4/30/2011

MACRO 2301

FISCAL POLICY AND MONETARY POLICY IMPACT ON THE U.S. ECONOMY.

Saturday Morning Class 9:00 a.m. 12:00 p.m. | Heather Lindquist

I: Executive Summary Fiscal policy is a tricky tool used by the United States government to cure an economic ill such as inflation, unemployment or poor GDP. The government can either pass laws to change government spending or change income taxes in order to shift the aggregate supply and demand curves. The United States recently survived the worst financial crisis since the Great Depression. President Obama and the United States government found themselves in uncharted waters. Through numerous tax breaks, transfer payments, subsidies and tremendous government spending, totaling more than $787 billion dollars, they were able to keep unemployment levels from crossing over 10% in 2009 and 2010. Despite their best efforts they were unable to create enough jobs to get our economy growing and have begun flirting with inflation. Monetary policy is a tool reserved for the Federal Reserve. Monetary Policy refers to the Federal Reserves attempt to control the United States money supply in order to influence inflation, promote employment and maintain the stability of the financial economy. In the recent financial crisis the Federal Reserve was able to use its traditional tools to monitor the money supply such as decreasing the discount rate, purchasing billions of treasuries in the open market and maintaining the reserve rate at 10%. The Federal Reserve reacted to a unique problem with a few new solutions such as creating five new lending institutions and extending financial support to critical banks and lending groups that are critical to the success of the United States economy. The United States Government and The Federal Reserve worked together to solve the problems that a free market economy would solve itself, if left alone. Ultimately, the combined efforts of both agencies were able to keep our financial economy intact and kept it from getting worse.

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II: Statement of the Problem After attending four months of Macroeconomics classes, I will attempt to apply the knowledge I have learned to explain the impact several fiscal and monetary policies had on our economy based on aggregate supply and demand throughout 2009 and 2010. III: Fiscal Policy Changes When the United States is functioning at an unacceptable level of unemployment or experiencing contracting real gross domestic product values, the government has two options available to them to help stimulate the economy. The government can pass laws to change government spending or change income taxes. Both of these options available to the United States government take the form of fiscal policy. Fiscal policy has the ability to shift the aggregate demand curve which causes real gross domestic product values to contract or expand. While fiscal policy is often used to stimulate the economy it is also an important tool used to fight inflation. III A1: American Recovery and Reinvestment Act Method President Obama faced an unprecedented financial crisis upon entering the White House in January 2009. According to data I obtained from The US
Figure 1

Bureau of Economic Analysis, President Obama entered the White House as the United States was experiencing a -6.3% annual growth decline in real GDP at the end of the fourth quarter of 2008, as seen in Figure 1. Despite these poor numbers in the fourth quarter, Real GDP increased 1.1 percent in 2008 (that is, from the 2007 annual level to the 2008
Bureau of Economic Analysis. "News Releases." 28 April 2011. Bureau of Economic Analysis U.S. Department of Commerce. 28 April 2011 <http://www.bea.gov/newsreleases/national/gdp/gdphighlights.pdf>.

annual level) compared with an increase of 2.0 percent

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in 2007. (Mataloni) United States citizens were growing extremely concerned over the rising unemployment rates. According to the Bureau of Labor and Statistics, the unemployment rate in December 2008 was 7.3% as seen in Figure 2. Prior to taking office our future President gathered together a panel of economic advisors and began creating a plan of action to help stimulate the United States Economy and address the issue of unemployment. The Obama administration looked to our past and decided to test out the advice from economist John Maynard Keynes. Keynes believed that a free market economy would always correct itself in the long run, however extreme government spending would jump start the economy and relieve human suffering in the short run. In February 2009, resident Obama unveiled his Keynesian like plan to
U.S. Bureau of Labor and Statistics. "Survey Output." U.S. Bureau of Labor and Statistics. 26 April 2011 <http://data.bls.gov/pdq/SurveyOutputServlet>.

