Government & Macroeconomic Policy

Fiscal Policy

Spending

Taxation

Deficits & Debt

Monetary Policy

Federal Reserve Structure

Monetary Policy Tools

Lecture 3 – Macroeconomics – Goals

By the end of this lecture, you should…

•Understand the role the government has in stabilizing the business cycle.

•The criteria that economists use in thinking about the usefulness of economic policy.

•How the Federal government conducts fiscal policy through spending and taxation.

•How the Federal Reserve conducts monetary policy through setting interest rates and the money supply.

Government & Macroeconomic Model

The government is an specific component of the macroeconomic model:

GDP = C + I + G + NXC = consumptionI = Investment

G = Government spending – taxesNX = Net Exports (exports – imports)

Government is the part of the model that can operate independently of the rest of the business cycle. This is because the size of government spending in the economy is determined by the political process.

Economists call government an “exogenous” factor since its value originates outside of the model and cannot explained by the model.

Economic analysis involves using a combination of analyzing statistics using models to determine the future path of the economy.

Economists analyze how the economy passes through the business cycle of recovery and recession by tracking how economic statistics change in their model of the economy.

Most of the time inflation is an issue at the peak of the business cycle and unemployment is an issue in the trough of the business cycle. Simultaneous inflation and unemployment is a clear sign of a dysfunctional economy.

Economic Policy and Business Cycle

Counter Cyclical Economic Policy

Government economic policy, because it is an exogenous factor, can be used to counter the business cycle to reduce the severity of recessions and the intensity of expansionary periods.

Y = C + I + G + NX

Because government economic policy can run counter to the business cycle, economists call it “counter cyclical”. Counter cyclical economic policy is designed to work as a “shock absorber” on the economy to smooth out GDP growth.

Types of Government Economic Policy

Government economic policy falls into two categories:

Fiscal Policy – Government spending and tax policies directed at affecting the amount of aggregate (or total) demand in the economy. Fiscal policy is represented by the “G” in the macroeconomic model.

Monetary Policy – Government, through the actions of a central bank, altering the size of the money supply in the economy. Monetary policy is less clearly shown in the macroeconomic model – the only variable it directly affects is the “r” (real interest rates) that directly affects the amount of investment. However, while it is not shown in the model, monetary policy influences consumption, investment and net exports.

Points of Economic Debate Over Policy

The debate over economic policy can be grouped according to several categories:

First – Can deliberate macroeconomic policy (beyond establishing property rights and a monetary system) have a beneficial affect on the economy? The answer to this question hinges on how quickly and smoothly an economy can return to General Equilibrium on its own.

Second – Are the benefits of an activist macroeconomic policy greater than the costs of the policy? The answer to this question hinges the opportunity cost of the policy – benefits of spending to the dead weight loss of taxes or low interest rates to higher inflation.

Third – Which is the more effective policy tool (fiscal or monetary policy) for what type of problem? The answer to this question hinges on the conditions in the economy and the political situation.

Department of Treasury – Fiscal Policy

The Treasury Department is the part of the Federal government that conducts all Fiscal policy actions for the government. The Department of the Treasury is part of the Executive branch and the Treasury Secretary is part of the President’s cabinet. However, all of its spending and taxing powers must be approved by Congress.

The Treasury Department oversees the following economic agencies for the federal government:•Internal Revenue Service•Financial Management Service•Bureau of Engraving and Printing and the Mint•Comptroller of the Currency•Bureau of Public Debt

Fiscal Policy - Components of Government Spending

Government spending can be divided into two categories:

Discretionary – Spending that is decided and established in annual budgets. Programs such as the military, education and infrastructure are examples of this type of spending. Counter cyclical economic policy is based on discretionary spending. This type of spending can also address long-term structural issues in the economy.

Mandatory – Spending programs established by law in which the amount is determined by the population that qualifies to receive the spending. Programs such as Social Security and Medicare are the largest examples of this type of spending. Interest Payments to support the Federal Budget Debt should be included with mandatory spending.

Two Big Points:Most of the Federal Budget is in Mandatory Spending, which is difficult to change.Many of the of the catagories that people focus on in the debate over the budget are really very small compared to the overall budget – cutting them would make no real difference in the Federal Budget.

How the Government Spends Money – The Breakdown of the Federal Budget

Based on current law, the major components of Federal are expected to change over the next several decades – note how the increases in social security, health care and interest on the Federal debt will be taking a larger part of GDP. This is a result of demographic shifts in the United States (the aging Baby Boomers)

Government Revenue - Considerations in Forming a Tax System

The first concern in any tax system is to raises the revenue sufficient for government operations. This does not mean that the government budget has to be balanced each year, but that the level of taxation is appropriate for the amount government over a length of time. For example, it makes more sense to have a balance budget over the course of a business cycle rather than have a balance budget in any given year.

