Economics Unit 6

balanced budget

budget in which revenues are equal to spending

How Quickly Does the Economy Self-Correct?

Economists disagree on the answer to this question. Their estimates for the U.S. economy range from two to six years. Since the economy may take quite a long time to recover on its own from an inflationary peak or a recessionary trough, there is time for policymakers to guide the economy back to stable levels of output and prices.

national debt

all the money the federal government owes to bondholders

operating budget

budget for day-to-day expenses

capital budget

budget for major capital, or investment, expenditures

Medicare

national health insurance program that helps pay for health care for people over age of 65 or with certain disabilities

tax exempt

not subject to taxes

real property

physical property such as land and buildings

personal property

possessions such as jewelry, furniture, and boats

incidence of a tax

the final burden of a tax

crowding-out effect

the loss of funds for private investment due to government borrowing

productive capacity

the maximum output that an economy can produce without big increases in inflation

What are forms of local govenrment?

towns, cityies, townships, counties, special districts, more than 87,000 local govenrments in US

What are tax bases and tax structures?

Tax bases can be based on a person's earnings, dollar value of a good or service being sold, value of a property, or the value of a company's profit. Three tax structures are proportional tax, progressive tax, and regressive tax. Federal income tax is a progressive tax.

How does the federal government get its money?

individual and corporate income, social insurance, excise, estate and gift, and import taxes

What is discretionary spending?

Spending on defence accounts for 1/2 of discretionary spending. Other spending too.

What is state tax revenue?

States can't tax imports or exports, can't tax goods sent between states, can't tax fed property or nonprofit organizations. States main source of revenue = sales tax. States withotu sales tax have an excise tax. Income tax, corporate income tax, licensing fee, severance tax, real proeprty tax, personal property tax.

what are the jobs of the local governmetn

public school systems law enforcement fire protection public facilites such as libraries, airports, etc. parks and recreational facilities public health public transportation elections recrod keeping social services

personal exemption

set amount that you subtract from your gross income for yourself, your spouse, and any dependents

witholding

taking tax payments out of an employee's pay before he or she receives it

How do taxes fund government programs?

taxation is the primary way that government gets money. Without revenue from taxes, government wouldn't be able to provide goods/services that it must provide for citizens.

deductions

variable amounts that you can subtract, or deduct, from your gross income

What is the relation between fiscal policy and the economy?

Government officials who take part in the budget process debate how much be spent on specific programs such as defence, education, and scientific research. The consider how much should be spent in total. The total level of government spending can be changed to help increase or decrease the output of the economy. Taxes can be raised or lowered to help increase or decrease the output of the economy. Fiscal policies that try to increase output are known as expansionary policies. Fiscal policies that try to decrease output are called contractionary policies.

corporate income tax

a tax on the value of a company's profits

tax return

form used to file income taxes

discretionary spending

spending category about which government planners can make choices

mandatory spending

spending on certain programs that is mandated, or required, by existing law

FICA

taxes that fund Social Security and Medicare

multiplier effect

the idea that every one dollar of government spending creates more than one dollar in economic activity

Policy Lags

As you can see, there are a couple of problems in the timing of macroeconomic policy. These are called policy lags.

What is Social Security?

Largest federal spending. More than 50 million receive monthly benefits. Social Security Administration = independent agency since 1995. Before then, spending was part of budget for Health and Human Services Department.

Social Security

Old-Age, Survivors, and Disability Insurance (OASDI)

Serving Government

The United States government has an operating budget of about $2.3 trillion. It raises about $1.1 trillion annually in taxes. It makes about $1 trillion in transfer payments through programs such as Medicare and Social Security. For its banking needs, the federal government turns to the Federal Reserve.

budget surplus

a situation in which the government takes in more money than it spends

tax assessor

an official who determines the value of a property

What are corporate income taxes?

Corporate taxes make up less than 10% of federal revenue. A corporation's taxable income is hard to find because businesses can make many deductions. Progressive tax. 15% ON $50,00 AND 35% ON $10,000,000.

Fiscal Policy in American History

Keynes present his ideas at the same time that the world economy was still engulfed in teh great Depression. President Herbert Hoover, influence by classical economics though that the economy was basically sound and would return to equilibrium on its own. His popular successor, President Franklin D. Roosevelt, was much more willing to increase government spending to help lift the economy out of depression. After the Democratic party won landslide victories in 1932 and 1934 federal elections, Roosevelt started several programs to pump money into the economy. Keynes theory was fully tested in the US during WWII. As the country geared up for war, government spending increased dramatically. The government spent large sums of money to feed soldiers and equip them with everything from warplanes to rifles to medical supplies. This money was given to the private sector in exchange for goods. Just as Keynesian economics predicted, the additional demand for goods and services moved the country sharply out of the Great Depression and toward full productive capacity. After the war, Congress created the Council of Economic Advisors. Between 1945 and 1960, US economy was healthy and growing despite a few minor recessions. The last recession continued into the term of President John F. Kennedy, with unemploymnet at 6.7%. Kennedy's chief financial policy adviser was walter Hller, a Keynesian who thought that the economy was below productive capavity. Heller believed that unemployment would fall to 4% if hte economy were at full capacity. He convinced Kennedy that tax cuts would stimulate demand and bring the economy closer to full productive capacity. Tax rates were extremely high in the early 1960s. The hihgest individual income tax rate was 90%, compared to the 40% today. The top business rate waas 52% compared with 35% toady. Kennedy proposed tax cuts, both because he agreed with Heller, and tax cuts are popular. Modified version of kennedy's tax cuts were enacted in 1964 after he was assassinated. Vietnam War raised government spending. Over next two years, the economy grew rapidly. Consumption and GDP increased by more than 4% a year. While there is no way to prove that the tax cut cuased this increase, the result is what Keynesian economics had predicted. Keynesian economics was used on many other occasions in the 1960s and 1970s to try to adjust the national economy. During the late 1970s, however, unemployment and inflation rates soard. Ronal Reagan became President in 1981 and instituted new policies based on supply-side economics. In 1981, Reagan proposed a tax cut that was put in place and reduced taxes by over 25% for three years. Unlike Keynes, Reagan did not believe that governmetn spending should be used to bring the economy out of a recession. After recession in 1982, the economy recovered. For many reasons, government spending continued to rise each year whiel Reagan was in office. During the Reagan and George H.W. Bush presidencies and first years of Bill Clinton's first term, the federal government spend much more money than it took in. This gap caused increasing concern among economicsts and policymakers.

Monetary Supply and Interest Rates

It is easy to see the cost of money if you are borrowing it. The cost—the price that you as borrower pay—is the interest rate. Even if you have your own money, however, the interest rate still affects you. The interest rate is also the cost of having money, because you are giving up interest by not saving or investing. Thus, the interest rate is always the cost of money. The market for money is like any other market. If the supply is higher, the price—the interest rate—is lower. If the supply is lower, the price—the interest rate—is higher. In other words, when the money supply is low, interest rates are high. When the money supply is high, interest rates are low.

What is Medicaid?

Largest source of funds for medical and health-related services for America's poorest people.

What are mandatory and discretionary spending?

Social security and Medicare = mandatory. Defence and education = discretionary spending. Percentage of federal spending that is mandatory has grown over the years, while the percentage of discretionary spending has decreased.

Open Market Operations

The most important monetary policy tool is open market operations. Open market operations are the buying and selling of government securities to alter the supply of money. Open market operations are by far the most-used monetary policy tool.

What is Federal aid to the state and local governments?

$406 million of federal monies is divided among states. Share cost of Midicaid, unemployment compensation, children, family and refugee programs. Fed money to state for education, lower-income housing, mass-transit, health care, highway construction, employent training, and other stuff. Fed grants-in-aid are grants of Fed moeny for closely defined prupsoe.

treasury bill

a government bond that is repaid within three months to a eyar

treasury note

a government bond that is repaid within two to ten years

automatic stabiliser

a government program that changes automatically depending on GDP and a person's income

Council of Economic Advisers (CEA)

a group of economists that advise the President on economic policy

Reducing Reserve Requirements

A reduction of the RRR would free up reserves for banks, allowing them to make more loans. It would also increase the money multiplier. Both effects would lead to a substantial increase in the money supply.

