Economic Policy. Learning Objectives: Economic Policy We will discuss American Economic Policy by looking at: –Fiscal and Monetary Policy –Federal Reserve

Economic PolicyEconomic Policy

Learning Objectives: Economic Policy

• We will discuss American Economic Policy by looking at:– Fiscal and Monetary Policy

– Federal Reserve System

– Budgeting – Taxing and Spending

– Debt and Deficits

– Goals of Fiscal Policy

– Trade Issues – Globalization, Balance of Payments, Protectionism

Key Terms: Economic PolicyKey Terms: Economic Policy• Fiscal Policy• Monetary Policy• Supply-Side Economics• Keynesianism• Chicago School• Laffer Curve• Federal Reserve System • Income Taxes• Sales Taxes• Property Taxes• Debt• Deficits• Globalization• Balance of Payments• Protectionism• Free Trade• Office of Management and Budget• Congressional Budget Office

•Regressive Taxes•Progressive Taxes•Quantity Theory of Money•GATT•NAFTA•WTO•FTAA•Discount Rate•Prime Rate•“It’s the Economy, Stupid…”•“Sin” Taxes•Inflation•Hyperinflation•Stagflation•Unemployment•“Black Budget”•Counter-Cyclical Policy•Gross Domestic Product (GDP)

What Government Does: Budgeting, Taxation, and Fiscal Policy

• Generally, the U.S. Government’s Generally, the U.S. Government’s involvement in the economy is three-fold:involvement in the economy is three-fold:

• To engage in To engage in Economic ManagementEconomic Management• To ensure To ensure Economic StabilityEconomic Stability• To provide a To provide a Legal Enforcement StructureLegal Enforcement Structure

What Government Does: Budgeting, Taxation, and Fiscal Policy

• Economic PolicyEconomic Policy– GoalsGoals

• Economic growthEconomic growth

• Low unemploymentLow unemployment

• Price stabilityPrice stability

• Positive balance of paymentsPositive balance of payments

• Minimizing diseconomiesMinimizing diseconomies

• Supporting key economic sectorsSupporting key economic sectors

Economic Policy

• Principal Economic Policy Perspectives in the U.S.:Principal Economic Policy Perspectives in the U.S.:• Keynesianism – Keynesianism – Liberal

– Manipulation of government spending/taxing to impact the economy

• Monetarism – Monetarism – Conservative

– Manipulation of the money supply to impact the economy

• Supply-Side – Newer conservative view Supply-Side – Newer conservative view

– Belief that tax cuts stimulate the economy and increase Belief that tax cuts stimulate the economy and increase government revenues over timegovernment revenues over time

Economic Policy

• Economic Policy ToolsEconomic Policy Tools– Fiscal policyFiscal policy

• TaxesTaxes

• SpendingSpending

• Deficits/DebtDeficits/Debt

– Monetary policy Monetary policy • The Federal Reserve BoardThe Federal Reserve Board

Fiscal and Monetary PolicyFiscal and Monetary Policy

Fiscal Policy Defined

• Fiscal policy is any government action that affects govt. spending or revenue.

• John Maynard Keynes provided the rationale for the use of fiscal policy to stabilise economic growth.

• Active use of fiscal policy was popular with governments from the 1950s to mid-1970s.

Fiscal Policy Defined

• If government revenue > government spending = Government budget surplus.

• If government revenue < government spending = Government budget deficit.

• Are deficits bad or are surpluses good?

How Does Fiscal Policy Work?How Does Fiscal Policy Work?

• Fiscal Rule:

Govt. spending and/or Taxes when economy is in recession.

Govt. spending and/or Taxes when economy is booming.

• Aim of this type of counter-cyclical fiscal policy is to ensure low unemployment.

Using Fiscal PolicyUsing Fiscal Policy

• A government needs to know a lot of information before it uses fiscal policy.

• In particular it needs to know:– Potential output– Actual output– The value of the multiplier for the economy.

