FIN 400 Week 2 Monetary and Fiscal Policy Example

Two Levers Pulling in Different Directions: How Federal Reserve Rate Increases and Pandemic-Era Fiscal Support Shaped the 2021-2023 Inflation, Read From a State Revenue Forecaster's Desk

[Student Name]

University of Phoenix

FIN/400: Public Finance

Week 2 Assignment

[Instructor Name]

[Date]

The state revenue office is a composite written for a model paper; policy dates and figures are drawn from the public record and the sources listed.

The revenue office of a composite Midwestern state saw sales tax collections rise 14 percent in fiscal 2022, far above the 3 to 4 percent it had forecast. Some of the gain was real growth in spending, and some was inflation that raised the dollar value of every taxable sale. The forecaster responsible for next year's estimate had to decide how much of the surge would last. Answering that question required understanding two sets of national decisions the state did not control: the Federal Reserve's monetary policy and Washington's fiscal policy. This paper explains both and how they shaped the period.

Monetary Policy and Its Tools

Monetary policy is conducted by the Federal Reserve, whose Federal Open Market Committee announces a target range for the overnight interbank lending rate known as the federal funds rate. In the current framework, the Fed steers that rate mainly by setting the interest it pays banks on reserve balances and by offering overnight reverse repurchase agreements, with open market purchases and sales of securities shaping the size of its balance sheet (Mishkin, 2022). Changes in the policy rate spread to mortgage rates, auto loans, corporate borrowing and the dollar's exchange value, which in turn affect spending and prices.

The Policy Rate Path

The Fed held its target range at 0 to 0.25 percent from March 2020 until March 2022. As consumer price inflation climbed, reaching 9.1 percent over the twelve months ending in June 2022, the Fed raised the target range eleven times, reaching 5.25 to 5.50 percent in July 2023. It also began reducing its holdings of Treasury and mortgage-backed securities in June 2022. Higher rates cooled home sales and big-ticket purchases first, which the forecaster saw in falling vehicle and furniture sales tax collections by early 2023.

Fiscal Policy and Its Tools

Fiscal policy belongs to Congress and the President, who set federal spending, taxes and transfers in budget and relief legislation. In 2020 and 2021, relief laws sent direct payments to households, expanded unemployment benefits and the child tax credit and sent aid to state and local governments. Household savings rose sharply, and spending on goods surged once restrictions eased. Fiscal policy also works without new laws through automatic stabilizers: income tax collections fall and unemployment benefits rise in a downturn, then reverse as the economy recovers.

How Large Is a Multiplier?

The effect of fiscal policy depends on the multiplier, the change in output from each dollar of spending or tax change. Blanchard and Perotti (2002) used quarterly data to estimate that spending increases raise output by roughly one dollar per dollar on impact, with tax increases lowering it, though the estimates were imprecise and varied by period. Multipliers are thought to be larger when the economy has idle workers and the central bank holds rates steady, and smaller when the economy is near capacity and the central bank raises rates in response. By late 2021 the economy was close to full employment, so additional demand was more likely to raise prices than output.

Policies Pulling Against Each Other

For much of 2021, both policies were expansionary. From 2022, monetary policy turned sharply restrictive while some fiscal support was still flowing, including state spending of federal aid. The two levers pulled in opposite directions. The Fed's increases eventually dominated: housing slowed, and inflation fell to near 3 percent by mid-2023, though the decline also reflected easing supply problems. For the forecaster, the lesson was that the sales tax surge rested on temporary forces, relief money and rising prices, that were already reversing.

A Rule as a Benchmark

Taylor (1993) proposed a simple rule describing how a central bank might set its policy rate: start from a neutral real rate plus inflation, then add half the gap between inflation and its target and half the gap between output and its potential. Using inflation of about 6 percent in early 2022, a 2 percent target, a neutral real rate near 0.5 percent and output close to potential, the rule suggests a nominal policy rate around 8.5 percent, far above the near-zero rate the Fed then held. The comparison shows why critics argued the Fed started late, while the Fed's defenders noted that the rule cannot account for supply shocks it expected to fade.

What the State Forecaster Learned

The forecaster built three lessons into the next estimate. First, revenue driven by inflation and transfers should be treated as temporary, so the office lowered its growth assumption for fiscal 2024 to 2 percent. Second, rising rates affect taxable spending on big items before other categories, so the office now tracks interest-sensitive sales separately. Third, the state's own spending of federal aid added to demand at the moment the Fed was trying to cool it, which the budget office should remember when timing one-time spending in future recoveries.

Why the Office Watches the Yield Curve

A state forecaster also reads monetary policy through the bond market. When short-term Treasury yields rose above ten-year yields in July 2022, the curve inverted, a pattern that has preceded most postwar recessions. The office did not treat the inversion as a forecast of recession by itself, since the 2022 inversion lasted far longer than earlier ones without a downturn following quickly. It did treat it as a reason to widen the range around its central revenue estimate and to present the legislature with a low case in which collections fall 3 percent. That low case, rather than the central estimate, set the size of the reserve the office recommended keeping. Reading the curve this way connects the Fed's decisions to a practical budget choice instead of leaving them as background.

Limits of Each Tool

Neither policy is precise. Monetary policy acts with long and variable lags and works mainly through borrowing, so it hits housing and business investment harder than other sectors. Fiscal policy requires legislation, which can arrive late, and spending programs are hard to reverse once started. Automatic stabilizers avoid the legislative lag but are modest in size at the state level, where balanced budget rules limit borrowing.

Conclusion

Monetary and fiscal policy have different owners, tools and lags. In 2021 to 2023, expansionary fiscal policy and near-zero rates helped push demand past what the economy could supply, and the Federal Reserve's rapid rate increases then pulled inflation down. A state revenue office reading that episode should separate durable growth from temporary support and watch how national policy shifts flow into its own tax base.

References

Blanchard, O., & Perotti, R. (2002). An empirical characterization of the dynamic effects of changes in government spending and taxes on output. The Quarterly Journal of Economics, 117(4), 1329-1368. https://doi.org/10.1162/003355302320935043

Mishkin, F. S. (2022). The economics of money, banking, and financial markets (13th ed.). Pearson.

Taylor, J. B. (1993). Discretion versus policy rules in practice. Carnegie-Rochester Conference Series on Public Policy, 39, 195-214. https://doi.org/10.1016/0167-2231(93)90009-L