Borrowing Money

As an alternative to creating money to cover a budget deficit, the federal government can borrow money. The government commonly borrows money by selling bonds. As you read in Chapter 11, a bond is a type of loan: a promise to repay money in the future, with interest. Consumers and businesses buy bonds from the government. The government thus has the money to cover its budget deficit. In return, the purchasers of the bonds earn interest on their investment over time. United States Savings Bonds allow millions of Americans to lend small amounts of money to the federal government for a period as brief as three months or as long as 30 years. In return, they earn interest on the bonds. Other common forms of government borrowing are Treasury bills, Treasury notes, and Treasury bonds. Treasury bills are short-term bonds that must be repaid within a year or less. Treasury notes cover periods from two to ten years. Treasury bonds may be issued for as long as 30 years. Federal borrowing lets the government undertake more projects than it could otherwise afford. These include projects such as building airports, highways, and national parks. Wise borrowing allows the government to create more public goods and services. Federal borrowing, however, also has serious disadvantages.

Budget Deficits and the National Debt

As you have learned, the federal government uses fiscal policy—taxing and spending—to make changes in the economy. Fiscal policy is a powerful tool. It can be used to help stimulate demand, increase production, create jobs, increase GDP, avoid recessions, control inflation, and stabilize economic growth. As you'll read in this section, raising government spending can lead to yearly budget deficits that add up to an enormous debt. The costs of this debt must be measured against the benefits of higher government spending.

Reserves

As you read in Chapter 10, the United States banking system operates as a fractional reserve banking system. Banks hold in reserve only a fraction of their funds—just enough to meet customers' daily needs. Banks then lend their remaining reserves, charging interest to earn returns. Each financial institution that holds deposits for customers must report daily to the Fed about its reserves and activities. The Fed uses these reserves to control how much money is in circulation at any one time. You'll read more about the Fed's role in controlling the money supply in the next section.

How Monetary Policy Works

Monetary policy alters the supply of money. The supply of money, in turn, affects interest rates. As you read earlier, interest rates affect the level of investment and spending in the economy.

The Problem of Timing

Monetary policy, like fiscal policy, must be carefully timed if it is to help the macro-economy. If policies are enacted at the wrong time, they could actually intensify the business cycle, rather than smooth it out. To see why, consider Figure 16.10.

How Banks Create Money

Money creation does not mean the printing of money. Banks create money not by printing it, but by simply going about their business. For example, suppose you take out a loan of $1,000. You decide to deposit the money in a checking account. Once you have deposited the money, you now have a balance of $1,000. Since demand deposit account balances, such as your checking account, are included in M1, the money supply has now increased by $1,000. The process of money creation begins here. Banks make money by charging interest on loans. Your bank will lend part of the $1,000 that you deposited. The amount that the bank is allowed to lend is determined by the required reserve ratio (RRR)—the fraction of the deposit that must be kept on reserve. This is calculated as the ratio of reserves to deposits. The RRR is the fraction of deposits that banks are required to keep in reserve. The required reserve ratio, which is established by the Federal Reserve, ensures that banks will have enough funds to supply customers' withdrawal needs. Suppose in our example that the RRR is 0.1, or 10 percent. This means that of your $1,000 demand deposit balance, the bank is allowed to lend $900. Let's say the bank lends that $900 to Elaine, and she deposits it in her checking account. Elaine now has $900 she didn't have before. Elaine's $900 is now included in M1. You still have your $1,000 demand deposit account balance, on which you can write a check at any time. Thus, your initial deposit to the bank, and the subsequent loan, have caused the money supply to increase by $ 1,000 + $ 900 dollars , 1,000 , plus dollars 900 for a total of $1,900. Now suppose that Elaine uses the $900 to buy Joshua's old car. Joshua deposits the $900 from Elaine into his checking account. His bank keeps 10 percent of the deposit, or $90, as required reserves. It will lend the other $810 to its customers. So, Joshua has a demand deposit balance of $900, which is included in the money supply, and the new borrower gets $810, which is also added to the money supply. This means that the money supply has now increased by $ 1,000 + $ 900 + $ 810 = $ 2,710 dollars , 1,000 , plus dollars 900 plus dollars 810 equals dollars , 2,710 —all because of your initial $1,000 deposit. (See Figure 16.5.)

federal budget

a plan for the federal government's revenues and spending for the coming year

fiscal year

a twelve-month period that can begin on any date

Where are state taxes spent?

education, public safety, highways and transportation, public welfare, arts and recreation, administration

Medicaid

entitlement program that benefits low-income families, some people with disabilities and elderly people in nursing homes

what is fiscal policy as a tool?

fiscal policies are used to achieve economic growth, full employment, and price stability. Government spends $250 million every hour and $6 billion every day, and $2.3 trillion every year. Fiscal policy decisions-how much to spend and how much to tax-are among the most important the federal government makes.

expansionary policies

fiscal policies, like higher spending and tax cuts, that encourage economic growth

contractionary policies

fiscal policies, like lower spending and higher taxes, that reduce economic growth

taxable income

income on which tax must be paid; total income minus exemptions and deductions

tax base

income property, good, or service that is subject to a tax

revenue

income received by a government from taxes and non-tax sources

entitlement

social welfare program that people are 'entitle to' if they meet certain eligibility requirements

classical economics

the idea that free markets can regulate themselves

demand-side economics

the idea that government spending and tax cuts help an economy by raising demand

hyperinflation

very high inflation

Keynesian Economics

Maynard Keynes didn't like the idea of waiting for the economy to recover on its own. He wanted to develop a comprehensive explanation of economic forces that would tell economists and politicians how to get out of economic crises like the Great Depression. It should also tell them how to avoid crises in the first place. In contrast to classical economics, Keynes wanted to give government a tool it could use now. Classical economists saw equilibrium of supply and demand for individual products. Keynes focused on the economy as a whole. Keynes looked at the productive capacity of the entire economy. Keynes tried to answer: why does the actual production in an economy sometimes fall far short of its productive capacity? Keynes said that the Great Depression was continuing because enither consumers nor businesses had inventive to spend enough to cause an increase in production. The only way to end the Depression would be if someone started spending. Keynes believed the spender should be government. In early 1930s, only government still had resources to spend enough to affect the whole economy. The government could make up for the drop in private spending by buying goods and services on its own. Keynes argued it would encourage production and increase employment. Then, as people went back to work, they would spend their wages on more goods and services. Then the government would step back once more when everything was fine again. This is known as demand-side economics because it involves changing demand to help the economy. These ideas are the basis of Keynesian economics which is the idea that the economy is composed of three sectors- individuals, business, and government- and that government actions can make up for changes in the other tow. Keynesian economics proposes that by using fiscal policy, government can help the economy. Keynes argued that fiscal policy can be used to fight two macroeconomic problems: periods of recession/depression and periods of inflation. The federal government should keep track of the total level of spending by consumers, businesses, and government in economy. If total spending begins to fall far below the level require to keep the economy running at full capacity, the government should watch out for the possibility of an upcoming recession or depression. Government can respond by increasing its own spending until spending by the private sector returns to a higher level. Or it can cut taxes so that spending and investment by consumers and businesses increases. President Franklin D. Roosevelt carried out expansionary fiscal policies after his election in 1932. His New Deal put people to work building dams, etc. all paid by government. Many argued that instead of creating new jobs, public works projedcts only shift employment from the private to the public sectors. The taaxes required to pay for them reduce demand in the private as much as they increase it in the public sector. Work relief jobs are less productive than private sector jobs because their goal is employment, not efficient production. Keynes said that government should use contractionary fiscal policy to prevent inflation. The government can reduce inflation either by increasing taxes or by reducing its own spending. Both of these actions decrease overall demand The key to fiscal policy power if the multiplier effect. The effects of changes in fiscal policy are multiplied. If federal government finds business investment is dropping, it begins to fear a recession. To prevent this, the government spend an extra $10 billion to stimulate the economy. With this government spending, demand, income, and GDP will increase by $10 billion. If government buys $10 billion good/services the $10 billion worth of goods/services has been produced. The businesses that sold the $10 billion in goods/services have earned an additional $10 billion. These businesses spend additional earning on wages, raw materials, and investment, sending money to workers, other suppliers, and stock holder. REcipients spend about 80% of that money. THe businesses that benefit from the second round of spending pass it back to households who will spend 80% of it. The next round will add an additional %5.1 billion to the economy and so on. When all these rounds of spending are added up, the inital government spending of $10 billion leads to an increase of $50 billion in GDP. The multiplier effect gives fiscal policy initiatives a much bigger kick than the initial amount spent. Fiscal policy is used to achieve many economic goals. One of most important things fiscal policy can achieve is a more stable economy. A stable economy is one in which there are no rapid changes in the economic indicators. What's more, set up properly, fiscal policy can come close to stabilizing the economy automotically. After WWII, federal taxes and spending on transfer payments (two key tools of fiscal policy) increased sharply. Taxes and transfer payments stablize economic growth. When national income is high, government collects more taxes and pays out less transfer payments. When income is low, government collects less in taxes and pays out more in transfer payments. Policymakers do not have to make changes in taxes and transfer payments for them to have their stabilising effect. Taxes and most transfer payments are tied to GDP and personal income, so they change automatically. Thus, taxes and trasnfer payments are known as automatic stabilizers.

