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Business Cycles: Characteristics and Causes • The two phases of a business cycle are recession and expansion. • A recession begins when the economy reaches a peak, and ends when it reaches a trough. • Expansion is a period of recovery from a recession. • Causes of the business cycle include external shocks, changes in investment spending, changes in monetary policy, fiscal-policy shocks, speculation and “bubbles,” and combinations of several of these factors. Business Cycles in the United States • During the Great Depression, real GDP declined nearly 50 percent and the number of unemployed people rose nearly 800 percent. • Causes of the Great Depression included an enormous gap in the distribution of income, easy credit, global economic conditions, and high U.S. tariffs. • Reforms established as a result of the Great Depression include Social Security, minimum wage, unemployment programs, Securities and Exchange Commission (SEC), and Federal Deposit Insurance Corporation (FDIC). Business Cycles in the United States • After World War II, business cycles became much more moderate, with shorter recessions and longer periods of expansion. • The Great Recession of 2008-09 was the longest and deepest recession in the United States since the Great Depression. Predicting the Next Business Cycle • Two methods of predicting business cycles are leading economic indicators and econometric modeling. • Leading economic indicators include the Dow-Jones Industrial Average (DJIA) and the leading economic index (LEI). • An econometric model is a mathematical model that uses algebraic equations to describe the state of the economy. Output-Expenditure Model: GDP = C + I + G + (X – M) Economic Indicators ● Inflation: Upward movement in the average levels of prices. Inflation is contrasted by deflation, which is a downward movement in the average level of prices ●Unemployment Rate: The number of people able and willing to work expressed as a percentage of the labor force. Labor force includes working individuals and unemployed individuals but does not include people who do not want to work Economic Indicators ● Gross Domestic Product (GDP): ○ The dollar value of all final goods and services produced by resources located in a country during a given year. A nominal GDP has not been adjusted for inflation. ● Percent Change in GDP: ○ A simple calculation that takes the previous GDP and divides it by the new GDP ■Positive would represent an increase, negative would represent a decrease Economic Indicators ● Consumer Price Index (CPI): ○ The measure of the average of a fixed "market basket" of consumer goods and services that are commonly bought by households. This statistic is computed monthly by the Bureau of Labor and Statistics. ● National Debt: ○ The total amount of money owed by the Federal Government to the owners of Government backed securities The Evolution of Money • In a barter economy, a mutual coincidence of wants is required for trade to take place. • Settlers in Colonial America used commodity money or fiat money. • Early paper currency in Colonial America was a form of fiat money. • Specie—silver or gold coins—were the most desirable form of money because of their mineral content and because they were in limited supply. • Pesos were nicknamed “talers,” which sounded like “dollars,” and the term “dollars” became so popular that it became the basic monetary unit in the U.S. money system. Characteristics and Functions of Money • Money must be portable, durable, divisible, and available, but in limited supply. • Money plays three roles in the economy: a medium of exchange, a measure of value, and a store of value. • Modern money shares the same fundamental characteristics of all money: portability, durability, divisibility, and scarcity. • Components of modern money include Federal Reserve Notes, metallic coins, and demand deposit accounts (DDAs). • The Fed defines money supply as M1 and M2. o M1: coins, currency, traveler’s checks, DDAs, checking accounts o M2: everything in M1, plus savings deposits, time deposits, and money market funds Early Banking in America • During the Revolutionary War, Continental dollars were printed. • The Constitution left the printing of paper currency to the individual states. • State banks received their operating charters from individual state governments. • Problems with pre-Civil War currency included: each bank printed its own currency, resulting in many different notes; banks issued too many notes; counterfeiting. • Congress printed paper money for the first time to pay for the Civil War. • The National Banking System was established in 1863, consisting of national banks that issued currency backed by federal bonds. • Other federal currencies included Gold Certificates and Silver Certificates. The Gold Standard • The United States went on the gold standard in 1900, allowing people to exchange other federal currencies for gold. • Advantages of a gold standard: people feel secure about currency and the government does not create too much money, so the money keeps its value. • Disadvantages of a gold standard: slowing of the money supply if gold is scarce and the risk that a people may their convert currency, depleting the gold supply. • In 1933, President Roosevelt issued orders denying U.S. citizens