Using Fiscal Policy

• What is the final effect on the economy of an increase in government spending of $10 billion dollars?

• An increase of $10 billion dollars will lead to a bigger increase in final output – a multiplier.

• Initial increase in spending multiplier = final increase in demand.

• End Result: Stronger economy.

Limits to Fiscal Policy

• Time lags– Decision and implementation lags

• Political interference

• Inefficiencies of the public sector

• Government debt has to be repaid.

• Past experience– Example: the oil-price shock of the 1970s

Tools that influence Fiscal PolicyTools that influence Fiscal Policy

– Spending levelsSpending levels– Spending prioritiesSpending priorities– Taxation (levels, types)Taxation (levels, types)– The tax system (federal, state, and local)The tax system (federal, state, and local)– Budget deficitsBudget deficits– TThe national debthe national debt

Federal Fiscal PolicyFederal Fiscal Policy

• People and Organizations who influence People and Organizations who influence economic policyeconomic policy

• Governmental actorsGovernmental actors– The PresidentThe President– CongressCongress– The Federal Reserve BoardThe Federal Reserve Board

• Societal actorsSocietal actors– Interest groupsInterest groups– Public opinionPublic opinion– Political partiesPolitical parties

What is Monetary Policy?What is Monetary Policy?

• Monetary policy is policy that affects the money supply or the rate of interest in order to affect the level of aggregate demand in an economy.

• Monetary policy tends to be designed and implemented by central banks and not by governments.

Instruments of Monetary Policy

• The most important role of central banks is monetary policy. They can control the money supply by:– Changing the reserve ratio– Issuing credit guidelines– The discount rate– Open market operation (most often used)

Monetary Policy and Economic Growth

• Central bank controls money supply using open market operations.

• Buy govt. bonds money supply • Sell govt. bonds money supply • If money supply then the interest rate falls.

• If money supply then the interest rate rises.

Monetary Policy and Economic Growth

• Open market operations:– Central bank buys bonds to money supply price of bonds interest rate consumption, investment and government spending in aggregate demand for goods and services

– Keynesian multiplier process income

Monetary Policy and Low Inflation

• Low inflation is the main goal.

• The Quantity Theory of Money– The more money in the economy, the greater

likelihood of inflation

– Control the flow of money and you reduce the chances of igniting inflation

Monetary versus Fiscal Policy

• Timing considerations– Monetary policy can be put into operation much more quickly

than fiscal policy.

– Fiscal policy works directly, monetary policy does not.

• Who is affected by the policy?– Fiscal policy can target specific groups.

Central Banking and Central Banking and Federal Reserve SystemFederal Reserve System

Central Banks and Monetary Policy

• Central banks were relatively new a century ago, but are now commonplace:– 1900: 18 central banks in the world.

– 2000: 173 central banks in the world.

The Role of Central Banks

• Issues currency.

• Acts as lender of last resort.

• Maintains integrity in a nation’s currency.

• Regulates the financial sector.

• Conducts monetary policy.

How Banks ‘Create Money’ - the Fractional Banking System

• Banks know from experience that they only need to hold a % of their deposits in the form of cash - a minimum reserve

• They can lend out the rest of their deposits to other customers requiring loans. This is how banks make profits

• Banks have the ability to ‘create’ money due to the fractional banking system

Central Bank Independence

• Why are central banks independent from the political process?

• Is central bank independence good?

• Are central banks accountable?

Central Banking in the U.S.: The Federal ReserveCentral Banking in the U.S.: The Federal Reserve

• The Federal Reserve System The Federal Reserve System tremendously influences Fiscal Policytremendously influences Fiscal Policy– What is the Federal Reserve Board?What is the Federal Reserve Board?– Established 1913 to regulate the U.S. banking system Established 1913 to regulate the U.S. banking system

by attempting to control the flow of money in the by attempting to control the flow of money in the economy.economy.

