of three in five citizens (60%) supports the increased spending by the government to help stimulate the economy (Global Poll Shows Support for Increased Government Spending and Regulation, 2009). Strongest support is for investments such as renewable energy, green technology, and giving financial support for troubled industries and companies.
Expansionary monetary policy is when a central bank, for example the Federal Reserve Bank (the Fed), uses its tools to stimulate the economy. Often times this means lowering the Fed funds rate in order to increase the money supply. What this does is it increases liquidity which gives the banks more money to lend. The result of this would be lower interest rates. The Fed’s use three tools when conducting monetary policy; open market operations, the discount rate, and reserve requirements (How the Fed Guides Monetary Policy, 2011).
The most common tool used is the open market operations tool. This is used to buy or sell government bonds on the open market. It is used to manipulate the short term interest rate and the supply of base money in an economy. The discount rate is the interest rate a Reserve Bank charges eligible financial institutions to borrow funds on a short term basis (How the Fed Guides Monetary Policy, 2011). A higher discount rate can indicate a more restrictive policy, while a lower rate can be used to signal a more expansive policy (How the Fed Guides Monetary Policy, 2011).
All financial institutions, whether or not they are members of the Federal Reserve System, must set aside a percentage of their deposits as reserves to be held either as cash or as reserve account balances. The Federal Reserve sets these requirements for all commercial banks, savings banks, savings and loans, credit unions, and U. S. branches and agencies of foreign banks (How the Fed Guides Monetary Policy, 2011). This tool is the least common used of the three. There are two kinds of assets that banks can count toward meeting the required reserve.
The first is valued cash such as currency and coins. The second, and largest, consists of funds the bank has on deposit with its direct Reserve Bank (Amacher & Pate, 2012). A change in the reserve ratio is rarely made and when a change is made it usually is in small amounts. A reduction in the ratio usually has a double impact on the money supply. First, it converts some required reserves into excess reserves. Second, it increases the size of the deposit multiplier (Amacher & Pate, 2012). An increase in the reserve ratio works in the opposite way.
The interest rate the Fed charges a bank is the discount rate (Amacher & Pate, 2012). The higher the rate, the less likely banks are to borrow. The discount rate acts more as a function than a tool in monetary policy. An increase in the discount rate indicates to banks that the Fed wants cool down the economy by reducing bank lending. An increase indicates the Fed’s desire to stimulate the economy. The Fed most likely would increase the discount rate when conducting monetary policy because by doing so, it would keep banks from using this source before turning to other less expensive alternatives.
Whether or not the Fed wants to buy or sell government securities depends on this; whether or not they want the funds rate to rise or fall. If the fed wants the funds rate to fall, it will buy government securities from a bank. What happens is that the Fed then pays for securities by increasing the bank’s reserves (frbsf. org, 2011). The banks will then have more reserves than it wants. Then the Fed can lend these unwanted reserves to another bank. If the Fed wants the funds rate to rise, then the opposite will happen. It will sell the government securities.
The fed receives payment in reserves from the banks, which will lower the supply of reserves in the banking system (frbsf. org, 2011). To tighten money and credit in the economy, the Federal Open market Committee (FOMC), directs the New York trading desk to sell government securities, collecting payments from banks by reducing their reserve accounts. With less money in these reserve accounts, banks will have less money to lend, interest rates will increase and consumer spending will decrease. This will have a negative effect on the economy. Some may argue that there can be too much expansionary monetary policy.
If the Fed stimulates the economy too much, that could trigger inflation. Inflation is when prices rise above the 2& inflation target that the Fed has set. What happens is that consumers will start buying immediately in order to avoid higher prices in the future. This raises the demand which will cause businesses to have to hire more workers to produce the product. The additional income will allow consumers to spend more which in turn will stimulate more demand. This will cause businesses to start raising prices because they know that they will not be able to produce enough.
They will also raise prices because they know that their costs will rise as well. This is what will cause an increase in inflation. During a recession, the government will implement expansionary economic policies. One type of policy conducted is fiscal policy. This policy consists of changes in taxes and government spending in order to stimulate the economy. The other is monetary policy, which is when a central bank, such as the Fed, uses tools to stimulate the economy. Both of these policies have been and will be used in the future to stabilize the economy.