Fiscal and Monetary Policy

1. Fiscal and Monetary Policy With special appearances by “Inflation” and “Unemployment” Presented to you by Real GDP, a product of American workers.

3. Expansionary Fiscal Policy • an increase in government expenditures and/or a decrease in taxes that causes the government's budget deficit to increase or its budget surplus to decrease.

4. Contractionary fiscal policy • is defined as a decrease in government expenditures and/or an increase in taxes that causes the government's budget deficit to decrease or its budget surplus to increase.

5. Fiscal policy is carried out by the legislative and/or the executive branches of government. The two main instruments of fiscal policy are government expenditures and taxes. The government collects taxes in order to finance expenditures on a number of public goods and services—for example, highways and national defense.

7. Budget Deficit • When government expenditures exceed government tax revenues in a given year, the government is running a budget deficit for that year. The budget deficit, which is the difference between government expenditures and tax revenues, is financed by government borrowing; the government issues long-term, interest-bearing bonds and uses the proceeds to finance the deficit.

8. Liberal views

9. Conservative views

12. National Debt • The total stock of government bonds and interest payments outstanding, from both the present and the past, is known as the national debt. Thus, when the government finances a deficit by borrowing, it is adding to the national debt. • Want to see something really scary??? • National Debt Clock

13. Budget Surplus • When government expenditures are less than tax revenues in a given year, the government is running a budget surplus for that year. The budget surplus is the difference between tax revenues and government expenditures. The revenues from the budget surplus are typically used to reduce any existing national debt • In the economic boom of the Roaring '20s, the Federal Budget ran surpluses for ten consecutive years. The last budget surplus was in ……..

14. 1998 to 2001!

15. Balanced Budget • In the case where government expenditures are exactly equal to tax revenues in a given year, the government is running a balanced budget for that year. • In 1835, under President Andrew Jackson, the US Federal Budget was balanced and the National Debt was paid in full. This has never happened since.

16. Classical view of Fiscal Policy • The classical view of expansionary or contractionary fiscal policies is that such policies are unnecessary because there are market mechanisms—for example, the flexible adjustment of prices and wages—which serve to keep the economy at or near the natural level of real GDP at all times. Accordingly, classical economists believe that the government should run a balanced budget each and every year.

17. Keynesian view of Fiscal Policy • The belief that expansionary and contractionary fiscal policies can be used to influence macroeconomic performance is most closely associated with Keynes and his followers. • Keynes and his followers believed that the way to combat the prevailing recessionary climate was not to wait for prices and wages to adjust but to engage in expansionary fiscal policy instead. The Keynesians' argument in favor of expansionary fiscal policy is illustrated in Figure 1 .

18. Expansionary Fiscal Policy • Expansionary fiscal policy is designed to stimulate the economy during or anticipation of a business-cycle contraction. This is accomplished by increasing aggregate expenditures and aggregate demand through an increase in government spending (both government purchases and transfer payments) or a decrease in taxes.

19. Expansionary Fiscal Policy • Expansionary fiscal policy leads to a larger government budget deficit or a smaller budget surplus. In general, expansionary fiscal policy works through the two sides of the government's fiscal budget -- spending and taxes. However, it's often useful to separate these two sides into three specific tools -- government purchases, taxes, and transfer payments.

20. Expansionary fiscal policy involves either a decrease of the income tax rates or a one-time rebate of taxes previously paid. The reduction in taxes provides the household sector with additional disposable income that can be used for consumption expenditures (C of GDP), which then stimulates aggregate production and employment and leads to further increases in income (another measure of the economy).

21. Expansionary Fiscal Policy: Tool # 1 Government Spending • Government purchases are expenditures by the government sector, especially those by the federal government, on final goods or services. “G” of GDP. These purchases are used to buy everything from aircraft carriers to paper clips, from office furniture to highway construction, from traffic lights to teacher salaries (Demand Side). Typically undertaken by individual government agencies. Highway construction, for example, is undertaken with funds appropriated to the Department of Transportation. Aircraft carriers are financed with funds appropriated to the Department of Defense. • Expansionary fiscal policy involves an increase in the funds appropriated to these assorted agencies. The agencies then make the additional purchases which stimulate aggregate production (Supply Side), boost income, and increase the level of employment.