Members Banks

All nationally chartered banks are required to join the Federal Reserve System. The remaining members are state-chartered banks that join voluntarily. Since 1980, all banks have equal access to Fed services like check clearing and reserve loans, whether or not they are Fed members. Each of the approximately 4,000 Fed member banks contributes a small amount of money to join the system. In return, they receive stock in the system. This stock earns them dividends from the Fed at a rate of up to 6 percent. A research arm of the Fed, the Federal Advisory Council (FAC), collects information about each district and reports to the Board of Governors about economic conditions within their districts. It consists of one member from each Federal Reserve District—twelve members in all. The FAC's main function is to provide feedback and advice to the Board of Governors concerning the overall financial health of each district. The FAC meets with the Board of Governors four times a year. The fact that the banks themselves, rather than a government agency, own the Federal Reserve gives the system a high degree of political independence. This independence helps the Fed to make decisions that best suit the interests of the country as a whole.

Continued Need for Reform

Although the Federal Reserve System helped to restore confidence in the banking system beginning in 1914, it has also learned through trial and error the best ways to fulfill its responsibilities. During the Great Depression, the financial crises of 1930-1933 were exactly the kinds of problems that the NMC had hoped to avoid by creating the Federal Reserve System. The system did not work well, however, because the twelve regional banks each acted independently. Their separate actions often canceled one another out. The Governor of the Federal Reserve Bank of New York (a bank with a close relationship to Wall Street and the investment community) believed that to counteract the growing recession, the government needed to pump money into investment and help Americans get back to work. Many of the other regional governors disagreed about what kinds of action to take. They were more concerned about maintaining gold reserves and with administrative issues than with helping the economy to recover from the widespread recession. By the time Congress forced the Fed to take strong action in 1932, it was too little, too late. The financial crisis had deepened to the point that recovery became long and difficult.

Banking History

As you read in Chapter 10, the issue of a central bank has been debated hotly since 1790, when Federalists lined up in favor of a central bank. The first bank of the United States issued a single currency. It also reviewed banking practices and helped the federal government carry out its duties and powers. Partly because of the continued debate over state versus federal powers, however, the first bank lasted only until 1811. At that time, Congress refused to extend its charter. Congress established the Second Bank of the United States in 1816 to restore order in the monetary system. However, many people feared that a central bank placed too much power in the hands of the federal government. Political opposition toppled the Second Bank in 1836 when its charter expired. A period of confusion followed. States chartered some banks, while the federal government chartered and regulated others. Reserve requirements—the amount of reserves that banks are required to keep on hand—were difficult to enforce, and the nation experienced a series of serious bank runs. The Panic of 1907 finally convinced Congress to act. The nation's banking system needed to address two issues. First, consumers and businesses needed access to increased sources of funds to encourage business expansion. Second, banks needed a source of emergency cash to prevent depositor panics that resulted in bank runs.

Setting Rates

As you read in Section 2, the discount rate is the interest rate that the Federal Reserve charges on loans to financial institutions. In the past, the discount rate was changed to increase or decrease the money supply. Today, the discount rate is primarily used as a mechanism to insure that sufficient funds are available in the economy. For example, during a financial crisis, there may not be enough funds available in the banking system to provide the necessary loans to businesses and individuals. In that case, the ability of banks to borrow at the discount rate from the Federal Reserve provides an important safety valve. Today, when the Federal Reserve makes its decisions on monetary policy, it does so by setting a target for the federal funds rate, which is the rate that banks lend reserves to one another. The Federal Reserve keeps the discount rate above the funds rate. Banks will initially borrow from one another at the federal funds rate. But if they need additional funds, they will turn to the Federal Reserve and borrow at the discount rate. When the Federal Reserve increases or decreases the federal funds rate, the discount rate will rise or fall with it. Changes in the federal funds rate and the discount rate affect the cost of borrowing to banks or financial institutions. In turn, these changes in interest rates affect the prime rate. The prime rate is the rate of interest that banks charge on short-term loans to their best customers—usually large companies with good credit ratings. Changes in the federal funds rate and discount rate are reflected in the prime rate. The discount rate, federal funds rate, and prime rate are short-term rates. They determine the cost of borrowing money for a few hours, days, or months. As you read in Chapter 12, short-term rates have a limited impact on the long-term growth of the economy. To influence long-term interest rates, the Federal Reserve must use other tools.

What is a 'fair' tax system?

Benefits-received principle: a person should pay taxes based on the level of benefits he or she expects to receive. This way, people who use the most benefits contribute the most to keep things nice. Ability-to-pay principle: People should pay taxes according to their ability to pay. People who earn more, pay more.

Monetary Policy Tools

Banks create money in their day-today operations. The Federal Reserve uses the tools of monetary policy to control the amount of money in circulation. In early 2001, when it appeared that economic growth was slowing, the Fed began reducing interest rates. The September 11 terrorist attacks further increased the need for such changes in economic policy. By early 2003, the Fed had cut interest rates 13 times, to 45-year lows. By reducing the cost of borrowing, the Fed hoped to encourage consumers to spend more money and stimulate economic growth. In this section you will see why the Fed uses these tactics to influence economic growth.

Regulated the Banking System

Banks, savings and loan companies, credit unions, and bank holding companies are supervised by various state and federal authorities. The Fed coordinates all regulatory activities.

Efforts to Reduce Deficits

Concerns about the budget deficits of the mid-1980s caused Congress to pass the Gramm-Rudman-Hollings Act, which created automatic across-the-board cuts in federal expenditures if the deficit exceeded a certain amount. This saved lawmakers from having to make difficult decisions about individual funding cuts. The Act exempted significant portions of the budget (such as interest payments and many entitlement programs) from the cuts. When the Supreme Court found that significant portions of the Act were unconstitutional, Congress attempted to correct the flaws. In 1990, however, lawmakers realized that the deficit was going to be much larger than expected. Because Congress had exempted so many programs from automatic cuts, funding for non-exempt programs would be dramatically reduced. To resolve the crisis, President George H.W. Bush and congressional leaders negotiated a new budget system that replaced Gramm-Rudman-Hollings. The 1990 Budget Enforcement Act created a "pay-as-you-go" system that requires Congress to raise enough revenue to cover increases in direct spending, so that the budget deficit cannot grow larger. In addition, at various times citizens and politicians have suggested amending the Constitution to require a balanced budget. In 1995, a balanced budget amendment passed in the House and failed by only a single vote in the Senate. Supporters argued that the amendment would force the federal government to be more disciplined about its spending. Opponents objected that a constitutional amendment would not be flexible enough to deal with rapid changes in the economy.

Federal Reserve Act of 1913

Congress created the National Monetary Commission (NMC) in 1908 to propose solutions to the nation's banking problems. Based on the NMC's recommendations, Congress passed the Federal Reserve Act in 1913. The resulting Federal Reserve System, now often referred to simply as "the Fed," was composed of a group of twelve independent regional banks. This central group of banks could lend to other banks in times of need.

Limits of Fiscal Policy

Difficulty of Changing Spending Levels: nearly 60% of the budget can't be changed, so the government struggles to change spending levels Predicting the Future: It is hard to predict business cycles. Lawmakers put off making changes in fiscal policy until they know about how the economy is performing, but by then it is too late. Delayed Results: It takes time to put these changes into effect. Political Pressures: If the members of Congress and President want to be reelected, they must sometimes make bad economic decisions to keep the people happy. Coordinating Fiscal Policy: Various branches of government must work together. It is hard for governments in fed, state, and local to work together whilst pursuing different goals. People disagree on how the economy is performing and what the fiscal goals should be. Fiscal policy has to coordinate with the monetary policies of the Federal Reserve. Short-term vs Long-term Effects: The short-term effect may be different to the long-term effect. E.g. a tax cut or increased government spending will give a temporary boost to the economic production and to employment, but when the economy turns to full employment, high levels of government spending combined with market spending will lead to increased inflation. Or if the government reduces spending, it might lead to a recession

What is defence spending?

Dropped since end of cold war. Consumes 20% of federal budget. Pays salaries of men in army. 1.4 million in uniform and 654,000 civilians working for armed forces. Buys weapons, and maintains military stuff.

Deficits, Surpluses, and the National Debt

During the 1980s and into the 1990s, annual budget deficits added substantially to the national debt. Several factors frustrated lawmakers in their attempts to control the deficits. As we have seen, much of the budget consists of entitlement spending that is politically difficult to change. Another large part of the budget consists of interest that must be paid to bondholders. Finally, specific budget cuts are often opposed by groups affected.

