Chapters 15 & 16

• TWO TOOLS: • Fiscal & Monetary Policy

• What’s the difference?• Fiscal Policy = Taxing & Spending

• Monetary Policy = manipulating the money supply

• FISCAL POLICY = The Budget:• The use of government spending and revenue collection to influence the economy

• Fed. government regulating taxes & spending – Public control

• The federal government makes key fiscal policy decisions each year when it establishes the budget.

• Taxing & Spending & Borrowing• By Congress & P (although Constitution gives Congress the most economic power)

• The federal government prepares a new budget for every fiscal year, from Oct. 1 to Sept. 30.• Who takes the first step in the

budget process?

1

2

3

4

• Expand or slow economic growth• Achieve full employment• Maintain price stability

• Expansionary policy: used to encourage economic growth, often through increased spending or tax cuts

• Contractionary policy: used to reduce economic growth, often through decreased spending or higher taxes

• Governments use expansionary fiscal policy to encourage growth -- either to prevent a recession or to move the economy out of a recession.

• This involveseither increasing government spending or cutting taxes, or both.

• Contractionary fiscal policy tries to decrease demand, and in doing so, reduce the growth of economic output.

• Why would the government deliberately slow down economic output?• Because fast growing demand can exceed supply.

• If producers cannot expand production to keep up with increasing demand, they will raise prices, which causes inflation.

• Fiscal policy can be difficult to practice.Fiscal policy can be difficult to practice.• Cumbersome, difficult task to increase or decrease the amount of federal spending.

• Entitlement programs make up the bulk of the budget.

• CHANGES TAKE TIME! • By the time the effects are felt, the economy might be moving in a different direction.

• Government officials want to get re-elected!• Makes it hard to always do what’s best for the economy

• CLASSICAL ECONOMICS.• Adam Smith• Free markets regulate themselves

• BUT, this idea challenged by the Great Depression since the economy was unable to regulate itself, which led to high unemployment and massive bank failures.

• Major problem is that this idea doesn’t address how long it would take for the market to return to equilibrium.

• British economist John Maynard Keynes - a new theory to explain the Depression.• Keynes argued that the Depression was continuing because neither consumers nor businesses had an incentive to spend enough to increase production.

• So… the only way to end the Depression, would be to find a way to boost demand.

• Government should step in and spend more money in order to boost demand.• The government could make up for the drop in private spending by buying goods and services on its own.

Demand-sideEconomics

• Keynes argued that fiscal policy can be used to fight periods of recession:• If consumer spending drops, government should respond by dropping its own spending until consumer spending goes back up.

• OR it can cut taxes so that spending and investment by consumers and businesses increases.

• Keynes also argued that the government can reduce inflation either by increasing taxes or by reducing its own spending.

• Based on the idea that the supply of goods drives the economy.

• Supply-side economists believe that taxes have a strong negative impact on economic output.

• Argument is that a tax cut increases total employment so much that the government actually collects more in taxes at the new, lower rate.

• Fiscal Policy History:• In the 1940s – spending up or down?

• Did Keynesian economics work?• Economy’s condition between 1945 and 1960?• JFK & LBJ?• Ronald Reagan – 1980s?

• Liberal theory – KEYNESIAN • John Maynard Keynes• Government as active

participant• spend $ to stimulate

demand & help a lagging economy

• Deficit spending not a problem

• Other followers of Keynesian theory?

• Conservative theory – SUPPLY-SIDE ECONOMICS• Decrease government’s involvement

• Big government taxes too heavily, spends too freely, regulates too tightly, and thereby actually curbs economic growth

• Stimulate supply of goods so cost of goods declines

• Greater production accomplished through tax cuts & spending cuts on social programs

• Budget surplus = a situation in which budget revenues exceed expenditures

• Budget deficit =Budget deficit = a situation in which budget expenditures exceed revenues

• National debt = the total amount of money the federal government owes to bondholders

• Effects of budget deficits on the 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 basically consists of two parts:

– Revenue—taxes– Expenditures—spending programs

• When revenues and expenditures are = the budget is balanced.

