Monetary and Fiscal Policy: Crash Course Government and Politics #48

Summary

In this Crash Course episode, Craig discusses the intricacies of monetary and fiscal policy. Monetary policy, managed by the Federal Reserve, involves controlling the money supply through interest rates and open market operations. Fiscal policy, on the other hand, refers to government taxation and spending. The video highlights the challenges of fiscal policy due to public reluctance for tax increases and government spending, leading to budget deficits. The episode also touches on the impact of supply-side economics on tax trends and the significance of mandatory spending, particularly on Social Security and Medicare.

Takeaways

• 💼 Monetary policy is the government's method of regulating the money supply in the economy, primarily managed by the Federal Reserve System.
• 🏦 The Federal Reserve was established in 1913 as America's central bank, consisting of 12 regional banks and two boards, with the main task of controlling inflation and encouraging full employment.
• 📈 The Fed's most significant function is setting interest rates and loaning money to banks, which influences the overall money supply and economic activity.
• 🏛️ The Federal Reserve operates independently to maintain a separation from political pressures and focus on broader economic interests.
• 💵 Fiscal policy involves the government's taxation and spending decisions, which can impact the economy but has been contentious in recent American politics.
• 📉 There's been a general trend towards lower and less progressive federal taxes in the U.S. over the past few decades, influenced by supply-side economic theories.
• 💳 Mandatory spending, including Social Security and Medicare, is largely uncontrollable and has a significant impact on the federal budget, making up a large portion of government expenditures.
• 📊 The U.S. federal government has faced challenges balancing its budget due to a combination of tax aversion and limited spending cut options, leading to reliance on monetary policy.
• 🌐 The American economy is vast and complex, with budget deficits being a point of debate influenced by differing economic perspectives and political considerations.
• 🏥 Discretionary spending, which includes areas like defense and healthcare, is the part of the budget subject to annual appropriations and is often the focus of spending debates.

Q & A

What are the primary tasks of the Federal Reserve System?

The Federal Reserve System's primary tasks are to control inflation and encourage full employment.

How does the Federal Reserve control the money supply?

The Federal Reserve controls the money supply primarily by setting interest rates and through open market operations, such as buying and selling government debt.

What is the significance of the discount rate set by the Federal Reserve?

The discount rate, set by the Federal Reserve, determines how much money banks will borrow from the Fed, which in turn influences the amount of money in circulation.

What is fractional reserve banking, and why is it important?

Fractional reserve banking is a system where banks hold only a fraction of their total deposits in cash reserves. It's important because it helps prevent catastrophic bank runs by ensuring banks have some cash on hand.

How does the reserve requirement affect the economy?

The reserve requirement affects the economy by controlling how much money banks can lend out. A higher reserve requirement means less money in circulation, while a lower one can increase the money supply.

What is Quantitative Easing, and how does it relate to the Federal Reserve's actions?

Quantitative Easing is a monetary policy where the central bank buys government bonds to increase the money supply. It relates to the Federal Reserve's open market operations.

Why is inflation important in the context of monetary policy?

Inflation is important because it represents a general rise in prices, which can be influenced by the amount of money in circulation. Monetary policy aims to control inflation to maintain economic stability.

How does the Federal Reserve's independence affect its decision-making?

The Federal Reserve's independence allows it to make decisions based on broader economic interests rather than political pressures, which is intended to ensure unbiased monetary policy.

What is fiscal policy, and why has it been contentious in the United States?

Fiscal policy refers to the government's ability to raise taxes and spend money. It has been contentious in the U.S. due to reluctance to raise taxes and disagreements over government spending.

What are uncontrollables or mandatory spending in the federal budget?

Uncontrollables or mandatory spending are items in the federal budget that must be spent by law, such as Social Security and Medicare, which are primarily funded through dedicated federal taxes.

How do the trends in tax policy over the past 30 years reflect on the U.S. economy?

Over the past 30 years, there has been a trend towards lower federal taxes and less progressive tax rates, which has contributed to budget deficits and shaped economic policy debates.

