(LSCS) Chapter 13: Fiscal Policy, Deficits, and Debt (HAND-OUTS) (HCCS) Chapter 11: Fiscal Policy and the Federal Budget � Fiscal policy is the use of government expenditure and revenue collection to influence the economy. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy such as

1) Aggregate demand, national production and the general price levels; 2) The pattern of resource allocation of factor inputs used in production and labor productivity; 3) The distribution of income, personal savings and social safety net programs, etc.

� Fiscal policy refers to the overall effect of the budget outcome on economic activity. The three possible stances of fiscal policy are:

1) A neutral stance of fiscal policy implies a balanced budget where G = T (Government Spending = Tax Revenue). 2) An expansionary stance of fiscal policy involves a net increase in government spending (G > T) through rises in

government spending, a fall in taxation revenue, or a combination of the two. This will lead to a larger budget deficit or a smaller budget surplus than the government previously had, or a deficit if the government previously had a balanced budget. Expansionary fiscal policy is usually associated with a budget deficit. This policy is mainly used to combat an unusual high level of unemployment or a recession.

3) A contractionary stance (G < T) occurs when net government spending is reduced either through higher taxation revenue, reduced government spending, or a combination of the two. This would lead to a lower budget deficit or a larger surplus than the government previously had, or a surplus if the government previously had a balanced budget. Contractionary fiscal policy is usually associated with a surplus. This policy is mainly used to eliminate the pending upward pressure on the general price level.

� The idea of using fiscal policy to combat recessions was introduced by John Maynard Keynes in the 1930s, partly as a response to the Great Depression. Governments spend money on a wide variety of things, from the military and police to services like education and healthcare, as well as transfer payments such as welfare benefits. This expenditure can be funded in a number of different ways:

1) Taxation (which will cut back private spending by firms and households) 2) Seigniorage, the benefit from printing money (which will cause inflation) 3) Borrowing money from the population, resulting in a fiscal deficit (which will push up interest rates) 4) Consumption of fiscal reserves 5) Sale of fixed assets (e.g., land).

� A fiscal deficit is often funded by issuing government bonds. These pay interest, either for a fixed period or indefinitely. If the interest and capital repayments are too large, a nation may default on its debts, which in turn, could bankrupt the whole country. Governments use fiscal policy to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment, and economic growth.

� Keynesian economics suggests that by running a budget deficit (by increasing government spending and decreasing tax rates) is the best ways to stimulate aggregate demand during a downturn. This can be used in times of recession or low economic activity as an essential tool for building the framework for strong economic growth and working towards full employment. In theory, the resulting deficits would be paid for by an expanded economy during the boom that would follow; thus, the budget eventually will be balanced.

� On the other hand, during an upturn in a business cycle, governments can use budget surplus to do two things: to slow the pace of strong economic growth, and to stabilize prices when inflation is too high. Keynesian theory posits that removing funds from the economy will reduce levels of aggregate demand and contract the economy, thus stabilizing prices or eliminate the threat of price inflation.

� Moreover, government spending could cause the interest rate to increase which potentially crowds out private spending by firms and households. If the increase in government spending is financed by a tax increase, the tax increase would tend to reduce private consumption. If instead the increase in government spending is not accompanied by a tax increase, government borrowing to finance the increased government spending would increase interest rates, leading to a reduction in private investment. Either way results in a lesser level of aggregate demand which, in turn, could cause a slowdown in the economy. Last, some classical and neoclassical economists, monetarists among other schools of thoughts argue that fiscal policy can have no stimulus effect on the economy.

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Source: http://en.wikipedia.org/wiki/Fiscal_policy,2010.

Notes: The following essays, illustrations and contents are copied directly from the Internet address http://welkerswikinomics.wetpaint.com (with the entries “Fiscal Policy and the AD/AS Model” and “Applying the extended AD/AS Model”) for general educational purposes ONLY. Date: 3/17/2012 ___________________________________________________________________________________________

Fiscal Policy and the AD/AS Model Notations used in this note: price level = Price Level; FE = full employment; r = real or current or actual; DI = disposable income

Fiscal Policy: Changes in Government Spending or/and Tax collections to (1) stimulate economy or (2) control inflation • Discretionary (active): Changes in Government Spending and Taxes are dependent on the Federal Government. • Non-Discretionary (passive/automatic): Changes are not initiated through congressional action.

