D2.Eco.12.9-12: Evaluating Monetary and Fiscal Policy in Different Economic Conditions

Overview

Lesson Procedure

65-80 minutes of class time across 5 phases.

1. Warm-Up5-10 minutes
2. Direct Instruction20 minutes
3. Guided Practice15-20 minutes
4. Independent Practice15-20 minutes
5. Closure10 minutes

1. Warm-Up5-10 minutes

   Warm-Up Prompt

   "A doctor would not give the same medicine for a fever and for a broken leg. Name three different things that can go wrong with a national economy. For each one, what do you think the government or the central bank should do, and what could go wrong with that cure?"

   Collect answers in three columns: problem, cure, side effect. Students usually name unemployment and inflation; add a sudden rise in oil prices and a run on banks if no one does. Tell students that D2.Eco.12.9-12 asks them to evaluate the selection of policies: not just to name the tools, but to judge whether a choice fits the condition, what it costs and who bears the cost.

2. Direct Instruction20 minutes

   The two toolkits for D2.Eco.12.9-12 (working definitions)

   Toolkit	Who uses it	Main tools	Strengths and limits
   Monetary policy	The central bank (in the United States, the Federal Reserve, whose Federal Open Market Committee (FOMC) sets the target for the federal funds rate)	Raising or lowering the policy interest rate; buying or selling securities (open market operations); lending to banks, including in a panic; large asset purchases; statements about future policy (forward guidance)	Can be changed at any meeting; works through borrowing and spending with delays of many months; a policy rate cannot go much below zero
   Fiscal policy	Congress and the President (or a parliament): taxes and spending	Changing government purchases, taxes or transfer payments such as unemployment benefits; automatic stabilizers, which are taxes and benefits that change on their own as incomes rise and fall	Can put money directly into the hands of people and places hit hardest; new laws take time to pass and carry out; borrowing adds to the national debt

   Part 1: Five questions for evaluating a policy choice. (1) Fit: does the tool push in the right direction for this condition? (2) Timing: how long before it works, and will it arrive too late? Economists separate the time to notice a problem, to decide and to feel the effect. (3) Side effects: what does it do to inflation, debt, interest rates or risk-taking? (4) Limits: is the tool available (a rate already near zero, debt already high)? (5) Who bears the cost? Savers, borrowers, workers and taxpayers are affected differently.

   Matching policy to conditions: the usual selection and the trade-off to evaluate

   Condition	Usual monetary choice	Usual fiscal choice	What makes the choice hard
   Recession: falling demand, rising unemployment, low inflation	Lower interest rates (expansionary)	Spending increases or tax cuts; let automatic stabilizers work	Lags; deficits; the zero lower bound if rates are already low
   Overheating: very low unemployment, rising inflation	Raise interest rates (contractionary)	Spending restraint or tax increases; avoid adding demand	Raising rates slows hiring; tax increases and spending cuts are unpopular
   Supply shock: prices up and output down at the same time (stagflation)	No choice helps both goals: tighten to fight inflation or ease to protect jobs	Targeted, temporary help; avoid broad stimulus that adds to inflation	Every choice worsens one of the two problems for a while
   Financial panic: runs on banks, credit frozen	Lend freely to sound banks against good collateral (lender of last resort)	Sometimes deposit guarantees or support for the banking system	Rescues can encourage risky behavior later (moral hazard)

   Part 2: Two real episodes. In October 1979 the Federal Reserve, led by Chair Paul Volcker, changed its procedures to slow the growth of money and bring down high inflation. In 2008 a financial crisis turned into what was, by many measures, the most severe recession since the 1930s, and the Fed cut its rate to nearly zero (Source 3). The table lets students compare the conditions and the Fed's choices. Economists still debate how both episodes should be judged: for example, whether the 1981-1982 recession was a necessary cost of ending high inflation, and whether policy in 2008-2010 did too much or too little.

