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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 involves either 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. • 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-side Economics • 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 = 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 foreignowned • 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 Manipulating the Money Supply • Managed by the Federal Reserve Board (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 STRUCTURE OF THE FED Owned by member banks -all national banks -some state banks Twelve Districts with Directors/ Presidents -but supervised by Fed in DC 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 Chairperson Janet Yellen The Federal Reserve System MONETARY POLICY: It’s all about: Interest rates Money supply Reserve requirements Margin requirements A main role of the FED is to keep up consumer confidence in the banking system! The Federal Reserve System Responsibilities of the Fed REGULATE BANKS • Approve mergers • Enforce truth-in-lending laws • Examine Banks • SET RESERVE & MARGIN REQUIREMENTS • SERVE BANKS • Check clearing • Lender of last resort FED • REGULATE $ SUPPLY • Adjust money supply to stabilize the economy • SERVE GOVERNMENT • Issuing Currency & Storing Cash • Selling, transferring, redeeming gov’t securities • Treasury Dept. Checking Account • 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 lower reserve fraction results in more monetary expansion •A higher reserve fraction results in less monetary expansion Formula: Deposit x 1 divided by RR = increased money supply $50,000