Outlines

00:00

🏛️ Introduction to Monetary and Fiscal Policy

In this segment, Craig introduces the topics of monetary and fiscal policy, emphasizing their significance in government and politics. He humorously acknowledges the potential lack of excitement from the audience and attempts to generate interest. Monetary policy is defined as the government's method of regulating the money supply within the economy, primarily managed by the Federal Reserve System. The Federal Reserve, established in 1913, is composed of 12 regional banks and two boards, with its main tasks being to control inflation and encourage full employment. Craig outlines the Fed's four basic functions, highlighting its role in setting interest rates and controlling the money supply through mechanisms like the discount rate and bank reserve requirements. The segment also touches on the Fed's Open Market Operations and the concept of quantitative easing. Craig concludes by noting the Fed's independence from political influence, which is crucial for its effective operation.

05:02

💼 Fiscal Policy and Government Spending

This paragraph delves into fiscal policy, which involves the government's power to raise taxes and allocate spending. Craig discusses the historical reluctance to raise taxes and the challenges in government spending, leading to budget deficits. He explains how the government can spend more than it collects in taxes by borrowing money through the sale of bonds, connecting this back to the previously discussed Open Market Operations. The paragraph then explores the concept of supply-side economics, which has influenced tax policy over the past few decades, leading to lower and less progressive taxes. Craig provides statistics on tax revenues and government spending, highlighting the steady percentage of revenue from taxes and the significant deficit. He also discusses mandatory spending, such as social security and Medicare, which are unlikely to be reduced due to demographic trends, public approval, and political considerations. The segment concludes by emphasizing the importance of understanding the American economy's complexity and the limited options for government spending and tax adjustments, which makes monetary policy a crucial tool for macroeconomic management.

Keywords

💡Monetary Policy

Monetary policy refers to the actions taken by a central bank, such as the Federal Reserve in the United States, to control the money supply and interest rates. It is a key tool for managing inflation and promoting economic stability. In the video, monetary policy is discussed as a less controversial method of influencing the economy compared to fiscal policy, with the Fed's ability to control the money supply being highlighted as a primary function.

💡Fiscal Policy

Fiscal policy involves the government's strategies related to taxation and spending to influence the economy. It is a more contentious area of economic management due to political debates over tax rates and government expenditure. The video script mentions fiscal policy as a tool that is often more challenging to implement due to differing political views on taxation and spending.

💡Federal Reserve System

The Federal Reserve System, often referred to as the Fed, is the central banking system of the United States. Established in 1913, it plays a crucial role in implementing monetary policy. The script explains that the Fed is composed of regional banks and boards, and it has the dual mandate of controlling inflation and encouraging full employment.

💡Inflation

Inflation is the rate at which the general level of prices for goods and services is rising, and subsequently, the purchasing power of currency is falling. The video discusses inflation in the context of monetary policy, explaining how an increase in the money supply can lead to higher prices, although it notes the complexity with examples of low inflation despite low-interest rates.

💡Interest Rates

Interest rates are the cost of borrowing money and the return on saving money. The Fed's control over interest rates is a central aspect of monetary policy. The script mentions that the Fed sets the discount rate, which influences how much money banks borrow and, in turn, affects the overall economy's money supply.

💡Bank Reserve Requirement

The bank reserve requirement is a regulation that dictates how much cash a bank must hold in reserve. This is part of the Fed's toolkit to control the money supply. The script explains that adjusting the reserve requirement can either reduce or increase the money in circulation, thereby influencing the economy.

💡Open Market Operations

Open Market Operations are the buying and selling of government securities by the central bank to influence the money supply and interest rates. The video script describes how the Fed uses these operations to either take money out of or put money into the economy, which is a key mechanism in managing the economy's liquidity.

💡Quantitative Easing

Quantitative Easing is a monetary policy tool used by central banks to stimulate the economy by purchasing large quantities of government bonds or other securities from the market. The script briefly mentions this concept in relation to the Fed's Open Market Operations, noting its complexity and its role in increasing the money supply.