   U.S. economy in two episodes, 1980-1983 and 2008-2010 (real data). Unemployment rate: BLS Current Population Survey, annual average of series LNU04000000. CPI: BLS CPI-U, U.S. city average, all items, annual average (1982-84 = 100); inflation is the percent change from the year before (1979 CPI 72.6; 2007 CPI 207.342). Federal funds rate: Federal Reserve Board, H.15, effective rate, average of the 12 monthly averages. All values rounded to one decimal place.

   Year	Unemployment rate (%)	CPI (annual average)	Inflation (%)	Federal funds rate (%)
   1980	7.1	82.4	13.5	13.4
   1981	7.6	90.9	10.3	16.4
   1982	9.7	96.5	6.2	12.3
   1983	9.6	99.6	3.2	9.1
   2008	5.8	215.303	3.8	1.9
   2009	9.3	214.537	-0.4	0.2
   2010	9.6	218.056	1.6	0.2

   • Monetary: is policy tight or loose? (real data)

     Use the data table. The real interest rate is about the federal funds rate minus inflation. Compare 1981 and 2010.

     Result: 1981: 16.4 - 10.3 = 6.1 percent, a very high real rate: tight policy aimed at inflation. 2010: 0.2 - 1.6 = -1.4 percent, a negative real rate: loose policy aimed at unemployment. The selections fit opposite conditions.

   • Monetary: a policy rule and the zero lower bound (real data)

     A simplified version of a rule proposed by economist John Taylor in 1993 says the policy rate should be about 2 + inflation + 0.5 x (inflation - 2) - (unemployment - normal unemployment). Apply it to 2009, assuming normal unemployment of 5 percent.

     Result: 2 + (-0.4) + 0.5 x (-0.4 - 2) - (9.3 - 5) = 2 - 0.4 - 1.2 - 4.3 = -3.9 percent. The rule calls for a rate far below zero, which a central bank cannot set. That is why the Fed turned to other tools in Source 3, and why some economists argued for fiscal policy.

   • Fiscal: timing public works (invented numbers)

     Source 2, paragraph 2 says to defer at least 10 percent of average public-works spending in normal years and spend the savings in the depression year, which comes about once in 10 years. Suppose average spending is $2.0 billion a year. How much is spent in each normal year and in the depression year?

     Result: Normal year: 2.0 - 0.10 x 2.0 = $1.8 billion; $0.2 billion is held back each year. Over 9 normal years, 9 x 0.2 = $1.8 billion is saved up. Depression year: 2.0 + 1.8 = $3.8 billion, 90 percent more than average.

   • Fiscal: how big is the effect? (primary source)

     Source 2, paragraph 5 compares $1,650 million of possible extra public-works wages with a $5,000 million drop in private wages. What fraction of the lost wages could public works replace?

     Result: 1,650 / 5,000 = 0.33, about one-third, which matches the report's phrase "one-third the deadweight." Even in the planners' own estimate, public works could offset only part of a depression.

   • Monetary: evaluating a panic response (invented)

     During a bank panic, a central bank offers loans only to the three largest banks, at a low interest rate. Evaluate the choice with Source 1.

     Result: It breaks both of Bagehot's rules. He wants loans made "at a very high rate of interest," not a low one, and he wants them made "on all good banking securities, and as largely as the public ask for them," not only to three banks. A better selection: lend to any sound bank with good collateral, at a penalty rate. Guided Practice asks for the reason Bagehot gives for each rule.

3. Guided Practice15-20 minutes

   Monetary policy in a panic and in a slump. Context note for Source 1: Walter Bagehot (1826-1877) edited The Economist in London. In 1873 the Bank of England held the last reserve of cash for the country's banks. An advance is a loan, and securities are assets such as bonds or bills that a borrower pledges to the lender (collateral). Context note for Source 3: the federal funds rate is the rate banks charge each other for overnight loans; agency debt and mortgage-backed securities are bonds tied to home loans.