Figure 2

the American public when he signed into law The American Recovery and Reinvestment Act, known as the ARRA. The purpose of the ARRA was to create new jobs, increase economic activity, save current jobs and create accountability and traceability in government spending. The recovery act intends to achieve these goals by:

Providing $288 billion in tax cuts and benefits for millions of working families and businesses Increasing federal funds for education and health care as well as entitlement programs (such as extending unemployment benefits) by $224 billion Making $275 billion available for federal contracts, grants and loans Requiring recipients of Recovery funds to report quarterly on how they are using the money. (The Recovery Act)

III B1: American Recovery Reinvestment Act Research Theory The President and Congress intended to stimulate the economy when passing the ARRA which approved $787 billion dollars in the form of additional government spending and tax cuts for individuals and businesses. In order to combat unemployment and increase Real GDP the United States Page | 4

Government created the following programs seen in Table 2. The aggregate demand curve is equal to the sum of consumer consumption, investments, government spending and the net of exports minus imports. All of the major provisions in the ARRA, as seen in Table 2, were created to expand and shift the aggregate demand curve. Their intent can be illustrated using the graph below. With the implementation of the ARRA, the government expected to see the aggregate demand curve shift from AD1 to AD2, as illustrated in Graph 1 below. Moving from AD1 to AD2 would increase employment and Real GDP because the AD curve shifts to the right, causing our quantity to increase from Q1 to Q2. The only drawback is minor inflation which is represented by the shift from the lower price of P1 to the higher price of P2.
Graph 1
Elmendorf, Douglas W. "The Estimated Impact of the American Recovery and Reinvestment Act on Employment and Economic Output From July 2010 Through September 2010." Congressional Budget Office. November 2010. 12 March 2011 <http://www.cbo.gov/ftpdocs/115xx/doc11524/05-24FederalReserve.pdf>

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III A1: Minimum Wage Increase Method July 24, 2009, the federal minimum wage increases to $7.25 per hour. This change reflects the third and final federal minimum wage increase as amended under the Fair Labor Standards Act (FLSA). (Labor Law Center) Many United States citizens will gain from the increase in the minimum wage rate, however many industries and individuals will be hurt as well. In theory, raising the minimum wage increases individuals disposable income but it also increases the number of people who enter the work force and labor costs incurred by corporations. The only way to combat this new expense is to cut back on unskilled labor or increase the price of products being manufactured. III A2: Minimum Wage Increase Research Theory Looking at Graph 2 below, the natural market equilibrium is located at the green star. Note that it is below the minimum wage rate enacted by the government. The increase in minimum wage is a price floor that causes a change in the quantity demanded creating a move along the demand curve from green star to red dot. The demand curve does not shift. At the natural equilibrium level corporations are willing to pay $5.50 per hour for 100 hours of labor per week. At the price floor corporations are willing to purchase 60 hours of labor per week at $7.25 per hour. The price floor has created a second problem because the increased hourly rate has now attracted more people into the workforce wanting to sell their skills, which is represented by the purple triangle. The increase in the minimum wage increases unemployment and creates a surplus of available hours in the market place.
Graph 2

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IV: Monetary Policy Changes Monetary policy refers to the Federal Reserves attempt to control the United States money supply in order to influence inflation, promote employment and maintain the stability of the financial economy. The Federal Reserve has three primary means of obtaining these objectives. They have the ability to increase or decrease the flow of money by purchasing treasuries in the open market, increasing or decreasing the discount rate or the required reserve rate banks must maintain on hand. Monetary policy cannot affect consumer consumption or government spending. The FED can only impact investments by manipulating the demand for money. Recently, the Federal Reserve was granted the authority to pay interest on bank reserves, giving it a new tool with which to influence the level of reserves in the system as well as interest rates in the broader financial market. (Congressional Budget Office) IVA: Monetary Policy Method As of today, our nation has survived the most serious economic financial crisis since the Great Depression. Unexpected losses on subprime mortgages (loans made to borrowers with poorer than average credit) as well as heightened uncertainty about how exposed some financial institutions might be to additional losses led to a sharp decline in the liquidity of some markets and the availability of credit. The contraction in lending became more severe as the turmoil spread beyond the subprime mortgage market, several large financial institutions failed, and the economy weakened. (Elmendorf) Monetary policy has the biggest impact on investment because the availability of money is tied directly to interest rates, which is the true cost of money. When individuals get paid the government takes their share first which turns into government spending. The remaining money is considered disposable income and consumers decide to save or spend. The amount saved becomes accessible to banks who loan 90% of the funds to other consumers or corporations. When more money is available, banks are forced to compete and it puts downward pressure on interest rates. Low interest rates encourage

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corporations to invest and borrow from banks to complete projects and individuals will look at taking on long term commitments such as mortgages. As you can see monetary policy has the ability to shift the aggregate demand curve causing real gross domestic product to either expand or contract. According to the May 2010 CBO Study, the Federal Reserve took the following actions in 2009 and 2010 to combat the financial crisis:

