Chapter 15 FISCAL POLICY The use of government spending and revenue collection to influence the economy. Fiscal policies are used to: Achieve economic growth Full employment Price stability Fiscal policy decisions how much to spend and how much to tax are among the most important decisions the federal government makes. These decisions create the federal budget The federal budget is a written document indicating the amount of money the government expects to receive for a certain year and authorizing the amount the government can spend that year. The government prepares a new budget for each fiscal year. A fiscal year is a twelve-month period that is not necessarily the same as the January-to- December calendar year. The federal government uses a fiscal year that runs from October 1 to September 30. Spending Proposals There are many offices to fund in the federal government. These offices write a detailed estimate of how much it expects to spend in the coming fiscal year. These reports are sent to the Office of Management and Budget (OMB). This office is a part of the executive branch. The OMB is responsible for managing the federal governments budget. In the Executive Branch The OMB will hold meetings to review the offices spending proposals. Representatives will explain their proposals and convince them to give them the money requested. The OMB usually gives out less money than requested The OMB then works with the Presidents staff to combine all offices budgets into a single budget document. The President presents the budget to Congress in January or February. In Congress Congress will carefully look over the budget. (debates and modifies) Congressional Budget Office (CBO) gives Congress independent economic data to help with its decisions The Appropriations Committee for each house submits bills to authorize specific spending. In the White House Congress sends the appropriations bills to the President. The President can: Sign the bill into law Veto the bill Creating the Federal Budget Federal agencies (offices) send request for money to the Office of Management and Budget (OMB) The OMB works with the President to create a budget. In January or February, the President sends this budget to Congress Congress makes changes to the budget and sends this new budget to the President The President signs the budget into law The President vetoes the budget. If Congress cannot get a 2/3 majority to override the Presidents veto. Congress and the President must work together to create a new, compromise, budget The total level of government spending can be changed to help increase or decrease the output of the economy. Taxes can be raised or lowered to help increase or decrease the output of the economy. Fiscal policies that try to increase output are known as expansionary policies Fiscal policies intended to decrease output are called contractionary policies EXPANSIONARY FISCAL POLICIES CONTRACTIONARY FISCAL POLICIES The government uses expansionary fiscal policy to encourage growth, either when the economy is in a recession or to try to prevent a recession. Expansionary policies fall into either or both of two categories: 1. Increasing Government Spending Raises output and increases jobs Increases aggregate demand which causes prices to rise 2. Cutting Taxes If government cuts taxes, people have more money to spend Try to decrease aggregate demand. This will reduce the growth of economic output. The government tries to slow down the economy because fast-growing demand can exceed supply Fiscal policies aimed at slowing growth of total output generally fall into either or both of two categories: 1. Decreasing Government Spending If the government spends less, it triggers a chain of events that may lead to a slower GDP growth 2. Increasing taxes If the government raises taxes, individuals have less money to spend Flowchart of Effects of Expansionary Fiscal Policy In the short term, government spending leads to more jobs and more output Shops and restaurants buy more goods and hire more workers to meet their needs Workers and investors have more money and spend more in shops and restaurants Companies that sell goods to the government earn profits, which they use to pay their workers and investors more and to hire new workers To expand the economy, the government buys more goods and services. Difficulty of Changing Spending Levels Significant changes in federal spending generally must come from the small part of the federal budget that includes discretionary spending. This gives the government less leeway for increasing spending or lowering spending. Predicting the Future Lawmakers may put off making changes in fiscal policy until they know more about how the economy is performing. Delayed Results By time policies are put into place, the economy might be moving in the opposite directions. Political Pressures There are times when it is a re-election year; politicians must make decisions that benefit people who elect them, not necessarily decisions that are good for the overall economy Coordinating Fiscal Policy For fiscal policies to be effective, various branches and levels of government must plan and work together. (Example: state and local governments may be pursuing different goals for fiscal policy than the federal government) Section 2 The idea that free markets regulate themselves is known as classical