   1Nothing, therefore, can be more certain than that the Bank of England has in this respect no peculiar privilege; that it is simply in the position of a Bank keeping the Banking reserve of the country; that it must in time of panic do what all other similar banks must do; that in time of panic it must advance freely and vigorously to the public out of the reserve.

   2And with the Bank of England, as with other Banks in the same case, these advances, if they are to be made at all, should be made so as if possible to obtain the object for which they are made. The end is to stay the panic; and the advances should, if possible, stay the panic. And for this purpose there are two rules: First. That these loans should only be made at a very high rate of interest. This will operate as a heavy fine on unreasonable timidity, and will prevent the greatest number of applications by persons who do not require it. The rate should be raised early in the panic, so that the fine may be paid early; that no one may borrow out of idle precaution without paying well for it; that the Banking reserve may be protected as far as possible.

   3Secondly. That at this rate these advances should be made on all good banking securities, and as largely as the public ask for them. The reason is plain. The object is to stay alarm, and nothing therefore should be done to cause alarm. But the way to cause alarm is to refuse some one who has good security to offer. The news of this will spread in an instant through all the money market at a moment of terror; no one can say exactly who carries it, but in half an hour it will be carried on all sides, and will intensify the terror everywhere. No advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business. That in a panic the bank, or banks, holding the ultimate reserve should refuse bad bills or bad securities will not make the panic really worse; the 'unsound' people are a feeble minority, and they are afraid even to look frightened for fear their unsoundness may be detected. The great majority, the majority to be protected, are the 'sound' people, the people who have good security to offer. If it is known that the Bank of England is freely advancing on what in ordinary times is reckoned a good security--on what is then commonly pledged and easily convertible--the alarm of the solvent merchants and bankers will be stayed. But if securities, really good and usually convertible, are refused by the Bank, the alarm will not abate, the other loans made will fail in obtaining their end, and the panic will become worse and worse.

   1The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent.

   2Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further.

   3Meanwhile, inflationary pressures have diminished appreciably. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters.

   4The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

   5The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

   1. The condition. Prompt: what condition is Bagehot writing about, and what is "the end," in his words, of lending in it? (Source 1, paragraph 2)
   2. The two rules. Pairs restate each rule in one sentence and write the reason Bagehot gives for it. Do not accept a rule without its reason.
   3. Another condition. Prompt: list every condition the FOMC names in Source 3, paragraphs 2 and 3. Then ask which of the two goals in paragraph 4 each condition affects.
   4. The tools. Prompt: the rate in paragraph 1 cannot fall further. Which other tools does paragraph 5 name? Have students sort them into "lending," "buying assets" and "statements about the future."
   5. Compare. Ask: in what way is the 2008 response like Bagehot's advice, and in what way is it different? Accept reasoned answers; the point is to connect a condition to a selection.
4. Independent Practice15-20 minutes

   Fiscal policy: timing and the case for and against. Context note for Source 2: in 1921, during a sharp postwar depression, President Warren Harding called a conference on unemployment chaired by Commerce Secretary Herbert Hoover. Its economists proposed planning public works (roads, buildings, harbors) years ahead. A bond issue is government borrowing; deadweight here means the dead weight of lost wages. Source 4 is written for this page and gives two views in plain words.

   1Public works—municipal, State, and Federal—should be contracted in years of industrial activity and expanded in years of depression to accomplish the following purposes:
   1. To revive private industry and to check industrial depression and unemployment.
   2. To prevent the demand of public works for materials and labor from conflicting with the needs of private industry.
   3. In general, to stabilize industry and employment.

   2Defer at least 10 per cent of the average annual public-works expenditures of Federal, State, and municipal agencies. Execute the deferred accumulations in the year of depression which occurs once in about 10 years.

   3This does not mean, however, that any specific piece of public works will be deferred more than two years—in most cases only one year. In order that plans may be quickly available when needed, do not defer appropriation for planning and engineering of any work authorized.