– Chairman and 7 Board of Governors appointed for 14 Chairman and 7 Board of Governors appointed for 14 year terms by the President – can’t be removed by the year terms by the President – can’t be removed by the President. President.

The Federal ReserveThe Federal Reserve


– There are 12 Federal Reserve Bank Regions (look at your There are 12 Federal Reserve Bank Regions (look at your Dollar bills – see Reserve Bank A, B, C, D, etc?)Dollar bills – see Reserve Bank A, B, C, D, etc?)

• The The Federal Reserve Regional Banks are important Regional Banks are important because they monitor and report on economic activity because they monitor and report on economic activity within their regionwithin their region

• Federal Reserve Regional Banks provide money to private banks, collect and clear checks, and maintain a system of reserve funds

• 1/3 of the nation’s private banks are members in the Federal Reserve System


• The Federal Reserve System regulates the supply of money in three ways:– Through the “Open Market Committee”

• The Committee sets policy with respect to buying and selling of federal government securities (bonds)

– Through Reserve Requirements• The amount of money member banks must keep on hand

– Through the Discount Rate• The interest rate charged member banks

• All three can impact interest rates, encourage or discourage economic growth, and push the economy in one way or the other

Budgeting: Taxing and Budgeting: Taxing and SpendingSpending

Federal BudgetingFederal Budgeting

• The U.S. federal budget is huge in global terms.

• Take the global gross world product. Roughly speaking, the U.S. federal budget alone, about $2.7 trillion dollars, is 1/15th of the world’s GDP.


• Federal spending covers many areas.• The main categories of federal spending,

making up almost three-quarters of the total, are four: – Defense (16%),

– Social Security (23%),

– Health and Medicare spending (20%),

– Interest payments (12%) on past borrowing.



• This makes for 73% of the total budget; the remaining 27% is allotted to such things as housing, foreign aid, transportation, education, etc.

• This does not include Social Security, which is an “off-budget” expenditure

• Also, it does not include the Intelligence Community’s budget, which is a so-called “Black Budget” – in other words: it is a secret. We have no idea how much the CIA, NSA, etc. spend.– No one in Congress is allowed to discuss it publicly.

– Estimations from non-U.S. sources placed it at a total of almost $50 billion dollars for FY 2003 (about 7% of the total budget)


• Federal spending as a percentage of GDP has hovered at close to 20% during the 1990s.

• In 1943, it was 45%

• In the early 1980s it had fallen to only 24%.

• Today it is around 30%.

Federal Budgeting: TaxesFederal Budgeting: Taxes

• The main categories of federal taxes, making up about 95% of the total, are:– Individual income taxes (48%).

– Corporate income taxes (10%).

– Payroll taxes for Social Security and Medicare (34%).

– Excise taxes on gasoline, cigarettes and alcohol (4%).

– The remaining 4% of taxes includes such things as estate taxes, customs fees, etc.

Federal Budgeting: TaxesFederal Budgeting: Taxes

• Tax receipts as a percentage of GDP has hovered in the high teens over the past four decades.

• Generally speaking, if the government runs a deficit between spending and revenue, it issues bonds; if it has a surplus, it pays them off.

• Some Comparisons are in order here…

Fiscal Balances for Selected Countries

Projected Surplus/deficit as a % of GDP

2002France -2.0Germany -2.8USA -1.0Japan -8.0Euro area -1.5EU -1.3Source: OECD World Economic Outlook June 2002

Government spending as a % GDPGovernment spending as a % GDP

1960 2000

France 35 48

Germany 33 44

Japan 17 32

USA 27 33

EU 32 50


• A debate exists over whether to include Social Security in budget discussions – principally because of the sheer size of the money involved (close to $4 Trillion dollars in current obligations).

• People sometimes want to leave out Social Security from discussions of the federal budget, on the grounds that it is run with a separate Trust Fund.

