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Is it Monetary Policy or Fiscal Policy?

This page authored by Ted Scheinman, Mt Hood Community College, Gresham, Oregon
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This material is replicated on a number of sites as part of the SERC Pedagogic Service Project

Summary

This activity will use a simple practice exercise to help students distinguish between monetary and fiscal policies. The basic format is the students will read a description of a policy and select whether the policy is fiscal or monetary policy or neither.

Learning Goals

1. Distinguish the difference between monetary policy and fiscal policy.

2. Identify whether a policy is expansionary policy or contractionary policy.

3. Predict the impact on GDP, Unemployment, and Inflation of the policy represented by the headlines.

4. Extend this exercise by completion of the Fed Chairperson Game, without getting fired.

Context for Use

This practice exercise should be undertaken by students who have learned the measures of economics activity, the basic macroeconomic aggregate demand/aggregate supply model of the economy, the use of fiscal policy and monetary policy to alter the outcomes of the economy. This activity addresses confusions that students might have as to the differences between fiscal policy and monetary policy.

Description and Teaching Materials

The following questions are provided on a card format, so that they can be printed on card stock, and used in class. Cut them out from the this attachment (Microsoft Word 2007 (.docx) 14kB Nov24 13) and put them in a card deck that should be shuffled.

I. II. What do you know? Identify which of the following are related to monetary policy or fiscal policy. In addition, identify what impact this headline will have on GDP, Unemployment, and/or Inflation

a. The Kane Street Journal reported that as a result of recent policy, the prime rate fell to a 30 year low.

b. The Department of Commerce reports that homes have become more affordable, as a result of a decrease in interest rates.

c. Following an expansion of military efforts, the consumer price index increased by 5% in the past year.

d. Lower tax rates have led to an increase in housing starts.

e. Due to current policy changes, the interest rate on credit cards has increased?

f. Banks are now required to hold larger excess reserves, resulting in higher interest rates.

g. The Federal Funds Rate dropped last week to 0.25%.

h. The Discount Rate has increased to 3.5%, to slow inflation.

i. Congress passed a bill increasing the Federal Debt limit.

j. As a result of the government policies because of a slowdown in the economy, the U.S. increased its deficit to a record $1.3 billion.

k. Government passed a budget that led to a greater deficit.

l. Funding for the military is increased.

m. The Inheritance Tax is eliminated.

n. The deduction for homeowner's interest payments is eliminated.

o. The tax rate on the top 5% of income earners is increased.

p. A subsidy is placed on corn used for making gasoline.

q. Funding for Education is increased.

r. Funding for Obamacare is delayed.

II. Which are monetary and which are fiscal policies? Which are expansionary and which are contractionary?

a. Headlines a., b., e. – h. are monetary policies.

b. Headlines b., c., i. – r. are fiscal policies.

c. Headlines represent expansionary policies in a., b., c., d., g., i., j., k., l., m., p., and q.

d. Headlines represent contractionary policies in e., f., n., o., and r.

WhIII. What impact will each of these headlines have on GDP, Unemployment, and/or Inflation, everything else remaining the same?

a. The Kane Street Journal reported that as a result of recent policy, the prime rate fell to a 30 year low. (Expansionary policy; GDP increase, Unemployment Decrease, Inflation Increase)

b. The Department of Commerce reports that homes have become more affordable, as a result of a decrease in interest rates. (Expansionary policy; GDP increase, Unemployment Decrease, Inflation Increase)

c. Following an expansion of military efforts, the consumer price index increased by 5% in the past year. (Expansionary policy; GDP increase, Unemployment Decrease, Inflation Increase)

d. Lower tax rates have led to an increase in housing starts. (Expansionary policy; GDP increase, Unemployment Decrease, Inflation Increase).

e. Due to current policy changes, the interest rate on credit cards has increased? (Contractionary policy; GDP decrease, Unemployment Increase, Inflation decrease)

f. Banks are now required to hold larger excess reserves, resulting in higher interest rates. (Contractionary policy; GDP decrease, Unemployment Increase, Inflation decrease)

g. The Federal Funds Rate dropped last week to 0.25%.(Expansionary policy; GDP increase, Unemployment Decrease, Inflation Increase)

h. The Discount Rate has increased to 3.5%, to slow inflation. (Contractionary policy; GDP decrease, Unemployment Increase, Inflation decrease)

i. Congress passed a bill increasing the Federal Debt limit. (Expansionary policy; GDP increase, Unemployment Decrease, Inflation Increase)