   4Consider the effect of a Federal bond issue as a loan in aid of municipal public works in years of depression, such loans to be made only (a) upon proof of national unemployment and industrial depression, as shown by industrial and unemployment statistics; (b) upon proof of the soundness and utility of specific public works proposed; (c) loan to be made to municipalities at a rate of interest not less than that paid by the Federal Government (note British policy); (d) advance preparation of engineering plans, which must be thought out and periodically revised in order to be ready for execution when the period of depression arrives (see practice of Indian Government), otherwise great waste will result; and (e) work to be executed upon a “commercial” basis and not a “relief” basis.

   [...]

   5Estimates of Otto T. Mallery of the Industrial Board of Pennsylvania measure the lifting power of public works as one-third the deadweight of such a depression as the present. An estimated possible $1,650 millions of additional public works wages in a year of depression is contrasted with an estimated $5,000 millions decrease in wages in private industry in a year of depression. (See charts following.)

   6The best time, and possibly the only time, for successfully inaugurating these measures is at once, during the period of depression.

   1SVHS-written sample interpretation. The two economists below are invented. Each states, in plain words, a view that real economists have defended for decades. Neither view is the page's answer.

   2Economist A: When a recession is deep, millions of people want to work and factories sit idle because buyers have stopped spending. The quickest cure is to put spending back into the economy. The central bank should cut interest rates first. But once its rate is near zero, it cannot cut much further, and families who are worried about their jobs may not borrow even at low rates. Then the government should step in: build roads and schools, send aid to states, and extend unemployment benefits. Running a larger deficit in a slump is sensible, because the borrowed money puts idle workers and machines back to use. The deficit can be reduced once the recovery is strong.

   3Economist B: Policy makers rarely know in time how deep a slump will be. By the time Congress agrees on a spending bill and the projects begin, the recovery may already be under way, and the extra spending adds to inflation and to the national debt instead. Government borrowing can also push up interest rates and crowd out private investment. Programs started in a crisis are hard to end. It is better to rely on steady rules that people can count on: a central bank that keeps inflation low and predictable, and a tax and benefit system that already pays out more in bad years without a new law. Discretion should be saved for true emergencies, such as a financial panic.

   4Both economists agree on some points. Both want low unemployment and stable prices. Both accept that the central bank should act fast in a panic. They disagree about how well governments can time their actions, how large the benefits of extra spending are, and how much weight to give to future debt.

   Questions for Sources 2 and 4:

   1. Source 2, paragraph 1: state the three purposes of timing public works. Which purpose is about avoiding harm in good years?
   2. Source 2, paragraphs 3 and 4: what two steps does the plan take so that projects are ready in time?
   3. Source 4: write each economist's main claim in one sentence. Then write one point they agree on.
   4. Which economist in Source 4 would be more comfortable with the 1921 plan? Give one reason from each source.

   Teacher note: for question 4, strong answers see that the plan has features both could like: it expands spending in a slump, as Economist A wants, and it is prepared ahead by a fixed rule, which answers part of Economist B's worry about timing.

5. Closure10 minutes

   Prescribe for Marisca. Students read Source 5, an invented scenario. They will use it for the exit ticket and for quiz questions 10-13, 16 and 20, so they should keep it in front of them.

   1Invented scenario, written for this page. Marisca is a fictional country with its own currency. Its central bank, the Bank of Marisca, sets a policy interest rate and can lend to banks. Its parliament sets taxes and spending. Economists in Marisca think unemployment of about 4.5 percent is normal when the economy is healthy, and the central bank's goal for inflation is 2 percent a year. Government debt is measured as a percent of Marisca's yearly total output (GDP).

   2Situation 1. Sales have dropped for six months. Unemployment has risen from 4.5 percent to 8.0 percent. Inflation is 1.0 percent. The policy rate is 3.0 percent. Government debt is 40 percent of GDP.