the right to redeem dollars for gold, although foreign countries could still do so. • In 1971, President Nixon declared that the U.S. would no longer redeem any dollars for gold. Creation of the Fed • Congress created the Federal Reserve System in 1913 as the nation’s central bank. • During the Great Depression, many smaller banks failed. • In 1933, President Roosevelt declared a bank holiday, during which all banks were required to close; most were allowed to reopen after Congress passed legislation to strengthen the banking industry. • The Federal Deposit Insurance Corporation (FDIC) was formed in 1933 to insure customer deposits. • All other forms of federal currency have now been replaced by Federal Reserve Notes. • Our monetary system today is sound and has a uniform currency, but some banks have become so large that they cannot be allowed to fail. Economic Impact of Taxes • Taxes can affect resource allocation by raising the price of a product, which makes people buy less, which in turn results in the company cutting back on production. • Taxes can be used to encourage or discourage certain types of activities; sin taxes help raise revenue while discouraging liquor and tobacco. • Distribution of income is affected by taxes. • Taxes change the incentives to save, invest, and work, which affects productivity and economic growth. • The incidence of a tax—the person or company who actually pays it—is not necessarily the entity that is taxed; if a utility is taxed, for example, it may pass the burden of the tax on to its customers in the form of higher rates. Characteristics and Types of Taxes • The three criteria for effective taxes are equity, simplicity, and efficiency. • No single tax has all three of the criteria for effective taxes. • Taxes in the United States are based on the benefit principle and the ability-to-pay principle. • The three types of taxes that exist in the United States today are proportional taxes, progressive taxes, and regressive taxes. Alternative Tax Approaches • Lawmakers want to find new tax revenues that alter the tax burden. • A flat tax is proportional to individual income after a threshold is reached, without exemptions or deductions. • The advantage of a flat tax is its simplicity, but it would remove many incentives (such as home ownership) built into the current tax code. • A value-added tax (VAT) would tax a product at every stage of production on a national basis and would be used instead of an income tax. • Advantages of a VAT include the difficulty of producers to avoid paying it, its widely spread incidence, and its ease of collection. • The main disadvantage of a VAT is that consumers cannot attribute higher prices to the almost invisible tax. Tax Reform Highlights • In 1986, Congress passed a sweeping reform that established the alternative minimum tax. • In 1993, top marginal tax brackets of 36 and 39.6 percent were added to help the government drive down the deficit. • In 2001, tax law was revised to lower the top four marginal tax brackets by 2006, introduced a new 10 percent bracket, and eliminated the estate tax on the wealthiest 2 percent of taxpayers by 2010. • In 2003, the government accelerated many of the 2001 reforms and reduced the capital gains tax bracket. • In 2013, Democrats in the White House and Senate added two top tax brackets. Monetary vs. Fiscal Policy ● Monetary Policy: ○ An Attempt to attain certain economic goals, such as lowering unemployment, by varying the money supply, interest, or conditions of credit. The Board of Governors of the Federal Reserve dictate this policy. ● Fiscal Policy: ○ An attempt to attain certain economic goals, such as achieving full employment, by varying the government's purchases of goods and services and its rate of taxation. This is controlled by Congress and influenced by the President. Fiscal Policy ● Fiscal policy is the government's ideas about spending and taxing ○ Advocates of Fiscal Policy believe that the way the government spends money and taxes citizens affects the nation's GDP ■ The belief is that the government is responsible, through spending and taxing, for stabilizing the economy Fiscal Policy ● Expansionary Fiscal Policy ○ Increase in government spending or decreasing taxes is used when the economy is "too slow." When the economy is faced with a recession, high unemployment and slow growth of the GDP ○ Looks Like: ■ Increased Government Spending ■ Lower Taxes ■ A combination of the two Fiscal Policy ●Contractionary Fiscal Policy ○Decreasing government spending or increasing taxes is used when the economy is growing too quickly ○Looks like: ■Decreased Government Spending ■Increased Taxes ■A combination of the two Fiscal Policy ●Fiscal Policy has many underlying effects ○The United States Government provides many goods and services to improve life for all classes ■Middle Class ●Increasing money for education ■Lower Class ●Serving as employer of last resort for low skilled, unemployed workers; welfare programs ■Upper Class Fiscal Policy ●Fiscal Policy can be directed to either the supply-side or the demand-side of economics ○Supply-side: ■All policies directed at helping the business and production side of the economy (changing incentives and interest rates) ○Demand-side: ■All policies directed at helping the consumers in the economy (altering taxes on consumption)