Aims: • Full Employment. • Control inflation. • Encourage Economic Growth.

The following fiscal policies defined here are discretionary, meaning they are at the option of the Federal government, often the Council of Economic Advisers (CEA). Expansionary fiscal policy: helps an economy out of recession and to reduce unemployment • Increase government spending (the most direct method)

o before the government spending increase : GDP↓, P ↓ o after the increase in government spending : G ↑ → AD ↑ → GDP ↑, P ↑, Unemployment ↓

• Tax reduction o before the tax reduction : GDP↓, P ↓ o after the tax reduction : T ↓ → DI ↑→ C↑→ AD ↑ → GDP ↑, P ↑, Unemployment ↓

• Combination of both to achieve greater effects, but by themselves, government spending leads to a higher level of GDP.

Result: Expansionary Fiscal Policy creates budget deficit (Government Spending > Tax Revenues), thus, shifting the graph to the right.

Contractionary fiscal policy: reduces demand-pull inflation (demand shifts out so P increase, Real GDP increase), usually applied when the economy is experiencing over-employment). Designed to deal with inflation.

• Increase tax o before the tax increase : P↑, Real GDP ↑ o after the tax increase : T ↑ → DI ↓ --> C↓ → AD ↓ → GDP ↓, P ↓, Unemployment ↑

• Decrease government spending o before the government spending: P↑, Real GDP ↑ o after the government spending: G ↓ → AD ↓ → GDP ↓, P ↓, Unemployment ↑

• Combination of both to achieve greater effects

Result: Contractionary Fiscal Policy creates budget surplus (Tax Revenues > Government Spending), thus, shifting the graph to the left. Applying the Extended AD/AS Model

Demand-pull inflation

• Demand-pull inflation occurs when demand for goods and services exceeds existing supplies. • Occurs when an outward shift in AD pulls up the price level as a result of excessive demand. • Increase in output beyond the full-employment causes inflation • Increase in AD (can be caused by any changes in the AD determinants of C, I, G, and Xn) drives up price level

and increases output in the short run, but in the long run nominal wages increase as workers demand higher wages to keep up with the increase in price and the SRAS curve shifts left. Thus, output returns to full employment and inflation occurs. Increase in AD drives up price level and increases output in the short run, but in the long run nominal wages increase and the SRAS curve shifts left.

• AD shifts rifht -->price level ↑ --> real GDP↑ (short run) --> nominal wages ↑ --> SRAS shifts left --> real GDP returns (to its prior level), price level↑

• In the long run, there is no growth in real domestic output. Instead, output remains the same but price level increases!

Cost-push inflation • This Occurs when producers raise prices to meet increased input costs. • Increase in the per-unit production costs shifts the AS curve to the left, thereby creating cost-push inflation • Leftward shift of AS curve is the initiating cause of price level increase • Chief cause of Stagflation: increased unemployment and inflation, combined.

� This is the hardest economic problem to combat

• If government tries to stay at full employment during cost-push inflation, an inflationary spiral may occur • If government takes a hands-off approach to cost-push inflation, a recession will occur. Although the recession

will eventually undo the initial rise in per-unit production cost, the economy will experience high unemployment and loss of output and it is uncertain how long it will take for the economy to self-correct.

• If the government tries to resolve Unemployment, then inflation will rise. If the government attempts to resolve inflation, then they face higher unemployment. (Phillips Curve illustrates this!)

• Short run AS shifts in: o Option 1. Government spends AD ↑ --> price level rises more --> inflation o Option 2. Government allows recession --> nominal wages ↓ --> AS shifts back to original

Recession

• Recession caused by decreases in AD • **Assumption: prices and wages are flexible downward • The gist of what the U.S is experiencing: recession caused by decrease in spending. • AD shifts left --> price level ↓ --> nominal wages ↓ --> AS shifts right --> price level ↓ --> real GDP ↑ (to

original) • There is dispute about this scenario because people wonder how long it would take in the real world for the

necessary downward price and wage adjustments to occur to go back to full employment • Economists agreeing with the economic theories of Keynesian recommend active monetary or fiscal policy to

fight recessions, rather than leaving it until it self corrects.