💡Deficits

A deficit occurs when a government's expenditures exceed its revenues, resulting in a need to borrow money. The video script discusses deficits in the context of fiscal policy, explaining the tension between the desire to spend on programs and the reluctance to raise taxes, which contributes to budget deficits.

💡Mandatory Spending

Mandatory spending, also known as uncontrollable spending, refers to government expenditures that are required by law, such as Social Security and Medicare. The script highlights these programs as significant parts of the federal budget that are unlikely to be reduced due to their importance and the political influence of the elderly population who benefit from them.

💡Discretionary Spending

Discretionary spending is government spending that is not mandatory, meaning it can be adjusted or cut at the discretion of Congress. The video script contrasts this with mandatory spending, noting that areas like defense and healthcare for the poor (Medicaid) are the largest components of discretionary spending and are often the focus of budget debates.

Highlights

Introduction to the topic of Monetary and Fiscal policy.

Monetary policy is less controversial but still contentious compared to fiscal policy.

The Federal Reserve System's role in controlling the money supply.

The creation of the Federal Reserve System in 1913 as America's central bank.

The Fed's two primary tasks: controlling inflation and encouraging full employment.

The Fed's four basic functions, with a focus on loaning money to banks and setting interest rates.

How the discount rate influences the amount of money banks borrow and circulate.

The concept of fractional reserve banking and the reserve requirement.

The impact of raising or lowering the reserve requirement on the economy.

Open Market Operations and the idea behind Quantitative Easing.

Inflation as a general rise in prices, potentially caused by the money supply.

The Federal Reserve's independence from Congress and its importance.

Fiscal policy as the government's ability to raise taxes and spend money.

The reluctance of Americans to raise taxes and the impact on fiscal policy.

The concept of supply side economics and its influence on tax policy.

Trends in federal taxes over the past 30 years, including lower rates for the wealthy.

The role of mandatory spending in the federal budget and its impact on deficits.

The political and demographic factors influencing Social Security and Medicare spending.

The limited range of government programs for discretionary spending.

The potential for balancing the budget through raising taxes or cutting spending.

The significance of the Federal Reserve system in macroeconomic policy.

Transcripts

Hello, I’m Craig and this is Crash Course Government and Politics and today we’re finally

gonna talk about a topic I know that you've all been waiting for: Monetary and Fiscal policy. Hurray!

You haven’t been waiting for monetary and fiscal policy? Are you sure? I’ve been talking

it up for weeks, you know? Well, let me see if I can’t convince you to be as excited

as I am. Monetary Policy! Wooo! Fiscal Policy! Yeah! I want to get fiscal, fiscal.

Come on and get fiscal… okay let’s start the show.

[Theme Music]

Let’s start with monetary policy because it’s not at all controversial.

Well, it kind of is controversial, but it’s less contentious than fiscal policy.

Monetary policy is basically the way the government regulates the amount of money in circulation

in the nation’s economy. Controlling the money supply is the primary task of the Federal Reserve

System and since it’s a little bit complicated, I’m going to talk about the other things that the Fed does first.

The Federal Reserve System was created in 1913 to serve as America’s central bank.

Before then, there were state and local banks as well as a Bank of the United States, which

was a much more limited central bank.

The Fed is made up of 12 regional banks, and two boards. The Federal Reserve Board of Governors, who are appointed by

the President, and the Federal Open Market Committee, which is partially appointed by the president.

The Fed has two primary tasks: to control inflation and to encourage full employment,

and it has four basic functions, but one of them is way more important than the others.

The Fed is responsible, ultimately for clearing checks, and for supplying actual currency,

most of which is kept in highly secure facilities staffed by robots. With laser eyes.

I don’t know if they have laser eyes.

The Fed also sets up rules for banks, although these can also be set by Congress. But the

most important thing that the Fed does is loan money to other banks and set interest rates.

