Explain how the federal government uses spending and tax policy and regulation, and how the Federal Reserve uses monetary tools, to moderate the business cycle and foster growth

Learning goal: Explain how the federal government uses spending and tax policy to maintain economic stability and foster economic growth, evaluate the economic costs and benefits that regulatory actions carry, and explain how the Federal Reserve System uses monetary tools to regulate the nation's money supply and moderate the effects of expansion and contraction in the economy.

The problem both policies address. A market economy does not grow at a steady rate. It moves through a business cycle: an expansion, when output, employment and incomes rise; a peak; a contraction, when they fall (a severe or prolonged contraction is called a recession); and a trough, after which expansion resumes. Contractions bring unemployment and lost income; expansions that run too fast can bring inflation, a sustained rise in the general price level. Economic stability means keeping those swings moderate: high employment with stable prices. Economic growth means a rising capacity to produce over the long run. The federal government pursues both through two separate channels controlled by different institutions: fiscal policy, set by Congress and the President, and monetary policy, set by the Federal Reserve.

Fiscal policy: spending and tax policy. Fiscal policy is the use of federal spending and taxation to influence the economy. Congress holds the power to tax and spend (Article I, section 8) and appropriates money by law; the President proposes a budget each year and signs or vetoes the bills. The federal fiscal year begins October 1. In a contraction, expansionary fiscal policy increases government spending, cuts taxes, or both, putting more purchasing power into the economy so that businesses sell more and hire. In an overheated expansion, contractionary fiscal policy cuts spending or raises taxes to slow demand and ease inflation. Some fiscal policy works automatically. Automatic stabilizers are programs whose effect changes with the economy without any new law: in a recession, unemployment insurance payments rise and income-tax collections fall because incomes fall, which cushions the decline; in a boom the reverse happens. When spending exceeds revenue in a year, the government runs a deficit and borrows by selling Treasury securities; the accumulated borrowing is the national debt. Critics of heavy deficit spending argue that government borrowing can raise interest rates and crowd out private investment and that debt must eventually be serviced; supporters argue that spending in a deep recession uses idle resources. Which effect is larger in a given case is debated among economists, and you should label claims about it as interpretation. Fiscal policy also fosters long-run growth through spending on infrastructure, education and research and through tax provisions designed to encourage investment. Its limitation is timing: Congress may take months to act, and the effects arrive later still.

Regulatory actions and their costs and benefits. Regulation is a government rule that requires or forbids conduct by businesses or individuals: emission limits, food-safety inspections, workplace-safety standards, banking capital requirements. Every regulation carries economic costs (compliance spending, paperwork, higher prices for consumers, and sometimes less competition when small firms cannot bear fixed compliance costs) and intended benefits (fewer injuries and deaths, cleaner air and water, fewer bank failures, more trustworthy markets). Under Executive Order 12866 (1993), which replaced a similar order of 1981, executive-branch agencies have been required to assess the costs and benefits of significant regulatory actions and, where the law allows, to adopt a regulation only on a reasoned determination that its benefits justify its costs. Cost-benefit analysis has conditions: benefits such as lives saved are hard to price, costs and benefits often fall on different people, and estimates depend on assumptions that deserve scrutiny.

The Federal Reserve System. The Federal Reserve, created by the Federal Reserve Act of 1913, is the central bank of the United States. Its Board of Governors in Washington has seven members appointed by the President and confirmed by the Senate for fourteen-year terms, which insulates them from short-term politics. Twelve regional Federal Reserve Banks serve districts; the Federal Reserve Bank of Cleveland serves the Fourth District, which includes Ohio. Monetary policy is set by the Federal Open Market Committee (FOMC): the seven governors, the president of the New York Reserve Bank and four of the other eleven Reserve Bank presidents, who vote in rotation. By law the Fed pursues maximum employment and stable prices (often called the dual mandate); since 2012 it has stated a goal of 2 percent inflation over the longer run.

Monetary tools. Monetary policy regulates the money supply and the cost of credit. The FOMC sets a target range for the federal funds rate, the rate at which banks lend reserves to one another overnight, and uses tools to keep the rate in that range. Interest on reserve balances: the rate the Fed pays banks on money they keep at the Fed; banks will not lend reserves for much less, so raising it pulls market rates up. Open market operations: buying or selling Treasury and other securities; a purchase pays for the securities by crediting bank reserves, adding money to the banking system, and a sale drains it. The discount rate: the rate charged when banks borrow directly from a Reserve Bank. Reserve requirements: the share of certain deposits banks must hold in reserve; the Fed reduced this requirement to zero in March 2020, so it is currently not an active tool, but it remains legally available.

