The Economy and Fiscal and Monetary Policy

An Economic Simulation: Econoland

Q7. What government expenditure decisions did you make during different phases of the simulation? How do changes in government spending affect the consumption level?

During the first and second years of the simulation, I kept corporate and individual income tax rates too high to sustain economic growth, and also kept the interest rate too high at 3% and then raised it to 7%, which discouraged borrowing for new investments. When the world economy slowed down, this further discouraged consumption. Lowering the interest rate by the third year was helpful, even with raising income and corporate taxes. Reinvesting the gains from such taxes into government infrastructure can be very helpful to further encourage spending by consumers and businesses. By the fourth year, despite the instability in the world economy, the lack of a budget surplus, government reinvestment in the economy, and keeping the interest rate stable resulted in continued growth.

But by the fifth year, by keeping government spending constant in a world where inflation is a significant factor, combined with a budget surplus, growth had slowed. This should have been a sign for a need for higher levels of government spending. Inflation means that the purchasing power of the same amount of money has been reduced. By year seven, despite the increased confidence in the global economy as a whole, the fact that government expenditures were not increased has resulted in slow growth within the country. The simulation underlines the fact that there must be a balance between attempting to spend within the government’s allocated budget and the need to stimulate growth.

In retrospect, more government spending would have been helpful. In the long run, by stimulating consumption, job growth, and business growth, this can result in more tax revenue and still ensure solvency. Changes in government spending can have a significant, positive impact on improving the economy.

Q10. In March 2020, the Federal Reserve Bank slashed its benchmark interest rate to nearly zero. Suppose the government wants to stimulate the economy without increasing interest rates. What combination of fiscal and monetary policy might accomplish this goal?

A key component of fiscal policy designed to stimulate the economy includes spending on infrastructure, spending on social programs, and investing in other government projects to encourage job growth and consumption. Lowering taxes and spending at a deficit can ensure that consumers and businesses have more money to spend and invest in the economy. Increasing transfer payments, or direct economic stimulus checks to consumers and businesses, can likewise encourage consumers not to put off large purchases or to buy more goods and services. Businesses can also invest in more raw materials and labor. Hiring more people can give people the confidence to spend their savings, knowing that they are likely to remain employed.

An expansionary monetary policy is also helpful to stimulate the economy. If raising interest rates are off the table because they are already very low or at zero, lowering the reserve requirements, or the amount of money banks must keep on reserve to avoid bank runs, can also be helpful. This ensures that banks can lend more money, and have more money circulating in the economy. The central bank can also lower the discount rate, or the rate banks charge to lend money to one another to meet reserve requirements and for other reasons, to ensure that consumers and businesses who want to borrow and spend money for various goods and services have the means to do so. Finally, the government can buy up treasury notes, further infusing liquid cash into the economy, rather than encouraging consumers to save money.