economics. For more than a century, classical economics dominated economic theory and government policies. The Great Depression, challenged this theory. Prices fell, therefore, demand should have increased enough to stimulate production as consumers took advantages of low prices Instead, demand also fell as people lost their jobs and bank failures wiped out their savings. According to classical economics, the market should have reached equilibrium, with full employment The Great Depression highlighted a problem with classical economics: It did not address how long it would take for the market to return to equilibrium John Maynard Keynes developed a new theory of economics to explain the Depression. A Broader View Focused on the economy as a whole. Productivity capacity, often called full employment output can sustain over a period of time without increasing inflation A New Role for Government Government should be the spender Demand side economics, the idea that government spending and tax cuts help an economy by raising demand. Keynesian economics, is the idea that the economy is composed of three sectors individuals, business, and government and that the government actions can make up the changes in the other two Avoiding Recessions and Depressions The federal government should keep track of the total level of spending by consumers, businesses, and government in the economy Controlling Inflation Government can use a contractionary fiscal policy to prevent inflation or reduce its severity The Multiplier Effect The idea that every one dollar of government spending creates more than one dollar in economic activity Automatic Stabilizers A government program that changes automatically depending on the GDP and a persons income Keynesian Economics Output High Output Low Output Productive Capacity Business Spending Business Spending Consumer Spending Consumer Spending Government In a recession or depression, businesses and consumers do not demand as much as the economy can produce. Keynes argued that government spending can bring the economy up to its productive capacity. Supply-side economics, stresses the influence of taxation on the economy. Supply-siders believe that taxes have strong negative influences on economic input The heart of the supply-side argument is that a tax cut increases total employment so much that the government actually collects more in taxes at the new, lower tax rate. budget surplus: a situation in which budget revenues exceed expenditures budget deficit : a situation in which budget expenditures exceed revenues Treasury bill : a government bond with a maturity date of 26 weeks or less Treasury note : a government bond with a term of 2 to 10 years Treasury bond : a government bond that is issued with a term of 30 years national debt : the total amount of money the federal government owes to bondholders crowding-out effect : the loss of funds for private investment caused by government borrowing What are the effects of budget deficits and national debt? A budget deficit leads to an increase in the amount that the government has to borrow. As the government borrows more money, the national debt increases, which means there are fewer funds available for investing. The federal budget is the basic tool of fiscal policy. The budget is made up of two parts: Revenue taxes Expenditures spending programs When revenues and expenditures are equal, the budget is balanced. In reality, the federal budget is almost never balanced and it either runs a surplus or a deficit. In which of the years shown on the graph did the budget have a surplus? When the government runs a deficit it can respond by creating money or borrowing money. Creating money helps pay workers salaries and citizens benefits, which works for relatively small deficits. But this approach can cause problems like inflation or, in some cases, hyperinflation. The federal government usually responds to a deficit by borrowing money. The government usually borrows money by selling bonds. Savings bonds allow people to loan the government small amounts of money and, in return, they earn interest on the bonds for up to 30 years. Other common forms of government borrowing are Treasury bills, Treasury notes, and Treasury bonds. In 2008, the national debt exceeded $9.4 trillion. Since this number is so large and is difficult to analyze, the size of the national debt is best looked at as a percentage of the gross domestic product (GDP) over time. Why does the national debt as a percentage of GDP soar during times of war? A national debt reduces the funds available for businesses to invest because in order to sell its bonds the government must offer a high interest rate. Individuals and businesses thus buy these bonds instead of investing in private business, which is known as the crowding-out effect. The second problem with a high national debt is that government must pay interest to bondholders. Over time, these interest payments have become very large and the government must pay out this interest and cannot spend this money on other programs such as defense, healthcare, or infrastructure. Another possible problem is that the debt may be foreign-owned and some fear that foreign countries may use their bondholdings as a tool to extract favors from the United States. Some people, like traditional Keynesian economists, believe that the benefits of achieving full productive capacity outweigh the costs of interest on the national debt. In the short term, deficit spending may help create jobs and encourage economic growth. But a budget deficit can be an effective tool only if it is temporary. Gramm-Rudman-Hollings Act: Created automatic across-the-board cuts in federal expenditures if the deficit exceeded a certain amount. Many programs, however, were exempt from cuts. The Supreme Court found some parts of this Act to be unconstitutional. 