4 Files 3:18 PM Fri May '13 Insert Draw Layout Review View Unit SMacroeconomic Policy Name: HR: FISCAL POLICY Use the space below to take notes during class. Disposable Income: How does a change in taxes impact disposable income? How does a change in government spending impact disposable income? Expansionary Fiscal Contractionary Fiscal Policy Policy Government Spending Pane! (b) Price IOVOI Draw the shift in AD Complete the "Fiscal Policy\" assignment in Canvas. 4 Files 3:18 PM Fri May '13 4 v.3: 80% - Insert Draw Layout Review View Unit SMacroeconomic Policy Name: HR: SPENDING AND TAXES Use the space below to take notes during class. Budget Deficit: Budget Surplus: Balanced Budget: Securities: Government debt: Progressive tax: Proportional tax: Regressive tax: Use the following website to answer the questions below: htt s: datalab.usas endin . 0v americas finance- uide 1. How much was the federal government's revenue this past year? 2. How much revenue is that per person in the U.S.? 3. What are the three largest sources of revenue for the federal government? 4. How much was the federal government's spending this past year? 5. How much spending is that per person in the U.S.? 6. What are the five largest spending categories for the federal government? 4 Files 3:18 PM Fri May '13 Insert Draw Layout Review View Unit SMacroeconomic Policy Name: HR: DEFICITS AND DEBT Use the space below to take notes during class. Consequences of the National Debt Use the following website to answer the questions below: https:[[datalab.usasgending.gov[americas- finance- uide 1. How much was the federal government's decit this past yea r? 2. How much of a deficit is that per person in the U.S.? 3. What trends in the deficit over time can you see from the graphs? 4. How much was the federal government's debt this past year? 5. How much of a debt is that per person in the U.S.? 6. What percentage of our GDP is the national debt? (hint: it may be over 100%) 7. Who are the top owners of America's debt? 4 Files 3:18 PM Fri May '13 Insert Draw Layout Review View Unit SMacroeconomic Policy Name: HR: MONEY Use the space below to take notes during class. Barter: Double coincidence of wants: Commodity money: Commodity-backed money: Fiat money: Functions of Money / Store of Value Definition: Medium of Exchange Definition: Unit of Account Definition: 4 Files 3:18 PM Fri May '13 Insert Draw Layout Review View Unit SMacroeconomic Policy Name: HR: "THE FED\" AND BANKING Use the space below to take notes during class. The Federal Reserve \"The Fed\": The Fed Chair: Financial intermediary: Savers 235.15 ,1- satay.\" 5'4"r $ r; i iiii Borrowers Complete the "The Fed and Banking\" assignment in Canvas. 4 Files 3:18 PM Fri May '13 Insert Draw Layout Review View Unit SMacroeconomic Policy Name: HR: MONEY MARKET Use the space below to take notes during class. Money Market Model: Money Supply: Money Demand: Equilibrium Interest Rates: 4 Files 3:18 PM Fri May '13 Insert Draw Layout Review View Unit SMacroeconomic Policy Name: HR: MONETARY POLICY Use the space below to take notes during class. Federal Open Market Committee (FOMC): Open Market Operations: Reserve Requirement: Discount Rate: Dec Res Req Dec DISC Rate Buv Bonds Increase In AD Inc Res Req Inc Disc Rate Sell Bonds Decrease In AD 4 Files 3:18 PM Fri May '13 Insert Draw Layout Review View Unit SMacroeconomic Policy Name: HR: MONETARY POLICY (Continued) Use the space below to take notes during class. Open Market Operations Reserve Requirements Expansionary Monetary Contractionary Monetary Policy Policy "easy money" "tight money" Discount Rates Impact on interest rates Draw the shift in AD Interest rates decrease Interest rates increase Paned (b) LRAS Complete the "Monetary Policy" assignment in Canvas. ''~'80%- 4 Files 3:18 PM Fri May '13 Insert Draw Layout Review View Unit SMacroeconomic Policy Name: HR: POLICY PRACTICE Draw a recessionary gap: A Draw an inflationary gap: Complete the \"Policy Practice\" assignment in Canvas. 4 Files 3:18 PM Fri May '13 Insert Draw Layout Review View Unit SMacroeconomic Policy Name: HR: _ POLICY GRAPHING PRACTICE These practice problems are to help you get used to using a model to express concepts we have been learning in class. You will have an opportunity to check your own work after each problem. 