• A Trust Fund is not a fund or account, per se, but a statutory (fiduciary) obligation on the part of the government.


• But accounting measures, like a trust fund, don’t change the reality that Social Security involves government taxes and spending. – A number of economists might advocate not changing Social

Security, but very, very few would say that it should not even be considered as part of the budget.

• In fact, for more than half the people in the country, the highest tax they pay is for Social Security.


• State and local budgets also comprise an important part of spending.– State and local budgets, as a group amounting to about $1

trillion dollars, are quite substantial, equal to almost half of federal government’s spending.

• This spending is focused mainly on education, criminal justice, and infrastructure. As a result, fixing these areas is up to state governors, not presidents.

– The total of all government spending in the U.S. – federal, state, and local – (about one-third of the total U.S. GDP) is the lowest rate of any industrialized country.

Debt and DeficitsDebt and Deficits

Federal Budgeting: Debt and DeficitFederal Budgeting: Debt and Deficit

• The U.S. experience with budget deficits since WWII has significantly changed– We had experienced some budget surpluses until

2001. After 9/11/01, we are now experiencing a series of growing federal deficits (currently projected at $440 billion dollars for the coming FY 2004), until about 2008


• Deficits and the debt are not to be confused– Deficit is the shortfall in revenue collection for a given fiscal year

– Debt is the accumulation of all deficits since the founding of the Republic

• The Federal Deficit for FY2003 is approximately $370 billion dollars

• The Federal Deficit projected for FY2004 is approximately $440 billion dollars

• The Federal Debt as of August 1, 2003 is $5.8 trillion dollars – yes, that’s Trillion with a T…


• The Debt/GDP measure is a useful device – One useful way to look at the overall debt picture is to divide the debt in any

given year by the GDP

– This has the effect of adjusting for inflation and for growth in the economy over time, and focusing on debt in proportion to the economy at that time

• The accumulated debt as a percentage of GDP in 1946 was 114%. This number fell to 46% in 1960 and to 26% by 1980. In the 1950s and 60s, deficits, when they occurred, were small

• Then a reversal occurred, and the number rose to 37% in 1985 and to 52% in 1995, though more recently it has started to level out (around 42%)


• The debt and deficit explosion of the 1980s gave way to balanced budgets in the late 1990s

• It has returned to another debt and deficit explosion in the last two years– Current Office of Management and Budget estimations

project budget deficits until at least 2008

– Current Congressional Budget Office estimations project budget deficits until at least 2011


• The U.S. had small budget deficits most years in the couple of decades leading up to 1980.– But deficits exploded in the mid-1980s, dramatically raising

the debt/GDP ratio.

• The reasons for these higher deficits included higher defense spending and tax cuts in the early 1980s, and higher interest payments and Social Security and health care spending in the later 1980s.


• However, in the 1990s a combination of sustained economic growth and several budget balancing packages brought the deficit under control. However, interest payments on the past debt remained very large– The September 11, 2001 attacks forced the Bush

Administration to increase defense spending, as well as domestic security spending

– Additional spending also occurred in an attempt to overcome the recession – the result: big deficits again

General Government Debt as a % of GDPGeneral Government Debt as a % of GDP

Debt as a % GDP

2002

France 58.5

Germany 60.9

USA 39

Ireland 33.8

Italy 107Source: OECD World Economic Outlook June 2002

Goals of Fiscal PolicyGoals of Fiscal Policy


• Fiscal policy is related to four important goals of government:– Reducing Unemployment and maintaining nearly

“full” employment.– Keeping Inflation Under Control.– Increasing Economic Growth.– Reducing the Trade Deficit.


• Fiscal policy can be used to address different kinds of unemployment through heightening aggregate demand. – For example, spending on job search assistance or tax breaks for

relocation might reduce frictional unemployment.– Redesigning tax burdens on employers or spending subsidies for the

unemployed might reduce structural unemployment.

