Economic Policy

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Economic Policy
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Learning Objectives Economic Policy

• We will discuss American Economic Policy by
  looking at
• Fiscal and Monetary Policy
• Federal Reserve System
• Budgeting Taxing and Spending
• Debt and Deficits
• Goals of Fiscal Policy
• Trade Issues Globalization, Balance of
  Payments, Protectionism

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Key Terms Economic Policy

• Fiscal Policy
• Monetary Policy
• Supply-Side Economics
• Keynesianism
• Chicago School
• Laffer Curve
• Federal Reserve System
• Income Taxes
• Sales Taxes
• Property Taxes
• Debt
• Deficits
• Globalization
• Balance of Payments
• Protectionism
• Free Trade
• Office of Management and Budget
• Congressional Budget Office

• Regressive Taxes
• Progressive Taxes
• Quantity Theory of Money
• GATT
• NAFTA
• WTO
• FTAA
• Discount Rate
• Prime Rate
• Its the Economy, Stupid
• Sin Taxes
• Inflation
• Hyperinflation
• Stagflation
• Unemployment
• Black Budget
• Counter-Cyclical Policy
• Gross Domestic Product (GDP)

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What Government Does Budgeting, Taxation, and
Fiscal Policy

• Generally, the U.S. Governments involvement in
  the economy is three-fold
• To engage in Economic Management
• To ensure Economic Stability
• To provide a Legal Enforcement Structure

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What Government Does Budgeting, Taxation, and
Fiscal Policy

• Economic Policy
• Goals
• Economic growth
• Low unemployment
• Price stability
• Positive balance of payments
• Minimizing diseconomies
• Supporting key economic sectors

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Economic Policy

• Principal Economic Policy Perspectives in the
  U.S.
• Keynesianism Liberal
• Manipulation of government spending/taxing to
  impact the economy
• Monetarism Conservative
• Manipulation of the money supply to impact the
  economy
• Supply-Side Newer conservative view
• Belief that tax cuts stimulate the economy and
  increase government revenues over time

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Economic Policy

• Economic Policy Tools
• Fiscal policy
• Taxes
• Spending
• Deficits/Debt
• Monetary policy
• The Federal Reserve Board

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Fiscal and Monetary Policy
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Fiscal Policy Defined

• Fiscal policy is any government action that
  affects govt. spending or revenue.
• John Maynard Keynes provided the rationale for
  the use of fiscal policy to stabilise economic
  growth.
• Active use of fiscal policy was popular with
  governments from the 1950s to mid-1970s.

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Fiscal Policy Defined

• If government revenue gt government spending
  Government budget surplus.
• If government revenue lt government spending
  Government budget deficit.
• Are deficits bad or are surpluses good?

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How Does Fiscal Policy Work?

• Fiscal Rule
• ? Govt. spending and/or ? Taxes when economy is
  in recession.
• ? Govt. spending and/or ? Taxes when economy is
  booming.
• Aim of this type of counter-cyclical fiscal
  policy is to ensure low unemployment.

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Using Fiscal Policy

• A government needs to know a lot of information
  before it uses fiscal policy.
• In particular it needs to know
• Potential output
• Actual output
• The value of the multiplier for the economy.

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Using Fiscal Policy

• What is the final effect on the economy of an
  increase in government spending of 10 billion
  dollars?
• An increase of 10 billion dollars will lead to a
  bigger increase in final output a multiplier.
• Initial increase in spending ? multiplier final
  increase in demand.
• End Result Stronger economy.

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Limits to Fiscal Policy

• Time lags
• Decision and implementation lags
• Political interference
• Inefficiencies of the public sector
• Government debt has to be repaid.
• Past experience
• Example the oil-price shock of the 1970s

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Tools that influence Fiscal Policy

• Spending levels
• Spending priorities
• Taxation (levels, types)
• The tax system (federal, state, and local)
• Budget deficits
• The national debt

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Federal Fiscal Policy

• People and Organizations who influence economic
  policy
• Governmental actors
• The President
• Congress
• The Federal Reserve Board
• Societal actors
• Interest groups
• Public opinion
• Political parties

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What is Monetary Policy?

• Monetary policy is policy that affects the money
  supply or the rate of interest in order to affect
  the level of aggregate demand in an economy.
• Monetary policy tends to be designed and
  implemented by central banks and not by
  governments.

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Instruments of Monetary Policy

• The most important role of central banks is
  monetary policy. They can control the money
  supply by
• Changing the reserve ratio
• Issuing credit guidelines
• The discount rate
• Open market operation (most often used)

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Monetary Policy and Economic Growth

• Central bank controls money supply using open
  market operations.
• Buy govt. bonds ? money supply ?
• Sell govt. bonds ? money supply ?
• If money supply ? then the interest rate falls.
• If money supply ? then the interest rate rises.

