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The United States Economy: Monetary and Fiscal Policy

Recession

Recession refers to a period when the economy experiences negative growth (Nagle, 2010). It occurs when there is no increase in the total value of goods and services in the economy, which is also referred to as the gross domestic product (GDP). The United States economy is not currently in recession because in the recent years, there has been an actual GDP growth (U.S. Bureau of Labor Statistics, 2012). The current growth rate arose from a heightened activity in the economy that lead to an overall increase in the value of goods and services traded. For example, there were increases in private sector portfolio investments. Other contributing factors included an increase in the total consumption level by consumers, and an increase in the export volume of the country (Nagle, 2010).

As the different components of the United States economy are growing, the overall economy expands. In the last quarter of 2011, the economy grew by a percentage of 2.4 arising from increased production in the economy (Trading Economics, 2012). In addition, an increase in the level of consumption by consumers leads to an increase in demand for goods and services, which compels producers and service providers to increase their supply. The overall output of the goods and services in the economy increases when consumer led demand continues to surge. On the other hand, when the GDP is increasing, there are more employment opportunities for the unemployed and underemployed.

Additionally, profits earned from the increased demand of goods and services allow firms to allocate more spending to non-core production ventures like research and development as well as advertising. These tend to stimulate alternative sectors of the economy and contribute more to the availability of money in the economy. A growing GDP causes the federal government expenditure proportion to decrease because of increased revenue. To illustrate the above explanation, there was an 8.3 percentage decrease in the unemployment rate in the last quarter of 2011 (U.S. Bureau of Labor Statistics, 2012). There were major increases in employment opportunities in the hospitality and manufacturing sector (U.S. Bureau of Labor Statistics, 2012).

Fiscal Policy Tools to Stimulate the Economy

The fiscal policy refers to the official strategy that the government uses to collect revenue for its operation and how it allocates the revenue back to the economy. Taxation is the main source of government revenue, while the state’s budget shows how much the government spends on the different sectors of the economy (GPO Access, 2008). The budget and taxation policies make up the fiscal policy and come in handy as tools to influence the economy to grow or stagnate (GPO Access, 2008).

Concisely, increasing the overall taxation levels in the economy will reduce the available disposable income among households and firms. Disposable income directly corresponds to the demand for goods and services available in the economy. Thus, a reduction in disposable income will lead to a stagnation of the economy if all other factors remain constant. On the other hand, an increase in government expenditure within the economy increases the disposable income of households and firms. Therefore, to stimulate the economy, the government should ensure that its fiscal policy leads to an increase in the overall disposable income. In turn, this will lead to an increase in demand for goods and services, which eventually stimulates their production and grows the gross domestic product.

As an advisor to president Obama, I would advocate for an increase in government spending on programs that will increase the amount of disposable income in the local economy. Here, the budget would serve as the best fiscal policy tool to stimulate the economy. From the president’s proposed budget of 2011, there is an increase in the amount of spending on programs, which cushion citizen’s income such as social security and Medicare (New York Times, 2010). To stimulate the economy further, the government should consider cutting its military budget spending, spent outside the country, in favor of sectors that will increase the GDP such as community and development funds, energy and agriculture (Center on Budget and Policy Priorities, 2011).

How the Federal Reserve can Increase Economic Growth

The Federal Reserve influences economic growth by altering the monetary policy. It has to stabilize output in the short run so that the long run price of commodities in the economy remains stable. The economy slows down when public demand shrinks. To stimulate demand of goods and services in the economy the Federal Reserve works with the monetary policy. Under monetary policy, the Federal Reserve can use open market operations, bank reserves, federal funds market, discount rates and foreign currency operations.

To increase economic growth, the Federal Reserve would lower the fund rate in the federal funds market. When the fund rate falls, banks and other financial institutions find it more profitable to lend to other sectors of the economy. The action increases the available capital for investment in the economy and stimulates economic growth when all other factors remain constant. Low borrowing costs make it cheaper for businesses and households to increase their spending and influence the more production, which increases the GDP.

A low fund rate leads to a reduction in the real interest rate chargeable to consumers and businesses. Moreover, the reduction makes it more profitable to invest in stocks and this leads to a surge in the demand and activity in the stock market. As stock prices continue to surge, households and companies become wealthy and are able to borrow or spend more thus stimulating further growth in the economy (Federal Researve Bank of San Francisco, 2004).

Money Supply Tools to Reduce Inflation

The Fed faces a challenge of stimulating growth in the economy through its monetary policy on one hand, while containing inflation on the other. A blind increase in the money supply, which increases the spending by households and firms, is likely to lead to high inflation rates. This occurs when the rate of spending increases do not match the production of goods and services in the economy.

The fed targets the real interest rate to control inflation. Increasing the real interest rate will lower the demand for loans by increasing borrowing costs. As these costs increase, the public finds it less attractive to spend and this reduces the overall demand for goods and services in the economy. However, the fed would not wish to reduce the overall production in the economy with high real interest rates in the long term. Thus, its activities of controlling the interest rates to contain inflation only happen in the short run. The Fed controls inflation in the long term by containing a large part of the expectations of future inflation. Future projects affect the spending patterns of firms and consumers in the short run. Thus, the Fed would maintain a steady policy on bank reserves and a steady increase of the funds rate.

References

Center on Budget and Policy Priorities. (2011). Center of Budget and Policy Priorities. Policy Basics: Where do Our Federal Tax dollars go? Web.

Federal Researve Bank of San Francisco. (2004). U.S. Monetary Policy: An Introduction. Web.

GPO Access. (2008). Citizen’s guide to the Federal budget: Fiscal year 2001. Web.

Nagle, J. (2010). How a recession works. New York, NY: The Rosen Publishing Group, Inc.

New York Times. (2010). Obama’s 2011 Budget Proposal: How It’s Spent. Web.

Trading Economics. (2012). U.S. GDP Growth Rate. Web.

U.S. Bureau of Labor Statistics. (2012). U.S. jobless rate down to 8.3%, Nonfarm Payrolls Up by 243K. Web.