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Chapter 34 – The Influence of Monetary and Fiscal Policy on Aggregate Demand. Money Market - the financial market in which financial instruments with high liquidity and very short maturities are traded
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Chapter 34 – The Influence of Monetary and Fiscal Policy on Aggregate Demand • Money Market - the financial market in which financial instruments with high liquidity and very short maturities are traded • Used by participants as a means for borrowing and lending in the short term; from several days to just under a year. • Money market securities consist of certificates of deposit (CDs), bankers acceptances, U.S. Treasury bills, commercial paper, municipal notes, federal funds and repurchase agreements (repos).
Money Market Graph Interest rate Money supply Equilibrium Interest rate r2 r1 Money demand Quantity of Money Md1 Md2 Quantity Fixed by the Fed
Increase in Money SupplyA Monetary Injection Money supply, MS1 MS2 (a) The Money Market Interest rate r2 r1 1. When the Fed increases the money supply . . . Money demand at price level P 2. . . . the equilibrium interest rate falls . . . 0 Quantity of money
Increase in Money Demand Money supply Interest rate 2. . . . which increases equilibrium interest rate . . . 1. . . . increases the demand for money . . . r1 r2 Money demand at price level MD2 Money demand at price level MD1 0 Quantity of money Quantity fixed by the Fed
Application – The Money Market Money supply, MS2 MS1 Interest rate Scenario: The Federal Reserve sells bonds in open-market operations. (a) The Money Market r1 r2 Money demand at price level P 0 Quantity of money
Application – The Money Market Money supply, MS1 MS2 Interest rate Scenario: The Federal Reserve buys bonds in open-market operations. (a) The Money Market r2 r1 MD 0 Quantity of money
Fiscal Policy and The Federal Budget • Fiscal Policy – Government spending policies that influence the macroeconomy. • These policies affect tax rates and government spending, in an effort to stabilize/control the economy. • Expansionary Fiscal Policy – involves increased government spending to stimulate the economy during or in anticipation of a business-cycle contraction • Contractionary Fiscal Policy - a decrease in government spending to slow the economy down during an inflationary economy
Tools of Fiscal Policy Two Tools of Fiscal Policy • Tax Policy – increase or decrease percentage of revenue from individual households and firms • Government Spending – increase or decrease in discretionary spending to affect AD
Tax Structures • Proportional Tax – % of income taxes remains the same for all income levels (Flat tax) • Progressive Tax – % of income paid in taxes increases as income increases (Federal Income Tax) • Regressive Tax - % of income paid in taxes decreases as income increases (Sales Tax)
Tax Structure Examples • 10% flat tax = $1,000 • 10% of income • 10% flat tax = $10,000 • 10% of income As income goes up, the percent of income taxed stays the same Proportional • 25% income tax = $25,000 • 25% of income • 10% income tax = $1,000 • 10% of income The more you make, the more they take. Progressive • 6% State Sales Tax • $5,000 in consumer goods = $300 • 3% of income • 6% State Sales Tax • $20,000 in consumer goods = $1200 • 1.2 % of income The more you make the less they take. Regressive
Who Bears the Burden? • What are the three tax structures and who bears the burden of each? • Progressive – more you make, more they take. Rich bear the burden. • Regressive – more you make, less they take. Poor bear the burden • Proportional – everyone pays the same percentage. The burden is spread equally amongst people in the economy.