• How often do you think the budget is actually balanced?– Almost never balanced; it either runs a surplus or a deficit.

• How does the federal government usually respond to a budget deficit?– By borrowing money.– From who?– Why doesn’t it just create new money?

• The deficit is the difference between expenditures and revenues in one year.• So … it will equal the amount of money the

government borrows for one fiscal year• The debt is the sum of all government borrowing

before that time (minus the borrowing that has already been repaid)

• So… every year that there is a budget deficit, the federal government borrows money to cover it and the national debt then increases.

• Current National Debt?

• #1 - Reduces the funds available for businesses to invest because in order to sell its bonds the government must offer a high interest rate. • So… individuals and businesses buy these bonds instead of investing in private business - known as the crowding-out effect.

• #2 - Government must pay interest to bondholders.• Over time, these interest

payments have become very large• The government must pay out this

interest and cannot spend this money on other programs such as defense, healthcare, or infrastructure.

• #3 - The debt may be foreign-owned• Causes a fear that foreign

countries may use their bondholdings as a tool to extract favors from the United States.

• A deficit causes federal government to borrow $ (bonds)• Interest paid on bonds is now part of federal budget• Economic downturns, external shocks, like

Hurricane Sandy, can lead to more borrowing• More borrowing makes interest payments a

larger piece of federal budget• The more interest that has to be paid, the

more the government has to borrow

• Managed by the Federal Reserve Board Federal Reserve Board (1913)(1913)

• Board of Governors appointed by P and confirmed by Senate & serve 14-yr. terms – why such long terms?

• insulation from political pressure

• Acts independently of government & regulates monetary policy in 3 ways

1. Manipulating the interest rate at which loans are given

2. Manipulating the amount of reserves --- $ banks must have available

3. Manipulates the money supply with bond sales/purchases

Manipulating the Money Supply

STRUCTURE OF THE FED

Owned by member banks-all national banks-some state banks

Board of Governors – 7 members-appointed by P & approved by Senate-14 year terms, staggered

Federal Open Market Committee-money supply & interest rates-12 voting members meet 8 x year

Federal Advisory Council-gives advice on overall economic health

Twelve Districts with Directors/Presidents

-but supervised by Fed in DC

ChairpersonJanet Yellen

The Federal Reserve System

It’s all about:

MONETARY POLICY:

Money supply

Interest rates

Reserve requirements

Margin requirementsA main role of the FED is to keep up consumer confidence in the banking system!

The Federal Reserve System

Responsibilities of the Fed

FED

REGULATE BANKS•Approve mergers•Enforce truth-in-lending laws•Examine Banks•SET RESERVE & MARGIN REQUIREMENTS

• SERVE BANKS

• Check clearing

• Lender of last resort

• SERVE GOVERNMENT• Issuing Currency &

Storing Cash• Selling, transferring,

redeeming gov’t securities

• Treasury Dept. Checking Account

• REGULATE $ SUPPLY

• Adjust money supply to stabilize the economy

• The Fed’s most visible function is its check-clearing responsibilities.

• The Fed can clear millions of checks at any one time using high-speed equipment.

How long does it take most checks to clear?

• Gold reserves in the Federal Reserve Bank of New York

Federal Reserve vaults in Dallas

Federal Open Market Committee & Money Supply

Government sells bonds - Money flows to the treasury - reduces the money supply in circulation

Government redeems (buys back) bonds - Money flows out of the treasury - increases the money supply

Fractional Reserve System & Money Supply

Allows the Fed to control the growth of the money supply.

A percentage of each deposit into a bank account must be kept in the bank. The remainder can be loaned out.

The Fed determines the percentage – called the reserve requirement

•A higher reserve fraction results in less monetary expansion

•A lower reserve fraction results in more monetary expansion

Formula: Deposit x 1 divided by RR = increased money supply

$50,000