Secondary concerns are where does the system place the burden of taxation and is the tax system simple.

In the area of tax burden, most economists and policy makers hold that a system which as a whole is progressive (not each specific tax) is preferable because it is more socially “fair” and it is macroeconomically counter cyclical because the tax burden in reduced during recessions and increases when the economy is doing well –the tax burden is spread across a business cycle.

Simplicity is important for the making it harder to evade taxes and to tax policy effective in providing incentives or disincentives for specific activities.

Types and Forms of Taxes

Taxes take the form of direct taxes, on persons or corporations, or indirect taxes, such as sales or import taxes).

Economists judge taxes based on their marginal effects – the percentage of tax paid on an additional income. This is referred to at a “marginal rate of taxation”.

•Progressive – The marginal rate of taxation increases as people earn more income.

•Proportional – The marginal rate of taxation is the same for all levels of income.

•Regressive – The marginal rate of taxation decreases as people earn more income.

Federal income taxes are progressive, in which people are divided into six brackets with rates from 10 – 35%. The historic high was 94% from 1939 - 1964.

How a Progressive Tax System Works

Under a tax system progressive system, people with a higher income pay a higher tax rate on their additional income. In such a system income is divided into tax brackets with higher tax rates on the upper brackets.

For example, consider a tax system show below with four brackets with a 5% tax increase for each bracket:

Income Bracket Tax Rate

$ 0 – 10,000 0 %

$10,000 – 20,000 5 %

$20,001 – 30,000 10%

$30,001 – 40,000 15%

In this system,

a person with a $20,000 income will pay $500.

A person with a 40,000 income will pay 5% on $10,000 plus 10% on 10,000 plus 15% on 10,000 for a total of $3000.

Note that both people pay the same amount of tax on their first $20,000 of income – the person with the higher income only pays more on their additional income.

Benefits of a Progressive Tax System

A progressive tax system has several built in economic benefits:

It is automatically counter cyclical – The tax burden shifts depending on the state of the economy. When the economy is strong and people have higher incomes then their tax burden goes up. However, when the economy is weaker and people’s incomes go down then their tax burden also goes down. In contrast to this, both proportional and flat taxes are pro-cyclical, which means the tax burden either stays the same on increases during economic recessions (which can make the economy even worse)

It generally distributes a person's lifetime tax burden on the years when it is easier for them to pay. In general, a person’s income is lower when they are a young adult and when they are retired and high when they are at middle age. A progressive tax system has people pay more taxes when they are in their high income years – when the additional tax burden has a lower impact on how they live their lives. A proportional or regressive tax puts more burden on older and younger people and can have a larger impact on how they live their lives.

Sources of Government Revenue – Tax Receipts

Most of the Federal revenue comes from three sources:

•Individual income taxes

•Payroll taxes – Social Security and FICA

•Corporate income taxes

When discussing taxes, it is important to remember that many people pay a lot of taxes that do not go to the Federal Government, but instead go to other parts of the government such as cities and states. For example, property taxes are paid to cities and towns and sales taxes are paid to states (many states also have separate income taxes)

Over the past 60 years payroll taxes have increased as a percentage of Federal revenue while corporate taxes have declined.

Government Deficits and Debt

Governments often spend more than they take in as revenue. This is partly a result of long-term infrastructure programs and the result of counter cyclical economic programs (the balance between spending and revenue is based on the business cycle and not annual accounting). Whenever a government spends more money than it gets in revenue, it is involved in deficit spending. The government makes up for the revenue gap by selling government bonds.

The deficit is an annual amount a government borrows to finance its operation. The deficit for 2012 was $1.1 trillion (7% of GDP). The expected deficit for 2015 is $564 billion (3.1% of GDP)

The debt is the accumulated deficits a government has run up – it is the total outstanding amount of government bonds. The expected 2015 total public debt is $18 trillion ($12 trillion or 73% is held by the public) .

The difference between spending and revenues represents the deficits the Federal government has be running – and is projected to run into the future. The sharp increase in deficits during the economic crisis was because of both increased government spending and a significant decline in revenue, because of lower incomes resulting in less income tax being paid.

Historical Record of Federal Debt

Ownership of Government Debt

The Federal Reserve System holds a large portion of the outstanding government debt – this is an important factor in controlling the money supply.

