Monetary and Fiscal Policy during the Great Depression

In the year 2000, United States economy experienced a period of slow growth that was characterized by financials crisis. The main cause of this recession was the housing bubble which burst during that time. When recession takes place in any economy, it usually comes along with very many complications. For instance, the level of unemployment increases rapidly because production is usually very low. The recession was a major blow to the U.S. economy as it cost the economy a significant amount of time and financial resources to recover.

When there is an economic problem like recession, the situation can either be rectified through a monetary policy or a fiscal policy. However, both policies are used in combination in order to come up with the most effective effects. Both monetary and fiscal policies act by reversing the negative effects impacted by the condition on the economy.

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For instance, since recession slows down the economy, the monetary and fiscal policies should be aimed at reviving the economy. Therefore, the decisions made should be geared towards the expansion of the economy. In order to solve this problem, the US government came up with expansionary monetary and fiscal policies. Expansionary policies help in reviving an economy after a recession.

Expansionary Monetary policy

An expansionary monetary policy is any action by the Fed that results in an increase to the total output or aggregate demand in an economy. An expansionary policy conducted during recession is aimed at stimulating economic growth. During recession, economic activities are generally slow and the entire economy comes into stand still (Cummins & Cohen 13).

In such a situation, any monetary decision should be directed towards the revival of the economy. This is achieved by ensuring that every monetary decision made is targeted towards the expansion of the economy.

One expansionary monetary policy which Fed conducted during the great recession is cutting down the interest rates. This policy leaves the level of inflation unchanged in the long run. However, the level of output will increase gradually in the long run. When the interest rates are low, people will tend to increase the amount borrowed since borrowing is now inexpensive.

As a result, the level of investment will increase hence promoting expansion in the total output. In 2008, the US government applied unique mechanism in an effort to solve the financial situations during that time. The fed government made an aggressive reduction in interest rates in 2008 going down to zero rates by the end of the year (Blinder & Zandi 10). This increased the level of production in the economy hence creating employment.

Later, the government was also engaged in other expansionary measures in order to boost the economy further. For instance, it bought treasury bonds. This also had a significant impact increasing the output during this time.

The fed also purchased Fannie Mae and Freddle Mac mortgage-backed securities (MBS) in an effort to lower the long term interest rates (Blinder & Zandi 15). When the government purchases securities, it increases the money in circulation. For instance, the bank will have more money to lend to the people. This acted by generating the economic growth hence solving the problem of recession.

However, increase in the interest rates will have the opposite impact on the economy and will worsen or trigger recession. When the rate of interest is high, the cost of borrowing will increase. Borrowers will be forced to pay back with more interest. This will discourage investors from borrowing. As a result, the level of investments will drop hence reducing the total output. In other words, all the monetary policies employed during recession should be aimed at reducing interest rates rather than increasing.

High interest grates will also have an impact on consumption. For instance, the consumption of durable products is sensitive to interest rates. In some cases, individuals requires some financing to be able to buy expensive durables like automobiles, Electronics like computers, house furniture among other things.

When the interest rate is high, then individuals will tend to cut down on consumption of such goods. In other words, the households will take into consideration the level of interest rates while making decisions to purchase durables.

In other words, the Fed government used expansionary monetary policy which left the level of interest at a low level. This acted by stimulating both consumption and investment. These activities had a significant impact in generating consumption in the economy.

Expansionary Fiscal Policy

Expansionary fiscal policy is any policy by the government that is aimed at generating economic expansion. During a recession, the total output in an economy usually falls as a result of slowed economic activities. The aggregate demand curve will therefore shift to the left.

The total output will fall below the potential level (American Century Investments par 5). This implies that the economy will be producing below its potential output. As a result, inflation will fall with time. In order to solve the situation, there is a need to implement an expansionary monetary policy.

During the great depression, fiscal policy played an important role in reviving the US economy. In this case, an expansionary monetary policy also was employed in the fight against the great recession. These include the decisions the government makes regarding spending and taxation. The US government employed the fiscal policy in its effort to bring the economy back to its original position. Fed also attempted to cut down taxes in order to expand the economy.

During the great recession for instance, the Fed government was expected to use an expansionary fiscal policy to solve the problem. Therefore, the government increased its spending. The government expenditure stimulated economic growth hence solving the major problem of recession. In other words, increase in government purchase led to increase in the aggregate demand which resulted in an increase in the total output.

The Ricardian equivalence theory helps in understanding how the fiscal policy interacts with decisions that consumers make in a certain economy. “This theory known as Ricardian equivalence implies that the impact of taxing and spending decisions on the economy may be counter-intuitive to what we would expect from our basic IS-LM analysis” (Weerapana par13).

In the Ricardian equivalence, it is assumed that in case the government cuts down taxes using a debt, such an act cannot lead to an increase in consumption. In other words, the spending increases and tax cuts, which are funded through a debt, cannot have any impact on the economy (Weerapana par 15). Therefore, this policy cannot be fully reliable in case of a recession where there is a need to expand production.

Ricardian equivalence indicated that the future budget situation can have a significant impact on the current budget situation. For instance, an announcement of a future increase in government spending will lead to a decrease in current spending because the government will increase taxes. When people expect the tax rate to rise, they will tend to cut down their spending as they expect their disposable income to fall in future from increased tax.

In some cases, the government purchases may have opposite effects. While this increase in the government purchases lead to an increase in demand for the goods and services, this may also lead to a rise in interest rates (Mankiw Taylor 35). High interest rates will result into a fall in the level of spending on investment leading to a drastic fall in the aggregate demand. The situation where a fiscal expansion lead to an increase in the interest that results in a fall in the aggregate demand is referred to as crowding effect.

Conclusion

In conclusion, this discussion has clearly shown that expansionary, fiscal and monetary policies played a pivotal role in saving the US economy from the great depression. During the period, the economy experienced slow growth. Expansionary monetary policy acted by reviving the economy hence increasing the output. Increase in production also helped in generating employment activities hence lowering the level of unemployment in the economy.

Works Cited

American Century Investments. “Monetary and Fiscal Policy.” American Century, 2011, July 21, 2011. http://americancentury.com/2011/07/inflation-series-part-ii-monetary-and-fiscal-policy/

Blinder, Allan and Zandi, Mark. “How the Great Recession Was Brought to an End.” Economy, 2010. July 21, 2011. http://www.economy.com/mark-zandi/documents/End-of-Great-Recession.pdf

Cummins, Jason and Cohen, Darrel. “A Retrospective Evaluation of the Effects of Temporary Partial Expensing.” Federal Reserve Board. No. 2006-19 (April 2006).

Mankiw, Gregory and Taylor, Mark. Economics. London: Cengage Learning EMEA, 2006.

Weerapana, Akila. “Monetary policy.” Wellesley, 2006. July 21, 2011. http://www.wellesley.edu/Economics/weerapana/econ102/econ102pdf/lecture%20102-22.pdf

Weerapana, Akila. “Fiscal policy.” Wellesley 2009. July 21, 2011. http://www.wellesley.edu/Economics/weerapana/econ102/econ102pdf/lecture%20102-21.pdf

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