This short essay will give you a fundamental understanding on what the federal government and the federal reserve do to manage the US economy.
History
First, I will tell you a little history to give you some important context. February 3, 1913 is one very important date in the history of the United States federal government. Why? It was the ratification of the 16th amendment. It states “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”
In other words, the federal government established a federal tax system. Before the federal tax system was created in 1913, the federal government was very small – only about 2-3% of the United States economy. Now, the federal government could collect taxes. This moment was a major catalyst in turning the federal government into what it is today.
With the ratification of the 16th amendment, the federal government now had the ability to use fiscal policy, or the use of government taxes and government spending, to affect the macroeconomy.
Important Terminology
Now, before I jump into the intricacies of fiscal and monetary policy, I want to get you up to speed on a few important economic terms. If you already know what these are, you can skip this section.
- Gross Domestic Product (GDP): It is the value of all final goods and services produced inside the US borders in a specific time period. It is one of the most important measurements both the federal government and the federal reserve use for gauging the health of the US economy.
- Inflation: Inflation is an overall sustained increase in price level. Today, inflation is measured by the consumer pricing index (CPI), which tracks the average prices of common goods and services like gas, food, and medical care.
- Unemployment: Simply put, unemployment is the number of unemployed people in the United States divided by the number of people working plus the number of people unemployed in the United States.
Now that we’ve talked about 3 of the most important macroeconomic indicators, let’s talk about how the Federal Government tries to influence the economy through Fiscal Policy.
Fiscal Policy
The US federal government engages in “fiscal policy” to affect the macroeconomy. Fiscal policy is the use of taxes and/or government spending to influence the macroeconomy. Members of the federal government, namely in the Treasury Department and the White House Council of Economic Advisors, monitor important measures such as GDP, inflation, and unemployment to gauge the health of the US economy.
When the economy appears to be sluggish (higher unemployment, lower inflation), the federal government conducts expansionary fiscal policy. This means that the government may cut taxes and/or increase its spending to help stimulate the economy. These efforts are targeted to increase consumer spending (~70% of GDP) and investment (~17% of GDP) to speed up the economy and avoid a recession.
On the other hand, when the economy appears to be overheating (low unemployment, higher inflation), the government conducts contractionary fiscal policy. That is, the government may increase taxes and/or decrease its spending to help slow down the economy. These efforts are targeted to decrease consumer spending and investment to ultimately slow down the economy. It is important to help slow down the economy if it is growing too fast in order to prevent high inflation, asset bubbles, and unsustainable growth that may cause bigger problems like a recession.
Now that we’ve covered the basics of fiscal policy and how the federal government influences the economy, let’s talk monetary policy.
Monetary Policy
Monetary Policy is conducted by the US’s central bank – The Federal Reserve. The Federal Reserve closely monitors important statistics such as GDP, inflation, and employment and has a “Dual Mandate.” The Dual Mandate lays out the Federal Reserve’s primary policy goals:
- Maintain Stable Prices
- Achieve Maximum Sustainable Employment
Thus, to work towards its Dual Mandate, the Federal Reserve conducts Monetary Policy: the adjustment of the money supply and/or interest rates to affect the macroeconomy. Simply put, the money supply is the total value of money in the economy at a given point in time. Adjusting the money supply has an effect on the interest rates in an economy which in turn affects consumer spending, investment, GDP, and the overall economy.
There are 3 primary mechanisms the Federal Reserve uses to adjust the money supply and interest rates:
- It sets reserve requirements: This is the minimum amount a bank must hold when a deposit happens. E.g. If the reserve requirement are set at 10% and John deposits $100 in Bank A, the bank must keep at least $10 of that money in the bank. It can then loan out the other $90 as it pleases.
- It changes the discount rate: The discount rate is the interest rate the Federal Reserve charges banks if they want to borrow money from the Fed. The Federal Reserve sets this directly.
- It changes the Federal Funds Rate: This is the interest rate at which commercial banks borrow and lend from and to each other overnight. The Federal Reserve sets the Federal Funds Rate by buying and selling treasury securities, or government debt.
Now let’s walk through a couple scenarios. If the Fed believes the economy is slowing down and may be heading for a recession, it may bring both the federal funds rate and discount rate down to help stimulate the flow of credit in the economy.
So, the fed can directly adjust the discount rate down. Now, to adjust the federal funds rate downwards, the Federal Reserve can buy treasury securities in the bond market.
The fed buying treasury securities in the bond market increases the amount of reserves banks have to lend out. The Fed would like for these banks to lend out this extra money, so the money supply will hopefully increase as a result. The demand increases for bonds, bond prices go up and the interest rate on these bonds go down. Consequently, the federal funds rate goes down, savings rates go down, and people and businesses spend and invest more as the price of borrowing is now lower, which increases consumer spending and investment speeding up the economy.
Now, on the other hand, consider that the fed is seeing signs that the economy is overheating, and the fed is afraid of inflation. To counteract against the economy overheating, the fed may want to increase both the discount rate and federal funds rate.
Again, the fed can directly adjust the discount rate up. To increase the federal funds rate, the fed can sell treasury securities in the bond market. Banks and the public buy these bonds but mostly banks. Thus, by buying these treasury securities, these banks have less money to loan out. The bank no longer has the money to meet the demand for loans, and so it increases rates on borrowing money. Supply for bonds go up, bond prices go down, and interest rates go up. Thus, the federal funds rate goes up, the price of borrowing goes up, and people and businesses spend and invest less and save more which slows down the economy.
Conclusion
Whew. Now that was a lot. It takes a bit more time to wrap your head around monetary policy but once you go through it a few times you’ll get it.
Finally, I want to highlight that this write-up should serve as a simple template for the macroeconomy. I covered many of the basics.
But, in reality, there are a lot more nuances and disagreements in terms of how the US should conduct monetary and fiscal policy.
However, by reading this article carefully, you are ahead of the vast majority of Americans and can begin to explore more.
For those interested in learning more, please check out the “Further Resources” section below. Thanks for reading.
And as always, please send me your questions, comments, and concerns: abhin@abhin-sharma.com
Further Resources
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Abhin Sharma 