What are other types of taxes?

Excise taxes: Excise tax is a general revenue tax on the sale or manufacture of a good. Federal excise taxes apply to gasoline, cigarettes, alcohol beverages, telephone services, cable television, etc. Estate taxes: Paid out of the person's estate before the heirs receive their shares. Person's estate includes money, real estate, cars, furniture, investments, jewellery, paintings, and insurance. Gift taxes: Goal of gift tax, established in 1924, was to keep people from avoiding estate taxes by giving away their money before they died. Tax law sets limits on gifts, but still allows tax-free transfer of fairly large amounts each year. Import taxes: Tariffs are intended to protect American farmers and industries from foreign competition.

Good Timing

Figure 16.10A shows the business cycle with a properly timed stabilization policy. The green curve, which shows greater fluctuations, is the business cycle as explained in Chapter 12. The goal of stabilization policy is to smooth out those fluctuations—in other words, to make the peaks a little bit lower and the troughs not quite as deep. This will minimize inflation in the peaks and the effects of recessions in the troughs. Properly timed stabilization policy smooths out the business cycle, as shown in the red curve in Figure 16.10A.

Check Clearing

Figure 16.3 shows how checks "clear" within the Fed system. Check clearing is the process by which banks record whose account gives up money and whose account receives money when a customer writes a check. The Fed can clear millions of checks at any one time using high-speed equipment. Most checks clear within two days—a remarkable achievement when you consider that the Fed deals with about 20 billion checks per year.

What are other mandatory spending programs?

Food stamps, Supplemental Security Income (SSI), and child nutrition. Insurance for federal workers, veterans' pensions, and unemployment insurance.

Contractionary Fiscal Policies

Government sometimes tries to slow economy because fast-growing demand exceeds supply. When demand exceeds supply, producers must choose between raising output and raising prices. If producers cannot expand production, they will raise their prices which leads to high inflation. Contractionary fiscal policies either decrease government spending or raise taxes. Decreasing Government Spending: If federal government spends less, there is a decrease in aggregate demand. Decrease in demand leads to lower prices. Lower prices encourage supplier to cut their production. Lower production lwoer growth rate and GDP of economy. Increasing Taxes: Individuals have less buying opwer and demand decreases.

What are taxes that affect behaviour

Government uses tax policies to discourage the public from buying harmful products. Taxes are used to encourage certain types of behaviour. Taxes deductions encourage certain stuff.

What are expansionary fiscal policies?

Governments use expansionary fiscal policies to raise the level output in the economy. They use expansionary policies when the is a recession or to prevent a recession. Expansionary fiscal policies either increase government spending or cut taxes. Increasing Government Spending: If the federal government increases its spending or buys more goods and services, it triggers chain of events that raises output and creates jobs. Government spending increases aggregate demand which causes prices to rise. According to law of supply, higher prices encourage more production. To do this, more jobs are created. An increase in demand leads to lower unemployment and increased output. Cutting Taxes: If federal government cuts taxes, individuals have more to spend, and businesses keep more of their profits. Consumers will have more money to spend on goods and services, and firms will have more money to spend on land, labor, and capital.

Bad Timing

If stabilization policy is not timed properly, however, it can actually make the business cycle worse, not better. For example, suppose that policymakers are slow to recognize the contraction shown as the green line in Figure 16.10B. Perhaps because their data are inaccurate or slow to arrive, government economists simply do not realize that a contraction is occurring until the economy is deeply into it. Some period of time may pass before they recognize the contraction. Likewise, it takes time to enact expansionary policies and have those policies take effect. By the time this takes place, the economy may already be coming out of the recession on its own. If the expansionary effects of a loose money policy affect the economy while it is already expanding, the result could be an even larger expansion that causes high inflation. If expansionary policies are enacted too late, the economy may have slowed down so much that businesses are reluctant to borrow at any rate for new investment. This dilemma, in which the central bank is unable to encourage lending with rate cuts, is called "pushing on a string."

Bond Sales

If the FOMC chooses to decrease the money supply, it must make an open market bond sale. In this case, the Fed sells government securities back to bond dealers, receiving from them checks drawn on their own banks. After the Fed processes these checks, the money is out of circulation. This operation reduces reserves in the banking system. Banks reduce their outstanding loans in order to keep reserves at the required levels. The money multiplier process then works in reverse, resulting in a decline in the money supply that is greater than the value of the initial securities purchase.

Monetary and Fiscal Policy

In 1929, the collapse of the stock market touched off a period of economic devastation known as the Great Depression. Millions of Americans found themselves unemployed and lost their homes, farms, and life savings.

Emergency Action

In 1933, President Franklin D. Roosevelt took emergency action and declared a bank "holiday." All banks closed temporarily to stop the banking panic. Congress then passed the Banking Act of 1933, which created the Federal Deposit Insurance Corporation (FDIC) to insure deposits. This meant that even if a bank failed, deposits would be guaranteed by the federal government. Meanwhile, banks became extremely cautious. They made fewer loans and kept enough cash on hand in case depositors all came at once to withdraw their funds. Banks began to hold substantial reserves, far in excess of those required by the Federal Reserve.

A Stronger Fed

In 1935, Congress adjusted the Federal Reserve's structure so that the system could respond more effectively to future crises. These reforms created the Federal Reserve System as we know it today. The new Fed enjoys more centralized power so that the regional banks can act consistently with one another while still representing their own districts' banking concerns.

Measuring the National Debt

In dollar terms, the size of the national debt is extremely large. In 2004, it exceeded $7 trillion! Such large numbers can be confusing. A more useful way to evaluate the size of the debt is to look at it as a percentage of GDP. Historically, debt as a percentage of GDP rises during wartime, when government spending increases faster than taxation, and falls during peacetime. Notice how the pattern changed in the 1980s, when the United States began to run a large debt, even though the country wasn't at war. The debt was in part a result of increases in spending during President Ronald Reagan's terms. As you read in the previous section, the Reagan administration also lowered tax rates to pull the economy out of a recession. The combined effect of higher spending and lower tax rates was several years of increased budget deficits. The government borrowed billions of dollars to cover these deficits, adding to the national debt. Meanwhile, an economic downturn in 1981-1982 reduced GDP. As a result, the ratio of debt to GDP grew very large for peacetime.

Classical Economics

In free market, people act in their own self-interest, causing prices to rise or fall so that supply and demand will always return to equilibrium. The idea that free markets regulate themselves = classical economics. Adam Smith, David Ricardo, and Thomas Malthus = classical economists. Classical economics dominated economic theory and government policies. But after Great Depression it changed. Prices fell so demand should have increased, but instead, demand also fell as people lost their jobs. Essentially, the Great Depression did the opposite of what classical economics said. Classical economics did not address how long it would take for markets to return to equilibrium.

Bank Failures

In late October 1929, dropping stock prices caused many panicked investors to sell their stocks, which resulted in the collapse of the stock market on October 29, 1929. Banks had invested heavily in the stock market and lost huge sums. Fearful that banks would run out of money, people rushed to their banks demanding their money. To pay back these deposits, banks had to recall loans from borrowers, but they could not do so fast enough to pay all the depositors demanding their money. Thousands of banks failed.

Approaches to Monetary Policy

In practice, the lags discussed here make monetary and fiscal policy difficult to apply. Interventionist policy, a policy encouraging action, is likely to make the business cycle worse if the economy self-adjusts quickly. Laissez-faire economists who believe that the economy will self-adjust quickly will recommend against enacting new policies. Economists who believe that economies emerge slowly from recessions, however, will usually recommend enacting fiscal and monetary policies to move the process along. The rate of adjustment may also vary over time, making policy decisions even more difficult. This debate over which approach to take with monetary policy will probably never be settled to the satisfaction of all economists.

What are the individual income taxes?

Individual income taxes makes up 45% of fed government revenue. The amount of federal income tax is determined on annual basis. Uses 'pay-as-you-earn' system. Individuals pay most of their income tax throughout the year as they earn income. Mid-April, they pay any additional income taxes they owe.

The Difference Between Deficit and Debt

Many people are confused about the difference between the deficit and the debt. The deficit is the amount of money the government borrows for one budget, representing one fiscal year. The debt, on the other hand, is a sum of all the government borrowing up to that time, minus the borrowings that have been repaid. The debt is the total of all deficits and surpluses.

What is the future of entitlement spending?

Medicare and Social Security spending increased in recent years and will increase in next few decades. Social Security payments will rise as baby boomer generation starts to retire. When baby boomers reach 65, Medicare spending will increase. Medicare costs grow due to expensive technology and people live longer. Currently 4 people pay cost for 1 medicare patient. 2050, only 2 people will pay for 1 medicare patient.

