MacroeconomicsTopic 9: “Explain the strategy behind government policies to stabilizethe economy and the specific role of the Federal Reserve.”Reference: Gregory Mankiw’s Principles of Microeconomics, 2nd edition, Chapter 20.Smoothing out the fluctuations: stabilization policyReal GDP in the United States has grown at about 3.3% per year since about 1875.Overtime this has led to the US becoming one of the richest countries in the world.Unfortunately, this growth in real GDP has not been smooth. In some years (expansions)GDP grows much faster than the long term trend, and inflation often increases. while inothers (called recessions) real GDP falls. The pattern of recessions and expansion iscalled the business cycle by economists. Since the burden of poor economic performanceduring recessions falls principally on the unemployed, policy aimed at eliminating thefluctuations associated with the business cycle seems desirable to most people.Government policy designed to smooth out the business cycle are called stabilizationpolicies. The two primary types of stabilization policy used in the United States aremonetary and fiscal policy.Monetary policyMonetary policy attempts to reduce the fluctuations in nominal GDP and unemploymentby manipulating the rate of growth in the money supply. Monetary policy is carried outby Federal Reserve Bank’s open market committee. The general strategy is to increasemoney growth during periods of higher unemployment (recession) and reduce moneygrowth during periods of inflation (excess expansion) Why does increasing the moneysupply raise aggregate demand?Economists following the writings of John Maynard Keynes believe that recessions stemmostly from unusually low aggregate demand for final goods and services. To combatlow aggregate demand a government policy must increase some component of aggregatedemand without commensurately reducing some other component.AggregateDemand=ConsumerSpending+InvestmentSpending+GovernmentPurchases+NetExportsMonetary policy attempts to increase aggregate demand during recession by increasingthe growth of the money supply. The theory of liquidity preference suggests thatincreasing the money supply will cause interest rates to fall. Lower interest rates causehigher investment spending which increases aggregate demand.When the Federal Reserve Bank increases the money supply through an open marketoperation, it is buying government bonds from large banks with newly created reserves.The additional reserves allow the banks to create new money through loans to privatecitizens and companies. As banks compete to make new loans, they will offer loans atlower interest rates. The new lower interest rates attract new borrowers. Mostborrowers are using the loans to purchase durable items such as cars, houses, or – in thecase of companies – new factories and equipment. As a result, the lower interest ratesincrease investment spending, and aggregate demand increases.• Why does monetary policy involve slower money growth during expansions ?While most economists believe that increasing money growth can affect aggregatedemand in the short run, in the long run a high rate of growth in the money supply leadsto inflation. As a result, the average rate of growth in the money supply should beslowed if inflation develops in the expansionary phase.If growing the money supply more rapidly during the recessions lowers interest rates andincreases investment spending, the slower growth of money during expansions raisesinterest rates an reduces investment spending and aggregate demand. When onecombines the effects on both recessions and recoveries, monetary policy reduces theswings in economic activity – it stabilizes the economy. Rather than growing unusuallyrapidly during the recovery, with monetary policy GDP should rise at a rate closer to thelong-term sustainable growth rate.• Interest rate targets and monetary policy at the Federal Reserve BankWhen the Federal Reserve Bank describes its monetary policy actions in the newspaper,it does not typically discuss the rate at which it will be increasing the money supply.Instead, the Fed typically announces an interest rate target for the federal funds interestrate. The idea is that the Fed will keep increasing the money supply until that interestrate is reduced to its target level. In the newspaper, they often say something like “TheFed has lowered interest rates from 5% to 4%,” meaning that the Fed will increase bankreserves until this happens. Increasing reserves in most cases will lead to an increase inthe money supply.Fiscal policyThe word “fiscal” refers to “budget.” Since most Keynesian economists believe thatrecessions arise from low aggregate demand, the phrase “fiscal policy” amounts to acollection of strategies that manipulate the government’s budget to affect aggregatedemand. In practice, fiscal policy involves using one of two strategies:Increasing Government Purchases: The government buys more goods and servicesduring recessions (paying with borrowed money), and then pays back the loans during therecovery by buying fewer goods and services.Cutting Taxes: The government reduces the amount of tax collections during recessions(borrowing money to pay the bills), and then pays back the loans during the recovery byraising taxes.Quantity ofMoneyInterestRatesMD1MD2MoneySupplyr1r2Quantity ofMoney fixedby the FedFigure 1: Crowding Out Fiscal policy increases aggregate demand, which raises Money Demand, causing higher Interest rates.Both strategies increase aggregate demand when it is low, but use different methods.Increasing government purchases during recessions should directly raise aggregatedemand. Cutting taxes should cause consumer spending to increase, raising aggregatedemand indirectly.Many factors complicate the use of fiscal policy. One factor that helps the governmentincrease aggregate demand during recessions is called the Keynesian multiplier effect.The multiplier may be illustrated with an example. Suppose that the government buys$100 million worth of new cars during a recession. The car companies now have toproduce more cars so they are likely to hire back some of the workers that they laid offearly in the recession. With new paychecks, these workers will now buy more goods andservices, causing an increase in aggregate demand. In the end aggregate demand rises bymore than the increase in government spending because of the