Expansionary Fiscal Policy: Explain the actions the federal government would tak

Question

Expansionary Fiscal Policy:

Explain the actions the federal government would take while engaging in expansionary fiscal policy in terms of the following:

Expansionary Monetary Policy:

The three tools the Federal Reserve Bank (The Fed) uses when conducting monetary policy are the required reserve ratio, the discount rate, and open market operations.

Explain the actions of the Fed in regard to the three tools.

Explain how these actions would affect the money supply, interest rates, spending, aggregate demand, GDP, and employment.

Explanation / Answer

Expansionary Fiscal Policy:

An expansionary fiscal policy measures include decrease in tax cut or increase in government spending. However, in certain cases the government may adopt both the measures.

Tax cuts: Tax cuts increases the disposable incomes inducing the individuals to spend more. This shifts the aggregate demand curve towards right increasing real GDP and employment.

Government spending: An increase in government increases the aggregate demand by the multiplier mechanism. For instance, a 100 billion-road project by government can induce 1000 billion based on the spending multiplier. It can be explained as, if the MPC of the economy is 0.5 that the multiplier is 1/1-0.8 = 5. Thus, an increase in spending by government increases the overall spending by 5 times. For instance, if government increases spending by 100 billion, the overall spending increases by 500 billion.

Thus, due to government spending, the aggregate demand curve shifts towards right increasing real GDP and employment.

Expansionary Monetary Policy:

Required reserve ratio: these are the manditary required reserves that should be maintained by the banks in their vaults or with the Fed. For ex; if required reserve is 20%, then the banks need to maintain 20% of their cash as reserves in their vaults or with the Fed.

During an expansionary monetary policy, the Fed decreases the required reserves, this decrease in required reserves increases the excess reserves in the banks increasing the lonable funds and money supply. An increase in money supply decreases interest rates inducing investment spending, this increases employment, and aggregate spending.

Discount rate: Is the rate at which Fed lends to the commercial banks. By decreasing the discount rates Fed adopts the expansionary policy.

With a decrease in the discount rate the commercial banks borrows more money from Fed, this increases the money supply. Further, it decreases the interest rates increasing investments, GDP, and employment.

Buying Securities: By buying securities from the commercial banks through open market operations The Fed increase the money supply in the economy, this increase in money supply increase the loanable funds, decreasing the interest rates. This enables more investments, aggregate spending, increased GDP and employment.

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