Lowered the discount rate to nearly 0% Created new lending programs for nondepository financial institutions Purchased treasuries in the open market to put downward pressure on interest rates Extended financial support to banks and institutions at risk of failing. If these institutions would have collapsed it would have caused a systematic collapse of United States financial markets. IVB: Monetary Policy Theory In an attempt to revitalize The United States failing economy, the Federal Reserve lowered the overnight borrowing rate they charge to fellow banks, known as the discount rate, to nearly 0%. The FED was unable to increase the money supply by lowering the reserve rate with banking institutions because banks were determined to stop loaning money. Desperate to increase the money supply, the FED created five new facilities to provide liquidity to nondepository financial institutions. Lastly, the FED began purchasing treasuries in the open market. The intentions of the Federal Reserve to increase investments and shift the aggregate demand curve can be viewed in Graphs 3 and 4. Graph 3 represents the increase in quantity demand of money when the money supply is increased. When the FED purchases treasuries it causes an increase in the quantity demand of money, which is reflected by M2. The FED pays consumers for the treasuries and they deposit the payments into their checking accounts which gives banks access to funds to lend out. This has a multiplying effect and continues increasing the flow of money into the economy
Graph 3

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putting downward pressure on interest rates as demonstrated by the orange dot and purple dot above. Looking at Graph 4, the increase in the banks money supply causes a movement along the investment demand curve from the orange dot to the purple dot. High interest rates generate very little demand for money. Corporations and individuals will put large purchases on hold when interest rates are 7%, see orange dot. At 3% interest, purple dot, people and corporations are willing to make additional investments and large purchases they may have been
Graph 4

putting off due to the higher interest rates. How does this impact GDP and unemployment? The actions taken by the

Graph 5

FED were done in the hopes of shifting the aggregate demand curve to the right due to the increased investment from individuals and corporations as seen in Graph 5. The FED is successfully fighting unemployment as real GDP moves from Q1 to Q2, but the cost of increased employment is inflation. The price level has moved from P1 to P2. By the end of 2009, the Federal Reserve owned $160 billion of agency debt and $908 billion of agency MBSs. Over the course of that year, the central bank had also purchased $300 billion of medium-and long-term Treasury securities. (Congressional Budget Office) In 2010 and 2011 the Federal Reserve has begun the second round of quantitative easing which has become known as QE2. All of the measures taken by the Federal Reserve are in an attempt to shift the aggregate demand curve to the right which will lower unemployment and increase real GDP.

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V: Findings and Conclusions: What impact did the fiscal and monetary policy changes made in 2009 and 2010 have on the US economy? Did President Obamas Keynesian test have the desired results? Did the FED shake the U.S. money tree hard enough? In order to answer these questions we must look at changes in GDP, unemployment and inflation throughout 2009 and 2010. According to Figure 3, taken from the Department of Labor and Statistics, The United States Economy lost 691 thousand jobs in the first quarter and 428 thousand in the second quarter of
U.S. Bureau of Labor and Statistics. "Survey Output." U.S. Bureau of Labor and Statistics. 26 April 2011 <http://data.bls.gov/pdq/SurveyOutputServlet>.

2009. As the amount of fiscal funds from the ARRA increased in the third and fourth quarters of 2009 the amount of jobs the United States citizens were losing dropped drastically compared to the first quarter of 2009. Table 1 represents the amount of tax cuts and payouts Americans received quarterly throughout 2009 from the distribution of ARRA fiscal stimulus funds. By the end of June only 104.1 billion dollars had been pushed into the economy in the form of
Council of Economic Advisers. "The Economic Impact of the American Recovery and Reinvestment Act of 2009." 13 January 2010. Recovery.gov. 12 March 2011 <http://www.recovery.gov/About/Documents/100113-economic-impact-arra-secondquarterly-report.pdf>.

tax cuts or outlays. By December 2009, onethird of the fiscal stimulus had been infused into

the United States economy in the form of payments or tax cuts which totaled 546.3 billion dollars. According to my aggregate supply and demand model on page 3, after infusing this much money into the economy we should have seen a tremendously larger spike in employment by the end of 2009 and Page | 10

most certainly by the end of 2010. Looking at Figure 3 the unemployment rate in December 2009 was 9.9% and 9.4% in December 2010. With all of the extreme measures taken by the FED and American government the unemployment rate should not have stayed above 9% for two years. Despite these obvious figures President Obama stated, So far, the Recovery Act is responsible for the jobs of about 2 million Americans who would otherwise be unemployed. [And] the Recovery Act is on track to save or create another 1.5 million jobs in 2010. (Jacobson) Is it possible
U.S. Bureau of Labor and Statistics. "Survey Output." U.S. Bureau of Labor and Statistics. 26 April 2011 <http://data.bls.gov/pdq/SurveyOutputServlet>.

