ECON 202 Final-Concept Questions
The 2 laws of functional finance
(1) government should spend and tax to maintain full employment and prevent inflation (i.e. when spending is too high, the government is to reduce spending and raise taxes; when spending is too low, the government should increase spending and lower taxes) (2) The second law of functional finance is that the government should borrow money only if it is desirable that the public should have less money and more government bonds. This helps achieve the rate of interest which results in the most desirable level of investment
How did money emerge according to Chartalism?
(1) money emerged because the state demanded payment of a tax (2) named the thing it will accept as payment for the tax, determines the unit of account (3) issues the thing it will accept in payment of taxes
Functional vs. Sound Finance
- "sound" finance is managing the budget in order to balance it (like how a household or business would) -functional finance is managing the budget to meet economic goals.
Sovereign government vs. non-sovereign government
-A sovereign government issues its own currency and therefore cannot run out of money -non-sovereign governments can run out of money. -Countries that joined the EU gave up the right to run the deficits they needed in order to get out of recessions/depressions. -Non-sovereign countries can go broke and they need to tax in order to finance spending.
What are Automatic stabilizers? Are they discretionary or nondiscretionary?
-Automatic stabilizers are federal expenditures and tax revenues that automatically change levels in order to stabilize an economic expansion or contraction. They are built into the federal budget to help fight unemployment and inflation. -Some examples of automatic stabilizers are: unemployment compensation, welfare, and personal income taxes. -They are nondiscretionary
Why is Chartalism also called a "state theory of money"?
-Because all money, historically, emerged from the state. -Essentially, currency is always issued by the state and the reason they are valued/accepted is because of the tax obligation that people have to the state. (The idea that taxes drive money)
Expansionary Monetary Policy
decrease is discount rate
What are bonds according to FF? Are the used to borrow in order to spend by the federal gov?
-Bonds are not used to "borrow" in order to be spent by the federal government. (Remember: When money is paid back to the government/redeemed, the money is destroyed) -According to FF, bonds are used to drain or inject excess reserves into the banking system in order to hit the target FFR.
What should the state do if there is involuntary unemployment?
-If there is involuntary unemployment, the state should increase its deficits to allow incomes to rise and generate more net saving. -This would also generate additional spending, and thus additional employment. -Involuntary unemployment results because the government has kept the supply of fiat money too scarce. -An increase (through deficit spending) would stimulate the private sector so that it would create more jobs and reduce unemployment.
Money emergence according to chartalism is different from neoclassical theory
-Neoclassicals believe that money emerged from a barter economy. -Moreover, according to chartelism, money is not an object (as it is in neoclassical theory), it is an IOU.
What is the purpose of "borrowing?"
-When the government spends, it creates reserves. -If it does not drain excess reserves, the FFR falls to zero. -To prevent that and hit its target, the government offers the public an interest earning alternative to money -The purpose of bond sales by the FED (central bank and treasury) is to drain excess reserves; the purpose of bond purchases is to add reserves -Bond sales destroy reserves; they do not provide the government with more currency to spend.
Crowding out
-a reduction in private-sector spending as a result of federal budget deficits financed by the U.S. Treasury borrowing. -It is when federal government borrowing increases interest rates, the result is lower consumption by households and lower investment spending by businesses -associated with orthodox school of thought
Crowding in
-an increase in private-sector spending as a result of federal budget deficits financed by U.S. Treasury borrowing; at less than full employment, consumers hold more Treasury securities, and this additional wealth causes them to spend more. -It is when business investment spending increases because of optimistic profit expectations -associated with heterodox/Keynesian school of thought
excess reserves in the banking system
-banks don't want to hang onto them (since they're non-interest earning) -they'll keep lowering the rate of interest to borrow them. -This will cause the FFR to approach zero. -The Fed then acts to take these reserves out of the banking system. -They do this by selling bonds. (the excess reserves are then used to pay for the bonds). -This prevents the FFR from dropping to zero
How do banks create money?
-based on the demand for loans. -Essentially, they create money out of nothing -. They just enter the amount into the spreadsheet. -They don't need deposits. -Loans make deposits (out of thin air), which then make reserves. -They just need a worthy borrower
According to orthodoxy, how do banks make loans?
-by practicing fractional reserve banking. -Fractional reserve banking is where banks keep only a percentage of their deposits on reserve as vault cash and deposits at the Fed (usually the amount mandated by the required reserve ratio). -The rest is excess reserves, which is what banks use to make loans. -they must have deposits in order to lend
What causes inflation?
