A review of fiscal policy issues
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A review of fiscal policy issues. Problems with Fiscal Policy. Cutting taxes and increasing spending is politically easy Raising taxes and decreasing spending is politically difficult Increasing AD can cause inflation (see graph). Deficits and the Nat’l Debt.

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Problems with fiscal policy
Problems with Fiscal Policy

  • Cutting taxes and increasing spending is politically easy

  • Raising taxes and decreasing spending is politically difficult

  • Increasing AD can cause inflation (see graph)

Deficits and the nat l debt
Deficits and the Nat’l Debt

  • A deficit occurs when the gov’t spends more than it collects in taxes in one year

  • Add up all the deficits, you get the National Debt

  • Current National Debt

Is the national debt evil
Is the National Debt EVIL?

  • No

    • We used to just owe this money to each other

    • Where’s the National Asset Clock?

  • Yes

    • China holds a huge part of this debt, which will drain money from future generations to pay them off, and it gives the Chinese huge power over the US

National budget
National Budget

  • The current administration has run up huge deficits and added trillions to the National Debt in the past 7 years.

  • Could you do better? Try your hand at balancing the Federal Budget by playing the Budget Game at

    National Budget Simulation

National budget simulation
National Budget Simulation

  • After trying the Budget Simulation, describe the results of your budget. This one page essay is due July 27. Include the print out of the results of your budget changes.


  • Oliver Wendell Holmes said that “Taxes are the price we pay for civilization”


  • Progressive tax

    • Takes a higher % from those people with higher incomes. Example: Income tax

    • Delores earns $300,000 in income and pays $93,000 in taxes (31%)

    • Marcus earns $30,000 in income and pays $4,500 (15%)

    • Fair? Utility of the lower or higher income

Regressive tax
Regressive tax

  • Regressive tax

    • Takes a higher % from those with lower incomes. Example: 10% sales tax on clothes

    • Mary earns $2,000,000 and spends $20,000 on clothes; she pays $2,000 in sales tax, or 0.1%

    • Tim earns $30,000 and spends $5,000 on clothes; paying $500 in taxes or 1.6%

Flat tax
“Flat Tax”

  • Flat tax

    • Takes the same % from all

  • Some people think Social Security is a flat tax, but no FICA taxes are taken from income over about $102,000

Fair tax
“Fair Tax”

  • A National Sales Tax is being proposed by some of the candidates for president

  • Advocates of the so-called "FairTax" claimed a 23 percent national sales tax can replace both the federal income tax and Social Security taxes.

  • Some opponents claim the actual rate would have to be at least 34 percent even if it fell on new homes, mortgage interest and a host of other products and services not usually subject to state or local sales taxes.

Is a fair tax really fair
Is a Fair Tax really Fair?

  • Richie Rich earns $1,000,000 in a year. He spends $200,000 of his income subject to the 24% “Fair” tax for a tax total of $48,000, or 4.8% of his income

  • Average Joe earns $50,000 in a year. He spends $40,000 subject to the “Fair” tax, which is $9,600, or 19% of his income.

  • Is this fair or just regressive?

Review of classical economics
Review of Classical Economics

  • Based on three basic ideas

    • Say’s Law

    • Equation of exchange

    • Self-regulating markets

Say s law
Say’s Law

  • Supply creates its own Demand.

  • The act of producing a product generates the income to buy that product

Equation of exchange
Equation of Exchange

  • MS x V = P x Y

  • MS is the money supply

  • V is Velocity of money

  • P is Price

  • Y is Output

Equation of exchange 2
Equation of Exchange (2)

  • If you increase the MS and V is constant then P X Y must go up. Usually it’s just Price increases though.

Self regulating markets
Self-Regulating Markets

  • Markets tend to settle at equilibrium and so government should stay out!

