Economics/Macroeconomics Principles and Policy

Effectiveness of government spending as a fiscal policy tool

Fiscal policies are the feasible government intervention measures for enhancing the stability of the economy. Instabilities come in the form of economic boom or economic recession. The recession is characterized by reduced economic activities which lead to loss of employment and lowering of the economy’s GDP. Faced with a recession, the government can intervene by lowering taxes or raising the level of government expenditure.

The direct effect of raising government expenditure is increased economic activity. Higher spending in defense, education and infrastructure entails creating demand for goods and services. This means that the two components of Aggregate Demand (AD) namely investment expenditure and consumption expenditure. The total effect is a rise in the economies AD. Since the economies GDP is defined by the intersection of the AD and Aggregate Supply (AS) curves. The increased government

Spending thus leads to an outward shift of the AD curve and consequently an increase in the level of output as shown below (, 2009, Par 2).

Effect of Government spending on the GDP

Y is the GDP level
Y is the GDP level

As can be seen from the graph, the shift in AD leads to an increase in outputs which is the intention of the increased government spending.

The effectiveness of expansion of government spending is however dependent on several factors. The financing mix adopted for the stimulus is the most important factor. This is due to the phenomenon called “the crowding out effect”. This effect arises from the financing mode that generates the funds used in expanding government spending. Usually governments borrow funds from the credits market to finance these expansionary activities. The effect of these is that credit becomes scarce leading to higher interest rates. High interest rates discourage borrowing by the private sector hence curtail the rate of increase in economic activities. This means the AD curve above does not shift to the maximum. The change from Y1 to Y2 is minimized. (, 2009, Par 4).

The effect of increased current government expenditure is stronger when accompanied by a plan which ensures that a significant proportion is financed through cutting future expenditures. This is due to the fact that commitment to lower future spending means that future taxes will be low. This enhances consumption and investment activities in the current period (Corsetti, & Müller, 2008, Par 4).

Again for the increased spending to work best, the monetary policy in place must be accommodative. Tightening the monetary policy only works to reduce the effects of the expansionary fiscal policy in stimulating the economy. This is because the tight monetary policy mops up the liquidity introduced by the higher spending.

Also, the existence of spare capacity in resource utilization affects the effectiveness of the government spending. If the resources are fully utilized, flooding money in the market leads to inflation instead of increased GDP. This factor is however not a daily consideration because it is quite rare to find an economy operating at full capacity.

However, it is also true that the effect of some of the projects undertaken using the funds take longer than the 18 month period in which the study was conducted. Investments in education may take much longer to yield fruits in form of better skilled workforce due to the period taken before beneficiaries can be productive. This lag could also contribute to the sub-optimal results observed after the 18 months.

Tools of monetary Policies

The Federal Reserve which is charged with the responsibility of maintaining a stable macroeconomic environment can use three main tools to control the amount of money supply in the economy. The tools are Open Market Operations, reserve requirements and the bank rates.

Tool 1 and how it works in affecting money supply

Open market operations are the most used tools used by the Federal Reserve in controlling money supply. They involve the buying and selling of treasury bills and treasury bonds to dealers who are mainly comprised of banks. Bills are short termed while bonds are long termed. Sale of these securities by the Fed involves mopping up money from the economy through the financial institutions. Buying the securities involves releasing money in to the economy. These securities are investments for the banks and hence offer some predetermined level of returns. The Fed can alter these rates of return to influence in interest rates. Increasing the returns from treasury bills and bonds attracts financiers who opt to lend to the Fed rather than to the firms due to higher security of their investments. This reduces the amount of credit available for businesses. Reducing the returns from the treasury bills and bonds discourages banks from lending to the Federal Reserve hence more money remains in circulation.

Tool 2 and how it works in affecting money supply

Reserve requirement is the ratio of bank deposits that the bank must maintain of deposit with the Federal Reserve. The Fed is legally mandated to set the reserve requirements. Raising the reserve requirement results in withholding of more money from circulation in the economy hence reduced money supply. Reducing the reserve requirements frees up more money for circulation in the economy. This is because banks are able to lend more money to businesses.

Tool 3 and how it works in affecting money supply

Bank rate refers to the rate at which the Federal Reserve lends to banks for short term loans. Increased bank rates increases the cost incurred by the banks in borrowing from the Fed hence discourages them from borrowing. The effect is reduced money supply as the banks ability to access funds for lending is curtailed. Still the higher rate charged to access credit from the Fed has to be compensated by the banks. This means the banks also raise their interest rates. Higher interest rates discourages borrowing hence more money is held up in financial institutions

Economy States

The state of an economy that is growing too quickly is called an economic boom. An economic boom is characterized by rapidly increased economic activity, high levels of employment which may lead to untenable increases in wage rates and high rates of inflation which ‘over heat’ the economy. More specifically a country is in a boom when its rate of GDP’s growth is higher than the general trend of the economy.

An economic recession on the other hand is characterized by slowed economic activities which leads to the loss of employment and a general reduction in the price of commodities(deflation). A country is in recession when the rate of growth is lower than the trend rate of the economy.

The graph below shows interactions of economic boom, recession and the general trend of the economy.

