Expansionary Policy

Expansionary policy is a macroeconomic policy that seeks to expand the money supply to encourage economic growth or combat inflation. One form of expansionary policy is fiscal policy, which comes in the form of tax cuts, rebates and increased government spending. Expansionary policies can also come from central banks, which focus on increasing the money supply in the economy. The U. S. Federal Reserve employs expansionary policies whenever it lowers the standard fed funds rate or discount rate or when it buys Treasury bonds on the open market, thereby injecting capital directly into the economy.I will focus this paper?on these policies and theories, and how the federal government would engage them?in an effort to move the economy out of a recession. The Great Depression challenged the classical model with the reality of a long depression and high unemployment. In The General Theory, Keynes attacked the classical model in two important ways. First, he identified some flaws in the mode l. Second, unlike the business cycle theorists, he offered a well-developed alternative model of the macroeconomy.This model was the basis for the Keynesian revolution, the change in macroeconomic theory and policy that occurred when Keynes's ideas displaced the classical explanation of how output and employment are determined. The Keynesian model begins with aggregate demand and works from there to employment, instead of the other way around (Amacher & Pate, 2012). In the 1930s Unemployment was high because planned spending was too low to generate the level of output that would result in full employment. Thus, too little spending was identified as the cause of unemployment.To reduce unemployment, planned spending had to increase. In the language of aggregate supply and aggregate demand (a model developed after Keynes), aggregate demand had to shift to the right. In attempting to identify the cause of employment, Keynes reasoned as follows: EXPANSIONARY POLICY 3 The level of employm ent is directly related to the level of production, or output. In a market economy, planned spending on the output of the business sector will determine the level of production. Firms adjust their levels of production to meet demand for their products. Put simply: Supply adjusts to demand.(In contrast, Say's law said that supply creates its own demand). Because employment depends on production and production responds to spending, the level of employment in a market economy depends on the level of planned spending in the economy (Perry, 2009). Before Keynes balanced budgets were generally accepted by politicians and the public as the responsible thing. Keynesian view challenged the desirability of balanced budgets. Argued that federal budget should be used to promote AD/full employment. Federal Budget influences AD two ways: ?Government spending on goods and services stimulates AD.National defense, highways, education, etc. Tax policy influences AD. Tax cut increases disposable incom e, increases PCE – C goes up. Business tax cut increases business investment on equipment, etc. Keynes argues that fluctuations in AD are the source of economy disturbances and create the bus cycle – â€Å"Animal Spirits. † Policy conclusion; stabilize the economy through fiscal policy (Perry, 2009). If economy is in recession, government should engage in expansionary fiscal policy†¦increase government spending and/or reduce taxes, increase budget deficit.Borrow money (to finance the deficit) from individuals, businesses or foreigners. Economy is in recession at due to animal spirits. Downward pressure on prices. Expansionary fiscal policy (active budget deficit) cut personal income taxes, cut corporate taxes; increase government spending government can pursue restrictive fiscal policy to reduce AD1 to AD2 (Investopedia, 2013). EXPANSIONARY POLICY 4 Keynesian view; government should engage in activist, discretionary, countercyclical policy to stabilize econ omy. Run deficit during recession to stimulate (increase) AD.Run surplus during expansion to restrain (decrease) AD. Since budget deficits are now permanent, restrictive policy now means a smaller deficit, not a surplus. If deficit goes from $200B to $100B, that is restrictive, even though there is still a deficit (Investopedia, 2013). When Keynes attacked the ideas of the classical school in The General Theory of Employment, Interest, and Money (1936), he was attacking the mainstream of 19th-century economic thought. In doing so, he ignored some important work by other economists, such as Henry Simons and Irving Fisher, who were working in the classical tradition.The ideas that Keynes criticized were those that drove the macroeconomic policies of his time. His contributions changed the policy approach to recessions and depressions for decades to follow (Amacher & Pate, 2012). Fiscal policy relies on changes in government spending and taxes (and transfer payments, which can be treat ed as negative taxes). In general, conservative Keynesians prefer tax changes, leaving the level of government spending constant. Liberal Keynesians are more likely to favor changes in government spending or transfer payments.Fiscal policy cannot be considered outside the context of the level and composition of existing government spending†¦ In the United States, a large share of the nation's income is claimed by government, and a substantial share of output is produced by or for government (Amacher & Pate, 2012). There are two kinds of fiscal policy. One kind is put into place and left to respond automatically to changes in the level of economic activity. The second kind, used less frequently, is deliberate action to change tax laws or enact new spending programs so as EXPANSIONARY POLICY 5 to influence the level of output, employment, and prices.Congressional legislation over the years, much of it enacted during the Great Depression, has created a system of tax collections an d transfer payments that change automatically in response to changes in national income. These automatic stabilizers partially offset changes in private spending and tend to reduce fluctuations in output and employment. They primarily include changes in income tax collections, Social Security and welfare benefits, and unemployment compensation claims. Because these automatic stabilizers are triggered by changes in the economy, they do not require further action by Congress (Amacher & Pate, 