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OHT Survey

Friday March 22, 2013 – Periods 2, 3, 6, 7

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Tools of Monetary Policy

Thursday March 21, 2013 – Periods 2, 3, 6, 7

The Fed has a number of monetary tools available to change the money supply and interest rates to affect real output, employment, and price levels.

Open market operations are the most frequently used tool of monetary policy because of their flexibility and immediate effects. Open market operations are the Fed’s purchases and sales of government bonds with member banks and the public. When the Fed buys bonds from a bank, it creates reserves in the bank’s deposit with the Fed, which the bank can then lend to customers. When the Fed buys bonds from the public, it puts a check in the hand of the consumer, who can deposit the funds in his bank. The two transactions are slightly different in effect, because the bank can loan the full excess reserves resulting from its sale of bonds to the Fed, but the bank must keep the required reserves from the customer’s deposit, leading to a smaller increase in the money supply. In either case, the Fed increases the money supply when it buys bonds, and it reduces the money supply when it sells bonds.

The reserve requirement is the most powerful tool of monetary policy, so it is only rarely used. A change in the percentage of deposits the banks must hold in reserve directly impacts the bank’s ability to increase loans and, therefore, the money multiplier. If the Fed increases the reserve requirement, banks cannot loan as much and the money supply falls. A reduction in the reserve requirement increases the potential growth of the money supply.

A third important tool of monetary policy is the discount rate, which is the interest rate the Fed charges member banks for loans. A reduction in the discount rate encourages banks to borrow from the Fed and, in turn, increase loans to their customers. As a result, the money supply increases. An increase in the discount rate discourages banks from borrowing from the Fed, reducing loans and the money supply.

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Federal Reserve

Wednesday March 20, 2013 – Periods 2, 3, 6, 7

The Federal Reserve System is the central banking system of the United States, specifically designed to shield its policymakers from political pressure. The Federal Reserve Board of Governors consists of seven members who are appointed by the president and confirmed by the Senate to serve 14-year terms. The 12 regional banks are publicly-controlled, yet privately owned by the member banks. They can be thought of as “bankers’ banks,” providing local banks with some of the same services local banks provide customers: a safe place to store savings and a place to get loans. The Federal Open Market Committee (FOMC) buys and sells government securities to change the nation’s money supply.

The Fed’s primary responsibility is to control the money supply. It also determines the reserve requirement, which is the percentage of deposits banks must hold and cannot loan out. The Fed also loans money to member banks, charging the discount rate as interest on the loan. In addition, the Fed issues currency, clears checks, serves as the federal government’s bank, and supervises the member banks.

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Deficits and Debt

Tuesday March 19, 2013 – Periods 2, 3, 6, 7

One potential problem of fiscal policy is the crowding-out effect. If government increases borrowing in order to conduct expansionary fiscal policy, the increased demand for funds can increase interest rates. Firms may respond by decreasing investment, reducing the effectiveness of the fiscal policy undertaken. Economists disagree about the strength of the crowding-out effect, as firms are already less likely to increase investment in a time of recession due to excess capacity.

The national debt is important primarily because of the effects of interest. Because ownership of the debt is concentrated in those with higher incomes, payment of interest increases the inequality of incomes. The payment of interest reduces government funds available to spend for other needs, and payment to foreigners who hold U.S. debt transfers those funds outside of the country. Crowding out is a much more important problem when the economy is at full-employment output, because increased government borrowing can reduce investment and compromise long-run economic growth. However, if the increased government spending is used for infrastructure improvements and research, long-run economic growth could be enhanced.

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Fiscal Policy Automatic Stabilizers

Monday March 18, 2013 – Periods 2, 3, 6, 7

Automatic stabilizers are policy programs whose actions are counter-cyclical and do not require specific action on the part of policymakers. For example, during recessions, government spending automatically increases for unemployment benefits, food stamps, and other programs when more people meet eligibility requirements. During inflation, the progressive tax system charges higher marginal tax rates for those whose incomes are rising faster than the inflation rate. While these automatic stabilizers can help to reduce the effects of economic cycles, discretionary fiscal and monetary policy are much more powerful tools to restore economic stability.

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Fiscal Policy

Friday March 15, 2013 – Periods 2, 3 , 6, 7

Fiscal policy allows policymakers to use changes in taxes and government spending to correct economic instability.

During a recession, aggregate demand falls, creating a recessionary gap which reduces output and employment. The government can use expansionary fiscal policy, reducing taxes or increasing government spending (or both) to stimulate aggregate demand and restore the economy to full employment output. Expansionary fiscal policy creates a budget deficit, as the government spends more than its revenue in a year, and such deficits add to the national debt.

It is important to note that changes in government spending and taxes have different levels of efficacy. While increases in government spending have a full multiplier effect because they are fully spent in the economy, reductions in taxes are less effective. Because households will choose to save part of a tax cut and spend the rest. Therefore, government would have to change taxes by a greater amount than it would have to change spending, if it wants to achieve the same effect in the economy.

The government uses contractionary fiscal policy to combat inflation, raising taxes, reducing government spending, or both. Because of the ratchet effect, prices that rise tend not to fall to their previous levels, so the focus is on halting the rise of inflation and reducing aggregate demand to reduce further pressure on prices. The rise in tax revenue and fall in government spending would reduce the deficit or even cause a budget surplus, which would reduce the national debt.

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