Economic Cycles

  • Price
  • Gdp growth
  • Boom
  • Trend
  • Recession
  • y-Gdp

Adjustments of the above describe monetary policies during an economic boom and a recession is as illustrated in the table below.

Monetary policy adjustments

  Monetary Tool                                    During a Boom                                                                    During Recession

Open Market Operations The Fed sells treasury bills and bonds. This slows down economic activity and inflation. The Fed buys back bills and bonds releasing funds to stimulate the economy.
Reserve Requirement The Fed raises the reserve ratio to curtail credit extension and slow down economy. The Fed lowers the reserve ratio availing more funds for circulation to stimulate economy.
Bank Rates The Fed raises the bank rates to curtail lending and slow down economy The Fed lowers bank rates to avail more funds for lending.

Current Position

Currently the Federal Reserve is engaged in issuing bills and bonds in large quantities to fund the stimulus package implemented to revive the economy which is in recession.

The current reserve requirement in the US is 10% of transaction deposit and has been the case since April 1992 when it was lowered from 12%. Reserve requirements changes are used in very rare cases as they make planning for lenders very difficult and impose costs when raised.

The Current Federal Reserve rate is at its rock bottom. It stands at 0-0.25 and was lowered in December 16 2008 from 1% rate. This is the target rate but the effective rate has been about 0.13%. The table below shows the recent changes in reserve target rates.

Table showing recent changes in Federal Reserve rates in the year 2008:

Date                               Increase/ Decrease                                       Level


December 16                               75-100                                                        0 – 0.25

October 29                                        50                                                                 1

October 8                                          50                                                                1.5

April 30                                             25                                                               2.00

March 18                                           75                                                               2.25

January 30                                       50                                                               3.00

January 22                                        75                                                               3.50

The writer’s recommendation is mainly in the Federal Reserve ratio. Owing to the financial crisis which has significantly hindered the free flow of credit in the economy, it is viable to reduce the reserve requirement from 10% to a single digit so as to free up more capital in the remaining banks. This will go along way in stimulating the economy more so because the inflation rate is low.

I would make the changes in pursuant the goal of availing more money to finance businesses. The major drawback would be the possibility of inflation rate increasing beyond safe levels due to increased money supply which would then curtail the effect of increased money supply in stimulating the economy.

Discussion Board

Tax reductions also known as tax cuts are effective tools of stimulating the economy. A reduction in taxation increases the disposable incomes available for individuals to use in consumption and savings. The direct effect is that the levels of consumption of households go up creating extra demand for good and services. This prompts producers to increase output levels hence both the GDP and employment levels go up. In addition increased savings avail more funds to financial institutions for lending. Increases in lending also contribute to the improved output production by enabling more firms to access credit.

In 2003 the Internal Reserve instituted changes in tax laws which largely sought to reduce taxes paid on dividends as well as capital gains. It also raised tax exemption amount s for alternative minimum tax for individuals.

The effectiveness of tax cuts is largely dependent on the ability of the freed up monies to boost consumption through household spending. In this regard, the category of economic group which receives the tax cuts is very important. If the larger percentage of the tax cuts lands in the pockets of the rich, then a big portion of it is left lying in the banks. This is because the consumption of the rich is not highly sensitive to income levels. On the other hand if the tax cuts target the middle and lower income individuals, the impact on the consumption levels is much higher.

In this regard the emphasis on cutting tax for divided incomes and capital gains raises questions. It is the rich who own the largest percentage of businesses through their ability to buy shares. In the context of the 2003 change of tax laws, in is the upper class gained most from the tax cuts. This implied that the full effect of the tax cuts in stimulating the economy to greater heights. Still the tax cuts lead to increased income gaps between the rich and the poor due to the skewed benefits towards the rich. In deed most knowledgeable economists including 10 Laureates opposed the implementation of the tax cuts as drafted.

Indeed the feeling of many Americans was that the breaks did little to improve their economic status. The feeling is that the breaks were meant to reward those who funded the Bush campaign. A closer look at the biggest beneficiaries depicts a trend of rewarding the wealthiest with tax breaks. Some describe the tax cuts as redistributing wealth to the rich. These are valid allegations considering the heavy effect the tax breaks have on the economy. The cuts have not effectively stopped the decline of the economy (Democratic, 2004, Par 4-6).

It is the writer’s view that the implementation of tax cuts be largely skewed towards the middle and lower income levels. This is not only ethical, but also the most effective way of stimulating the economy. Tax cuts should target small businesses; lower income taxes should also be levied on the low income earners for maximum effect. Less emphasis should be laid on dividends and capital gains as they mainly benefit the rich.


Democratic, 2004. Americans not buying Bush Tax cut rhetoric -60% got 0 -CEOs raise 100k/get. Web.

AmosWeb Encyclonomic WEB*pedia, 2009. Expansionary Fiscal Policy. Web.

Federal Reserve Bank Of New York, 2009. Tools of Monetary Policy. Financial Education For All. Web.

Corsetti, G., & Müller, G., (2008). The effectiveness of fiscal policy depends on the financing and monetary policy mix. Vox. Web., 2009. Fiscal Policy. Web.