1990 Budget Enforcement Act: Created a pay-as-you- go system that required Congress to raise enough revenue to cover increases in direct spending that would otherwise contribute to the budget deficit. A Constitutional amendment requiring a balanced budget has been suggested but it has yet to pass through Congress. In the late 1990s, the federal government actually ran a surplus. This surplus was the result of budget procedures that helped control government spending, tax increases under President Clinton, and a generally strong economy. The surplus of the late 1990s was short-lived. The end of the stock market boom, an economic slowdown, and a new federal income tax cut reduced federal revenues. The 9/11 attacks also added to the downturn in the economy. As a result, the federal government returned to deficit spending and we remain in a deficit today. 1 monetary policy : the actions that the Federal Reserve System takes to influence the level of real GDP and the rate of inflation in the economy reserves: deposits that a bank keeps readily available as opposed to lending them out reserve requirements : the amount of reserves that banks are required to keep on hand How is the Federal Reserve System organized? The Federal Reserve System has: A seven-member Board of Governors with one governor acting as the chair 12 District Reserve Banks 2600 member banks The Federal Reserve Systems most prominent task is to act as the main spokesperson for the countrys monetary policy. Monetary policy refers to the actions that the Fed takes to influence the level of real GDP and the rate of inflation in the economy. The role of a central bank in the U.S. economy has been hotly debated for many centuries. The First Bank of the United States, which issued a single currency and reviewed banking practices, only lasted until 1811, when Congress refused to extend its charter. The Second Bank of the United States was established in 1816 to restore order to the monetary system. It lasted until 1836, when its charter expired. A period of chaos and confusion followed. Reserve requirements were difficult to enforce among the various state and federal chartered banks. The Panic of 1907 finally convinced Congress to act. The nations banking system needed to address two issues: Greater access to funds A source of emergency cash to prevent bank runs The Federal Reserve Act of 1913 attempted to solve these problems. This Act created the Federal Reserve System, which consists of 12 banks that can lend money to other banks in times of need. In 1935, Congress adjusted the Federal Reserve so that it could respond more effectively to future crises. The new Fed enjoyed a more centralized power so that the regional banks were able to act consistently with one another while still representing their own districts banking concerns. The Federal Reserve System is overseen by the Board of Governors of the Federal Reserve. This seven-member board is appointed by the President with the advice and consent of the Senate. The President also appoints the chair of the Board of Governors from among these seven members. Recent chairs have been economists from business, the academic world, or government. Alan Greenspan, a former economics professor and head of the Presidents Council of Economic Advisors has been the most notable chair of modern times. Ben Bernanke, the head of the CEA and former economics professor as well, became chair in 2006, when Greenspan stepped down. The Federal Reserve Act divided the United States into 12 Federal District - one Federal Reserve Banks is located in each district. Each district is made up of more than one state and Congress regulates the makeup of each Reserve Banks board of nine directors to make sure it represents many interests. All nationally chartered banks are required to join the Federal Reserve System. State-chartered banks join voluntarily. All banks have equal access to Fed services whether or not they are Fed members. Each of the 2,600 member banks contributes a small amount of money to join the system, which means the banks themselves own the Fed, keeping the system politically independent. About 40 percent of all United States banks belong to the Federal Reserve. The Federal Open Market Committee (FOMC) makes key monetary policy decisions about interest rates and the growth of the United States money supply. FOMCs decisions can affect financial markets and rates for mortgages as well as many economic institutions around the world. FOMC members include: All 7 members of the Board of Governors 5 of the 12 district bank presidents President of the New York Federal Reserve Bank The six other district bank presidents who serve one-year terms on a rotating basis check clearing : the process by which banks record whose account gives up money and whose account receives money when a customer writes a check bank holding