Figure 3

the stimulus package would increase GDP and not affect unemployment levels? There are drastic differences of opinions about the impact of the ARRA and the actions of the FED amongst Democrats and Republicans. Upon the second anniversary of the ARRA, Republican George Allen said, "Instead the American people have endured 21 consecutive months of 9 percent or higher unemployment, 2.6 million jobs have been lost, and our nations debt has hit a record-setting $14 trillion." (Geiger) Another provision of the ARRA allowed a one-time stimulus payment to be made to elderly individuals with the hope of stimulating consumer spending. In 2009, the Social Security Administration administered the delivery of one-time economic recovery payments of $250 for most recipients of Social Security, Railroad Retirement, Supplemental Security Income, and Veterans' Benefits. (Office of Publications & Special Studies) The majority of the Social Security Administration funds paid out did not
Bureau of Labor and Statistics. "Focus of Prices and Spending Consumer Expenditures 2009: Volume 1 Number 16." March 2011. United States Department of Labor Bureau of Labor and Statistics. 20 March 2011 <http://www.bls.gov/opub/focus/volume1_number16/cex_1_16.htm#footnote1>.

help stimulate the economy. Paying off debt is good for consumers personal financial well being but it

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does nothing to stimulate the economy. Paying off debt has the same economic impact as saving. According to Chart 1, from the U.S. Bureau of Labor and Statistics, 58% of individuals receiving the $250 stimulus payment either saved the money or paid off debt. With only 40% of Americans actually spending their stimulus money the multiplier effect of these funds was greatly reduced. Since the marginal propensity to consume, MPC, in this case is .4 the multiplier is 1.7 (1/1-MPC). According to The Suns Financial Diary website, nearly 55 million Social Security beneficiaries will receive the one time stimulus payment. This is an influx of approximately 13.7 billion dollars that could have had a significantly higher multiplier effect than 1.7. The $250 Social Security stimulus for 2010 was cancelled. According to About.com, the 2009 United States GDP growth rate was -2.6% and 2.9% for 2010. The aggregate demand curve continued to contract, shifting to the left, in 2009 which is exactly the
Figure 4

opposite of what Obama and the FED were trying to accomplish. As you can see from Figure 4 GDP began feeling the impacts of the fiscal and monetary policy towards the end of 2009 and throughout 2011. The economy in 2010 grew but not at a fast enough rate to impact

TradingEconomics.com, US Bureau of Economic Analysis . "U.S. Economy Grew 1.8% in Q1." 28 April 2011. Trading Economics. 29 April 2011 <http://www.tradingeconomics.com/united-states/gdp-growth>.

unemployment and as the figures are calculated for the first quarter of 2011 the outlook remains troubling. As of today, the FED has decided to continue running the printing presses by purchasing treasuries and continuing the QE2 initiative. The FED will continue to keep downward pressure on interest rates which will continue to increase the money supply. In the meantime U.S. citizens are getting concerned about inflation. With the FED and the government both focused on shifting the aggregate demand curve outward, inflation is a frightening reality. The all items index rose 2.7 percent Page | 12

in the last 12 months, the largest increase since December 2009. The energy index has now risen 15.5 percent over the last 12 months, with the gasoline index up 27.5 percent. (Trading Economics.com, U.S. Bueau of Labor and Statistics) VI: Summary When I was a little girl I snuck a bottle of Flintstones vitamins into my room and tried to open the bottle and eat them. My father found me and explained that what I was doing was very wrong and I could have poisoned myself. I didnt understand how taking something that was good for your body could have the opposite effect. After completing this project I am left with my fathers words running through my mind, Sometimes, too much of a good thing can really hurt you. Perhaps too much economic intervention by the government and FED has only succeeded in creating future problems of inflation and taking our national debt to an all time high! Are we not already experiencing inflation at the gas pumps today? Based on the consistently high unemployment rates and low GDP, I believe the fiscal and monetary policies did not achieve their full impact. However, I believe that the fiscal and monetary policies I discussed prevented our economy from self destructing.