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Monetary Policy and Economic Growth

• Open market operations
• Central bank buys bonds to ? money supply
• ? price of bonds
• ? interest rate
• ? consumption, investment and government spending
• ? in aggregate demand for goods and services
• Keynesian multiplier process
• ? income

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Monetary Policy and Low Inflation

• Low inflation is the main goal.
• The Quantity Theory of Money
• The more money in the economy, the greater
  likelihood of inflation
• Control the flow of money and you reduce the
  chances of igniting inflation

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Monetary versus Fiscal Policy

• Timing considerations
• Monetary policy can be put into operation much
  more quickly than fiscal policy.
• Fiscal policy works directly, monetary policy
  does not.
• Who is affected by the policy?
• Fiscal policy can target specific groups.

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Central Banking and Federal Reserve System
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Central Banks and Monetary Policy

• Central banks were relatively new a century ago,
  but are now commonplace
• 1900 18 central banks in the world.
• 2000 173 central banks in the world.

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The Role of Central Banks

• Issues currency.
• Acts as lender of last resort.
• Maintains integrity in a nations currency.
• Regulates the financial sector.
• Conducts monetary policy.

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How Banks Create Money - the Fractional Banking
System

• Banks know from experience that they only need to
  hold a of their deposits in the form of cash -
  a minimum reserve
• They can lend out the rest of their deposits to
  other customers requiring loans. This is how
  banks make profits
• Banks have the ability to create money due to
  the fractional banking system

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Central Bank Independence

• Why are central banks independent from the
  political process?
• Is central bank independence good?
• Are central banks accountable?

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Central Banking in the U.S. The Federal Reserve

• The Federal Reserve System tremendously
  influences Fiscal Policy
• What is the Federal Reserve Board?
• Established 1913 to regulate the U.S. banking
  system by attempting to control the flow of money
  in the economy.
• Chairman and 7 Board of Governors appointed for
  14 year terms by the President cant be removed
  by the President.

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The Federal Reserve
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The Federal Reserve

• There are 12 Federal Reserve Bank Regions (look
  at your Dollar bills see Reserve Bank A, B, C,
  D, etc?)
• The Federal Reserve Regional Banks are important
  because they monitor and report on economic
  activity within their region
• Federal Reserve Regional Banks provide money to
  private banks, collect and clear checks, and
  maintain a system of reserve funds
• 1/3 of the nations private banks are members in
  the Federal Reserve System

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The Federal Reserve

• The Federal Reserve System regulates the supply
  of money in three ways
• Through the Open Market Committee
• The Committee sets policy with respect to buying
  and selling of federal government securities
  (bonds)
• Through Reserve Requirements
• The amount of money member banks must keep on
  hand
• Through the Discount Rate
• The interest rate charged member banks
• All three can impact interest rates, encourage or
  discourage economic growth, and push the economy
  in one way or the other

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Budgeting Taxing and Spending
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Federal Budgeting

• The U.S. federal budget is huge in global terms.
• Take the global gross world product. Roughly
  speaking, the U.S. federal budget alone, about
  2.7 trillion dollars, is 1/15th of the worlds
  GDP.

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Federal Budgeting

• Federal spending covers many areas.
• The main categories of federal spending, making
  up almost three-quarters of the total, are four
• Defense (16),
• Social Security (23),
• Health and Medicare spending (20),
• Interest payments (12) on past borrowing.

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Federal Budgeting
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Federal Budgeting

• This makes for 73 of the total budget the
  remaining 27 is allotted to such things as
  housing, foreign aid, transportation, education,
  etc.
• This does not include Social Security, which is
  an off-budget expenditure
• Also, it does not include the Intelligence
  Communitys budget, which is a so-called Black
  Budget in other words it is a secret. We
  have no idea how much the CIA, NSA, etc. spend.
• No one in Congress is allowed to discuss it
  publicly.
• Estimations from non-U.S. sources placed it at a
  total of almost 50 billion dollars for FY 2003
  (about 7 of the total budget)

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Federal Budgeting

• Federal spending as a percentage of GDP has
  hovered at close to 20 during the 1990s.
• In 1943, it was 45
• In the early 1980s it had fallen to only 24.
• Today it is around 30.

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Federal Budgeting Taxes

• The main categories of federal taxes, making up
  about 95 of the total, are
• Individual income taxes (48).
• Corporate income taxes (10).
• Payroll taxes for Social Security and Medicare
  (34).
• Excise taxes on gasoline, cigarettes and alcohol
  (4).
• The remaining 4 of taxes includes such things as
  estate taxes, customs fees, etc.