22. While an increase in government purchases have been used frequently over the years to implement expansionary fiscal policy, it can be a relatively involved process. Moreover, additional government purchases leads to a relatively larger government sector. For these reason, policy makers often opt for the second fiscal policy tool -- taxes.

23. Expansionary Fiscal Policy Tool #2: Taxes • The second of three fiscal policy tools is taxes, primarily personal income taxes levied by the federal government, but other taxes are also used. Taxes are the involuntary payments that the government sector imposes on the rest of the economy to generate the revenue needed to provide public goods and to undertake other government functions. Personal income taxes are more specifically the taxes collected on the income received by members of the household sector. • The federal income tax system, administered by the Internal Revenue Service (IRS), involves a set of tax rates that are applied to the income received by the taxpayers. The bulk of the taxes are withheld from employee paychecks by then paid to the federal government by employers. And discrepancy between taxes withheld and the actual tax liability is then settled when income tax returns are filed at the end of the year.

24. The ever popular “tax cut” • Because tax changes tend to be administratively easier to implement, they are often preferred over government purchases when conducting expansionary fiscal policy. Moreover, political leaders and voters usually prefer a reduction in the tax burden to an increase in government spending. • What is one possible negative result of an overall decrease in personal income tax?

25. Transfer Payments: Tool #3 • The third fiscal policy tool is transfer payments. Transfer payments are payments made by the government sector to the household sector with no expectations of productive activity in return. The three common transfer payments are Social Security benefits to the elderly and disable, unemployment compensation to the unemployed, and welfare to the poor. Like the income tax system, transfer payments rely on a payment schedule based on qualifying characteristics of the recipients -- age, employment status, income, etc. Those who meet the criteria then receive payments.

26. Transfer Payments=more $ in your pocket • May be some sort of across-the-board lump-sum payment to all who qualify. That is, the unemployment compensation might be increased by 5 percent or all Social Security recipients might receive an extra $500 payment. The increase in transfer payments provides the household sector with additional disposable income that can be used for consumption expenditures (C of GDP), which then stimulates aggregate production and employment and leads to further increases in income (Demand Side Fiscal Policy).

27. What is Monetary Policy? • In the United States, the Federal Reserve is in charge of monetary policy. Monetary policy is one of the ways that the U.S. government attempts to control the economy. If the money supply grows too fast, the rate of inflation will increase; if the growth of the money supply is slowed too much, then economic growth may also slow. In general, the U.S. sets inflation targets that are meant to maintain a steady inflation of 2% to 3%.

28. Monetary Policy and the Federal Reserve • Expansionary fiscal policy is one of several stabilization policies available to the federal government to address business-cycle problems. The Federal Reserve System can also get into the act of stimulating the economy through expansionary monetary policy.

29. The “Fed” • The Federal Reserve System, also known as "The Fed," is the central bank of the United States. In its role as a central bank, the Fed is a bank for other banks and a bank for the federal government. It was created to provide the nation with a safer, more flexible, and more stable monetary and financial system. The Federal Reserve System is a network of twelve Federal Reserve Banks and a number of branches under the general oversight of the Board of Governors. The Reserve Banks are the operating arms of the central bank. • Created in 1913 by the Federal Reserve Act

30. What does the Federal Reserve do? • Holds cash reserves that banks can borrow from and we can use to insure our deposit at our local bank (FDIC) • Makes loans at low interest rates to commercial banks and the government • Buys and sells government “securities” like bonds (paper promises to pay back a loan with interest in the future)

31. Expansionary Monetary Policy: • To correct a business-cycle contraction and address the problem of unemployment, the Federal Reserve System can increase the money supply and decrease interest rates. This is accomplished by buying U.S. Treasury securities (bonds backed by the U.S. government that pay interest) in the open market, lowering the discount rate (the interest banks charge each other), and reducing reserve requirements (how much money banks have to keep on hand, they can loan out more like this and make more money available to you and I).