Beyond that, Americans and American institutions own a substantial amount of the debt and foreigners own close to a quarter of the debt (a large part of this are central banks of other nations).

Effects of of Government Debt

Government debt can create both benefits and problems depending on the nature of the spending and the quantity of spending. While future generations inherit the debt, they also inherit the assets.

Benefits: Government spending can be used to build infrastructure and fund education that might lead to future economic growth that otherwise would not have happened. In this way, government spending can have a “crowding in” effect.

Burdens: Government spending can divert investment resources from private investment and can “crowd out” private investment (important source of economic growth). In addition, interest payments on the debt can limit future spending and budget options.

Monetary Policy

Governments, through their central banks, can affect the money supply of a country in order to affect the economy. A central bank regulates the money supply for the country and oversees other banks. Central banks are not business or commercial banks –they do not make loans or take deposits from individuals and businesses. Central banks are bankers’ banks. They hold banks’ deposits and make loans to banks. Most central banks have a large degree of independence from the governments of their nations in directing monetary policy.

Roughly speaking, increases in the money supply can encourage economic growth or decreases the money supply to restrict economic growth.

Central banks have a number of economic tools at their disposal to affect the economy, but generally these tools are focused on interest rates and controlling the quantity of money.

Monetary Policy - Federal Reserve

The Federal Reserve System is a network of twelve district Federal Reserve Banks spread across the United States. The twelve regional banks helps in managing monetary policy because part of the nation may in recession while in another part the economy is booming. Each district bank monitors the economic conditions in its region and contributes to developing national monetary policy.

The Federal Reserve System is run by the seven members of the Board of Governors. They are appointed by the President and approved by Congress. Each member serves for a term of fourteen years and can be re-appointed to more terms.

The monetary policy is determined by the Federal Open Market Committee (FOMC) – made up of the Board of Governors and five of the district bank presidents. The FOMC meets several times each year in secret to set the Fed’s monetary policy. The minutes or details of the meetings are not released to the public for three months after the meeting.

Federal Reserve Districts in the United States

Structure of the Federal Reserve System

The president of the New York Fed has a permanent seat on the FOMC because much of monetary policy is conducted by the trading desk of the New York Fed.

Origin and Purpose of the Federal Reserve System

The Federal Reserve System was formed in 1913 to respond to financial crises – the Panic of 1907 was the event that resulted in the formation of the Fed. In its original inception the Fed was to oversee the banking system, supply currency to the economy and serve as a “lender of last resort” in a financial crisis.

The Fed was organized to be a public-private institution. It is under limited political control by the President and the Congress who approve of the members of the Board of Governors. However, the district branch presidents are chosen by the member financial institutions in each region of the country.

In the aftermath of the Great Depression (in which the Fed did little to prevent the crisis) with the support of Keynesian economic thinking, the Fed developed into an institution that engaged in macroeconomic policy to manage the economy.

Fed Independence & Dual Mandate

The Fed is an independent organization – no part of the government has direct authority over it or its policies. Fed independence is designed to make it a non-political economic actor that will make policy based on what is appropriate for the economy, instead of what is politically convenient. This independence also allows the Fed to respond quickly to changing events in the economy.

In 1977, during the period of stagflation, Congress amended the Federal Reserve Act to give the Fed the policy goal “to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” Essentially, this gave the Fed the mission of conducting policy with a focus on both maintaining low inflation and low unemployment.

Federal Reserve Policy Tools

The Fed traditionally relies on three main policy tools to effect the money supply and the economy:

Reserve Requirement – The Fed sets the amount of reserves that a bank must hold as percentage of the deposits it has. For example, if a bank has a 5% reserve requirement and it has $100 in deposits from customers, it must hold $5 in reserves.

Discount Rate – The Fed serves as “lender of last resort” to member banks. The discount rate is interest rate it changes member banks for overnight loans.

Open Market Operation – This is the primary tool used by the Fed. The Fed buys and sells government bonds (with money that it “creates”) in the bond market. It does this to affect the money supply and influence the Federal Funds rate or the “inter-bank lending rate” – the rate at which banks lend to each other.

FED Structure & Policy Tools

Historic Trend of Federal Funds Rate & GDP

Note – On this graph positive output gaps mean below potential and negative output gaps mean above potential.