How Fiscal Policy Influences Aggregate Demand Expansionary vs. Contractionary Fiscal Policy • Expansionary Fiscal Policy - increased spending, tax cuts to stimulate AD • Contractionary Fiscal Policy – reduced spending, tax hikes to slow down AD
Tax Video • http://www.youtube.com/watch?v=iVAybRTmIyw
Individual Income Taxes • Tax Bracket – scheduled rate at which you are taxed based on your annual income • Marginal tax rate – is the tax rate that applies to the last unit of currency
Individual Income Taxes $934.00
Individual Income Taxes • Taxable Income – A person’s gross income minus exemptions and deductions (link)
Tax Deductions • http://www.youtube.com/watch?v=EFI2Fuq3dP8
Individual Income Taxes • Example: A person with an income of $10,000 • $8,375 x .10 = $837.5 • $1625 x .15 = $243.75 • Total tax paid = $837.5 + $243.75 = $1081.25
Bush Tax Cuts – “Fiscal Cliff” http://www.cbsnews.com/video/watch/?id=50135875n
Other Types of Taxes • FICA (Federal Insurance Contributions Act) – payroll tax, funds Social Security and Medicare. • Social Security – funds people of old-age, survivors and disabilities, established in 1935, originally to provide old-age pensions of workers • Medicare – national health insurance program that helps pay for people over age of 65 or with certain disabilities • Medicaid – national health insurance for people within the poverty threshold • Unemployment – insurance for workers laid off through no fault of their own
Payroll tax Video • http://www.youtube.com/watch?v=yB1DdBP3FH0&list=PL6C78E46B824BFF89&index=7&feature=plpp_video
Other Types of Taxes • Excise tax – tax on specific goods, cigarettes, alcohol, phone service, cable, internet, etc. • Estate tax – “death tax”, tax on estate or value of money and property of a person who has died • Gift tax – tax on money or property that one living person gives to another; a person can give up to $14,000 a year tax-free per individual • Tariff – import tax on foreign goods brought into the country
Who bears the burden? • What are the three tax structures and who bears the burden of each? • Progressive – more you make, more they take. Rich bear the burden. • Regressive – more you make, less they take. Poor bear the burden • Proportional – everyone pays the same percentage. The burden is spread equally amongst people in the economy.
Federal Spending • Mandatory Spending – programs that lawmakers are required by existing laws to spend money on (Social Security, Medicare, Medicaid, etc.) • Discretionary Spending – spending that government can adjust; increase or decrease (Defense, environment, scientific research, etc.)
Government Video • http://www.youtube.com/watch?v=rG1DUn8mMwk&list=PL6C78E46B824BFF89&index=1&feature=plpp_video
Budget Deficits and the National Debt • Balanced budget – money going into the U.S. Treasury is the same amount of money going out • Revenue = Spending • The last balanced budget occurred in 1997 under President Bill Clinton
Balancing the Budget • Budget Surplus – occurs when the government takes in more than it spends • Revenue > Spending • Budget Deficit – occurs when the government spends more than it takes in • Revenue < Spending
Dealing with a Budget Deficit • Reduce Spending – cut spending on government programs • Increase Taxes • Print money – the government can print or inject money into economy • Borrow money – government borrows money by selling bonds on the primary market • Bonds sold domestically or globally • China owns 1 trillion dollars in U.S. bonds
The National Debt • National debt – the total amount of money the federal government owes to bondholders • Combination of all borrowing over time • Budget deficit – the amount of money the government owes to bondholders in one fiscal year
China Video • http://www.youtube.com/watch?v=rG1DUn8mMwk&list=PL6C78E46B824BFF89&index=1&feature=plpp_video
Keynesian Economics • Keynesian economics - macroeconomic theory of 20th century British economist John Maynard Keynes. • Laissez Faire (no government interference) in private sector can lead to inefficient macroeconomic outcomes • Advocates active policy responses by the public sector (monetary policy and fiscal policy) to stabilize the business cycle • Book
Keynesian Economics • Advocates a mixed economy, predominantly private sector, but with a large role of government and public sector • Served as the economic model during the latter part of the Great Depression, World War II, and the post-war economic expansion (1945–1973) • Lost influence until the global financial crisis in 2007, which caused a resurgence in Keynesian thought. • President George W. Bush was heavily anti-Keynesian (except in 2007) • President Barack Obama, used Keynesian economics through government stimulus programs to attempt to assist the economic state.
Aggregate Supply and DemandClassical, Keynesian, and NeoClassical Models Price Level Price Level AD2 AD2 Y2 Classical Economics Keynesian Economics Price Level AD1 AD1 AD1 Classical Output Output Output Y2 Y1 Intermediate (short-run) Keynesian Y1 Keynesian Economics Neoclassical Economics
Multiplier Effect • Multiplier effect – additional shifts in AD that result when expansionary fiscal policy increases income, which leads to consumer spending • Investment accelerator – positive response to the increase in aggregate demand leads to capital deepening
Multiplier Effect Price level $20 billion 2. . . . but the multiplier effect can amplify the shift in aggregate demand. Aggregate demand, AD1 AD2 AD3 Quantity of Output 1. An increase in government purchases of $20 billion initially increases aggregate demand by $20 billion . . .