Imagine you are listening to the radio around 1900 and there is news that the economy is going into recession. Most likely, sooner or later you will not have a job and there will not be as many goods available due to lack of production. The only thing of value will end up being the money in your checking and savings accounts, so the only option you have is to go to the bank and get that money. The problem: all the other people who just heard that announcement are thinking the same thing, and now there will be a bank run, or worse yet, a bank panic. This was a serious dilemma prior to 1913, the year the Federal Reserve Bank was established, because there was no way to guarantee that the economy would remain stable. Although bank panics were not an everyday occurrence, it was something that citizens had to worry about more than today. However, when the Federal Reserve Act of 1913 was established, two policies were enabled to monitor and help control the stability of the economy: to this day they remain a very important part of our government and these courses of action they are known as monetary. policy and fiscal policy.
To fully understand the purpose of monetary and fiscal policy, it is important to look at the structure behind them. The basis for these policies comes from the Federal Reserve. The “Fed” is a fairly simple system to understand: it is the central bank of the United States. This central bank is divided into districts; the Board of Governors is the most recognized, but the Federal Open Market Committee is also included. Today, the Chairman of the Board of Governors is Benjamin Bernanke, and he oversees all actions that are taken.
The Federal Reserve is the only bank with the power to control a bank run or bank panic. It keeps money available to lend to smaller banks as a last resort in tough economic times. Therefore, the Federal Reserve plays a very important role in controlling the US money supply.When the “Fed” was established, so was monetary policy. In the book Macroeconomics by R. Glenn Hubbard and Anthony Patrick O’Brien, monetary policy is defined as “the actions that the Federal Reserve takes to manage the money supply and interest rates to pursue economic objectives.” These certain objectives include maintaining a stable economy, increasing economic growth, keeping unemployment at a satisfactory low level, and keeping the prices of goods and services stable to minimize the chances of inflation.
The Federal Reserve uses three different monetary policy tools to maintain the money supply. These tools include open market operations, controlled by the Federal Open Market Committee, and discount rate and reserve requirements, which are controlled by the Board of Governors. Open market operations are a tool used by the FOMC to increase the money supply by buying and selling Treasury securities. The trading desk of the Federal Reserve Bank in New York is designated to buy these securities and the sellers deposit them with the banks. These deposits increase the bank’s reserve, which in turn increases the total money supply because there will also be an increase in loans and deposits in checking accounts (Hubbard / O’Brien). The FOMC also has the power to decrease the money supply by reversing the operations of that same process.
The branch of the “Fed” that controls the other two tools of monetary policy is the Board of Governors. One tool, the discount rate, is defined as “the interest rate the Federal Reserve charges for discounted loans (Hubbard / O’Brien). If a bank needs to increase the money available in its vault, also known as reserve , to the “Fed” for the money, and this loan is known as a discount loan. However, unless the Federal Reserve has become the last resort in the event of a recession, banks do not typically take out discounted loans.
In certain cases, such as Black Tuesday, when the worst stock market crash hit the United States, discounted loans did not save the economy. It wasn’t until after the Great Depression that the bank run sparked a severe bank panic that Congress established deposit insurance. In other words, before the Federal Deposit Insurance Corporation, a person was not assured that the money they had in the bank was safe or that they would be able to get it back if the economy went into recession.
The third monetary policy tool that is also controlled by the Board of Governors to help manage the money supply is reserve requirements. However, it is a rare occasion for the Fed to change the reserve requirements. In essence, changing reserve requirements involves banks making “significant alterations in holdings of loans and securities” (Hubbard / O’Brien). Although it is not a common course of action, it still has a purpose. When the Federal Reserve lowers reserve requirements, it allows banks to use surplus money to lend instead of keeping it in the vault. Conversely, if the Fed chooses to increase the reserve requirement, banks will have less money to lend. Either way, though, the Fed makes the switch based on the assumption that it will help the economy. All these monetary policy tools are followed with the intention of meeting the objectives set out above. On the other hand, fiscal policy also plays an important role in helping to maintain a stable economy.
Fiscal policy is defined as “changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives” (Hubbard / O’Brien). Fiscal policy is similar to monetary policy in terms of what you try to achieve, but it varies due to the way you try to do it. Changes in taxes and expenses are controlled solely through the federal government.
A better understanding of fiscal policy can be explained through the insights of John Maynard Keynes. His theory emerged after the Great Depression and said that if governments spent more money in times of economic decline, it would soon stimulate the economy. He argued that through excessive government spending, revenues would increase and so would purchases of goods and services. Eventually, this would stabilize the economy and pull the country out of decline and into a state of economic growth. His theory was tested when President Franklin D. Roosevelt took action during World War II and spent an excessive amount of money that ended in economic growth, as Keynes had said he would (What is fiscal policy?).
More recently, starting in the 1980s, the main objective of fiscal policy has focused on reducing the budget deficit that has skyrocketed since World War II. Due to things like new technologies and foreign trade opportunities, economic growth has occurred automatically and the deficit keeps increasing (What is fiscal policy?). The war in Iraq has also caused the deficit to rise steadily, and George W. Bush is currently under pressure to find a way to decrease it. Although the general objective of fiscal policy is to achieve broad objectives of the economy, it is now also focused on smaller objectives.
In conclusion, monetary and fiscal policies are extremely crucial to keeping the economy safe. Since the beginning of the 19th century, the general period of economic growth has consistently outpaced the period of economic recession. The Great Depression was an event that, hopefully, will not happen again, or at least not in the near future. With the knowledge that the government now has, the economy is most likely to improve, or at least maintain a satisfactory level of stability.