Yet with this pattern of government spending reductions, the economic results defied what many expected: the cuts did not impair growth. Each week, we will send you the latest in publications, media, and events featuring Mercatus research and scholars. Skip to main content. Sparking New Thinking Read Discourse magazine Online journal dedicated to promoting and defending classical liberal values with new and innovative thinking.
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Government Spending. Research Papers. Each involved some form of investment in equities either centrally, through the trust fund, or in a decentralized manner, through individual accounts. Late in the decade, with the emergence of on-budget surpluses, the possibility of general revenue contributions to the Social Security system came under serious consideration.
In the end, President Clinton decided to pursue Social Security reform based on general revenue contributions to the trust fund and centralized investment in equities rather than creating individual accounts, but his proposal was not adopted.
Download Citation Data. Frankel, Jeffrey and Peter Orszag eds. Reinforcing this independence, the Fed conducts its most important policy discussions in private and often discloses them only after a period of time has passed. It also raises all of its own operating expenses from investment income and fees for its own services.
The Federal Reserve has three main tools for maintaining control over the supply of money and credit in the economy. The most important is known as open market operations, or the buying and selling of government securities. To increase the supply of money, the Federal Reserve buys government securities from banks, other businesses, or individuals, paying for them with a check a new source of money that it prints ; when the Fed's checks are deposited in banks, they create new reserves -- a portion of which banks can lend or invest, thereby increasing the amount of money in circulation.
On the other hand, if the Fed wishes to reduce the money supply, it sells government securities to banks, collecting reserves from them. Because they have lower reserves, banks must reduce their lending, and the money supply drops accordingly.
The Fed also can control the money supply by specifying what reserves deposit-taking institutions must set aside either as currency in their vaults or as deposits at their regional Reserve Banks.
Raising reserve requirements forces banks to withhold a larger portion of their funds, thereby reducing the money supply, while lowering requirements works the opposite way to increase the money supply. Banks often lend each other money over night to meet their reserve requirements. The rate on such loans, known as the "federal funds rate," is a key gauge of how "tight" or "loose" monetary policy is at a given moment. The Fed's third tool is the discount rate, or the interest rate that commercial banks pay to borrow funds from Reserve Banks.
By raising or lowering the discount rate, the Fed can promote or discourage borrowing and thus alter the amount of revenue available to banks for making loans. These tools allow the Federal Reserve to expand or contract the amount of money and credit in the U. If the money supply rises, credit is said to be loose. In this situation, interest rates tend to drop, business spending and consumer spending tend to rise, and employment increases; if the economy already is operating near its full capacity, too much money can lead to inflation, or a decline in the value of the dollar.
When the money supply contracts, on the other hand, credit is tight. In this situation, interest rates tend to rise, spending levels off or declines, and inflation abates; if the economy is operating below its capacity, tight money can lead to rising unemployment. Many factors complicate the ability of the Federal Reserve to use monetary policy to promote specific goals, however.
For one thing, money takes many different forms, and it often is unclear which one to target. In its most basic form, money consists of coins and paper currency. Coins come in various denominations based on the value of a dollar: the penny, which is worth one cent or one-hundredth of a dollar; the nickel, five cents; the dime, 10 cents; the quarter, 25 cents; the half dollar, 50 cents; and the dollar coin. A more important component of the money supply consists of checking deposits, or bookkeeping entries held in banks and other financial institutions.
Individuals can make payments by writing checks, which essentially instruct their banks to pay given sums to the checks' recipients. Time deposits are similar to checking deposits except the owner agrees to leave the sum on deposit for a specified period; while depositors generally can withdraw the funds earlier than the maturity date, they generally must pay a penalty and forfeit some interest to do so.
Money also includes money market funds, which are shares in pools of short-term securities, as well as a variety of other assets that can be converted easily into currency on short notice. The amount of money held in different forms can change from time to time, depending on preferences and other factors that may or may not have any importance to the overall economy.
Further complicating the Fed's task, changes in the money supply affect the economy only after a lag of uncertain duration. Monetary Policy and Fiscal Stabilization The Fed's operation has evolved over time in response to major events.
The Congress established the Federal Reserve System in to strengthen the supervision of the banking system and stop bank panics that had erupted periodically in the previous century.
As a result of the Great Depression in the s, Congress gave the Fed authority to vary reserve requirements and to regulate stock market margins the amount of cash people must put down when buying stock on credit.
Still, the Federal Reserve often tended to defer to the elected officials in matters of overall economic policy. Treasury borrow money at low interest rates.
Later, when the government sold large amounts of Treasury securities to finance the Korean War, the Fed bought heavily to keep the prices of these securities from falling thereby pumping up the money supply.
The Fed reasserted its independence in , reaching an accord with the Treasury that Federal Reserve policy should not be subordinated to Treasury financing. But the central bank still did not stray too far from the political orthodoxy. During the fiscally conservative administration of President Dwight D. Eisenhower , for instance, the Fed emphasized price stability and restriction of monetary growth, while under more liberal presidents in the s, it stressed full employment and economic growth.
During much of the s, the Fed allowed rapid credit expansion in keeping with the government's desire to combat unemployment.
But with inflation increasingly ravaging the economy, the central bank abruptly tightened monetary policy beginning in This policy successfully slowed the growth of the money supply, but it helped trigger sharp recessions in and The inflation rate did come down, however, and by the middle of the decade the Fed was again able to pursue a cautiously expansionary policy.
Interest rates, however, stayed relatively high as the federal government had to borrow heavily to finance its budget deficit. Rates slowly came down, too, as the deficit narrowed and ultimately disappeared in the s. The growing importance of monetary policy and the diminishing role played by fiscal policy in economic stabilization efforts may reflect both political and economic realities.
The experience of the s, s, and s suggests that democratically elected governments may have more trouble using fiscal policy to fight inflation than unemployment. Fighting inflation requires government to take unpopular actions like reducing spending or raising taxes, while traditional fiscal policy solutions to fighting unemployment tend to be more popular since they require increasing spending or cutting taxes.
Political realities, in short, may favor a bigger role for monetary policy during times of inflation. One other reason suggests why fiscal policy may be more suited to fighting unemployment, while monetary policy may be more effective in fighting inflation.
There is a limit to how much monetary policy can do to help the economy during a period of severe economic decline, such as the United States encountered during the s. The monetary policy remedy to economic decline is to increase the amount of money in circulation, thereby cutting interest rates.
But once interest rates reach zero, the Fed can do no more. The United States has not encountered this situation, which economists call the "liquidity trap," in recent years, but Japan did during the late s. With its economy stagnant and interest rates near zero, many economists argued that the Japanese government had to resort to more aggressive fiscal policy, if necessary running up a sizable government deficit to spur renewed spending and economic growth.
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