The Fiscal and Monetary Policy and Economic Fluctuations Essay

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The Fiscal and Monetary Policy and Economic Fluctuations

Compared to five years ago, the U.S. economic situation has improved. The real gross domestic product (GDP), a macroeconomic measurement used to “summarize the total production of [the] entire economy” (O’Sullivan, Sheffrin, & Perez, 2012), has shown positive growth since the bottom point of the recent recession that occurred in 2009. (See graph in Figure 1.) In actuality, by 2012, growth in the U.S. GDP surpassed that of the 2007 pre-recession point. on the other hand, the key economic indicators of interest rates, inflation, and unemployment were examined for the same time period, from 2007 to 2013, in an effort to discover potential correlations between them. First, U.S. government security interest rates published by the U.S. Treasury reflect a steady reduction since the height of the recession in 2009. Specifically, in 2007, the average annual rate was 2.34 percent and in 2012 it was .017; a 99 percent decrease of 2.323 percent over this five year period. (See graph and table in Figure 2.)

It is most imperative to go over that the vast majority of the reduction in government security interest rates occurred between 2009 and 2012, reflecting a correlation and potential Treasury reaction to the 2009 recession that is indicated in the previously discussed U.S. GDP. Second, U.S. inflation rates published by the Bureau of Economic Analysis reflect a steady and marginal growth since the height of the recession in 2009. It is important to recognize that inflation, as defined by O’Sullivan, Sheffrin, and Perez (2012) is the “percentage rate of change of a price index”. These authors/economists propose that either the GDP or the Consumer Price Index can be used to conclude inflation (O’Sullivan, Sheffrin, & Perez, 2012). Conversely, the Federal Open Market Committee (FOMC), a section body of the Board of Governors of the Federal Reserve System (n.d.), uses a component of the GDP called the personal consumption expenditures to measure inflation.

Following the FOMC’s lead, the percentage change in personal consumption expenditures was used to observe the U.S. inflation values. (See graph and table in Figure 3.) In 2007, prior to the recession, inflation for the U.S. was at 2.5 percent. At the height of the recession, inflation dropped to -0.1 percent and has climbed back to 1.8 percent by 2012. Finally, the U.S. unemployment rates, a measurement of “those individuals who do not currently have a job but who are actively looking for work” (O’Sullivan, Sheffrin, & Perez, 2012), published by the Bureau of Labor Statistics reflect a peak of 9.9 percent in 2009 when viewed for the five year period of 2007 through 2012. Not coincidently, this peak is at the height of the recession and correlates with patterns of both the lowest interest rates and the highest inflation rates for the same period.

In 2007, the rate was at 4.6 percent, climbing to the peak recession rate previously mentioned and lowering to 7.4 percent by the middle of 2013. Please note that the natural rate of unemployment in the U.S., the rate of unemployment where economists believe there is full employment, is between 5 and 6.5 percent (O’Sullivan, Sheffrin, & Perez, 2012). In other words, the rate of 7.4 percent reached in the middle of 2013 is actually very close to what economists would consider a fully employed nation. Changes in Interest Rates, Inflation, and Unemployment

A recession is defined as “a period when real GDP falls for six or more consecutive months” (O’Sullivan, Sheffrin, & Perez, 2012). The U.S. Bureau of Labor Statistics (2012) identifies the 18 month period of December 2007 to June 2009 as the most recent U.S. recession, the longest and deepest of the post-World War II era. According to senior CNBC editor Mark Koba (2011, July), “the 2007-2009 recession was mostly blamed on a housing bubble.” Mr. Koba (2011, July) further explains that the housing prices had increased to a point that could not be maintained and they subsequently plummeted. This resulted in thousands of borrowers that could not afford to pay their loans. At the same time, Wall Street financial instruments tied to these loans were now revealed to be worth very little.