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Works Cited
Amadeo, Kimberly. "GDP Current Statistics." 25 March 2011. About.com. 30 March 2011 <http://useconomy.about.com/od/economicindicators/a/GDP-statistics.htm>. Bernanke, Ben S. "The Crisis and Policy Response." 13 January 2009. Federal Reserve.gov. 9 April 2011 <http://www.federalreserve.gov/monetarypolicy/bst_crisisresponse.htm>. Bureau of Economic Analysis. "News Releases." 28 April 2011. Bureau of Economic Analysis U.S. Department of Commerce. 28 April 2011 <http://www.bea.gov/newsreleases/national/gdp/gdphighlights.pdf>. Bureau of Labor and Statistics. "Databases, Tables & Calculators by Subject." 2011 April 29. United States Department of Labor Bureau of Labor and Statistics. 29 April 2011 <http://data.bls.gov/timeseries/LNS14000000>. . "Focus of Prices and Spending Consumer Expenditures 2009: Volume 1 Number 16." March 2011. United States Department of Labor Bureau of Labor and Statistics. 20 March 2011 <http://www.bls.gov/opub/focus/volume1_number16/cex_1_16.htm#footnote1>. Congressional Budget Office. "The Budgetary Impact and Subsidy Costs of the Federal Reserve's Actions During the Financial Crisis." May 2010. Congressional Budget Office. 20 March 2011 <http://www.cbo.gov/ftpdocs/115xx/doc11524/05-24-FederalReserve.pdf>. Council of Economic Advisers. "The Economic Impact of the American Recovery and Reinvestment Act of 2009." 13 January 2010. Recovery.gov. 12 March 2011 <http://www.recovery.gov/About/Documents/100113-economic-impact-arra-second-quarterlyreport.pdf>. DeVault, ryan Christopher. "New 'Making Work Pay' Tax Credit Will Give Workers a Tax Break in 2009 and 2010." 31 March 2009. Associated Content.com. 30 March 2011 <http://www.associatedcontent.com/article/1612373/new_making_work_pay_tax_credit>. Elmendorf, Douglas W. Congressional Budget Office. 2010. April 2011 <http://www.cbo.gov/ftpdocs/115xx/doc11524/05-24-FederalReserve.pdf>. Geiger, Jacob. "George Allen says 2.6 million jobs have been lost since stimulus bill was signed." 28 February 2011. PolitiFact. 20 March 2011 <http://www.politifact.com/virginia/statements/2011/feb/28/george-allen/george-allen-says-26million-jobs-have-been-lost-s/>. Jacobson, Louis. "Obama says stimulus is responsible for 2 million jobs saved or created." 17 February 2010. PolitiFact. 27 March 2011 <http://www.politifact.com/truth-ometer/statements/2010/feb/17/barack-obama/obama-says>.

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Kestenbaum, David. "Economists Question Keynes-Inspired Stimulus." 6 August 2010. NPR.org. 20 March 2011 <http://www.npr.org/templates/story/story.php?storyId=129031780>. Labor Law Center. Labor Law Center. <http://www.laborlawcenter.com/t-federal-minimum-wage.aspx>. Mataloni, Lisa. 26 March 2009. <http://www.bea.gov/newsreleases/national/gdp/2009/gdp408f.htm>. Office of Publications & Special Studies. The United States Department of Labor Bureau of Labor and Statistics. 16 4 2011 <http://www.bls.gov/opub/focus/volume1_number16/cex_1_16.htm#footnote1>. The Recovery Act. <http://www.recovery.gov/About/Pages/The_Act.aspx>. Trading Economics.com, U.S. Bueau of Labor and Statistics. "U.S. Inflation Raises 2.7% in March." 15 04 2011. Trading Economics. 20 04 2011 <http://www.tradingeconomics.com/united-states/inflation-cpi>. TradingEconomics.com, US Bureau of Economic Analysis . "U.S. Economy Grew 1.8% in Q1." 28 April 2011. Trading Economics. 29 April 2011 <http://www.tradingeconomics.com/united-states/gdpgrowth>. U.S. Bureau of Labor and Statistics. "Survey Output." U.S. Bureau of Labor and Statistics. 26 April 2011 <http://data.bls.gov/pdq/SurveyOutputServlet>. Zandi, Mark. "Moody's Analytics." 11 April 2011. Economy.com. 27 April 2011 <http://www.economy.com/dismal/article_free.asp?cid=198872&src=mark-zandi>.

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