That’s why when you hear about the Federal Reserve, nine times out of ten it’s about

interest rates, because that’s the main way the Fed controls the money supply.

The Fed loans money to banks, sweet, sweet money, which they in turn loan out to businesses

and individuals and, like all loans, the Fed charges interest. The Fed sets the rate on

the interest, called the discount rate, and this determines, mostly, how much money banks will borrow.

The lower the rate, the more banks will borrow and the more money goes into circulation.

Other banks peg the interest rates they charge to the Fed’s rate, charging slightly more,

so in this way the Fed determines, or sets, interest rates in the economy as a whole.

The Fed also creates regulations that control how much money circulates in the economy.

One of these is the bank reserve requirement, or the amount of money in cash that a bank has to have on hand.

Now the amount of money that a bank holds in reserve is only a fraction of the total

amount of money held in deposit at the bank – that’s why it’s called fractional

reserve banking – but the reserve requirement is there so that you don’t get catastrophic

bank runs like we saw during the Great Depression when so many frightened depositors took their

money out of banks that the banks failed.

Raising the reserve requirement reduces the amount of money in circulation and lowering

it pumps more money into the economy.

The Federal Reserve also sets the interest rate banks charge to lend money to each other,

which again controls the amount of money that circulates.

If banks are charging each other a lot of money to borrow, they won’t borrow as much,

and they won’t lend as much to firms and individuals and there will be less money in the economy as a whole.

There’s at least one more important way that the Fed influences the money supply in

the U.S. and that’s through Open Market Operations.

This is a fancy way to say that the Fed buys and sells government debt in the form of treasury

bills, or government bonds. When the Fed sells bonds, it takes money out of the economy,

and when it buys them more money goes into the economy.

This is the idea behind what was known as Quantitative Easing, which is really complicated.

To be honest, I’m not crazy about wading into economics here, and thankfully there’s

a whole other series to do that, but I have to mention inflation at this point.

Inflation is a general rise in prices that can be caused by a number of things, but one

of them is the amount of money that circulates. If there’s more money around, there’s

more that can be spent and this makes it possible for prices to go up.

But this isn’t an absolute rule, as of 2016 we’ve had years of basically zero interest

rates, which means it’s really cheap to borrow money, which means that there should

be a lot of money in circulation, yet inflation remains quite low.

Hey, it’s real cheap to borrow money. Can I borrow two bucks? No! [punches eagle] He never has any money.

Usually low interest rates tend to cause inflation and reduce unemployment, and high interest

rates are expected to cool down an overheating economy, but that hasn’t happened much in

the past few years. I’ll say again, I glad this isn’t an economic series.

It’s important to note here that the Federal reserve is an independent body, meaning that

its board of governors and chairperson are not elected or really subject to much regulation

from Congress. And they throw the best parties. That’s probably why.

This is intentional and probably a good idea. Ideally, you want people in charge of the

money supply to be able to look after broader interests than their own re-election, and

this is why the Fed is supposed to be insulated from politics and remain independent.

Ok, so that’s monetary policy, which is one lever that the federal government can

use to influence the economy. Increasingly it’s the only lever, because in America

we have a hard time with fiscal policy.

What’s that, you might be asking? Fiscal policy refers to the government’s ability

to raise taxes and spend the money it raises. Since I know that by this episode you’ve

been paying a lot of attention to American politics, you know that in the past 20 or

30 years, at least, Americans have generally been reluctant to raise taxes, and somewhat

reluctant to have the government spend money. The difference between these two goals – spending

money and not raising taxes – largely explains why we have deficits.

Before we get into tax policy, which I know is what you’ve been waiting for, calm down,

I need to point out that the way the government can spend more money on programs than it takes

in taxes is by borrowing it, which the government does by, you guessed it, selling bonds.

Good thing we talked about Open Market Operations.

Let’s tax the Thought Cafe people with a lot of work, by talking about taxes and spending in the Thought Bubble.

