Monday
30 August
1330-1500 (IS)
"If it sounds easy, you don't have all the facts."
James L. Brewer.
Overview
As we learned in Topic 1, John Maynard Keynes observed that, contrary to the opinion of Adam Smith, market economies do not always function perfectly. To remedy this, he suggested that governments should have an important role.
The fact is that pure free market economies do not exist. Even in the most open economy - the United States - the government is significantly involved in management. The most pro-business person would not debate that government performs a legitimate, essential role in economic management (e.g. printing currency, regulating and supervising banks). The real issue is the extent to which and in which areas government should be involved.
There are two main categories of economic "tools" available to governments: fiscal and monetary. Such tools are applied both to correct the problems studied in the previous Topic, or - better still - to avoid the onset of such problems before they begin.
Fiscal policy is defined as the changes in government spending and tax collections for the purpose of achieving a full-employment and non-inflationary domestic output. By increasing spending during a period of recession, governments augment demand; the result is increased employment and incomes as the economy strives to produce the additional goods and services. If spending is increased too much, government "competition" for relatively finite resources (e.g. credit) with the private sector can result in inflation and increased deficits. When there is inflation, governments increase taxes, reducing demand by taking money away from potential consumers. In the extreme, however, high taxation reduces growth and employment to the overall detriment of the economy.
Monetary policy affects the supply of money available to the economy. By and large, monetary policy in the United States is implemented by its central bank, The Federal Reserve System (known as "the Fed"). Monetary policy also is used to stimulate full employment and minimize inflation. The most important way the Fed influences the supply of money is through open market operations, that is, the buying and selling of government bonds in the open market. Probably the most visible tool of monetary policy used by the Fed is the establishment of loan interest rates, which it does by adjusting the amount it charges banks to borrow funds. The end result is one already familiar to you: when there is more money available, consumer (businesses and individuals) demand increases, triggering an increase in supply (the output of goods and services), more employment, etc. The downside, as you have also seen, is that too much stimulation to the market can produce inflation and all of its consequences.
The management of fiscal and monetary policy is key to the operation of most economies. As you will learn in Topic 7, such policies usually are at the core of recommendations made by the International Monetary Fund (IMF) when economies find themselves in crisis (e.g., Indonesia, Thailand).
Objectives
- Understand the nature and application of fiscal and monetary policy.
- Understand the role of monetary and fiscal policy in optimizing economic performance and addressing economic problems, such as inflation and unemployment.
- Understand the role of, and the tools employed by, the Federal Reserve System.
Issues for consideration
- What are the relative strengths and weaknesses of fiscal and monetary policy?
- What is the impact of economic globalism on the effectiveness of fiscal and monetary tools?
- How important is the political independence of the U.S. Federal Reserve System? What are the risks on both sides of the issue (i.e. too much or too little independence)?
- Consider European economic integration, specifically the creation of a single currency. Will this new configuration increase or decrease the effectiveness of the use of fiscal and monetary tools in Europe?
- How do fiscal and monetary policies affect savings and investment?
Required readings (89 pages)
* Baumol and Blinder: Chapters 28 (pgs. 649-654, 657-666), (16 pgs.)
* "In The Money," James Rowe, The Washington Post, February 10, 1999 (16 pgs)
* Heilbroner and Thurow: Chapters 8 (14 pgs.), 9 (9 pgs.), 10 (8 pgs.) and 11 (11 pgs.)
* Budget Planning Perspective from the President's Budget Proposals over a five year period (5 pgs.)
* "Glittering Economic Prizes," (pg. 19); "Desperately Seeking a Perfect Model," (pgs. 67-69); "The Good and Bad Model Guide," (pg. 68); "Unfinished Battle," (pg. 77), The Economist, April 10, 1999 (10 pgs.)
Suggested reading
* Baumol and Blinder: Chapters 29 (14 pgs.) and 30 (22 pgs.)
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