How the tools moderate the cycle. When a contraction comes with inflation at or below its goal, the Fed typically lowers its target rate, making loans cheaper so households and businesses borrow and spend more; in March 2020, as the pandemic struck, it cut the range to 0 to 0.25 percent. When inflation runs above its goal, the Fed typically raises rates to slow borrowing and spending; between March 2022 and July 2023 it raised the range to 5.25 to 5.50 percent. Monetary policy acts faster to decide than fiscal policy, because the FOMC meets eight times a year and needs no legislation, but its effects on the economy also arrive with a lag. These are typical responses, not automatic rules: the FOMC decides from its outlook for both employment and inflation, and when a contraction and high inflation come together its two goals pull in opposite directions.

A fully worked model. Suppose, hypothetically, unemployment is rising and inflation is below 2 percent. Fiscal response: Congress extends unemployment benefits and funds road repairs; automatic stabilizers are already working as tax receipts fall. The deficit grows. Monetary response: the FOMC lowers the target range; the Fed lowers the interest it pays on reserves and buys Treasury securities, adding reserves. Banks lower loan rates; a family refinances; a firm borrows to buy equipment. Regulatory dimension: a pending rule requiring new safety equipment in factories carries compliance costs in the downturn; the agency weighs those costs against the injuries prevented. The policies are coordinated in aim but decided by different bodies.

The misconception. Students often think the President or Congress sets interest rates, or that the Fed spends tax money. Congress and the President control fiscal policy; the Fed, deliberately independent in its monetary decisions, controls monetary policy, and it does not tax or appropriate.

Worked example 1 — classifying a policy: Classify each: (a) Congress cuts payroll taxes for one year: fiscal, expansionary. (b) The FOMC raises the target range for the federal funds rate: monetary, contractionary. (c) Unemployment insurance payments rise during a recession with no new law: fiscal, an automatic stabilizer. (d) The Fed sells Treasury securities from its holdings: monetary, contractionary, because payment drains bank reserves. The step students skip is asking who acted (Congress and the President, or the Fed) before asking which direction.

Worked example 2 — a regulatory cost-benefit calculation: Suppose, hypothetically, a proposed rule requires guards on a type of machine. The agency estimates 2,000 affected factories, each spending $15,000 once to comply: 2,000 × $15,000 = $30,000,000 in costs. It estimates the rule prevents 300 serious injuries a year, each costing an average of $40,000 in medical care and lost wages: 300 × $40,000 = $12,000,000 a year. Over three years the benefits total $36,000,000, exceeding the one-time $30,000,000 cost, assuming the estimates hold. The analysis leaves out pain and suffering (a benefit not priced) and the chance that small factories close (a cost not priced), which is why a reasoned determination must discuss what the numbers omit.

Worked example 3 — tracing an open market purchase: The Fed buys $1 billion of Treasury securities from dealers. It pays by crediting $1 billion to the reserve accounts of the dealers' banks. Banks now hold more reserves. When reserves are scarce, that puts downward pressure on short-term interest rates and supports lending; in the Fed's present ample-reserves system, the rate is steered mainly by the interest paid on reserves, and large purchases work mostly by lowering longer-term rates. In an expansion threatening inflation the Fed would do the opposite: sell securities, draining reserves. The model assumes other tools, such as interest on reserve balances, are held steady.

Policy-response table: Build a table with two scenarios as rows (a recession with low inflation; an expansion with rising inflation) and four columns: discretionary fiscal policy, automatic stabilizers, monetary tools, and a regulatory consideration. Fill each cell with a specific action, the body that takes it, and its expected effect.

Independent performance: Write a 600-word memo to a member of Congress from Ohio on how federal policy should respond to a current economic condition. Success criteria: you describe the condition using a source you cite (for example, a Bureau of Labor Statistics release); you recommend at least one spending or tax measure and explain how it maintains stability or fosters growth; you identify the Federal Reserve's likely response, naming a specific tool and how it affects the money supply; you evaluate one regulation's costs and benefits, stating what cannot be priced; you distinguish fiscal from monetary authority correctly; and you label your predictions as interpretation.