-demand-pull factors, which is a rise in the general price level resulting from an excess of total spending (demand) -cost-push factors, which is an increase in the general price level resulting from an increase in the cost of production.
What is the purpose of taxing?
-ensure that the government's money is accepted by the people because, in order to fulfill their tax liability, people will demand/need to obtain the government's money. -create sellers of goods and services that can be purchased by the government. The purchase, then, allows the government to transfer certain goods and services from the private sector into the public domain to serve the public good. -also regulate demand and can affect distribution. Taxes can regulate demand because the government can raise taxes to curtail spending and avoid inflation.
Are Surpluses sustainable?
-no -if the government ran a surplus every year, that means that the government is taking more in taxes than it is spending. -Eventually, everyone would run out of money in order to fulfill their tax liability. (Surpluses also unleash strong deflationary forces).
Government spending: Chartalism vs. orthodox account of deficit spending?
-orthodox theorists: believe that the government must borrow, by using bonds, in order to spend -Chartalism, the Federal Government spends by issuing checks or directly crediting bank accounts (they create money)
Trickle down economics
-supply side fiscal policy -by cutting taxes on the rich/capitalists, they'll create more jobs and hire more workers (thereby increasing aggregate supply). The idea is that the extra income that the capitalists now have will "trickle down" into the pockets of the additional workers that they hire.
shortage of reserves in banking system
-the FFR will increase. -In order to prevent this, the Fed needs to add reserves into the banking system. -They do so by making an open market purchase and buying bonds from the banking system.
Federal government is not like a household
-the federal government is the issuer of its own currency -it does not have a budget like all households and businesses - it is only constrained by what is offered for sale in exchange for its currency. -All other constraints are self-imposed -Ultimately, no limitation on how much it spends.
What must the federal government do in order to deficit spend?
-the government must spend more than it collects in taxes. -Neoclassicals believe that, financing deficit spending requires that government to borrow from the private sector by issuing bonds
What should the state do if there is demand-pull inflation?
-the state should take away some of the people's spending power through taxation.
What is problematic about the orthodox account of the emergence of money?
-there wasn't a barter economy to begin with -first known monies were valueless -today's money (fiat) is not backed by gold standard/anything with intrinsic value -assert that markets and specialization occurred before money -history seems to suggest that this is not the case
Deficit Spending
-when G > T -It is part of expansionary fiscal policy
Are Deficits Sustainable?
-yes -because they are a private sector surplus at the expense of a government deficit. -Deficits by the government are not a problem because, if the government issues its own currency, there is no solvency risk. -In other words, the federal government can always make any and all payments in its own currency, not matter how large the deficit is, or how few taxes it collects.
Open Market Purchases
A purchase of government securities injects reserves into the banking system and increases the money supply. (Increases money supply).
Open Market Sales
A sale of government securities by the Fed reduces reserves in the baking system and decreases the money supply. (Decreases money supply).
How does the government spend according Chartalism?
According to Chartalism, the Federal Government spends by issuing checks or directly crediting bank accounts (they create money).
too big
According to FF, we know that the deficit is _____ _______ when there is demand-pull inflation.
too small
According to FF, we know that the deficit is ______ ______when there is involuntary unemployment.
control the money supply
According to orthodoxy, what is the role of the FED?
The Federal Reserve
According to orthodoxy, who controls the money supply?
Good
Are deficits good or bad according to FF?
Bad
Are surpluses good or bad according to FF?
No
Is the Federal government ever financially constrained?
No
Can a sovereign government ever run out of money (go bankrupt)?
How does orthodox theory explain the emergence of money?
Money emerged from a Barter economy (C-C'). Money made the exchange of goods and services more efficient (C-M-C') because it eliminates the need to satisfy a double coincidence of wants.
Sector Balances
S - I = G - T + X - M -(S-I) is net private sector savings. -(G-T) is government spending. -(X-M) represents the foreign sector/is net exports. -In order for the private sector to net save, the other two sectors must (on balance) spend more than their income.
equal
S - I = G - T + X - M If the foreign sector is balanced, then the federal government's deficit must _______ non-government (private sector) surplus.
decrease
S - I = G - T + X - M If the government decreases the deficit, then net private savings __________ by the same amount.
increase
S - I = G - T + X - M If the government increases deficit, then net private savings __________ by the same amount.
eliminates the double coincidence of wants
What is the most important function of money for Orthodox economists?
