Download III - Economic Policy

Economic Policy
Learning Objectives: Economic Policy
• We will discuss American Economic Policy by
looking at:
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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 Policy
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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
involvement in the economy is three-fold:
• To engage in Economic Management
• To ensure Economic Stability
• To provide a Legal Enforcement Structure
What Government Does: Budgeting, Taxation, and Fiscal Policy
• Economic Policy
– Goals
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Economic growth
Low unemployment
Price stability
Positive balance of payments
Minimizing diseconomies
Supporting key economic sectors
Economic Policy
• Principal Economic Policy Perspectives in the U.S.:
• Keynesianism – Liberal
– Manipulation of government spending/taxing to impact
the economy
• Monetarism – Conservative
– Manipulation of the money supply to impact the
economy
• Supply-Side – Newer conservative view
– Belief that tax cuts stimulate the economy and increase
government revenues over time
Economic Policy
• Economic Policy Tools
– Fiscal policy
• Taxes
• Spending
• Deficits/Debt
– Monetary policy
• The Federal Reserve Board
Fiscal 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?
• 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 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
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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 Policy
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Spending levels
Spending priorities
Taxation (levels, types)
The tax system (federal, state, and local)
Budget deficits
The national debt
Federal Fiscal Policy
• People and Organizations who influence
economic policy
• Governmental actors
– The President
– Congress
– The Federal Reserve Board
• Societal actors
– Interest groups
– Public opinion
– Political parties
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:
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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:
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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
Federal 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
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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 Reserve
• The Federal Reserve System
tremendously influences Fiscal Policy
– What is the Federal Reserve Board?
– Established 1913 to regulate the U.S. banking system
by attempting to control the flow of money in the
economy.
– Chairman and 7 Board of Governors appointed for 14
year terms by the President – can’t be removed by the
President.
The Federal Reserve
The Federal Reserve
– There are 12 Federal Reserve Bank Regions (look at your
Dollar bills – see Reserve Bank A, B, C, D, etc?)
• The Federal Reserve Regional Banks are important because
they monitor and report on economic activity within 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
• 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
Spending
Federal 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 Budgeting
• Federal spending covers many areas.
• The main categories of federal spending,
making up almost three-quarters of the total, are
four:
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Defense (16%),
Social Security (23%),
Health and Medicare spending (20%),
Interest payments (12%) on past borrowing.
Federal Budgeting
Federal Budgeting
• 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 Budgeting
• 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: Taxes
• The main categories of federal taxes, making up about
95% of the total, are:
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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: 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
France
Germany
USA
Japan
Euro area
EU
Source:
Projected Surplus/deficit
as a % of GDP
2002
-2.0
-2.8
-1.0
-8.0
-1.5
-1.3
OECD World Economic Outlook June 2002
Government spending as a % GDP
France
Germany
Japan
USA
EU
1960
35
33
17
27
32
2000
48
44
32
33
50
Federal Budgeting
• 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.
Federal Budgeting
• 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.
Federal Budgeting
• 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 Deficits
Federal 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
Federal Budgeting: Debt and Deficit
• 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…
Federal Budgeting: Debt and Deficit
• 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%)
Federal Budgeting: Debt and Deficit
• 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
Federal Budgeting: Debt and Deficit
• 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.
Federal Budgeting: Debt and Deficit
• 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 GDP
France
Germany
USA
Ireland
Italy
Source:
Debt as a % GDP
2002
58.5
60.9
39
33.8
107
OECD World Economic Outlook June 2002
Goals of Fiscal Policy
Federal 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.
Federal Fiscal Policy
• 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.
Federal 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).
Federal Fiscal Policy
• 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).
Federal Fiscal Policy
• 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.
Federal Fiscal Policy
• 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.
Federal Fiscal Policy
• 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).
Federal Fiscal Policy
• 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.
Federal Fiscal Policy
• 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 shortterm goals, preferring monetary policy instead. Fiscal
policy is essentially for long-term investment.
Review 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 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?