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Federal Budgeting Taxes

• Tax receipts as a percentage of GDP has hovered
  in the high teens over the past four decades.
• Generally speaking, if the government runs a
  deficit between spending and revenue, it issues
  bonds if it has a surplus, it pays them off.
• Some Comparisons are in order here

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Fiscal Balances for Selected Countries

• Projected Surplus/deficit
• as a of GDP
• 2002
• France -2.0
• Germany -2.8
• USA -1.0
• Japan -8.0
• Euro area -1.5
• EU -1.3
• Source OECD World Economic Outlook June 2002

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Government spending as a GDP

• 1960 2000
• France 35 48
• Germany 33 44
• Japan 17 32
• USA 27 33
• EU 32 50

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Federal Budgeting

• A debate exists over whether to include Social
  Security in budget discussions principally
  because of the sheer size of the money involved
  (close to 4 Trillion dollars in current
  obligations).
• People sometimes want to leave out Social
  Security from discussions of the federal budget,
  on the grounds that it is run with a separate
  Trust Fund.
• A Trust Fund is not a fund or account, per se,
  but a statutory (fiduciary) obligation on the
  part of the government.

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Federal Budgeting

• But accounting measures, like a trust fund, dont
  change the reality that Social Security involves
  government taxes and spending.
• A number of economists might advocate not
  changing Social Security, but very, very few
  would say that it should not even be considered
  as part of the budget.
• In fact, for more than half the people in the
  country, the highest tax they pay is for Social
  Security.

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Federal Budgeting

• State and local budgets also comprise an
  important part of spending.
• State and local budgets, as a group amounting to
  about 1 trillion dollars, are quite substantial,
  equal to almost half of federal governments
  spending.
• This spending is focused mainly on education,
  criminal justice, and infrastructure. As a
  result, fixing these areas is up to state
  governors, not presidents.
• The total of all government spending in the U.S.
  federal, state, and local (about one-third of
  the total U.S. GDP) is the lowest rate of any
  industrialized country.

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Debt and Deficits
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Federal Budgeting Debt and Deficit

• The U.S. experience with budget deficits since
  WWII has significantly changed
• We had experienced some budget surpluses until
  2001. After 9/11/01, we are now experiencing a
  series of growing federal deficits (currently
  projected at 440 billion dollars for the coming
  FY 2004), until about 2008

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Federal Budgeting Debt and Deficit

• Deficits and the debt are not to be confused
• Deficit is the shortfall in revenue collection
  for a given fiscal year
• Debt is the accumulation of all deficits since
  the founding of the Republic
• The Federal Deficit for FY2003 is approximately
  370 billion dollars
• The Federal Deficit projected for FY2004 is
  approximately 440 billion dollars
• The Federal Debt as of August 1, 2003 is 5.8
  trillion dollars yes, thats Trillion with a T

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Federal Budgeting Debt and Deficit

• The Debt/GDP measure is a useful device
• One useful way to look at the overall debt
  picture is to divide the debt in any given year
  by the GDP
• This has the effect of adjusting for inflation
  and for growth in the economy over time, and
  focusing on debt in proportion to the economy at
  that time
• The accumulated debt as a percentage of GDP in
  1946 was 114. This number fell to 46 in 1960
  and to 26 by 1980. In the 1950s and 60s,
  deficits, when they occurred, were small
• Then a reversal occurred, and the number rose to
  37 in 1985 and to 52 in 1995, though more
  recently it has started to level out (around 42)

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Federal Budgeting Debt and Deficit

• The debt and deficit explosion of the 1980s gave
  way to balanced budgets in the late 1990s
• It has returned to another debt and deficit
  explosion in the last two years
• Current Office of Management and Budget
  estimations project budget deficits until at
  least 2008
• Current Congressional Budget Office estimations
  project budget deficits until at least 2011

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Federal Budgeting Debt and Deficit

• The U.S. had small budget deficits most years in
  the couple of decades leading up to 1980.
• But deficits exploded in the mid-1980s,
  dramatically raising the debt/GDP ratio.
• The reasons for these higher deficits included
  higher defense spending and tax cuts in the early
  1980s, and higher interest payments and Social
  Security and health care spending in the later
  1980s.

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Federal Budgeting Debt and Deficit

• However, in the 1990s a combination of sustained
  economic growth and several budget balancing
  packages brought the deficit under control.
  However, interest payments on the past debt
  remained very large
• The September 11, 2001 attacks forced the Bush
  Administration to increase defense spending, as
  well as domestic security spending
• Additional spending also occurred in an attempt
  to overcome the recession the result big
  deficits again

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General Government Debt as a of GDP

• Debt as a GDP
• 2002
• France 58.5
• Germany 60.9
• USA 39
• Ireland 33.8
• Italy 107
• Source OECD World Economic Outlook June 2002

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Goals of Fiscal Policy
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Federal Fiscal Policy

• Fiscal policy is related to four important goals
  of government
• Reducing Unemployment and maintaining nearly
  full employment.
• Keeping Inflation Under Control.
• Increasing Economic Growth.
• Reducing the Trade Deficit.