If the economy is at full employment and the government runs a deficit (overspends) then it can cause inflation.
Under what conditions is a deficit likely to be inflationary?
If the economy is below full employment, a deficit is not likely to cause inflation. However, special cases, short-term inflation can occur due to bottlenecks.
Under what conditions is a deficit not likely to generate inflation?
Medium of exchange, unit of account, store of value
What are the 3 functions of money?
-open market operations -discount rate -required reserves ratio
What are the FED's discretionary monetary policy tools ?
The need to fulfill tax liabilities.
What creates demand for fiat currency according to Chartalism?
During a boom, government spending decreases (less people need to collect unemployment compensation, etc.) and taxes increase (more people paying income tax).
What do automatic stabilizers do during a boom?
During a recession, government spending increases (unemployment, welfare) and taxes decrease (less people paying income tax)
What do automatic stabilizers do during a recession?
-A government deficit occurs when federal expenditures exceed tax revenues collected -The national debt is the total amount owed by the federal government to the owners of government securities.
What is the difference between the deficit and the debt?
What happens to money when you pay your taxes?
When taxes are collected, money is destroyed.
government spends
When the _______________ ____________, the level of reserves in the banking sector increase.
pay your taxes
When you ______ _______ ______, you reduce the level of reserves.
orthodox
Which group of theorist (orthodox/heterodox) advocates supply-side fiscal policy?
because the sovereign government issues their own money, so they won't ever run out of it.
Why can't a sovereign government ever run out of money (go bankrupt)?
Federal Funds Market
a private market in which banks lend reserves to each other for less than 24 hours.
Store of Value
ability of money to hold value over time; you can save money and be confident that you can spend it In the future; money is completely liquid, meaning that it is immediately available to spend in exchange for goods and services without any additional expense
Inflation
an increase in the general (average) price level of goods and services in the economy
Nondiscretionary Policy
automatic stabilizers like taxes and government spending that automatically change in response to changes in real GDP.
Expansionary Monetary Policy
decrease in required reserve ratio
Discretionary policies controlled by the FED
discount rate, required reserve ratio, interest rate target for FFR
Supply-side fiscal policy
fiscal policy that emphasizes government policies that increase aggregate supply in order to achieve long-run growth in real output, full employment, and a lower price level. Examples of supply side fiscal policies are: decrease prices of resources, technological improvements, lower taxes on the rich, subsidies, and deregulation)
Contractionary Monetary Policy
increase in discount rate
Contractionary Monetary Policy
increase in required reserve ratio
Expansionary Fiscal Policy
increasing government spending and reducing taxes
Contractionary Fiscal Policy
increasing taxes and reducing government spending
Non-Discretionary policies controlled by the FED
open market operations
Expansionary Monetary Policy
open market operations purchase
Contractionary Monetary Policy
open market operations sale
Medium of Exchange
primary function of money to be widely accepted in exchange for goods and services; money removes the problem of coincidence of wants because everyone is willing to accept money in payment, rather than haggling over goods and services; money increases trade by providing much more convenient method of exchange than a cumbersome barter system
Unit of Account
provides a common measurement of the relative value of goods and services; without dollars there is no common denominator; we must therefore decide if one pizza equals a box of pencils, 20 oranges equal a quart of milk
What does the Fed do?
sets the target rate/essentially controls the Fed Funds Rate
Exogenous Money
the belief that money supply is determined by the central bank (outside factors). It is the belief that deposits depend on government because they print the cash, which then makes reserves and reserves make loans
Open Market Operations
the buying and selling of government securities by the Federal Reserve System
Discretionary Policy
the deliberate use of changes in government spending or taxes to alter aggregate demand and stabilize the economy; conscious government intervention to make some form of adjustment in response to something
Federal Funds Rate
the interest rate banks charge for overnight loans of reserves to other banks.
Why are fiscal and monetary policy not independent?
•Because fiscal policy determines the amount of fiat money available to pay taxes, this impacts the money supply. •The monetary policy is concerned with the money supply. •(in short, when government spends or taxes (fiscal policy) it increases or decreases the amount of reserves (money supply, therefore monetary policy) in the economy).
Why are open market operations by the FED non-discretionary?
•it is used to prevent a Fed Funds market break, with the FFR reaching zero percent. •The central bank and/or Treasury must drain excess reserves to prevent this, which is done through bond sales that are automatically triggered when the overnight rate is not met due to excess reserves. •This prevent the overnight rate from falling, allowing central bank to hit its target.