  • Laissez-faire

Keynesian economics
Keynesian Economics

  • Rejects those three beliefs

    • Demand creates supply

    • Velocity isn’t stable

    • Markets can settle into a Great Depression

Criticisms of keynesian fiscal policy
Criticisms of Keynesian fiscal policy

  • Can result in deficits and increase the National Debt

Keynesian monetary policy
Keynesian Monetary Policy

  • In addition to Fiscal Policy, Keynesian economics also had another tool that might be used to fine tune the economy:

  • Monetary Policy

  • To understand Monetary Policy, we first have to understand Money

What is money
What is Money?

  • 1. Medium of Exchange

  • 2. A Store of Wealth

  • 3. A Unit of Account to compare value or price

What has been used as money
What has been used as Money?

  • 1. Large stones in So. Pacific

What has been used as money1
What has been used as Money?

  • 1. Large stones in So. Pacific

  • 2. Shells in West Africa

  • 3. Commodity money like gold

  • 4. Cigarettes in POW camps

Measures of money
Measures of Money

  • Transaction money called M1

  • currency+demand deposits+traveler’s checks

  • Broad Money M2 includes M1 + savings accounts and money market accounts

Short history of banks
Short History of Banks

  • Goldsmiths in the Middle Ages

  • Banks printed their own money

  • US government printed greenbacks during the civil war

The fed the banks bank
The FED, the banks’ bank

  • Today’s banks are required to belong to the FED or the Federal Reserve Bank

The fed

  • Created in Dec. 1913

  • 12 branch banks

  • Clears checks between banks, hold reserves, provides cash, provides loans for member banks

  • Chairman and a Board of Governors, Ben Bernancke current FED chairman

Three tools of the fed
Three tools of the Fed

  • 1. The Reserve Ratio

  • 2. Discount rate and Federal Funds rate

  • 3. Open market operations

Reserve ratio
Reserve Ratio

  • The percent of demand deposits required to be held with the FED as reserves or cash in the bank

  • Currently between 3% and 10%

  • Changed infrequently, updated one a year in December or January

Discount and fed funds rate
Discount and Fed Funds Rate

  • The Discount rate is the interest rate that the FED charges banks on short term loans

  • The Federal Funds rate is the interest rate, set by the FED, that banks can charge each other for short term loans of reserves

  • Currently 5.25%

Discount and fed funds rate1
Discount and Fed Funds Rate

  • These have been reviewed every 2-3 months recently

  • If the rate increases, M1 decreases

  • If the rate decreases, M1 should increase

Open market operations
Open Market Operations

  • Occur every day when the FED buys or sells government bonds

  • If the FED buys bonds, it puts money into the banks’ excess reserves, and increases the Money Supply

  • If the FED sells bonds, banks give the FED excess reserves, reducing the Money Supply

A simple banking example
A Simple Banking Example

  • Steve’s Bank

  • Assets Liabilities

  • $500 $500 initial deposit

  • $450 $450 loan

  • $950 $950 total cash

  • $400 $400 another loan

  • $1,350 $1,350 total cash

Monetary policy
Monetary Policy

  • Series ofactions that might result in an increase of Aggregate Demand

  • This series is similar to the gears on a standard shift car, and so is sometimes called the Transmission Mechanism

Transmission mechanism first gear little honda
Transmission Mechanism:First Gear (little honda)

  • First Gear:

    • The FED identifies a recession

    • so the board of governors shifts policy and decides to BUY Government Bonds, putting money into banks’ excess reserves,

    • or the FED lowers the discount rate or the federal funds rate, which allows banks to increase their excess reserves by short-term borrowing

Second gear
Second Gear

  • The banks see that they have extra reserves so the banks can…

  • Loan that money to investors

  • To attract loan customers, banks should … interest rates

  • Lower interest rates

Third gear
Third Gear

  • Investors see that interest rates have gone down. They re-examine investment options, and determine the potential profit of the investment, known as the Marginal Efficiency of Investment or MEI

Third gear cont d
Third Gear Cont’d

  • If the MEI is greater than the interest rate then investors will borrow and invest.

  • If the MEI is less than the interest rate, then borrowing the money to invest would cause a loss so investment would not occur.