New Fed Policy Tools for Current Crisis

The rapid collapse of the economy in 2008 forced the Fed to react quickly to save the financial markets (and by extension) the whole economy from spiraling into depression. In doing this, the Fed ran up against the limits of its traditional policy tools that work well when the financial system in functioning, but lose their effectiveness when the financial system becomes dysfunctional – which was the case in 2008. Between mid-2007 and the end of 2008, the Fed cut the Federal Funds interest rate from 5.25% to 0.25%. As a result, the Fed adopted a new policy tools to adapt to the changing conditions of the financial crisis and recession.

In general, these policies were focused on specific goals:

•Supply liquidity to financial markets to keep credit moving in the economy.

•Support financial institutions while they repaired their balance sheets.

•Reduce borrowing costs so consumers could lower their debt burden and have money to support consumption in the economy.

Federal Reserve’s Asset Balance Sheet

The arrow is September 2008, when Lehman Brothers collapsed and AIG was “rescued” by the government – beginning of the credit crisis. Source of Chart: Cleveland Fed

Liquidity Support to Financial Markets

In the first phase of the crisis, the Fed moved quickly to supply liquidity to financial markets to keep credit moving in the economy. Many parts of the economy depend on access to money through the financial system to coordinate economic activity. The problem was that financial markets were starting to freeze up and the economy was suffering from a “credit crisis” which meant that many companies could not get the credit they needed to carry out normal business transactions – this had the potential to cause the wider economy to grind to a halt.

At the same time, many large financial institutions were either “technically bankrupt” or on the verge of bankruptcy. The fear was that some of these institutions were systemically crucial to the functioning of financial markets – these firms were “too big to fail”. For this reason, the Fed (with help from the Treasury) moved to provide these firms with very low cost credit that guaranteed the survival of the institutions. This allowed these institution to continue to function and, as a result, allowed the financial markets to keep going.

The Fed expanded it powers in unprecedented ways to pump liquidity into the markets and prevent the credit markets from “freezing up”. The Fed did this under Article 13(3) in the Federal Reserve Act allows the Fed to make loans to “any individual, partnership or corporation that the borrower is unable to obtain credit from a banking institution” these unprecedented policies included :

•Term Auction Facility &Primary Dealer Credit Facility – Banks can borrow from Fed using highly rated assets as collateral.

•Term Securities Leading Facility – Banks can borrow Treasury securities from Fed in return for “highly rated” assets as collateral.

•A series of programs to provide lending to directly support the commercial paper market, money market and other credit markets.

Support for the Broader Economy in Recovery

After the financial crisis passed, the Fed moved to provide support to the broader recovery in the economy – in particular the housing market. At this point the Fed was limited because its traditional tool for supporting the economy is through adjusting short term interest rates. However, interest rates were already close to zero – which is the effective limit of interest rates (they cannot go below zero).

At this point, the Fed modified its traditional policy of buying short term government bonds (of terms less than two years) to buying longer term bond and mortgages (mortgage backed securities). This had the effect of forcing down long term interest rates and was known as the policy of “Quantitivative Easing”

The result has been historic low long term interest rates. However, these policies are very controversial, since they may cause higher inflation (part of the policy is based on changing inflationary expectation). It is not clear how effective the Quantitative Easing policy has been in getting economic recovery.

As the credit crisis passed, but the depth of the recession became clear, the Fed moved from providing liquidity to lowering long term interest rates for two different reasons using two different tools:

Support housing market – the Fed began to buy mortgage backed securities to lower the interest rates on mortgages, with the goal of allowing people to refinance and encourage people to buy houses.

Encourage investment and stop the “flight to safety” in government bonds – the Fed began the policy of “quantititative easing” or buying long term government bonds, which would lower their returns, which would cause investors to put their money elsewhere to get better returns.

Exiting Quantitative Easing

Since economic growth has remained slow and unemployment the Fed has adopted a policy of stating its future Federal Funds Rate policy. The Fed has made it clear that it will be continuing the current Federal Funds Rate at 0–0.25% “at least through mid-2015”. When this will happen in is currently a big point of debate.

In addition, The Fed has been ending its policy of “Quantitative Easing” purchases of $85 billion a month. It engaged in a process of “tapering” its monthly purchases by $10 billion a month. When and how the Fed will reduce its balance sheet is the next big question.

What is the Fed’s exit strategy from its balance sheet?

The Fed claims it can either let the purchased bonds and mortgages mature and naturally phase out – however that could take a long time. The Fed says it can also sell the bonds and mortgages back onto the markets, once they recover – not quite sure when that will happen and the effect it will have on financial markets.

If there is a sudden economic recovery that results in higher inflation (which looks very unlikely), the Fed can return to its traditional policy tools and raise interest rates to slow economic activity.