   3Situation 2. Factories are running overtime and many shops cannot find workers. Unemployment is 3.2 percent. Inflation is 7.5 percent and rising. The policy rate is 2.0 percent. Government debt is 45 percent of GDP, and parliament has just passed a large tax cut.

   4Situation 3. A war far away has doubled the price of imported fuel. Inflation has jumped to 6.0 percent. Unemployment has risen to 6.5 percent because high fuel costs force businesses to cut back. The policy rate is 0.5 percent. Government debt is 95 percent of GDP.

   5Situation 4. Rumors spread that two large banks made bad loans. Savers line up to withdraw their deposits from many banks, including healthy ones that made good loans. Banks stop lending to each other. Unemployment and inflation have not changed yet.

   Exit ticket (index card): "Choose one Marisca situation. Name one monetary and one fiscal choice you would select, and one cost or risk of your choice." Sort the cards by situation and use the disagreements to open the next class.

   Teacher note. Source 4 states two schools of thought in simplified form; real economists hold many positions between them. Grade the reasoning, not the side a student takes. Sources 1 and 2 use the language of their time ("relief basis," "deadweight"). The page does not judge any current official, party or pending policy. The real data are annual averages; monthly figures differ.

Differentiation Strategies

Assessment Guidance

1. Question 1 of 20 · Multiple Choice

   In Source 1, paragraph 2, why does Bagehot want panic loans made "at a very high rate of interest"?

   ATo earn the largest possible profit for the Bank of England during the panic BTo punish the banks whose bad loans caused the panic in the first place CTo discourage borrowing by people who do not really need the money DTo slow the economy down and lower inflation after the panic

2. Question 2 of 20 · Multiple Choice

   In Source 1, paragraph 3, why does Bagehot insist on lending to anyone who offers good security?

   ABecause refusing such a borrower would spread alarm through the market BBecause the law required the Bank of England to lend to everyone who asked CBecause good security always earns the Bank a high profit DBecause the Bank of England had no other use for its reserve

3. Question 3 of 20 · Multiple Choice

   In Source 1, paragraph 3, why does Bagehot think lending freely in a panic need not cause the Bank losses?

   AThe government had promised to repay the Bank for any losses BInterest rates were so high that any losses would be covered CMerchants were legally required to repay the Bank before others DLoans have good security, and bad business is a tiny share

4. Question 4 of 20 · Multiple Choice

   Source 2, paragraph 1 gives as one purpose "to prevent the demand of public works for materials and labor from conflicting with the needs of private industry." What is the economic idea behind it?

   APublic works should always be cut back so that the budget stays balanced BPublic spending in a boom competes with firms for workers and materials CPrivate businesses should be paid to build public works DPublic works create more jobs in good years than in bad years

5. Question 5 of 20 · Multiple Choice

   Source 2, paragraph 4 requires "advance preparation of engineering plans." Which problem of fiscal policy does this address?

   AProjects might be built by workers brought in from other countries BPublic works might cost more than private projects CProjects might start too late to help, or be wasteful if rushed DInterest rates might be too low during a depression

6. Question 6 of 20 · Multiple Choice

   A state spends an average of $5 billion a year on public works and follows the 1921 plan in Source 2, paragraph 2, deferring 10 percent in each of 9 normal years. How much can it spend in the depression year?

   A$5.5 billion B$9.5 billion C$4.5 billion D$10.0 billion

7. Question 7 of 20 · Multiple Choice

   According to Source 3, paragraphs 2 and 3, which conditions led the FOMC to cut its target rate in December 2008?

   AWeakening activity and jobs, strained credit, and easing inflation BRising inflation and a shortage of workers in many industries CA rise in energy prices that pushed up the cost of living DStrong consumer spending and rapid growth in industrial production

8. Question 8 of 20 · Multiple Choice

   Source 3, paragraph 5 says the Fed will buy agency debt and mortgage-backed securities. What reason does the statement give?