• In a recession, spending more or taxing less could pump up aggregate demand and reduce cyclical unemployment (commonly referred to as Keynesian Economics). This can be a rather expensive fiscal policy.


• Cutting inflation:– Reducing aggregate demand will bring

down inflation.– This would require a “tight” fiscal policy or

lower spending or higher taxes (commonly referred to as Monetary Policy or Monetarism).


• Increasing economic growth:• Growth is based on investment in the future, which

requires savings in the present.

• Reducing federal borrowing, or building up a budget surplus, will increase the amount of capital available for private investment, and so will tax proposals to make consumption less attractive and investment more attractive (commonly referred to as Supply-Side Economics).


• Reducing the trade deficit:– The trade deficit measures the net amount of foreign

investment capital flowing into the U.S.– Today we import and export 25% of the GDP (around $250

billion dollars this year). Thirty years this figure was 13%.– 25 - 30 million U.S. jobs depend on foreign trade and

investment.– Almost 40% of goods household consumption are made

abroad. – By saving more domestically, we would be less reliant on that

foreign capital.


• There is a 5th goal, one that is implied… the President’s Re-election!– The better the economy, the better the President’s

approval ratings in the opinion polls. – The better the approval ratings, the greater the chance

that the President will be re-elected (or get Congressional approval of his economic proposals).

– Every President will attempt to manipulate fiscal policy in order to help himself and his political party.


• Employment and inflation policies tend to run in “opposite” directions, thus leading to “counter-cyclical policy.”– Fiscal policy has limited application.

• There are problems with the timing of fiscal policy.

– Conceiving, enacting, and seeing the effects of fiscal policy might take 18 months or more.

• This is why President Bush pushed so hard to get taxes cut now in time for November 2004 (it was the mistake his father made by not manipulating fiscal policy quick enough in mid-to-late 1991 for the 1992 election).


• Counter-Cyclical Policy sometimes causes unexpected effects in: investment, imports, savings, and prices.

• For example, imagine that you want to simulate the economy with loose fiscal policy. Some possible unexpected side effects of this policy include:

• Running deficits that dominate the available monies available for borrowing, thereby reducing levels of domestic investment.

• Having the extra demand flow into imports rather than domestic products.

• Having the extra demand lead to higher inflation.


• There are many political difficulties encountered in counter-cyclical behavior.– Since the Great Depression, many economic policy makers

have called on the government to take counter-cyclical fiscal policy: spend in bad times, be tight-fisted in good times.

– Politically, this is very tough.

• A lot of economists believe this isn’t so useful for short-term goals, preferring monetary policy instead. Fiscal policy is essentially for long-term investment.

Review QuestionsReview Questions

• What policies does the government use to encourage and/or discourage private sector activity?

• Is all income redistribution from richer to poorer? What other kinds are there?

• Is the U.S. Income Tax a progressive tax? What about sales tax?

• What are the five main expenditures of the federal government?

• What are the two main government healthcare programs in America?

• Can the U.S. government deficit spend – spend more than it takes in?

• Have we been running a deficit or surplus since the late 1990s?

• Do Congress and the President get complete discretion when creating the annual budget?

• What is the Federal Reserve System and the Federal Reserve Board and what do they do?

Discussion QuestionsDiscussion Questions

• What is the impact of the federal debt on citizens? On the economy? Should we be concerned with a $6 trillion dollar debt?

• Why is the Chair of the Federal Reserve more important to the economy than the President?

• How successful was/is Keynesianism? Supply-side? Monetarism? Should we just shoot all of the economists and make-do? ;o)

• How would you reform the tax code? What about dropping the income tax for a national sales tax? What impact would that have on business? On the poor?

• Is the Social Security system sound – does it need reform of some sort?

Documents

Economic Policy. Learning Objectives: Economic Policy We will discuss American Economic Policy by looking at: –Fiscal and Monetary Policy –Federal Reserve