Structure of the Federal Reserve

Member banks themselves own the Federal Reserve System. Like so many American institutions, the structure of the Federal Reserve System represents compromises between centralized power and regional powers. (See Figure 16.1.)

What are entitlement programs?

Minus interest on nation debt, most mandatory spending goes to entitlement programs. Fed guarantees assistance to all that meet requirements. Some entitlements are 'means-tested'. Meaning that people with higher incomes receive lower benefits or no benefits at all. Medicaid is 'means-tested'. Social Security isn't 'means-tested'.

Other Views of a National Debt

Not everyone agrees that the national debt is such a large problem. Traditional Keynesian economists believe that fiscal policy is an important tool that can be used to help achieve full productive capacity. To these analysts, the benefits of a productive economy outweigh the costs of interest on national debt. However, a budget deficit can only be an effective tool if it is temporary. If the government runs large budget deficits each year, the costs of the growing debt will eventually outweigh the benefits.

Outside Lags

Once a new policy is determined, it takes time to become effective. This time period, known as the outside lag, also differs for monetary and fiscal policy. For fiscal policy, the outside lag lasts as long as is required for new government spending or tax policies to take effect and begin to affect real GDP and the inflation rate. This time period can be relatively short, as with a tax rebate that returns government revenues to households eager for spending money. One statistical model concluded that an increase in government spending would increase GDP after just six months. Outside lags can be much longer for monetary policy, since they primarily affect business investment plans. Firms may require months or even years to make large investment plans, especially those involving new physical capital, such as a new factory. Thus, a change in interest rates may not have its full effect on investment spending for several years. This conclusion is supported by several studies that suggest that the outside lag for monetary policy is probably rather long. More than two years may pass before the maximum impact of monetary policy is felt. Given the longer inside lag for fiscal policy and the longer outside lag for monetary policy, it is not obvious which policy has the shorter total lag. In practice, partisan politics and budgetary pressures often prevent the President and Congress from agreeing on fiscal policy. Because of the political difficulties of implementing fiscal policy, we rely to a greater extent on the Fed to use monetary policy to soften the business cycle.

The National Debt

One problem with the government borrowing money is that it creates a national debt. The national debt is the total amount of money the federal government owes to bondholders. Every year that there is a budget deficit, and the federal government borrows money to cover it, the national debt will grow. The national debt is owed to investors who hold Treasury bonds, bills, and notes. If you have a federal savings bond, that bond represents money you have loaned the government. Bonds issued by the United States federal government are considered to be one of the safest investments in the world. The national debt is owned by investors in the United States and around the world who have put their money and their trust in the federal government. In this way, a modest national debt is good because it offers a safe investment for individuals and businesses. Because the United States federal government is widely viewed as stable and trustworthy, the federal government can borrow money at a lower rate of interest than private citizens or corporations can. Lower interest rates benefit taxpayers by reducing the cost of government borrowing.

Using Monetary Policy Tools

Open market operations are the most used of the Federal Reserve's monetary policy tools. They can be conducted smoothly and on an ongoing basis to meet the Fed's goals. The Fed changes the discount rate less frequently. It usually follows a policy of keeping the discount rate in line with other interest rates in the economy in order to prevent excess borrowing by member banks from the Fed. (See the graph "Key Interest Rates" on page 542 in the Economic Atlas and Databank.) Today, the Fed does not change reserve requirements to conduct monetary policy. Changing reserve requirements would force banks to make drastic changes in their plans. Open market operations or changes in the discount rate do not disrupt financial institutions. The Federal Reserve uses these monetary policy tools to adjust the money supply. Why the Fed would want to change the money supply, and the effects of monetary policy, are the subjects of the next section.

Factors that Affect Demand for Money

People hold money for a variety of reasons. The amount of money that firms or individuals hold depends generally on four factors: cash needed on hand interest rates price levels in the economy general level of income People and firms need to have a certain amount of cash on hand to make economic transactions—to buy groceries, supplies, clothing, and so forth. The more of your wealth you hold as money, the easier it will be to make economic transactions. Of course, we can't earn interest on money that we hold as cash. As interest rates rise, it becomes more expensive for individuals to hold money as cash rather than placing it in assets that pay returns, such as bonds, stocks, or savings accounts. So as interest rates rise, people and firms will generally keep their wealth in assets that pay returns. In other words, they demand less money in the form of cash. (See Figure 16.4.) The general price level in the economy affects the demand for money, too. As price levels rise, so does the demand for cash. If your usual cost for an outing with your friends is $25 and prices rise 10 percent, you will now need $27.50 for a night out. The final factor that influences money demand is the general level of income. On a personal level, if you take an after-school job that pays you $75 per week, you will likely carry around more cash than you did before. On a national level, as GDP or real income rises, families and firms keep more of their wealth or income in cash.

Interest Rates and Spending

Recall from Chapter 12 that interest rates are important factors of spending in the economy. Lower interest rates encourage greater investment spending by business firms. This is because a firm's cost of borrowing—or of using its own funds—decreases as the interest rate decreases. Firms find that lower interest rates give them more opportunities for profitable investment. If a firm has to pay 15 percent interest on its loans, it may find few profitable opportunities. If interest rates fall to 8 percent, however, the firm may find that some opportunities are now profitable. If the macroeconomy is experiencing a contraction—declining income—the Fed may want to stimulate, or expand, it. It will follow an easy money policy. That is, it will increase the money supply. An increased money supply will lower interest rates, thus encouraging investment spending. Such a policy may, however, encourage overborrowing and overinvestment, followed by layoffs and cutbacks. If the economy is experiencing a rapid expansion that may cause high inflation, the Fed may introduce a tight money policy. That is, it will reduce the money supply. The Fed reduces the money supply to push interest rates upward. By raising interest rates, the Fed causes investment spending to decline. This brings real GDP down, too. Even though it can only alter the money supply, the Fed has a great impact on the economy. The money supply determines the interest rate, and the interest rate determines the level of aggregate demand. Recall from Chapter 12 that aggregate demand represents the relationship between price levels and quantity demanded in the overall economy. The level of aggregate demand helps determine the level of real GDP. (See Figure 16.9.)

What is Medicare?

Serves 42 million people (most over 65 years old). Program pays for hospital care bills for people who suffer from disabilities and diseases. Medicare funded by withheld taxes.

What are the characteristics of a good tax?

Simplicity: Tax laws should be simple and easily understood. Taxpayers and businesses should be able to keep necessary records, prepare their own tax forms, and pay taxes a predictable schedule. Efficiency: Government administrators should be able to collect taxes without spending too much time or money. Taxpayers should be able to pay taxes without giving up too much time. Taxpayers shouldn't have to pay too much money in fees. Certainty: It should be clear to a taxpayer when a tax is due, how much money is due, and how the tax should be paid. Equity: The tax system should be fair, so that no one bears too much or too little of tax burden.

What are other discretionary spendings?

Small part of budget. Pays for: education training scientific research student loans technology national parks and monuments law enforcement environmental cleanup housing land management transportation disaster aid foreign aid farm subsidies salaries of civilian branches of federal government

What are social security, medicare, and unemployment taxes?

Social Security taxes: Employers withhold money under Federal Insurance Contributions Act (FICA) for Social Security and Medicare. Most FICA taxes goes to OASDI. Social Security (OASDI) was founded in 1935 to ease Great Depression. Social Security was first a retirement fund to provide old-age pensions. Today it benefits surviving family members of wage earners to disabled people. Tax cap of $90,000. Medicare taxes: FICA funds Medicare. Bothe employees and self-employed people pay Medicare tax on all their earnings. No ceiling as for Social Security payments. Unemployment taxes: Paid by employers. The tax pays for an insurance policy for workers. If workers are laid off through no fault of their own, they can file an 'unemployment compensation' claim to collect benefits for a fixed number of weeks. To get benefits, an unemployed person must be actively seeking another job

What is the process of the federal budget?