2012).Transactions involving bonds, reserves, loans to banks, and Federal Reserve notes are the tools of monetary policy. The Fed uses the money supply and interest rates to affect output, employment, and the price level. The Fed has three ways to influence the money supply: open market operations, changes in the discount rate, and changes in the reserve ratio. Open market operations involve buying and selling bonds to affect banks' reserves. The discount rate affects the level of bank borrowing f rom the Fed. Changes in the reserve ratio affect excess reserves (Investopedia, 2013).The Fed's preferred tool is open market operations. Open market operations are purchases and sales of bonds by the Fed on the open market in order to affect bank reserves. Open market operations are a very flexible tool. The impact on reserves can be precisely determined to be as large or as small as desired. Open market operations can be reversed if necessary and can be done without any ordeal. They are done by the Federal Reserve Bank of New York. Bonds are bought and sold through brokers in New York City. The New York district bank has this responsibility because New York is the financial center of the country.The New York Fed, however, does not buy and sell on EXPANSIONARY POLICY 6 the basis of its own decisions. It carries out the directives of the FOMC. (Amacher & Pate, 2012). These changes are shown on the T-accounts of Banks. If the Fed buys a bond from an individual or a firm, the seller w ill deposit the check from the Fed in a bank. The bank will clear the check through the Fed, and its reserves with the Fed will increase by the amount of the sale. No matter where the Fed buys bonds, bank reserves increase by the amount of the Fed purchase. Banks may also borrow directly from the Fed.Borrowing from the Fed by banks is called â€Å"using the discount window. † The interest rate the Fed charges a bank is called the discount rate. The higher the rate, the less eager banks are to borrow. The discount rate is normally lower than other interest rates at which banks could borrow. When an increase in the reserve ratio leaves banks with too little reserves. Banks have to contract their deposits by selling interest-earning assets or eliminating loans. Such a forced contraction creates a difficult situation for both banks and their loan customers. It takes time to adjust.For this reason, the Fed may cushion the impact of a decline in bank reserves by keeping the discoun t window open (Amacher & Pate, 2012). Each Federal Reserve Bank sets a discount rate for the depository institutions of its district, but the rates are usually the same in all 12 districts. Normally the discount rate is slightly below the market interest rate. The discount rate functions as a signal more than as a direct tool of monetary control. A decrease signifies the Fed's desire to stimulate the economy. Changes in the discount rate also alter the profitability of borrowing from the Fed in order to relend.A lower rate makes borrowing from the Fed more attractive and encourages banks to hold fewer excess reserves. They know they can easily borrow from the Fed if necessary (Amacher & Pate, 2012). EXPANSIONARY POLICY 7 The Fed sets and changes the reserve ratio. There are two kinds of assets that a bank can count toward meeting the required reserve. One is currency and coins, or vault cash. The second, and larger, consists of funds the bank has on deposit with its district Reserve Bank. The Fed requires depository institutions to hold reserves equal to certain fractions of the different kinds of deposits they have.The reserve ratio is higher for banks with deposits over $40 million. One reason why banks collapsed during panics before the Fed was created was that their reserves were too small or not readily available. In practice, reserves now have little to do with the safety of checking and savings account deposits. Their safety is ensured by deposit insurance. However, reserves do ensure that banks will have some ready funds to meet withdrawals. A change in the reserve ratio changes the maximum size of the money supply, not by changing bank reserves, but by changing the deposit multiplier.The deposit multiplier is the reciprocal of the reserve ratio. When the reserve ratio changes from 20% to 10%, the deposit multiplier increases from 5 to 10. A reduction in the reserve ratio has a double impact on the money supply. First, it converts some required reserve s into excess reserves. Second, it increases the size of the deposit multiplier. Decreasing the ratios leaves depositories initially with excess reserves, which can induce an expansion of bank credit and deposit levels and a decline in interest rates (Perry, 2009).A change in the reserve ratio is more complex than open market operations because of this double impact. Because it is such a powerful tool, changes in the reserve ratio are made rarely and in small amounts. Even a change of a fraction of a percent can have a very large (and somewhat uncertain) impact on the economy and can be very unsettling to banks. Both economists and politicians have disagreed over the effectiveness of the EXPANSIONARY POLICY 8 Fed in using its monetary policy tools. The debates of the 19th century over how freely banks should lend are still alive.There is still support for a policy of easy money, unlimited credit, and inflation among those who are in debt and want to be able to borrow more and pay it back with cheaper dollars. There are also groups who support a hard-money policy, ranging from those who simply want monetary growth carefully controlled to those who would like to return to full-bodied money, usually a gold standard (Perry, 2009). Keynesians would advocate an increase in the money supply (expansionary monetary policy), which would decrease interest rates, increase spending, increase AD, increase prices and output, and decrease unemployment.Keynesians believe in more flexibility or â€Å"discretion†, with the Fed adjusting money supply to respond to economic conditions. Expansionary Policy is a useful tool for managing low-growth periods in the business cycle, but it also comes with risks. First and foremost, economists must know when to expand the money supply to avoid causing side effects like high inflation. There is also a time lag between when a policy move is made (whether expansionary or contractionary) and when it works its way through the economy.