TJP

Stimulate the Economy with Monetary Policy

By Byron A. Ellis-October 21, 2008

The Administration, Congress, Bernanke and Paulson have not demonstrated sound judgment in diagnosing the root cause of the economic problems. As a result, they have applied a shotgun solution.

However, it appears that the Federal Reserve Chairman, Ben Bernanke, has finally figured out that consumers are the ones in need of help. And, he is now recommending fiscal stimulus. Nonetheless, he could use monetary policy, which he controls to stimulate the economy.

The mission of the Federal Reserve (Fed) is to influence money and credit condition in the economy to achieve maximum employment, stable prices, and moderate long-term interest rates. In addition to supervising and regulating banking institutions to ensure safety and soundness of the nation’s banking system and to protect the credit rights of consumers. The Fed is also in charged of maintaining the stability of the financial system and containing systemic risk that may arise in financial markets and providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation's payments system.

The current financial crisis is indicative that the Federal Reserve mission was not accomplished.

Policy makers can stimulate the economy through fiscal or monetary policies. Fiscal policy is controlled by Congress and is usually initiated by the President; the instruments of fiscal policy are tax rates and government spending. The Fed controls monetary policy; the instruments of monetary policy are changes in the stock of money, changes in the discount rate and control over the banking system.

Fiscal and monetary stimuli are demand management policies, as opposed to supply management policies applied in the recent bank bailouts. Supply stimulus is often associated with trickle down economics.

The Fed and the Administration should keep in mind that too much tinkering with the economy can produce wild economic swings, high interest rates, and inflation.

When the economy slows down, aggregate demand diminishes causing a reduction in gross domestic product (GDP). Aggregate demand is the total demand for goods and services in the U.S. economy. And, a decrease in aggregate demand is generally followed by a decrease in aggregate supply and a rise in unemployment.

Actual aggregate demand can be viewed as consumption plus investment plus government spending (C + I + G) and it is approximately equal to the GDP. However, consumption is approximately 60% of GDP, investment is about 20% of GDP, and government spending about 20% of GDP.

Clearly, if policy makers want to stimulate GDP, targeting consumption would be the appropriate variable, but the Administration targeted investment and gave $250 billion dollars to banks with no strings attached.

The economic crisis is due to rising crude oil prices, which severely affected consumers’ budgetary outlays. However, crude oil prices are falling, which means that consumers’ real incomes are rising. Thus, they will be able to demand more goods and services.

Therefore, any stimulus, whether fiscal or monetary, has to account for the current rise in real income due to falling energy prices. Hence, fiscal policy may not be the appropriate stimulus. Monetary policy is a less blunt policy instrument than fiscal policy and it appears to be, at this juncture, the more appropriate stimulus tool.

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