First, ever since Ronald Reagan came to office there has been a hostility towards higher

taxes and government spending that is theoretically based in an idea called supply side economics.

I’m not going to discuss the details of the theory or even whether it’s right or

wrong or somewhere in between, but the basic thrust is that if you lower taxes on businesses

and individuals, the individuals will be able to spend more, the businesses will be able

to invest more, and the economy as a whole will grow. It’s a simple and politically

powerful idea and has set the terms of the debate for a generation.

In general, over the past 30 years the trend is for there to be lower federal taxes and

for them to be less progressive, meaning that wealthier people pay a lower percentage of

their income in Federal taxes. The wealthy still pay the largest share of federal taxes

overall, though, so it’s not completely accurate to say that they aren’t paying.

Since Reagan, and especially during the presidency of George W. Bush, income tax rates on the

highest earners have fallen, as have taxes on estates (although they did go up again)

and on capital gains and dividends. President Obama did raise tax rates, but primarily on

people earning above $450,000 a year.

Corporate tax rates have also declined and Social Security taxes have gone up, which

is important because this is the federal tax that most of us are most likely to pay.

Overall the percentage of revenue that the federal government receives from taxes has held pretty

steady at between 43% and 50%. If you’re interested in the numbers, for 2013 the government

received almost $2.8 trillion in tax revenues. And it spent $3.5 trillion, which math tells

us means a deficit of around 700 billion dollars.

Thanks, Thought Bubble. When people say that they need to cut spending and balance the

budget, this is what they are talking about, but it’s not quite as simple as just spending

less, because there are some places where the government can’t cut spending even if they want to.

There are certain items in the federal budget that must be spent because they are written

into law by Congress. These are called uncontrollables, or mandatory spending.

One uncontrollable that relates to monetary policy is interest payments on federal debt.

The government can’t not pay its interest, otherwise no one would lend us money.

That's just how lending works, or it's supposed to work.

Farm price supports – subsidies – are also counted as uncontrollables, and they

are important, but not nearly as important as the two big-ticket mandatory spending items.

These are social security and Medicare, and they are paid for with dedicated federal taxes.

They provide income and health insurance for elderly people and it’s unlikely that the

amounts the government spends on them is going to decline anytime soon for three reasons.

First, is that the population is aging, meaning that the percentage of older Americans is

rising in proportion to younger Americans. This means that more people will be receiving

Social Security payments, which leads us to the second reason they are unlikely to go down: people like them.

The third reason is more political: older people tend to vote more regularly, so a politician

who wants to keep their job is unlikely to vote for cuts in Social Security or Medicare.

So, here’s the thing about the Federal Reserve and economics: The American economy is really

huge, and really complicated, and has some issues that need addressing.

Whether you care a lot about budget deficits or don’t think they're a big deal will depend

a lot on your feelings about economics in general, but there are a couple of things to keep in mind.

First, there's only a limited range of programs on which the government can choose to spend

or not spend. These are called discretionary spending and when people call for cuts in

government spending, this is what they mean.

By far the largest chunk of government spending goes into defense, over $600 billion in 2013,

but the next largest item is healthcare for the poor, Medicaid, at $498 Billion.

Nothing else even comes close.

Spending on the Department of Education, for example, was $41 billion in 2013.

The second thing to bear in mind is that in addition to cutting spending, the government

could balance its budget by doing what everyone loves - raising taxes. It's done this on occasion,

but the political consequences can be pretty tough. Just ask George H.W. Bush.

Finally, the combination of Americans’ aversion to raising taxes and the government’s limited ability

to cut spending means that monetary policy becomes its major lever in broad-based macroeconomic policy.

That’s why we paid so much attention to the Federal Reserve system at the beginning

of this episode, and why you probably should too.

Thanks for watching. See you next time.

Crash Course Government and Politics is produced in association with PBS Digital Studios. Support

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technology and media to advance social equity. Learn more about their mission and initiatives

at Voqal.org. Crash Course was made with the help of all these broad based macroeconomic

policy makers. Thanks for watching.