company: a company that owns more than one bank federal funds rate : the interest rate that banks charge each other for loans discount rate : the interest rate that the Federal Reserve charges commercial banks for loans What does the Federal Reserve do? The Federal Reserve: Serves as banker and financial agent for the U.S. government Issues currency Clears checks Supervises lending practices Acts as a lender of last resort Regulates the banking system through reserve requirements and bank examinations Regulates the money supply Among the most important functions of the Fed is to provide banking and fiscal services to the federal government. The U.S. government pays out about $1.2 trillion each year to support social insurance programs. To handle its banking needs when dealing with such large sums, the federal government turns to the Federal Reserve. The Fed also sells, transfers, and redeems securities, such as government bonds, bills, and notes. Under the Federal Reserve System, only the federal government can issue currency, which takes place at the United States Mint. The Feds most visible function is its check-clearing responsibilities. The Fed can clear millions of checks at any one time using high-speed equipment. Most checks clear within two days. How long does it take most checks to clear? To ensure stability, the Federal Reserve monitors bank reserves throughout the banking system. The Fed Board studies proposed bank mergers and bank holding company charters to ensure competition in banking and financial industries. The Fed also protects consumers by enforcing truth-in-lending laws, which require sellers to provide full and accurate information about loan terms. Banks lend each other money on a day-to-day basis, using money from their reserve balances. Banks can also borrow money from the Fed. They do this routinely and especially during financial emergencies. The Fed acts as a lender of last resort, making emergency loans to commercial banks so that they can maintain required reserves. The Fed coordinate the regulating activities of banks, savings and loan companies, credit unions, and bank holding companies. Each financial institution that holds deposits for customers must report daily to the Fed about its reserves and activities. The Fed uses these reserves to control how much money is in circulation at any one time. The Fed and other regulatory agencies also examine banks periodically to make sure that each institution is obeying laws and regulations. Bank examiners can force banks to sell risky investments or to declare loans that will not be repaid as losses. They can also classify an institution as a problem bank and force it to undergo more frequent examinations. The Federal Reserve is best known for its role in regulating the nations money supply. The Feds job is to consider various measures of the money supply and compare those figures with the likely demand for money. The more money held as cash, the easier it is to make economic transactions. But, as interest rates rise, people and firms will generally keep their wealth in assets that pay returns. The general level of income also influences money demand. Too much money in the economy leads to inflation. It is the Feds job to prevent this by keeping the money supply stable. In an ideal world, where real GDP grew smoothly and the economy stayed at full employment, the Fed would increase the money supply just to match the growth in the demand for money. Chapter 16 Section 3 The Department of Treasury is responsible for manufacturing money. The Federal Reserve is responsible for putting the dollars into circulation. The process is called money creation, and it is carried out by the Fed and by banks all around the country. Banks create money not by printing it, but by simply going about their business. Banks make most money by charging interests on loans The amount that the bank is allowed to lend is determined by the required reserve ratio (RRR), the fraction of the deposit that must be kept on reserve Money Creation $1,000+$900+$810=$2,710 You deposit $1,000 into your checking account Your $1,000 deposit minus $100 in reserves is loaned to Mike, who gives it to Mary Marys $900 deposit minus $90 in reserves is loaned to another customer At this point, the money supply has increased to $2,710 $100 held in reserve $900 available for loans $90 held in reserve $810 available for loans The amount of money that will be created, is given by the money multiplier formula, which is calculated as 1 RRR. The money multiplier tells us how much money will increase after an initial cash deposit to the banking system. To apply the formula: Initial cash deposit X 1. RRR Example, the RRR is.01, so the money multiplier is 1 .01 = 10. This means that the deposit of $1,000 leads to a $10,000 increase in the money supply Banks will sometimes hold excess reserves, which are reserves greater than the required amount. Ensures that the banks will always be able to meet the customers demands and the Feds requirements Reducing Reserve Requirement A reduction of the RRR would free up reserves for banks, allowing them to make more loans. It would also increase the money multiplier. Both effects would lead to a substantial increase in the money supply Increasing Reserve Requirements A slight increase in the RRR would force banks to hold more money in reserves. This