Spending Proposals: Federal budget must fund many offices and agencies in the federal government. Before the budget can be put together, each federal agency writes a detailed estimate of how much it expects to spend in the coming fiscal year. These spending proposals are sent to a special unit of the executive branch, the Office of Management and Budget (OMB). The OMB is part of the Executive Office of the President. The OMB is responsible for managing the federal governments budget. Its most important job is to prepare the federal budget. In the Executive Branch: The OMB holds several meetings to review the Federal agencies' spending proposals. Representatives from the agencies must explain their spending proposals to convince the OMB to give them the money. Usually, the OMB gives them less than what they asked for. OMB then works with the President's staff to combine all individual agency budgets into a single budget document. This document gives the President's overall spending plan for the coming fiscal year. The President present the budget to Congress in January or February. In Congress: The President's budget is only a starting point. Congress makes changes depending on its relationship with the president. Congress modifies the President's budget. Members of Congress rely on the assistance of the Congressional Budget Office (CBO). Founded in 1974, the CBO gives Congress independent economic data to help with its decisions. Most of the work is done by small committees. Working in different houses in Congress, committees in the House and Senate analyse the budget and hold hearing at which agency officials and other can speak about the budget. The committees combine their work to propose one initial budget resolution which must be adopted by May 15. The resolution is not intended to be final, but gives initial estimates for revenue and spending to guide the legislators as they continue working on the budget. September, the budget Committees propose a second budget resolution that sets binding spending limits. Congress must pass this resolution by September 15. Finally, the Appropriations Committees for each house submit bills to authorise specific spending. By this time, the new fiscal year is about to stat and Congress faces pressure to get these appropriations bills adopted and submitted to the President before the previous year's funding ends. If Congress cannot finish in time, it must pass short-term emergency spending legislation known as 'stop-gap funding' to keep the government running. If Congress and the President cannot agree on temporary funding, government 'shuts down' everything except the most essential federal offices. In the White House: Congress sends appropriations bills to the President who signs them into law. If he vetoes any of these bills, Congress must either come up with enough votes to override the veto or work with the President to write an appropriations bill on which both sides can agree. Once that is completed, the President signs the new budget into law.

Supply-Side Economics

Supply-side economics stresses the influence of taxation on the economy. Supply-siders believe that taxes have strong negative influence on economic output. While Keynesian economics uses government to change aggregate demand, supply-side economic tries to increase economic growth by increasing aggregate supply. Supply-side economists often use the Laffer curve to show the effects of taxes. The Laffer curve shows the relationship between the tax rate set by the government and the total tax revenue that the government collects. The total revenue depends on both the tax rate and the health of the economy. The Laffer curve illistrates that high tax rates may not bring in much revenue if these hgih tax rates cause economic activity to decrease. Suppose government imposes a tax on the wages of workers. If the tax rate is zero, as at point a on the graph, the government will collect no revenue, although the economy will prosper from lack of taxes. As government raises tax rate, it starts to collect some revenue. To the left of point b, higher tax rates will discourage some people from working as many hours and prevent companies from investing and increasing production. The net effect of a higher tax rate and a slightly lower tax base is an increase in revenue. To the right of point b, the decrease in workers' effort is so large that the higher tax rate decreases the total tax revenue. In essence, high rates of taxation will eventually discourage os many people from working that tax revenues will fall sharply. The heart of the supply-side argument is that a tax cut increases total employment so much that the government actually collects more in taxes at teh new, lower tax rate. Actual experience has proven that while a tax cut encourages some workers to work more hours, the end result is a relatively small increase in the number of hours worked. In general, taxpayers do not react strongly enough to tax cuts to increase tax revenue.

What are balancing tax revenues and tax rates?

Tax should generate enough revenue that citizens' needs are met. Tax rates are that rate at which people are taxed. If tax rates are lower, people can use more money to stimulate the economy. People argue low tax rates are better than high ones.

How are individual income taxes payed?

Tax withholding: Employers withhold your income, then send it to the federal government as 'instalment payment' on your upcoming annual income tax bill. Filing a tax return: Employers give employees a report showing how much income tax has already been withheld and payed. Employee then completes tax return. Employees declare income to government and find their taxable income. Deductions include such items as interest on a mortgage, donations to charity, medical expenses, and state and local tax payments. Federal income tax returns must be riled by midnight on April 15 (or the next business day if April 15 is a weekend). Tax bracket: Federal income = progressive tax. There are six different tax rates applied to different range of income, or tax brackets.

Who bears the tax burden?

Taxes affect more than just people who send in checks to pay tax. If government places a $0.50 per gallon gasoline tax and collects tax from service stations, you think the burden of tax only falls on service stations because they mail checks to government. But when a tax is imposed on a good, the cost of supply the good increases. The supply of the good then decreases at each and every price level. This shifts the supply curve left. If demand is inelastic, the tax will increase the price per gallon be a large amount. Consumers bear the tax. If demand is elastic, price level will stay the same and consumers don't bear much tax. The more inelastic the demand, the more sellers can shift the tax onto the buyers.

Money Creation

The Department of the Treasury is responsible for manufacturing money. The Federal Reserve is responsible for putting dollars into circulation. How does this money get into the economy? The process is called money creation, and it is carried out by the Fed and by banks all around the country. Recall from Chapter 15 the multiplier effect of government spending. The multiplier effect in fiscal policy holds that every one dollar change in fiscal policy creates a change greater than one dollar in the economy. The process of money creation works in much the same way.

The Federal Open Market Committee

The Federal Open Market Committee (FOMC) makes key decisions about interest rates and the growth of the United States money supply. The committee meets about eight times a year in private to discuss the cost and availability of credit, for business and consumers, across the country. Announcements of the FOMC's decisions can affect the financial markets, the rates for home mortgages, and many other economic institutions around the world. You will read more about the effects of monetary policy later in this chapter. Members of the Federal Open Market Committee are drawn from the Board of Governors and the twelve district banks. All seven members of the Board of Governors sit on the FOMC. Five of the twelve district bank presidents also sit on the committee. The president of the New York Federal Reserve Bank is a permanent member. The four other district presidents serve one-year terms on a rotating basis. The Board of Governors holds a majority of the seats on the FOMC, giving them effective control over the committee's actions. After meeting with the FOMC, the chair of the Board of Governors announces the committee's decisions to the public. The Federal Reserve Banks and financial markets spring into action as they react to Fed decisions. In the next section, you will read about how the Fed's decisions are carried out and what functions the Federal Reserve serves.

Twelve District Reserve Banks

The Federal Reserve Act divided the United States into twelve Federal Reserve Districts, as shown on Figure 16.2. One Federal Reserve Bank is located in each of the twelve districts. Each Federal Reserve Bank monitors and reports on economic and banking conditions in its district. Each Federal Reserve District is made up of more than one state. The Federal Reserve Act aimed to establish a system in which no one region could exploit the central bank's power at another's expense. Congress also regulated the makeup of each Bank's board of nine directors to make sure that many groups' interests would be represented. Member banks elect three bankers and three leaders in industry, commerce, or other businesses to their district boards. The remaining three directorships, appointed by the Board of Governors of the Federal Reserve, represent broad public interests. The district president is then elected from among these nine directors.

The Board of Governors

The Federal Reserve System is overseen by the Board of Governors of the Federal Reserve. The Board of Governors is headquartered in Washington, D.C. Its seven members are appointed for staggered fourteen-year terms by the President of the United States with the advice and consent of the Senate. The terms are staggered to prevent any one President from appointing a full Board of Governors and to protect board members from day-to-day political pressures. Members cannot be reappointed after serving a full term. Geographical restrictions on these appointments ensure that no one district is over-represented. The President also appoints, from among these seven members, the chair of the Board of Governors. The Senate confirms the appointment. Chairs serve four-year terms, which can be renewed. The chair acts as the main spokesperson for monetary policy for the country. Monetary policy refers to the actions the Fed takes to influence the level of real GDP and the rate of inflation in the economy. Recent chairs of the Fed have been economists from business, academia, or government. Alan Greenspan, whose previous career was in building economic forecasting models, has been the most notable chair of the Fed in recent years. He took office in 1987, serving both Republican and Democratic administrations. (See page 424 for a profile of Greenspan.)

Serving Banks

The Federal Reserve also provides services to banks throughout the nation. Its most visible function is in its check-clearing services. In addition, it safeguards bank reserves and lends reserves to banks that need to borrow to maintain legally required reserves.

Governmetn Securities Auctions

The Federal Reserve also serves as a financial agent for the Treasury Department and other government agencies. The Fed sells, transfers, and redeems government bonds, bills, and notes, or securities. It also makes interest payments on these securities. The Treasury Department periodically auctions off government bills, bonds, and notes to finance the government's activities. The funds raised from these auctions are automatically deposited into the Federal Reserve Bank of New York.

Bank Examinations

The Federal Reserve and other regulatory agencies also examine banks periodically to make sure that each institution is obeying laws and regulations. Examiners may make unexpected bank visits to make sure that banks are following sound lending practices. Bank examiners can force banks to sell risky investments or to declare loans that will not be repaid as losses. If examiners find that a bank has taken excessive risks, they may classify that institution as a problem bank and force it to undergo more frequent examinations. Examiners would take the same action for banks that have low net worth. Net worth equals total assets minus total liabilities. In addition, any bank that goes to the Fed for emergency loans too often will be subject to financial review and close government supervision.

