22 Fiscal

Government securities include: • Treasury bills, or T-bills, mature in one

Fiscal Policy in Action The government's annual budget spans many categories, including national defense, healthcare, education, infrastructure, and many others. The government has many programs from which to choose when increasing spending. This may include things like expanded budgets for higher education, a new national program for rebuilding bridges, or special grants to states that are financially struggling. These increases, however, can only be made when there is enough additional revenue. Tax collections are also part of fiscal policy. If the government collects fewer taxes, the private sector, citizens and businesses, has more to spend. This allows the private sector to stimulate the economy by spending more. Taxes are collected from many areas, such as corporate profits, sales taxes, and individual income taxes. Depending on the state of the market, the government may reduce some or all of these. This is often done by granting tax credits, a preset amount that can be deducted from personal or corporate taxes. It can often be difficult for the government to time its fiscal policy to match the needs of the economy. Bad timing can have serious repercussions. For example, if the government borrows money to increase spending, interest rates can rise because the government competes against the private sector to borrow money. Excessive government borrowing makes it more expensive for the private sector to borrow and thus causes the unintended consequence of slowing the economy.

High aggregate demand strengthens the economy and lessens government involvement. When the economy is strong, prices increase due to fierce competition for resources. Businesses hope the government will reduce its spending to reduce this competition.

In theory, the government will assume a contractionary fiscal policy position. This means it will spend less money than it earns by cutting its spending or by raising taxes. Instead of a deficit, it will have a surplus. A surplus is the amount of taxes that are leftover after spending. If the economy is stable, the government will take a neutral fiscal policy position and will maintain spending and taxes at their current rate. The government can pay for its deficits by using money it has saved from past surpluses. However, it more often pays by borrowing from the public. This is done by selling documents issued by the Treasury Department, called securities, which promise future repayment at a specific time or in intervals over time.As an incentive, the total repayment amount is greater than the purchase price. This is because the Treasury pays interest on each type of security. This is the equivalent of a person charging interest to the Treasury for a loan. Therefore, these securities are investments that reward buyers. The time of final repayment depends on the particular security and is referred to as maturity. Maturity is the set date upon which the Treasury agrees it will pay back the loan plus the interest amount.Treasury securities are very liquid, meaning they can be traded quickly and easily. They are also popular because they are seen as a very safe place to store money. They can be purchased directly from and redeemed by the U.S. Treasury website. Banks and investment brokerage firms also sell Treasury securities. Most government securities can be publicly traded and the ownership transferred. A person who has purchased a government security and does not want to wait for it to mature may choose to sell it to another person for less profit.

When the economy is weak, aggregate demand is too low. The concern is that unemployment may increase because fewer workers are needed. Economic growth may return too slowly. Government can step in and spend more revenue and/or lower taxes to stimulate demand. This compensates for slower activity in the private sector.

In theory, the government will assume an expansionary fiscal policy position, also called deficit spending. This means it will spend more money than it earns from tax revenue.

Fiscal Policy Effects Businesses and individuals respond to fiscal policy changes in many different ways. This response is related to the amount of funds government is spending. Businesses sometimes respond to increased government spending by positioning themselves to benefit. For example, if the government announces it will pay for the construction of a new interstate highway crossing the country, asphalt makers may invest in new trucks and increase production in anticipation of winning a contract. Government is a large customer of business and much of the economy is connected to it. When government spending is reduced, many businesses must cut back or focus on finding opportunities in the private sector. If government borrowing increases interest rates, businesses and individuals will borrow less because this means it will cost more to repay the loan in the long run. This may result in lower investment, lower prices, and slower economic activity.

Monetary Policy Principles Monetary policy is the adjustment of an economy's money supply by a central bank in order to maintain price stability, lower unemployment, and ensure economic growth. In the U.S., this is done by the Federal Reserve System.To be healthy, an economy requires proper management of money supply, the amount of money available for use in the economy at any given moment. If money supply growth exceeds the growth of the overall economy, the result will be inflation, or the general rise of prices for goods and services.Inflation occurs when consumers have more disposable income, and they are willing to pay higher prices for goods. This drives up the prices in the market and causes a devaluation of the money supply. When this happens, the increase in prices creates an atmosphere of fear and uncertainty that slows business activity.Deflation occurs during the decline of prices due to insufficient money supply. This can be destructive because not enough money is spent to keep businesses active. Layoffs and unemployment will increase.Monetary Policy in Action The Federal Reserve, often referred to simply as "the Fed," is responsible for conducting monetary policy. In other words, it is responsible for changing the money supply to its most ideal level. It has several tools it can use in its attempts to do so.However, its most effective and commonly used tool is called open market operations whereby it buys or sells U.S. Treasury bonds. These bonds are used by many citizens, banks, and businesses as a safe investment.When the Fed sells U.S. Treasury bonds in the market, it absorbs money that might have gone to other uses in the economy. This effectively lowers the money supply. In other words, when people buy the bonds, they are investing money that they might have spent elsewhere. Selling of Treasury bonds is referred to as tightening, a part of contractionary monetary policy. When the Fed buys Treasury bonds, it releases new money into the economy, increasing money supply. The purchase of Treasury bonds is part of expansionary monetary policy.Adjusting the discount rate is another way the Fed controls the supply of money. The discount rate is the interest rate the Fed charges the borrowers. Banks are able to borrow directly from the Fed when they need to. Banks do this to meet their constantly changing needs. They also borrow from other banks.When the Fed increases the discount rate, banks will pass on this increase to their customers by raising the interest rates they charge.The Fed also has the power to change the reserve requirements of banks, which is the percentage of a bank's total deposits that must be kept in its possession and not loaned to borrowers.Because banks can lend more money than their customers have deposited, they are able to essentially create more money. However, there is a percentage limit on how much more money a bank may create. A higher reserve requirement results in less bank lending and therefore less money in the economy. A lower requirement can result in the opposite effect.Monetary Policy Effects Monetary policy can have a more direct influence on businesses and individuals than fiscal policy because of its effect on interest rates. Interest rates are the cost of borrowing and the payment for lending.Interest rates are calculated as a percentage of the original loan. This extra percentage that must be paid back to the bank is the manner in which the bank earns a profit from lending the money.An environment of high interest rates can cause difficulty for businesses. They are dependent on borrowing for financing company growth and investment. A factory owner may borrow money if rates are low to double the size of operations, which leads to new jobs and business activity. On the other hand, if interest rates are high, the company may decide to not borrow money and expand. Workers who might have been given jobs remain unemployed. Low interest rates may encourage borrowing, but they do the opposite for saving. Ordinary people have less incentive to save if they are paid little for their cash deposits in banks. They will instead be more likely to spend their money on large items such as homes and cars, with which they can get loans from their banks at a low rate. People may also pursue higher risk investments in the stock market in order to beat the low interest the bank is paying. This may result in problems when investments go bad.

Fiscal Policy Principles Fiscal policy is the system of revenue, funds obtained from taxes, and the manner in which the revenue will be spent in order to influence the economy. It centers on aggregate demand, the total demand for final goods and services in the economy.

Most theories on modern fiscal policy are based on the works of famed English economist John Maynard Keynes (1883-1946). He advocated a strong role of government in managing the economy by adjusting spending levels and tax rates.