The surprise to the financial market resulted in less business investing and profits subsequently and drastically declined. The business investment slowdown, in turn, led to more bankruptcies and higher unemployment rates. With a decrease in spending, GDP and inflation dropped while the unemployment rate rose. As previously mentioned, lower production represented by the reducing GDP is ultimately tied to a reduction in spending which, in turn, is tied to a rise in unemployment and a drop in inflation, reflecting a slow-down in economic growth. In an attempt to stimulate growth, the Federal Reserve is known to lower interest rates in order to attract businesses and consumers to spend. Figures 1 through 4 clearly correlate the drop in GDP during this recession to higher unemployment, lower inflation, and lower interest rates. With this knowledge, it is easy to understand that the GDP, unemployment, and inflation are all indicators used by the National Bureau of Economic Research, “the official arbiter of U.S. recessions” (U.S. Bureau of Labor Statistics, 2012).

Encouraging Spending through Fiscal and Monetary Policy for Economic Growth Monetary policy is made by the Federal Open Market Committee (FOMC), which consists of the members of the Board of Governors of the Federal Reserve System and five Reserve Bank presidents (Board of Governors of the Federal Reserve System, n.d.). The FOMC currently identifies 6 possible policy tools or strategies they can employ; 1) open market operations, 2) discount rate, 3) reserve requirements, 4) interest on required reserve balances and excess balances, 5) term asset-backed securities loan facility, and 6) term deposit facility. In lieu of the lowering interest rates observed in 2009, the most likely contributor of monetary policy to influence this economic reaction is open market operations (OMOs). OMOs, as defined by the Board of Governors of the Federal Reserve System (n.d.) is, “the purchase and sale of securities in the open market by a central bank”.

The short-term objective is specified by the FOMC, but historically, it is used to adjust the supply of reserve balances to keep the federal funds rate—the interest rate at which depository institutions lend reserve balances to other depository institutions overnight—close to the target established by the FOMC. In fact, in late 2008, the FOMC established a near-zero target range for the federal funds rate. Moreover, OMOs are now placing downward pressure on longer-term interest rates, supporting job creation and economic growth by making more accommodating and attractive financial conditions (Board of Governors of the Federal Reserve System, n.d.). Fiscal policy—the actions that a government takes through tax cuts, tax incentives, disincentives, and government spending, to stimulate aggregate demand by increasing the amount of spending that households and firms wish to do—is very often used in conjunction with monetary policy (Viard, 2009). The Economic Stimulus Act of 2008 provided several actions to prompt economic growth in an attempt to avert a recession.

Probably the most familiar of those actions were the tax rebates received by taxpayers below the income limit. This fiscal policy allotted payments of 300 dollars per person and 600 dollars for married couples filing jointly. Moreover, eligible taxpayers received 300 dollars per dependent child, in addition to the previously mentioned payment. Just as with monetary policy, this fiscal policy attempts to provide more money for spending to increase the aggregate demand. With the demand increased, businesses produce more product and hire more employees, increasing inflation to a healthy level and spurring economic growth as reflected in the GDP.


Board of Governors of the Federal Reserve System. (n.d.). Monetary Policy. Retrieved from: Koba, M. (2011, July). Recession: CNBC Explains. CNBC Explains. Retrieved from U.S. Bureau of Labor Statistics. (2012). The Recession of 2007-2009. Retrieved from Viard, A. (2009). Tax Policy during the Recession: The Role of Fiscal Stimulus. Retrieved from the American Enterprise Institute website: Figure 1. Percent change from preceding period in Real Gross Domestic Product, 2007 to 2012. Graph and table adapted from Table 1.1.1: Percent Change From Preceding Period in Real Gross Domestic Product (A), extracted August 24, 2013. Retrieved from the U.S. Department of Commerce, Bureau of Economic Analysis, Interactive Data website: Figure 2. Interest rate percent per year of U.S. government securities, 2007 to 2012 (inflation-indexed long-term average). Graph locally created from data extracted from Selected Interest Rates (Daily) – H.15, August 24, 2013, unique identifier: H15/H15/RIFLGFL_XII_N.A. Retrieved from the Board of Governors of the Federal Reserve System, Economic Research and Data website: Figure 3. Percent change from preceding period in prices for Personal Consumption Expenditures, 2007 to

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