Federal Reserve Functions

The Federal Reserve functions as the government's banker and as a banker's bank. It regulates the nation's banking system. It also monitors and regulates the nation's money supply. As the central bank of the United States, the twelve district banks that make up the core of the Federal Reserve System carry out several important functions. The Federal Reserve System does the following: provides banking and fiscal services to the federal government provides banking services to member and nonmember banks regulates the banking industry tracks and manages the national money supply to meet current demand and to stabilize the economy

Regulating the Money Supply

The Federal Reserve is best known for its role in regulating the nation's money supply. You will recall from Chapter 10 that economists and the Fed watch several indicators of the money supply. M1 is simply a measure of the funds that are easily accessible or in circulation. M2 includes the funds counted in M1 as well as money market accounts and savings instruments. Economists also measure M3. M3 goes even further to include large time deposits and some government securities. The Fed's job is to consider these various measures of the money supply and compare those figures with the likely demand for money.

Predicting Business Cycles

The Federal Reserve must not only react to current trends. It must also anticipate changes in the economy. How should policymakers decide when to intervene in the economy?

Federal Government's Banker

The Federal Reserve serves as banker for the United States government. It maintains a checking account for the Treasury Department. It processes payments such as social security checks, IRS refunds, and other government payments. For example, if you receive a check from the federal government and cash it at your local bank, the Federal Reserve deducts the amount from the Treasury's account.

Monetary Policy and Macroeconomic Stabilisation

The Federal Reserve uses monetary policy to try to tame business cycles. The unpredictable length of business cycles, however, makes it difficult to determine when it is wise to intervene in the economy. Adherents of monetarism believe that the money supply is the most important factor in macroeconomic performance. How, then, does monetary policy influence macroeconomic performance?

Balancing the Budget

The basic tool of fiscal policy is the federal budget. It is made up of two fundamental parts: revenue (taxes) and expenditures (spending programs). When the federal government's revenues equal its expenditures in any particular year, the federal government has a balanced budget. There is the same amount of money going into and coming out of the Treasury. In reality, the federal budget is almost never balanced. Usually, it is either running a surplus or a deficit. A budget surplus occurs in any year when revenues exceed expenditures. In other words, there is more money going into the Treasury than coming out of it. A budget deficit occurs in any year when expenditures exceed revenues. In other words, there is more money coming out of the Treasury than going into it. Assume the federal government starts with a balanced budget. If the government decreases expenditures without changing anything else, it will run a budget surplus. Similarly, if it increases taxes—revenues—without changing anything else, it will run a surplus. The same sort of analysis describes budget deficits. If the government increases expenditures without changing anything else, it will run a deficit. Similarly, if it decreases taxes without changing anything else, it will run a deficit. The deficit can grow or shrink because of forces beyond the government's control. During a recession, fewer people are working, and tax revenues fall as spending on antipoverty programs rises. Surpluses and deficits can be very large figures. The largest deficit was about $400 billion, in 2004.

Return to Deficits

The changeover from deficits to surplus brought with it a different set of political concerns. Investors who had come to rely heavily upon Treasury bonds as the basic "safe" investment worried that the federal government would remove all bonds from the market as it repaid its debt. As a 2000 presidential candidate, George W. Bush pledged to use the surplus to guarantee Social Security into the new century, provide additional medical benefits to seniors, and reduce income taxes. However, the surplus was short-lived. The end of the stock market boom, an economic slowdown, and a new federal income tax cut reduced federal revenues. The terrorist attacks of September 11, 2001 dealt a double blow to the federal budget by disrupting the economy and imposing new defense and rebuilding costs. In response, the federal government returned to deficit spending. President Bush announced that national security and economic growth, not a balanced budget, were his administration's primary goals. In 2003, President Bush signed a second tax bill that further lowered taxes on regular income, dividends, and capital gains. The president promised the bill would energize the American economy and create jobs for unemployed workers. However, the 2004 federal budget included an approximately $400 billion deficit with even more borrowing projected for future years. In the short term, deficit spending may help create jobs and encourage economic growth. The long-term outlook for the federal budget is uncertain. Federal spending on Social Security and Medicare is projected to rise sharply in the next thirty years as large numbers of Baby Boomers leave the job market and retire. With new retirees outnumbering new workers, balancing the budget is expected to become ever more difficult.

What is the federal budget?

The federal budget is a written document indicating the amount of money the government expects to receive for a certain year and authorising the amount the government can spend that year. Federal budget is a plan to pay for the federal government's expenditures. Federal government prepares new budget each fiscal year (October 1 to September 30). Federal budget takes 18 months to prepare. 4 basic steps in the federal budget process.

Problems of a National Debt

The first problem with a national debt is that it reduces the funds available for businesses to invest. This is because in order to sell its bonds, the government must offer a high interest rate to attract buyers. Individuals and businesses, attracted by the high interest rates and the security of investing in the government, use their savings or profits to buy government bonds. However, every dollar spent on a government bond is one fewer dollar that can be invested in private business. Less money is available for companies to expand their factories, conduct research, and develop new products, and interest rates rise. Economists call this the crowding-out effect, because federal borrowing "crowds out" private borrowing by making it harder for private businesses to borrow. A national debt, then, can hurt investment and slow economic growth over the long run. On the other hand, more investment in the private sector can lead to lower prices, more jobs, and overall higher standards of living. The second problem with a high national debt is that the government must pay interest to bondholders. The more the government borrows, the more interest it has to pay. Paying the interest on the debt is sometimes called servicing the debt. Over time, the interest payments have become very large. At the beginning of the twenty-first century, the federal government spent about $250 billion a year servicing the debt. Moreover, there is an opportunity cost—dollars spent servicing the debt cannot be spent on something else, like defense, health care, or infrastructure.

Creating Money

The government could create new money to pay salaries for its workers and benefits for citizens. Traditionally, governments simply printed the bills they needed. Today, the government can create money electronically by depositing money in people's bank accounts. The effect is the same. This approach works for relatively small deficits, but can cause severe problems when there are large deficits. Why? When the government creates more money, it increases the amount of money in circulation. This increases the demand for goods and services and can increase output. But once the economy reaches full employment, output cannot increase. The increase in money will mean that there are more dollars, but the same amount of goods and services. Prices in the economy rise so that a greater amount of money will be needed to purchase the same amount of goods and services. In other words, prices go up, and the result is inflation. As you read in Chapter 13, high levels of inflation are a serious economic problem. Covering very large deficits by printing more money can cause very high inflation, called hyperinflation. This happened in Germany and Russia after World War I, Brazil and Argentina in the 1980s, and Ukraine in the 1990s. If the United States experienced hyperinflation, a shirt that cost $30 in June might cost $50 in July, $80 in August, and $400 in December!

Is the Debt a Problem?

The growth of the national debt during the Reagan administration led many to focus on the problems caused by a national debt. In general, two problems can arise from a national debt.

Inside Lags

The inside lags are delays in implementing policy. These lags occur for two reasons. First, it takes time to identify a problem. While economists have developed sophisticated computer models for predicting economic trends, they still cannot know for sure that the economy is headed into a new phase of the business cycle until it is already there. Statistics may conflict and it can take up to a year to recognize a serious economic problem. A good example of this problem occurred in 1990. Although a recession began in July 1990, Alan Greenspan, the chair of the Board of Governors of the Federal Reserve, testified in October 1990 that the economy had not yet slipped into recession. Looking back, however, we now know that a recession had begun months earlier. Even Greenspan, an economic expert with the staff of the Fed and other resources at his disposal, was slow to recognize that a recession had begun. A second reason for inside lags is that once a problem has been recognized, it can take additional time to enact policies. This problem is more severe for fiscal policy than for monetary policy. Fiscal policy, which includes changes in government spending and taxation, requires actions by Congress and the President. Since Congress must debate new plans and get the approval of the President, it may take time before a new policy is enacted. The enactment of monetary policy, on the other hand, is streamlined. The Federal Open Market Committee meets eight times each year to discuss monetary policy—more often if necessary. Once it has decided that changes are called for, the FOMC can make open market policy or discount rate changes almost immediately.

End-of-Century Surpluses

The late 1990s brought a welcome reversal of fortune. For the first time in thirty years, the President and the Office of Management and Budget (OMB) were able to announce that the government was running a surplus. How did this happen? First, the new budget procedures begun under President Bush and extended under President Clinton did help Congress control the growth of government spending. Second, tax increases by President Clinton in 1993 resulted in more federal revenue. Finally, the strong economy and low unemployment during the 1990s meant that more individuals and corporations were earning more money—and thus paying more in taxes.

