Ch. 21 Reflection: Short Run Economic Fluctuations

Ch. 21 Reflection: Short-Run Economic Fluctuations

            Consumer confidence is important for the government to consider when enacting interest rate hikes and fiscal policies. For instance, in a recession, people tend to deplete their savings and hold onto liquid assets like cash money instead of investing. Most consumers will not choose to invest heavily in the market, in real estate, bonds, or big capital purchases until the market looks to be recovering. In a recession, there are a few things that the Fed can do to improve consumer confidence. The easiest is to lower interest rates to encourage spending and investment. The second is to use forward guidance by guaranteeing the consumer that rates will stay low. The third option is the most radical, is used less frequently and is called quantitative easing. This happened during the Great Recession when the government bought mortgages, corporate debt and “longer-term government bonds” which increased bank reserves nationwide and allowed for further lending.
            In a boom, for instance, when the stock market is strong, the Fed might raise interest rates. This “tightening of monetary policy reduces the demand for goods and services, which reduces profits” for firms. Thus, stock prices often fall when this happens, which lowers consumer confidence. Both monetary policy and fiscal policy are used by the government to help grow and stabilize the economy. A type of fiscal policy that the government can use to stimulate the economy is called the multiplier effect. This happens when the government awards a big contract to a private company, the private company then hires more employees to fulfill the contract and the leverage of the government purchase is multiplied throughout the economy. 
            The crowding-out effect works to oppose the multiplier effect and happens because of interest rate hikes during fiscal expansion. This combined with changes in taxes can also affect consumer confidence. Since changes in taxes take a while to set in, the government has to be very careful when to enact interest rate hike and higher taxes so that is doesn’t cause a recession. This delay is known as lag time. Lag time is one of the biggest “x” factors when the government has to forecast consumer confidence and make hard decisions on policy changes. For instance, when consumers and businesses think a recession is likely, they reduce consumption and investment. However, when consumers and businesses are optimistic about economic growth they increase consumption and investment, which spurs higher production but potentially higher inflation as well. Because of these consumer habits, the Fed must time their policy adjustments accordingly and account for the lag time needed for consumers to respond.

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