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Federal Fiscal Policy

• Fiscal policy can be used to address different
  kinds of unemployment through heightening
  aggregate demand.
• For example, spending on job search assistance or
  tax breaks for relocation might reduce frictional
  unemployment.
• Redesigning tax burdens on employers or spending
  subsidies for the unemployed might reduce
  structural unemployment.
• In a recession, spending more or taxing less
  could pump up aggregate demand and reduce
  cyclical unemployment (commonly referred to as
  Keynesian Economics). This can be a rather
  expensive fiscal policy.

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Federal Fiscal Policy

• Cutting inflation
• Reducing aggregate demand will bring down
  inflation.
• This would require a tight fiscal policy or
  lower spending or higher taxes (commonly referred
  to as Monetary Policy or Monetarism).

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Federal Fiscal Policy

• Increasing economic growth
• Growth is based on investment in the future,
  which requires savings in the present.
• Reducing federal borrowing, or building up a
  budget surplus, will increase the amount of
  capital available for private investment, and so
  will tax proposals to make consumption less
  attractive and investment more attractive
  (commonly referred to as Supply-Side Economics).

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Federal Fiscal Policy

• Reducing the trade deficit
• The trade deficit measures the net amount of
  foreign investment capital flowing into the U.S.
• Today we import and export 25 of the GDP
  (around 250 billion dollars this year). Thirty
  years this figure was 13.
• 25 - 30 million U.S. jobs depend on foreign trade
  and investment.
• Almost 40 of goods household consumption are
  made abroad.
• By saving more domestically, we would be less
  reliant on that foreign capital.

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Federal Fiscal Policy

• There is a 5th goal, one that is implied the
  Presidents Re-election!
• The better the economy, the better the
  Presidents approval ratings in the opinion
  polls.
• The better the approval ratings, the greater the
  chance that the President will be re-elected (or
  get Congressional approval of his economic
  proposals).
• Every President will attempt to manipulate fiscal
  policy in order to help himself and his political
  party.

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Federal Fiscal Policy

• Employment and inflation policies tend to run in
  opposite directions, thus leading to
  counter-cyclical policy.
• Fiscal policy has limited application.
• There are problems with the timing of fiscal
  policy.
• Conceiving, enacting, and seeing the effects of
  fiscal policy might take 18 months or more.
• This is why President Bush pushed so hard to get
  taxes cut now in time for November 2004 (it was
  the mistake his father made by not manipulating
  fiscal policy quick enough in mid-to-late 1991
  for the 1992 election).

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Federal Fiscal Policy

• Counter-Cyclical Policy sometimes causes
  unexpected effects in investment, imports,
  savings, and prices.
• For example, imagine that you want to simulate
  the economy with loose fiscal policy. Some
  possible unexpected side effects of this policy
  include
• Running deficits that dominate the available
  monies available for borrowing, thereby reducing
  levels of domestic investment.
• Having the extra demand flow into imports rather
  than domestic products.
• Having the extra demand lead to higher inflation.
  

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Federal Fiscal Policy

• There are many political difficulties encountered
  in counter-cyclical behavior.
• Since the Great Depression, many economic policy
  makers have called on the government to take
  counter-cyclical fiscal policy spend in bad
  times, be tight-fisted in good times.
• Politically, this is very tough.
• A lot of economists believe this isnt so useful
  for short-term goals, preferring monetary policy
  instead. Fiscal policy is essentially for
  long-term investment.

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Review Questions

• What policies does the government use to
  encourage and/or discourage private sector
  activity?
• Is all income redistribution from richer to
  poorer? What other kinds are there?
• Is the U.S. Income Tax a progressive tax? What
  about sales tax?
• What are the five main expenditures of the
  federal government?
• What are the two main government healthcare
  programs in America?
• Can the U.S. government deficit spend spend
  more than it takes in?
• Have we been running a deficit or surplus since
  the late 1990s?
• Do Congress and the President get complete
  discretion when creating the annual budget?
• What is the Federal Reserve System and the
  Federal Reserve Board and what do they do?

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Discussion Questions

• What is the impact of the federal debt on
  citizens? On the economy? Should we be
  concerned with a 6 trillion dollar debt?
• Why is the Chair of the Federal Reserve more
  important to the economy than the President?
• How successful was/is Keynesianism? Supply-side?
  Monetarism? Should we just shoot all of the
  economists and make-do? o)
• How would you reform the tax code? What about
  dropping the income tax for a national sales tax?
  What impact would that have on business? On the
  poor?
• Is the Social Security system sound does it
  need reform of some sort?