Stabilising the Economy

The laws of supply and demand affect money, just as they affect everything else in the economy. Too much money in the economy leads to a general rise in prices, or inflation. A glut of dollars lessens their value. In inflationary times, it will take more money to purchase the same goods and services. It is the Fed's job to keep the money supply stable. In an ideal world, in which real GDP grew smoothly and the economy stayed at full employment, the Fed would increase the money supply just to match the growth in the demand for money. If the Fed could accomplish this, the country would experience very low inflation rates and, ideally, the economy would remain at full employment. As you read in Chapter 15, however, it is hard to predict economic effects. The Fed uses its tools to stabilize the economy as best it can. In the next section, you will read about the tools that the Fed can use to help the economy function at full employment without contributing to inflation.

Increasing Reserve Requirements

The process also works in reverse. Even a slight increase in the RRR would force banks to hold more money in reserves. This would cause the money supply to contract, or shrink. Although changing reserve requirements can be an effective means of changing the money supply, the Fed does not use this tool often because it is disruptive to the banking system. Even a small increase in the RRR would force banks to call in significant numbers of loans, that is, to require the borrower to pay the entire outstanding balance of the loan. This may be difficult for the borrower. For this reason, the Fed rarely changes reserve requirements.

Reserve Requirements

The simplest way for the Fed to adjust the amount of reserves in the banking system is to change the required reserve ratio. It is not, however, the tool most used by the Fed.

Federal Reserve Response

These excess reserves concerned the Federal Reserve, which feared that banks might distribute that money, possibly causing inflation. In 1937, the Fed raised reserve requirements for the banks, thus lowering the money supply to prevent inflation. Banks responded by cutting back their loans even further to have enough cash for depositors. This Federal Reserve policy had an unintended negative result. Banks reduced lending, which led to a recession. Since that time the Fed has learned not to make sharp increases in reserve requirements.

The Money Multiplier

This process will continue until the loan amount, and hence the amount of new money that can be created, becomes very small. The amount of new money that will be created, in the end, is given by the money multiplier formula, which is calculated as 1 ÷ RRR. 1 divides , cap rcap rcap r. The money multiplier tells us how much the money supply will increase after an initial cash deposit to the banking system. To apply the formula, we multiply the initial deposit by the money multiplier: Increase in money supply = initial cash deposit × 1 RRR In our example the RRR is 0.1, so the money multiplier is 1 ÷ 0.1 = 10 . 1 divides 0.1 equals 10 . This means that the deposit of $1,000 leads to a $10,000 increase in the money supply. As of 2003 in the United States, banks were required to hold 3 percent reserves against demand deposit assets up to $41.3 million and 10 percent on all demand deposit assets exceeding $41.3 million. In the real world, however, people hold some cash outside of the banking system, meaning that some funds leak out of the money multiplier process. Also, banks sometimes hold excess reserves, which are reserves greater than the required amounts. These excess reserves ensure that banks will always be able to meet their customers' demands and the Fed's reserve requirements. The actual money multiplier effect in the United States is estimated to be between 2 and 3. The Federal Reserve has three tools for adjusting the amount of money in the economy. These tools are reserve requirements, the discount rate, and open market operations.

Supervising Lending Practices

To ensure stability in the banking system, the Federal Reserve monitors bank reserves throughout the system. Each of the twelve Federal Reserve Banks sends out bank examiners to check up on lending and other financial activities of member banks. They also study proposed bank mergers and bank holding company charters to ensure competition in the banking and financial industries. A bank holding company is a company that owns more than one bank. The Board of Governors approves or disapproves mergers and charters based on the findings and recommendations of the Reserve Banks. The Federal Reserve also protects consumers by enforcing truth-in-lending laws, which require sellers to provide full and accurate information about loan terms. Under a provision called Regulation Z, millions of consumers receive information about retail credit terms, auto loans, and home mortgages every year.

appropriations bill

a bill that sets money aside for specific spending

The Federal Reserve System

To stabilize the nation's banking system, Congress created the Federal Reserve System in 1913. The Federal Reserve is owned by individual member banks. It is overseen by a small but powerful Board of Governors. As a private institution serving a public function, the Federal Reserve is a central bank relatively free from government control. The American banking system is a compromise between supporters and opponents of a central bank. As a symbol of this compromise, the Federal Reserve System is the privately owned, publicly controlled central bank of the United States.

Lender of Last Resort

Under normal circumstances, banks lend each other money on a day-to-day basis, using money from their reserve balances. These funds are called federal funds. The interest rate that banks charge each other for these loans is the federal funds rate. Banks can also borrow from the Federal Reserve. They do so routinely and especially in financial emergencies such as severe recessions. The Federal Reserve acts as a lender of last resort, making emergency loans to commercial banks so that they can maintain required reserves. The rate the Federal Reserve charges for these loans is called the discount rate. You will read more about the role of the discount rate in the economy of the United States in Section 3.

Issuing Currency

Under the Federal Reserve System, only the federal government can issue currency. The Department of the Treasury issues coins minted at the United States Mint. The district Federal Reserve Banks issue paper currency (Federal Reserve Notes), which is printed at the Bureau of Engraving and Printing. As bills become worn or torn, the Federal Reserve takes them out of circulation and replaces them with fresh ones.

Bond Purchases

When the Federal Open Market Committee (FOMC) chooses to increase the money supply, it orders the trading desk at the Federal Reserve Bank of New York to purchase a certain quantity of government securities on the open market. The Federal Reserve Bank buys these securities with a check drawn on Federal Reserve funds. The bond seller then deposits the money from the bond sales in its bank. In this way, funds enter the banking system, setting in motion the money creation process described earlier.

Responding to Budget Deficits

When the government runs a deficit, that means it did not take in enough revenue to cover its expenses for the year. When this happens, the government must find a way to pay for the extra expenditures. There are two basic actions the government can take to do so.

Monetary Policy and Inflation

You have already read that expansionary policy, if enacted at the wrong time, may push an economy into high inflation, thus reducing any beneficial impact. This is the chief danger of using an easy money policy to get the economy out of a recession. An inflationary economy can be tamed by a tight money policy, but the timing is again crucial. If the policy takes effect as the economy is already cooling off on its own, the tight money could turn a mild contraction into a full-blown recession. The decision of whether to use monetary policy, then, must be based partly on our expectations of the business cycle. Some recessions are short-run phenomena that will, in the long run, disappear. Some inflationary peaks may also be expected to last for the short run and end in the long run. Given the timing problems of monetary policy, in some cases it may be wiser to allow the business cycle to correct itself rather than run the risk of an ill-timed policy change. If a recession is expected to turn into an expansion in a short time, the best course of action may be to take a laissez-faire approach to the economy and let the economy correct itself. On the other hand, if we expect a recession to last several years, then all but the most conservative onlookers would recommend an active policy. So the question is this: How long will a recessionary or inflationary period last?

Keynesian economics

a form of demand-side economics that encourages government action to increase or decrease demand and output

treasury bond

a government bond that can be issued for as long as 30 years

tax

a required payment to a local, state, or national government

supply-side economics

a school of economics that believes tax cuts can help an economy by raising supply

budget deficit

a situation in whcih the government spends more money than it takes in

regressive tax structure

a tax for which the percentage of income paid in taxes decreases as income increases

progressive tax structure

a tax for which the percentage of income paid in taxes increases as income increases

proportional tax structure

a tax for which the percentage of income paid in taxes remains the same for all income levels

individual income tax

a tax on a person's earnings

tariff

a tax on imported goods

gift tax

a tax on money or property that one living person gives to another

sales tax

a tax on the dollar value of a good or service being sold

estate tax

a tax on the estate, or total value of the money and property, of a person who has died

property tax

a tax on the value of a property

Congressional Budget Office (CBO)

government agency that provides economic data to Congress

Office of Management and Budget (OMB)

government office that manages the federal budget

What is balancing state budgets

govervnor prepares budget with help of budget agency. legistlature discusses and approves budget. 49 state require balanced budgets.

What are state budgets?

operating budget includes salaries of state employees, supplies, and maintenance of facilities. Capital budget includes building new bridges and raods. Most capital budget expenses are covere by long-term borrowing and sale of bonds.

What a local taxes?

property taxes, sales, excise, income tax, payroll tax,

What is the relation between taxation and the constitution?

the Constitution gave each branch of government certain powers. First power granted to Congress was power to tax. Constitution placed limits on certain taxes. First, purpose of tax must be for the common defence and general welfare. Second, federal taxes must be the same in every state.Congress cannot tax church services. Constitution prohibits taxing exports. Government can only tax imports. Congress cannot levy or impose taxes unless they are divided among the states according to population.

fiscal policy

the use of government spending and revenue collection to influence the economy

tax incentive

the use of taxation to encourage or discourage certain behaviour