Tuesday, February 19, 2008
Monetary vs. Fiscal Policy
This article looks at what ability monetary policy has to influence output in the U.S.. If you're thinking about this, remember when we talked about the slopes of the IS curve and how that affects monetary policy. Steep IS curves mean monetary policy is less effective, and flat IS curves imply monetary policy is more effective. So what might be happening in the loanable funds market to make the IS curve get steeper?
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Dr. Vollrath,
The link for this article is the same link as the last article. Please check.
Thanks!
Got it. This should be fixed now. Thanks for bringing it to my attention.
Faulty Powers' author evaluates whether or not the Fed's monetary policy is suitable for preventing or easing an economic recession. For this article monetary policy involves the discount ratio, or the interest rate at which banks can borrow from the Fed.
The author first addresses the fact that many consumers and investors alike are losing faith in the Federal Reserve. Some believe this is because "overly loose monetary policy got the economy into this mess." When the Fed repetitively lowered interest rates in the past a housing and credit bubble developed. This means that property values are accelerated to the point where they become unable to maintain levels in relation to income, and other factors. Thus, housing prices fall and most home owners are left with a mortgage debt higher that the value of their property.
This all adds up to consumers that are apprehensive about spending. More weary consumers mean that the Fed is less likely to convince people to spend more. Investors are also less willing to spend money "when the market value of their assets is shrinking."
The author then explains that decreasing asset prices negatively affect the credit market as well. Money is less abundant when these prices fall, so borrowing is less of an option even though lower interest rates should boost spending. This is another example of how monetary policy might be less advantageous against a possible recession. Some of the author's sources from the bond markets believe that the interest-rate cuts will only escalate inflation. They even say that a recession might initiate some give on upward inflationary pressure.
Although there are several ways that the Fed is less successful, the author also recognizes that they can still influence spending in other ways. Demand can be stimulated with a growth in disposable income due to lower rates. It is doubtful that decreasing the interest rates will boost house prices, but it might impede the rate and amount that prices do fall. However, some consumers and investors with less owed will be able to profit from the decreased rates.
The author concludes by posing an important question, why do we need fiscal stimulus (i.e. tax rebate) if the Fed still has leverage in several markets? One already discussed reason is because of the mistrust in the Fed's abilities, and to possibly avoid complete dependency on monetary policy. Some even argue that fiscal policy can stimulate demand quicker than slashing interest rates. Nonetheless, these decisions about fiscal policy would be left to politicians (eek!) who may be too slow to act in a recession and fearful to raise taxes during periods of economic prosperity.
The optimal use of monetary policy is for helping the economy to balance out. Under certain situations however, fiscal policy can be of aid. Such as: when demand abruptly sinks, when the interest rate drops to zero, and/or in the presence of a persistent and tolling recession. The Fed still holds some power to help stave off a recession but it also might be necessary to combine it with fiscal policy.
One concept which we studied, that I recognized in the article was the relationship between the effectiveness of monetary policy with the willingness of firms to invest. Since firms are not likely to invest because of the falling prices, monetary policy has less of an impact on output. From class I know that a steep IS curve indicates that in fact, monetary policy’s significance is reduced. A steep IS curve also reaffirms that investors are skeptical because a huge change in the interest rate will only slightly adjust output, so there would be no benefit for the firm to invest.
This article was easy enough to understand, I only had to Wiki a few terms! It also helped to put words to some of the models/concepts from class by applying them to what is going on now in the US economy. I also liked that even in somewhat technical writing there can be humor!
Recent monetary policies of Federal Reserve have created a loss of faith among general Americans. Fed’s failed monetary policies caused severe damage in housing and credit card market. This resulted not only fall in asset prices, high consumer debt and bank losses, but also reduced Fed’s ability to increase spending in the economy through monetary policy. Although monetary policies still have some ability to revive economic slowdown, in the current situation fiscal policies will be more effective to revive country’s economic situation.
Federal Reserve when reduces short term interest rates, consumers tend to spend more on assets, such as shares and homes, resulting in the increase of their price. This leads to more spending until the point when market boom ends. For example, the reduction in short term interest in loans led to huge spending in assets like houses. In current situation this boom has ended and prices have started to fall. As a result people have become “savers instead of “shoppers”. Fed can always reduce interest rates, but with current situation where consumers are skeptical about spending, increase in interest rates will only lead to inflation. In such an economic condition, when market demand and interest rate has fallen, and economy is approaching or into recession, fiscal policies will be more effective in increasing national spending and production.
Apparently fiscal policy seems the most effective way-out of the situation but policy makers have to keep in mind that effectiveness of the fiscal policy will also depend on the consumer’s marginal propensity to consume. Therefore the proportion in which income increases due to fiscal policies (such as tax subsidy) will depend on how much is consumer likely to spend. If consumers remain skeptical in spending, income will not increase in significant proportion. In that case country will get into deeper recession. Moreover the timing of the policy execution is also important because as more time passes away and economy gets into deeper recession, it reduces consumer’s spending habit furthermore
This article discusses if monetary policy is still effective against economy slowdown or recession. Faith in the Federal Reserve is not what is used to be, and many people are losing confidence. One cause is the feeling that overly loose monetary policy got the economy into this mess. Repeated cuts in interest rates during the last downturn, in 2001-03, fueled the housing and credit bubbles that are now bursting to such damaging effect. The legacies of that boom—falling asset prices, high consumer debt and bank losses—may now hamper the ability of central banks to prop up spending.
