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Fiscal and Monetary Policies and the U.S. Economy

During the period of economic downturn, a stimulating policy (expansionist) is carried out, which implies an increase in government spending and a decrease in tax rates. During the upsurge, a contractionary (restrictive) policy is carried out. In the time of recession, a stimulating fiscal policy (fiscal expansion) is provided, which consists of the following: an increase in government spending, tax cuts, combining government spending growth with tax cuts. The aforementioned leads to deficit financing but provides a reduction in the decline in production (Hubbard & O’Brien, 2018). In conditions of inflation, a contractionary (restraining) policy is being pursued. It is called fiscal restriction: cutting government spending, increase in taxes, combining government spending cuts with rising taxation (Hubbard & O’Brien, 2018). This policy focuses on a positive budget balance, which causes a reduction in production.

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Thus, when the corporate income tax rate is increased, it is a contractionary fiscal policy. When defense spending is increased, it is part of an expansionary fiscal policy. If families are allowed to deduct all daycare expenses from their federal income taxes, it also means that the state pursues an expansionary fiscal policy. However, selling Treasury securities by the Federal Reserve Bank means an expansionary monetary policy, and when the Federal Reserve Bank buys Treasury securities, it is a contractionary fiscal policy.

Fiscal policy in the state is carried out using its own instruments. The government’s fiscal policy instruments are economic mechanisms that help achieve the goals set for fiscal policy. The set of fiscal policy instruments includes government subsidies, and manipulation of various types of taxes (personal income tax, corporate tax, excise taxes) by changing tax rates or lump-sum taxes. In addition, the instruments of fiscal policy include transfer payments and other types of government spending. Different instruments affect the economy in different ways. The choice of a particular type of government spending is also important since the multiplier effect can be different in each case.

Depending on the phase of the cycle in which the economy is located, and the type of fiscal policy corresponding to it, the instruments of the state’s fiscal policy are used in different ways. Thus, the instruments of stimulating fiscal policy are the following: increase in government purchases; tax cuts; increased transfers (Hubbard & O’Brien, 2018). The instruments of the contractionary fiscal policy are as follows: reduction of government purchases; increase in taxes; reduction in transfers (Hubbard & O’Brien, 2018). Accordingly, when the Federal Reserve Bank sells Treasury securities, it means a contractionary monetary policy, and vice versa – selling Treasury securities by the Federal Reserve Bank corresponds to an expansionary monetary policy. Increasing the corporate income tax rate is in frames of a contractionary monetary policy while increasing defense spending is a sign of an expansionary monetary policy.

While the optimal version of the state budget is a deficit-free budget or a budget where surplus is present, in practice, such a balanced budget not always can be achieved. The lack of deficit in the budget does not mean yet the “health” of the economy. A budget surplus resulting from more economical and efficient use of budget funds with 100% financing of budgeted expenditures is a positive phenomenon (Hubbard & O’Brien, 2018). However, if higher budget revenues were obtained only as a result of a favorable economic situation, were the result of savings, boom or underfunding of expenses, and so on, then there is no reason to positively assess the budget surplus.

The budget deficit is not an indicator of poor management. Indeed, if the state pays more money than it receives, then this increases the purchasing power in society – people buy more and enterprises sell more, increasing the ‘engagement’ of resources. Therefore, a deficit is useful in the period of unemployment, but in the phase of growth, it is dangerous, as it leads to inflation, since the growth of purchasing power is not accompanied by an adequate increase in production due to the depletion of resources. There are cases when the state purposefully creates a budget deficit, and this, in turn, leads to stimulating economic growth in the country, especially during crises.

Sources of financing the budget deficit are receipts of funds to the budget, directed to cover the difference arising from the excess of budget expenditures over its revenues, and the repayment of previously attracted debt obligations (Hubbard & O’Brien, 2018).

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US Treasuries, together with securities issued by other federal agencies (Agency securities), constitute gross federal debt. At the same time, the latter account for only 0.2% of the debt, therefore, namely the Treasury securities attract special attention as an instrument of financing the budget deficit. Depending on the maturity, Treasury securities are divided into treasury bills, treasury notes, and treasury bonds.

In the case of U.S. Treasury securities to fund the deficit, the national debt will grow. It is obvious that the current amount of debt for the United States is not the limit: due to the costs associated with measures to restore the American economy after the coronavirus pandemic, the government’s debt will continue to grow. If the US government continues to pursue a policy of constant budget deficits, then the debt to GDP ratio could rise even more.

In the savings market, as in other markets, price plays a key role: it adjusts in such a way as to balance the supply and demand of savings, and the cost of savings is the interest rate. All things being equal, the higher the interest rate, the more likely people are to save and the less likely they are to borrow. However, a situation may arise if the supply of savings is so great that the interest rate – the price that provides a balance in this market – permanently goes into the negative zone. Then there is a gap between the rate that balances the market and the rate that actually characterizes the current state of the economy. This imbalance puts the economy in long-term stagnation with chronically low-interest rates and low economic growth.

According to the neoclassical point of view, the budget deficit, covered by debt, causes a decrease in savings, an increase in market interest rates, crowding out of private investment and, as a result, a slowdown in economic growth. The neoclassical concept is based on the following premises (Hubbard & O’Brien, 2018):

  1. The economy consists of prudent individuals who plan their consumption throughout the entire life cycle;
  2. The consumption trajectory of each individual is defined as a solution to the intertemporal optimization problem;
  3. In each period of time, market equilibrium is achieved with full employment of resources;
  4. Borrowing and lending are carried out in the economy at the market rate of interest (Bernheim, 1989).

The budget deficit partially shifts the tax burden onto future generations of households. The current generation is freeing up a share of disposable income, which leads to an increase in current consumption. With full employment of resources, increased consumption implies a reduction in national savings. As a result of the decline in savings, the supply of loans in the financial markets decreases. To bring financial markets back to equilibrium, loan prices, that is, interest rates should rise. Rising interest rates are crowding out private investment, which negatively affects economic growth.

References

Hubbard, R., & O’Brien, P. (2018). Economics (7th ed.). Pearson.

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StudyCorgi. (2022, July 28). Fiscal and Monetary Policies and the U.S. Economy. Retrieved from https://studycorgi.com/fiscal-and-monetary-policies-and-the-u-s-economy/

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StudyCorgi. "Fiscal and Monetary Policies and the U.S. Economy." July 28, 2022. https://studycorgi.com/fiscal-and-monetary-policies-and-the-u-s-economy/.

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StudyCorgi. 2022. "Fiscal and Monetary Policies and the U.S. Economy." July 28, 2022. https://studycorgi.com/fiscal-and-monetary-policies-and-the-u-s-economy/.

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StudyCorgi. (2022) 'Fiscal and Monetary Policies and the U.S. Economy'. 28 July.

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