j. As a result of the government policies because of a slowdown in the economy, the U.S. increased its deficit to a record $1.3 billion. (Expansionary policy; GDP increase, Unemployment Decrease, Inflation Increase)

k. Government passed a budget that led to a greater deficit. (Expansionary policy; GDP increase, Unemployment Decrease, Inflation Increase)

l. Funding for the military is increased. (Expansionary policy; GDP increase, Unemployment Decrease, Inflation Increase)

m. The Inheritance Tax is eliminated. (Expansionary policy; GDP increase, Unemployment Decrease, Inflation Increase)

n. The deduction for homeowner's interest payments is eliminated. (Contractionary policy; GDP decrease, Unemployment Increase, Inflation decrease)

o. The tax rate on the top 5% of income earners is increased. (Contractionary policy; GDP decrease, Unemployment Increase, Inflation decrease)

p. A subsidy is placed on corn used for making gasoline. (Expansionary policy; GDP increase, Unemployment decrease, Inflation decrease)

q. Funding for Education is increased. (Expansionary policy; GDP increase, Unemployment decrease, Inflation increase)

r. Funding for Obamacare is delayed. (Contractionary policy; GDP decrease, Unemployment Increase, Inflation decrease)

I. IV. Brief examination of monetary policy, which is conducted by the Federal Reserve, fiscal policy which is undertaken by Congress and the President. If the student and teacher have access to this material in a textbook, this section can be ignored.

a. Monetary Policy: There are several ways that that interest rates can be reduced:

i. Open market operations.

1. Open market operations are undertaken to influence the Federal Funds Rate and other rates that are related to this rate.

2. If the Federal Reserve wants to stimulate the economy, it will undertake a purchase of securities, which will give banks more excess reserves. When banks have more excess reserves, they will tend to loan more money out, everything else remaining the same.

3. If the Federal Reserve wants to restrict the economy, because of inflation, it will undertake a sale of securities, which will give banks fewer excess reserves. When banks have less excess reserves, they will tend to loan less money out, everything else remaining the same.

ii. Discount rates.

1. When the Federal Reserve acts as a lender of last resort, they lend money to banks based on collateral. The interest rate charged on these "emergency" loans is called the Discount rate.

2. If the Federal Reserve wants to stimulate the economy, it will lower the Discount Rate, which makes it easier for banks to lend out those last few dollars they have in excess reserves, leading to lower interest rates, everything else remaining the same.

3. If the Federal Reserve wants to restrict the economy, it will raise the Discount Rate, which makes it more expensive for banks to lend out those last few dollars they have in excess reserves, everything else remaining the same. Therefore they will not lend out as much, restricting credit.

iii. Required reserves.

1. Although this is not often used, the Federal Reserve is able to change the portion of total reserves that a bank must keep as Required Reserves.

2. If the Federal Reserve wants to stimulate the economy, it could lower the Required Reserve Ratio, which gives banks more excess reserves and makes it easier for banks to lend out money, leading to lower interest rates, everything else remaining the same.

3. If the Federal Reserve wants to restrict the economy, it could raise the Required Reserve Ratio, which gives banks fewer excess reserves and makes it more expensive for banks to lend out money, leading to higher interest rates, everything else remaining the same.

4. Fiscal policy, which is conducted by Congress, can be intentional or unintentional.

b. Tax Policy

i. Tax policy can work in a variety of ways, changing the incentives of businesses or consumers to spend and earn money. Sometimes there are unintended consequences of tax policy.

ii. If Congress wants to stimulate the economy, it could lower taxes, which would lead to increased spending by consumers and businesses, everything else remaining the same.

iii. If Congress wants to restrict the economy, it could raise taxes, which would lead to reduced spending by consumers and businesses, everything else remaining the same.

c. Government Spending increases or decreases.

i. Government spending policy can work in a variety of ways, changing the flow of money to the circular flow in the economy, directly increasing GDP and reducing unemployment. Sometimes there are unintended consequences of spending policies.

ii. If Congress wants to stimulate the economy, it could increase government spending, which would lead to an increase in GDP and increasing employment, everything else remaining the same.

iii. If Congress wants to restrict the economy, it could reduce spending, which would lead to a decrease in GDP, employment, and inflation, everything else remaining the same.

V. Extension of practice exercise. This exercise can be extended to explain in detail the operations of these tools. Some questions that can be addressed are:

a. How can the Federal Reserve affect interest rates?

b. How could Congress help stimulate the economy?

c. How could the Federal Reserve help stimulate the economy?

d. How do open market operations work?






Teaching Notes and Tips


Assessment

See The Fed Chairman Game

References and Resources