32. Sound good? Hmmm.. Remember, too much money can lead to inflation; inflation raises prices

33. Restrictive Monetary Policy or “Tightening the money supply” • Increase reserve requirements • Increased interest rates • Scarcity increases value • Done to decrease inflation

34. What is “INFLATION”?

35. Wage-Price Spiral • The wage-price spiral is one concept that deals with the causes and consequences of inflation, and it is most popular in Keynesian economic theory. It is also known as the "cost-push" origin of inflation. Another cause of inflation is known as "demand-pull" inflation, which monetary theorists believe originates with the moneysupply.

36. Cost-Push Inflation vs. Demand-Pull • Do you remember how much less you paid for things even two years ago? This increase in the general price level of goods and services in an economy is inflation, measured by the Consumer Price Index (the price of that “market basket of frequently purchased goods) and the Producer Price Index (what producers pay for their supplies) But there are different types of inflation, depending on its cause. Here we examine cost-push inflation and demand-pull inflation. Factors of InflationInflation is defined as the rate (%) at which the general price level of goods and services is rising, causing purchasing power to fall. This is different from a rise and fall in the price of a particular good or service. Individual prices rise and fall all the time in a market economy, reflecting consumer choices or preferences and changing costs. So if the cost of one item, say a particular model car, increases because demand for it is high, this is not considered inflation. • .

37. When does inflation occur? • Inflation occurs when most prices are rising by some degree across the whole economy. This is caused by four possible factors, each of which is related to basic economic principles of changes in supply and demand: Increase in the money supply. • Decrease in the demand for money. • Decrease in the aggregate supply of goods and services. • Increase in the aggregate demand for goods and services.

38. In this look at what inflation is and how it works, we will ignore the effects of the money supply on inflation and concentrate specifically on the effects of aggregate supply and demand: cost-push and demand-pull inflation • Cost-Push InflationAggregate supply is the total volume of goods and services produced by an economy at a given price level. When there is a decrease in the aggregate supply of goods and services stemming from an increase in the cost of production, we have cost-push inflation. • Cost-push inflation basically means that prices have been “pushed up” by increases in costs of any of the four factors of production (labor, capital, land or entrepreneurship) when companies are already running at full production capacity. • With higher production costs and productivity maximized, companies cannot maintain profit margins by producing the same amounts of goods and services. As a result, the increased costs are passed on to consumers, causing a rise in the general price level (inflation).

39. Demand-Pull InflationDemand-pull inflation occurs when there is an increase in aggregate demand, categorized by the four sections of the macroeconomy: households, businesses, governments and foreign buyers. When these four sectors concurrently want to purchase more output than the economy can produce, they compete to purchase limited amounts of goods and services. • Buyers in essence “bid prices up”, again, causing inflation. This excessive demand, also referred to as “too much money chasing too few goods”, usually occurs in an expanding economy.

40. Unemployment • Cyclical- unemployment rises and falls with the business cycle’s up and downs. • Ex: The Great Depression, the Great Recession • Seasonal- workers are laid off during “down times” for their job, this happens regularly • Ex: Agricultural workers • Frictional- when people are moving from one job to another • Ex: leaving a job as a waitress to start teaching • Structural- when your skills no longer meet the needs of the job market • Ex: typist that has NO computer skills, telegraph operator

41. The Stock Market • If you want to invest in business you may purchase “shares” of a company. This is purchasing partial ownership of the company. The more shares you own, the more of the company you own. • People purchase stock as investments, hoping to make a profit, either from sharing in the company’s profits (dividends) or by selling the stock for more than they paid for it.

42. Trade and Tariffs • The U.S. specializes in many things it produces. We are experts at making steel for example. Specialization increases production. • We are no self-sufficient, however. We do not produce enough oil to meet our fuel needs, so we trade for it. • Imports coming in to the country are taxed, this is called a tariff.

43. Tariffs • We want to export more goods than we import, this is called a trade surplus. • We receive money from goods we sell to other countries. • To help keep American products attractive to consumers, we make sure foreign IMPORTS are not too cheap by taxing them as they come into the country. This is called a tariff. It protects our products by encouraging people to buy them because they cost less than foreign goods.

44. Incentives • Why do people work? They choose particular jobs not just for the pay, but for non-monetary incentives such as: • Fringe benefits (insurance, vacations) • Good working conditions • Job security • Satisfaction level is high