We learned in class that the steeper IS curves the less effective monetary policy is, and flatter the IS curve means the monetary policy is more effective. If the IS curve get steeper in the loanable funds market, there are big changes in r (interest) and small changes in y (income).
The Economist article “Faulty Powers,” the author discusses the monetary policy being implemented by the Fed and evaluates its appropriateness in warding off economic contraction or in the very least, limiting its effects. The primary avenue of monetary policy employed by the Fed is raising or, in this case, lowering the discount ratio—the interest rate the Fed charges on loans to banks—which controls the real interest rate.
If there is faith in the Fed, and specifically faith that it will defend the current valuation of currency, then employment of this monetary policy aims to merely shift which point along the Phillips curve the economy will rest at: temporarily increase inflation in order to combat unemployment. The article reports that consumers and businesses and investors appear to be losing faith in the Fed. One explanation for this is a widespread belief that consistent expansionary monetary policy without contractionary measures to counter it later is one of the causes of the current debacle. In the past and paralleling the present, repetitive reductions in interest rates cause the development of a housing and crediting bubble which subsequently bursts, causing home owners to owe a mortgage higher than the value of their home.
When faith is lost in the Federal Reserve, expansionary monetary policy changes people’s future expectations of inflation, causing the Phillips curve to shift to the right, causing both more inflation and more unemployment. This is what is feared. This fear manifests itself in a reluctance to consume, undermining the ability of expansionary policy to increase consumption.
The author goes on to question the importance of fiscal policy in the form of a large, weighty stimulus package while the Fed maintains leverage in several markets. One possibility is that it is not important and will be unable to cause an increase in production because either the market reacted quickly enough and raised prices to offset any increase in output, or the rising output is counteracted by a decrease in net exports. The other possibility is that the government is reacting to a perceived drop in faith in the Fed and is attempting to make up for this.
My reaction to this article was worry that there may be considerable loss of faith in the fed than I thought and irritation knowing that reporting that there is a loss of faith causes a further loss of faith. I also think it is ironic that a magazine would report a self-fulfilling negative expectation when reductions in magazine subscriptions are one of the most meaningful indicators of a recession.
Fiscal policy versus monetary policy, which ones is a better way to pull the United States out of its recession slump? According to an article in The Economist, there is no one policy that is better than the other. There are some who have already lost faith in the Federal Reserve is not what it used to be. So what’s the reason for this lost in faith? It is because the U.S. has too loose of a monetary policy. Some other reasons responsible for this is interest rate cuts as well as the bursting of the housing and credit bubbles. These repetitious cuts on the interest rate will in return only rise up the inflation, and that is a problem in itself. “Although monetary policy is normally best placed to help stabilize the economy, there are some circumstances where fiscal policy can help” all in all, it is necessary to have both fiscal and monetary policy and neither one is better than the other. It’s the matter of which one to use at the right time.
The looseness of monetary policy is causing the IS slope to become steeper because it is not as effective as it can be. This article also brings across the point of how influential and effective monetary policies are on investments. It makes people want to invest more when prices are low and not so much the price rises.
Personally, I thought that this article did a good job of comparing monetary policy to fiscal policy. It was an easy read and not cluttered up with too many economic terms that would usually turn off the interests of the common reader. The title is also an attention grabber. Because the title is the first thing that a person reads it has to grab hold of the reader’s attention within the first five seconds. So when I saw this article and only reading through the title and the first sentence after the byline it made me want to read more into the article.
Hang Nguyen
The article states there’s a decrease on reliance of the Fed to save the day since Greenspan left the chairmanship. Politicians and pundits are advocating the use of fiscal policy (stimulus package) with the approval of the new chair, Bernanke. One reason is that the loose monetary policies in 2001-2003 may have put the economy where it is now, creating the housing and credit bubble. Falling asset prices (stocks and housing), consumer debt and bank losses (credit market trouble related to the housing situation) may have limited the Fed’s ability to increase spending and thus increase GDP. The article mentions that when the Fed reduces interest rates, this typically increase asset values due to the small discount on future earnings. However, now that the housing bubble has burst, the added wealth from these housing which impact s spending does not exist anymore. Additionally, with falling house prices, this makes people more of savers than spenders. With investment hampered for fear of shrinking value, this leaves the market in a bind. Household debt is at a high of 130% of disposable income versus 100% in 2000, a sign of our borrowing days. Another reason for not using monetary policy at the current environment is that there is inflationary fear. However, the bond markets are anticipating that there is enough slack in the economy slowdown to counter this inflationary pressure.
The central banks have not lost their power as they can still effect consumers behavior (spend now or later). In countries like Britain and Spain, these central banks have more power as the mortgage rates are fixed to central bank’s policy rate or fixed for short periods. The articles presents that the reasons for use of fiscal policy are: it’s an election year, it relieves the over-reliance to monetary policy, and that fiscal policy can increase demand quicker. The issue is that it puts more power to the politicians which may in fact take longer to agree on an economic solution or will not have the fortitude to making critical decisions in boom or bust situations due to public pressure. The articles states that monetary policy is best for stabilizing the economy, fiscal policy is good for helping long or deep recessions.
Key economic topics discussed are: monetary versus fiscal policy, and alluded to the way asset (stock) values are determined. Monetary policy comes from the central bank, the FED, by regulating currency to affect interest rates. The FED has various options available such as open market operations (buying and selling bonds) and the control of the bank reserve ration. Fiscal policy comes from the government through their spending decisions as well as the tax requirements. The stimulus package is a tool used by the government. In class, we learned that the value of a stock is dependent on the interest rate, growth rate and the current profit. However, this is simplified from the original teaching that share value is related to the current and future.
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