   ATo raise interest rates on home loans and slow inflation BTo pay for new government spending on roads and schools CTo replace the federal funds rate as the main policy rate DTo provide support to the mortgage and housing markets

9. Question 9 of 20 · Multiple Choice

   In Source 3, paragraph 4, the FOMC says weak conditions "are likely to warrant exceptionally low levels of the federal funds rate for some time." What kind of tool is this sentence?

   AAn open market sale of Treasury securities BA change in tax rates by Congress CForward guidance about future policy DA loan to a bank under Bagehot's rules

10. Question 10 of 20 · Multiple Choice

    Use Source 5, Situation 2. About what is Marisca's real policy interest rate (the policy rate minus inflation)?

    A-5.5 percent B+9.5 percent C+5.5 percent D+2.0 percent

11. Question 11 of 20 · Multiple Choice

    Use Source 5, Situation 1, and the simplified rule from Example 2 with normal unemployment of 4.5 percent. What policy rate does the rule suggest?

    A6.0 percent B2.5 percent C-2.0 percent D-1.0 percent

12. Question 12 of 20 · Multiple Choice

    Use Source 5, Situation 2. How should the new tax cut be evaluated?

    AIt is the right choice, because tax cuts always lower inflation in the short run BIt adds spending to an overheating economy and works against the central bank CIt does not matter, because only the central bank can affect inflation DIt is the right choice, because unemployment is too high

13. Question 13 of 20 · Multiple Choice

    Use Source 5, Situation 3. Which statement best evaluates the choices facing Marisca?

    ACut taxes sharply, because a larger deficit always cures a supply shock quickly BDo nothing, because a war abroad cannot affect Marisca's economy CTightening fights inflation but costs jobs, and high debt limits fiscal help DLower the policy rate to zero, because inflation will fall by itself

14. Question 14 of 20 · Multiple Choice

    Which argument in Source 4 belongs to Economist B?

    ABy the time a spending bill takes effect, the recovery may be under way BRunning a larger deficit in a slump is sensible CFamilies who fear for their jobs may not borrow even when interest rates are low DThe government should build roads and schools in a recession

15. Question 15 of 20 · Multiple Choice

    Which piece of evidence from this lesson would most strengthen Economist A's case in 2009?

    AInflation was 13.5 percent in 1980 BThe federal funds rate averaged 16.4 percent in 1981, the highest in the table CUnemployment was 5.8 percent in 2008 DThe 2009 funds rate averaged 0.2 percent with 9.3 percent unemployment

16. Question 16 of 20 · Short Answer

    Use Source 5, Situation 4, and Source 1. What should the Bank of Marisca do, and why? Name one risk of your choice.

    Show model answer

17. Question 17 of 20 · Short Answer

    Use the data table and Diagram 2. Evaluate the Federal Reserve's selection of tight monetary policy in 1981-1982. Give one benefit and one cost, with numbers, and say whether you think the choice was justified.

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18. Question 18 of 20 · Short Answer

    Evaluate the FOMC's selection in Source 3. Use at least two conditions from the statement and the 2009-2010 rows of the data table, and include one criticism a skeptic might make.

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19. Question 19 of 20 · Short Answer

    Would Economist B in Source 4 support the 1921 plan in Source 2? Explain, using details from both sources.

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20. Question 20 of 20 · Short Answer

    Use Source 5, Situation 3. Recommend one monetary and one fiscal choice for Marisca. Use the simplified rule (normal unemployment 4.5 percent) as one piece of evidence, and answer one objection to your plan.

    Show model answer

These standards connect to D2.Eco.12.9-12: prerequisites to review first, parallel standards at the same level, and next steps that build on it.

Standard text: National Council for the Social Studies (NCSS), The College, Career, and Civic Life (C3) Framework for Social Studies State Standards: Guidance for Enhancing the Rigor of K-12 Civics, Economics, Geography, and History (Silver Spring, MD: NCSS, 2013). NCSS was not involved in the production of this lesson and does not endorse it.