would cause the money supply to shrink, or contract. A small increase in the RRR would force banks to call in a significant number or loans, that is, require the borrower to pay the entire outstanding balance of the loan. The simplest way for the Fed to adjust the amount of reserves in the banking system is to change the required reserve ratio. It is not, however, the tool most used by the Fed. The Fed rarely changes reserve requirements. Money Supply Banks reduce lending, causing the money supply to contract Reserve Requirements Reserve Requirement An increase in reserve requirement causes banks to increase reserves. Money Supply Banks increase lending, causing the money supply to expand Reserve Requirement A reduction in reserve requirements causes banks to decrease reserves Changes in the discount rate affect the cost of borrowing from the Fed. In turn, changes in the discount rate can affect the prime rate The prime rate is the rate of interest banks charge on short-tem loans to their best customers usually large companies with good credit ratings. Changes in the discount rate are reflects in the prime rate. Discount Rate An increase in the discount rate makes banks less willing to borrow from the Fed. Money Supply Banks reduce lending in order to build reserves, causing the money supply to contract. Money Supply Banks increase lending, causing the money supply to expand Discount Rate A decrease in the discount rate makes banks more willing to borrow from the fed Discount Rate The most important monetary policy tool is open market operations. Open market operations are the buying and selling of government securities to alter the supply of money. Bonds Circulating Through bond sales, the Fed removes reserves from the banking system Money Supply Banks reduce lending, causing the money supply to contract Money Supply Banks increase lending, causing the money supply to expand Bonds Circulating The Feds purchase of bonds increases reserves in the banking system Open market operations are the most used of the Federal Reserves monetary policy tools. The Fed changes the discount rate less frequently. Today, the Fed does not change reserve requirements to conduct monetary policy. Changing reserve requirements would force banks to make drastic changes in their plans. The Federal Reserve uses these monetary policy tools to adjust the money supply. Chapter 16 Section 4 Monetarism is the belief that they money supply is the most important factor in macroeconomic performance. The Money Supply and Interest Rates The cost the price that a borrower pays is the interest rate. The interest rate is always the cost of money The market for money is like any other market. If the supply is higher, the price the interest rate is lower. If the supply is lower, the price the interest rate is higher Interest Rates and Spending Lower interest rates encourage greater investment spending by business firms. If the macroeconomy is experiencing a contraction declining income the Fed may want to stimulate it, or expand it. They will follow an easy money supply, it will increase the money supply. An increased money supply will lower interest rates, thus encouraging investment spending. If the economy is experiencing a rapid expansion that may cause high inflation, the Fed may introduce a tight money policy. That is, it will reduce the money supply. Effects of Monetary Policy Money Supply Interest Rate Aggregate Demand Interest Rate Money Supply Real GDP Aggregate Demand Real GDP GOOD TIMING BAD TIMING Monetary policy, like fiscal policy, must be carefully timed if it is to help the macroeconomy. If policies are enacted at the wrong time, they could actually intensify the business cycle, rather than smooth it out. Real GDP Time Business Cycle Business Cycle with properly timed stabilization policy The green curve, which shows greater fluctuations, is the business cycle. The goal of stabilization policy is to smooth out those fluctuations to make the peaks a little bit lower and the troughs not quite as deep. Proper timed stabilization policy smooths out the business cycle, the red line. Real GDP Time Business Cycle Business Cycle with poorly timed stabilization policy If stabilization policy is not timed properly it can actually make the business cycle worse, not better. INSIDE LAGSOUTSIDE LAGS The inside lags are delays in implementing policy. These lags occur for two reasons: 1. Economist cannot know for sure that the economy is headed into a new business cycles, despite computer models 2. Once a problem is recognized, it can take additional time to enact policies Outside lag, the time it takes for monetary policy to have an effect; differs for fiscal and monetary policy Fiscal policy, the outside lag lasts as long as is required for new government spending or tax policies to take effect and begin to affect real GDP and inflation rate Much longer for monetary policy, since they primarily affect business investment plans Monetary Policy and Inflation Fiscal Policy ToolsMonetary policy tools Expansionary tools1.Increasing government spending 2.Cutting taxes 1.Open market operations: bond purchases 2.Decreasing the discount rate 3.Decreasing reserve requirements Contractionary Tools1.Decreasing government spending 2.Raising taxes 1.Open market operations: bond sales 2.Increasing the discount rate 3.Increasing reserve requirements