(LSCS) Chapter 16: Interest Rates and Monetary Policy (HAND-OUTS) Recommended: Chapters (14: Money, Banking, and Financial Institutions) – (15: Money Creation) (HCCS) Chapter 15: Monetary Policy Recommended: Chapters (12: Money, Banking, and the Financial System) – (14: Money and the Economy)

� Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest to attain a set of objectives oriented towards the growth and stability of the economy. Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (to achieve policy goals).

� U.S. monetary policy affects all kinds of economic and financial decisions people make in this country—whether to get a loan to buy a new house or car or to start up a company, whether to expand a business by investing in a new plant or equipment, and whether to put savings in a bank, in bonds, or in the stock market, for example. Monetary policy is conducted by the Federal Reserve System (a.k.a. The Fed), the nation’s central bank, and it influences demand mainly by raising and lowering short-term interest rates.

� In the long run, the amount of goods and services the economy produces (output) and the number of jobs it generates (employment) both depend on factors other than monetary policy. These factors include technology and people’s preferences for saving, risk, and work effort. So, maximum sustainable output and employment mean the levels consistent with these factors in the long run. But the economy goes through business cycles in which output and employment are above or below their long-run levels. Even though monetary policy can’t affect either output or employment in the long run, it can affect them in the short run. For example, when demand weakens and there’s a recession, the Fed can stimulate the economy—temporarily—and help push it back toward its long-run level of output by lowering interest rates. That’s why stabilizing the economy—that is, smoothing out the peaks and valleys in output and employment around their long-run growth paths—is a key short-run objective for the Fed and many other central banks.

� For the most part, the demand for goods and services is not related to the market interest rates quoted in the financial pages of newspapers, known as nominal rates. Instead, it is related to real interest rates—that is, nominal interest rates minus the expected rate of inflation. For example, a borrower is likely to feel a lot happier about a car loan at 8% when the inflation rate is close to 10% (as it was in the late 1970s) than when the inflation rate is close to 2% (as it was in the late 1990s). In the first case, the real (or inflation-adjusted) value of the money that the borrower would pay back would actually be lower than the real value of the money when it was borrowed. Borrowers, of course, would love this situation, while lenders would be disinclined to make any loans.

� The object of monetary policy is to influence the performance of the economy as reflected in such factors as inflation, economic output, and employment. It works by affecting demand across the economy—that is, people’s and firms’ willingness to spend on goods and services.

� The Fed can’t control inflation or influence output and employment directly; instead, it affects them indirectly, mainly by raising or lowering a short-term interest rate called the “federal funds” rate. Most often, it does this through open market operations in the market for bank reserves, known as the federal funds market. The interest rate on the overnight borrowing of reserves is called the federal funds rate or simply the “funds rate.” It adjusts to balance the supply of and demand for reserves. For example, if the supply of reserves in the fed funds market is greater than the demand for reserves, then the funds rate falls, and if the supply is less than the demand, then the funds rate rises.

� The major tool the Fed uses to affect the supply of reserves in the banking system is open market operations—that is, the Fed buys and sells government securities on the open market. These operations are conducted by the Federal Reserve Bank of New York. Suppose the Fed wants the funds rate to fall. To do this, it buys government securities from a bank. The Fed then pays for the securities by increasing that bank’s reserves. As a result, the bank now has more reserves than it wants. So the bank can lend these unwanted reserves to another bank in the federal funds market. Thus, the Fed’s open market purchase increases the supply of reserves to the banking system, and the federal funds rate falls. When the Fed wants the funds rate to rise, it does the reverse, that is, it sells government securities. The Fed receives payment in reserves from banks, which lowers the supply of reserves in the banking system, and the funds rate rises.

Sources: 1) U.S. Monetary Policy; Federal Reserve Bank of San Francisco / 2004. 2) http://en.wikipedia.org/wiki/Monetary Policy; 2010.