Fourth gear
Fourth Gear

  • Firms borrow money to invest. As Investment increases, so does Aggregate Demand.

  • As the impact of investment ripples then AD increases even more and Output (Y) increases as well, ending the recession.


  • Keynes pointed to potential problems in moving between the “gears”, problems he called slippages

  • 1. What if the FED tries to buy bonds but nobody is selling?

  • 2. What if banks sell bonds, but just sit on their reserves and don’t loan them out?

More slippages
More Slippages

  • 3. What if MEI is not greater than the interest rate?

  • 4. What if Investment doesn’t occur, just transfer of wealth?

Monetary policy plusses and minuses
Monetary Policy plusses and minuses

  • The recognition lag for monetary and fiscal policies are the same

  • The implementation lag for monetary policy can be one day. The fed can change from buying to selling bonds overnight, and can change interest rates almost as fast

  • The impact lag is difficult to predict because of the slippages mentioned previously

More monetary analysis
More monetary analysis

  • Some critics feel that fighting inflation by raising interest rates is like trying to fight a fever by raising your temperature.

  • When the Fed fights inflation with high interest rates, some sectors of the economy are impacted; housing, construction and automotive industries are particularly prone to downturns when interest rates increase


  • A new school of economic thought developed, led by Milton Friedman

  • Monetarists based their theories on three basic principals:

    • Permanent Income Hypothesis

    • Equation of Exchange

    • Monetary Rule

Permanent income hypothesis
Permanent Income Hypothesis

  • The Monetarists believe that consumers make choices based on their past, present and future income.

  • A change in income from a temporary fiscal policy will not have a permanent economic impact

Equation of exchange1
Equation of Exchange

  • Any change in monetary or fiscal policy will only result in inflation

  • Ms x V = P x Y

  • If velocity and output are fixed, any increase in the money supply will just drive up prices

Equation of exchange cont d
Equation of Exchange (cont’d)

  • If AD increases, that causes a temporary increase in Y, but also creates “demand pull” inflation

  • AS reacts to this price level increase with “cost push” inflation, as their costs go up, they shift AS back

  • The monetarist Long Run Aggregate Supply Curve is straight up and down

Monetary rule
Monetary Rule

  • The Monetarists’ believed

    • fiscal and monetary policies create inflation

    • government intervention in the economy creates instability

    • Greed was better than government

  • Milton Friedman

  • This led them to advocate for a monetary rule: steady, predictable growth in the money supply, of about 4%

Rational expectations
Rational Expectations

  • This economic theory suggested that fiscal and monetary policy would be ineffective because you can’t fool all the people all the time

  • According to this theory, people make rational economic decisions after considering all the available information

Rational expectations cont d
Rational Expectations (cont’d)

  • A criticism of this theory centers on the ability of people to adjust their decisions as conditions change. People can’t renegotiate their mortgage or labor contract every time the economy changes.

  • Gathering this information takes knowledge, time and money that many people don’t have

Supply side economics
Supply Side Economics

  • A new economic theory became popular in the 1980’s; Supply Side Economics

  • The basic premise was to shift the AS curve out, creating more output at lower prices

  • Supply-siders felt that lowering taxes and removing government regulations would allow the AS curve to shift out

Supply side economics cont d
Supply Side Economics (cont’d)

  • The Laffer Curve suggested that tax rates could be cut and tax revenue would increase at the lower rate, because economic activity would increase

  • Taxes were cut by about 25%

  • Government expenditures also increased during this time, driving up deficits and doubling the national debt

Supply side economics cont d1
Supply Side Economics (cont’d)

  • Some argued that cutting taxes and increasing spending was really a double dose of Keynesian economics

  • The deregulation of some businesses resulted in crises in some industries, including the savings and loan industry


  • This trend toward more deregulation may have led to problems in the energy sector and the financial sector in recent years

  • Even Alan Greenspan said he may have overestimated the ability of self-regulating markets to protect the economy

  • Alan Greenspan "I was wrong"