What is the federal funds rate, and why does the Federal Open Market Committee (FOMC) raise or lower the target rate? The federal funds rate is the rate charged by one depository institution on an overnight sale of immediately available funds (balances at the Federal Reserve) to another depository institution; the rate may vary from depository institution to depository institution and from day to day. The target federal funds rate is set by the Federal Open Market Committee (FOMC). By setting a target federal funds rate and using the tools of monetary policy--open market operations, discount window lending, and reserve requirements--to achieve that target rate, the Federal Reserve and the FOMC seek "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates," as required by the Federal Reserve Act.

At each of its meeting, the FOMC examines a number of indicators of current and prospective economic developments. Then, cognizant that its actions affect economic activity with a lag, it must decide whether to alter its target for the federal funds rate. An actual decline in the rate stimulates economic growth, but an excessively high level of economic activity can cause inflation pressures to build to a point that ultimately undermines the sustainability of an economic expansion. An actual rise in the rate curbs economic growth and helps contain inflation pressures, and thus can promote the sustainability of an economic expansion; too great a rise, however, can retard economic growth too much. The FOMC's actions on the target federal funds rate are undertaken to achieve the maximum rate of economic growth consistent with price stability and moderate long-term interest rates.

What are the historical changes in the target federal funds rate? The Federal Reserve's objective in using the tools of monetary policy may be a desired quantity of reserves or a desired price of reserves--the federal funds rate. During the 1980s, the approach gradually changed from seeking a desired quantity of reserves toward attaining a specified level of the federal funds rate, a process that was largely complete by the end of the decade. In 1995, the FOMC began announcing its target level for the federal funds rate. Historical changes in the target federal funds rate.

What is the money stock, and how does the Federal Reserve influence it? Generally, the money stock consists of currency held by the public; transaction, savings, and time deposits held by the public at depository institutions; the assets of money market mutual funds; and certain other depository institution liabilities. The Federal Reserve affects the money stock chiefly by its influence over interest rates. When the Federal Open Market Committee lowers the target federal funds rate, the rate at which depository institutions purchase and sell overnight funds to one another in the market falls, and so do other short-term interest rates. Lower short-term market interest rates increase the attractiveness of the rates paid on deposits at commercial banks and other depository institutions because changes in these rates tend to lag changes in market rates. Consequently, the public tends to purchase the assets included in the money stock, and money growth increases. Conversely, when the FOMC raises the target federal funds rate, the federal funds rate increases, as do other short-term interest rates. The rates paid on assets included in the money stock become less attractive, and money growth slows.

What is the discount rate? The discount rate is the interest rate that an eligible depository institution is charged to borrow funds, typically for a short period, directly from a Federal Reserve Bank. By law, the board of directors of each Reserve Bank sets the discount rate independently every fourteen days subject to the approval of the Board of Governors. Originally, each Reserve Bank set its discount rate to reflect the banking and credit conditions in its own District. Over the years, the transition from regional credit markets to a national credit market has gradually produced a national discount rate. As a result, the Federal Reserve maintains a uniform structure of discount rates across all Reserve Banks.

How does the Federal Reserve maintain the stability of the financial system? The Federal Reserve's roles in conducting monetary policy, supervising banks, and providing payment services to depository institutions help it maintain the stability of the financial system.

Using the monetary policy tools at its disposal, the Federal Reserve can promote an environment of price stability and reasonably damped fluctuations in overall economic activity that helps foster the health and stability of financial institutions and markets. The Federal Reserve also helps foster financial stability through the supervision and regulation of several types of banking organizations to ensure their safety and soundness. In addition, the Federal Reserve operates certain key payment mechanisms and oversees the operation of the payment system more generally, with the goal of strengthening and stabilizing the system.

The Federal Reserve engages in all these activities on a routine basis, but the stabilization activities of a central bank are especially evident and critical during periods of financial stress, such as those that occurred following the stock market decline of October 1987, the international debt crisis in the fall of 1998, and the terrorist attacks in September 2001. In these instances, the Federal Reserve promoted financial system stability by providing ample liquidity (balances at the

Federal Reserve) through large open market purchases of securities (using short-term repurchase agreements) and by extending discount window loans to depository institutions.

Source: The Federal Reserve Board, 2010; http://www.federalreserve.gov/generalinfo/faq/faqmpo.htm

The Foundation of Monetary Policy: The Quantity Theory of Money

A Summary of How Monetary Policy Works