1. The economy is in an inflationary gap. a. Draw and economy experiencing an inflationary gap. b. Would the Federal Reserve raise or lower the discount rate? c. Draw the shift in the AD/SRAS/LRAS model that would take place following the change in the discount rate. 2. The economy is in a recessionary gap. a. Draw the economy in a recessionary gap. b. Would the government increase or decrease government spending? c. Draw the shift that would result from that change in spending. L 4 Files 3:19 PM Fri May '13 Insert Draw Layout Review View Unit SMacroeconomic Policy Name: HR: POLICY GRAPHING PRACTICE 3. The economy is experiencing inflation of 5% and unemployment of 3%. a. Draw an economy experiencing the appropriate gap based on those numbers. b. Should the FOMC buy or sell securities on the open market? c. Draw the shift in the AD/SRAS/LRAS model that would take place following the change in open market operations. 4. The economy has an unemployment rate of 10% and an inflation rate of 1%. a. Draw an economy experiencing the appropriate gap based on those numbers. b. Name TWO things the President and Congress could do to close the gap. c. Draw the shift that would result from those actions. d. What would be the consequence of your actions on the federal budget? 4 Files 12:39 PM Mon May 16 Insert Draw Layout Review View Unit SMacroeconomic Policy Unit 5Macroeconomic Policy Learning Targets: - Evaluate the structure and functions of money in the United States, including the role of interest rates o Evaluate types of taxes (i.e., progressive, regressive) and earned benefits with eligibility criteria (e.g., Social Security, Medicare, Medicaid). Justify the selection of fiscal and monetary policies in expanding or contracting the economy I Evaluate the intended and unintended costs and benefits (i.e., externalities) of government policies to improve market outcomes and standards of living. I Analyze the effectiveness of how people, government policies, and economic systems have attempted to address income inequality and working conditions both now and in the past. Policy Basics Policy Tools National governments have two tools for influencing the macroeconomy. The first is monetary policy, which involves managing the money supply and interest rates. This is done by the central bank--known as the Federal Reserve or "The Fed". The second is fiscal policy, which involves changes in government spending/purchases and taxes. This is done by Congress and the President. They can be used to close inflationary gaps and recessionary gaps to return to long-run equilibrium (though not without consequence!) These policies support the goals of 3% real GDP growth, 5% unemployment, and 2% inflation we discussed earlier. Fiscal Policy Fiscal policy is the use of government spending and tax policy to influence the path ofthe economy over time. Graphically, we see that fiscal policy, whether through changes in spending or taxes, shifts the aggregate demand outward (rightward) in the case of expansionary fiscal policy and inward (leftward) in the case of contractionary scal policy. Expansionary fiscal policy increases the level of aggregate demand, through either increases in government spending or reductions in tax rates. Expansionary policy can do this by (1) increasing consumption by raising disposable income through cuts in personal income taxes or payroll taxes; (2) increasing investment spending by raising after-tax profits through cuts in business taxes; and (3) increasing government purchases through increased federal government spending on final goods and services and raising federal grants to state and local governments to increase their expenditures on final goods and services. Contractionary fiscal policy does the reverse: it decreases the level of aggregate demand by decreasing consumption, decreasing investment, and decreasing government spending, either through cuts in government spending or increases in taxes. The aggregate demand/aggregate supply model is useful in judging whether expansionary or contractionary fiscal policy is appropriate. Expansionary policies will shift AD to the right and close recessionary gaps, whereas contra ctionary policies will shift AD left can close inflationary gaps. Federal scal policies include discretionary fiscal policy, when the government passes a new law that explicitly changes tax or spending levels. The 2009 stimulus package is an example. Changes in tax and spending levels can also occur automatically, due to automatic stabilizers, such as unemployment insurance and food stamps, which are programs that are already laws that stimulate aggregate demand in a recession and hold down aggregate demand in a potentially inflationary boom. We will learn much more about scal policy next unit. Access for free at httpszllopenstax.org/books/principles-economics-Ze/pagesH-intr0duction 4 Files 12:39 PM Mon May 16 Insert Draw Layout Review View Unit SMacroeconomic Policy Monetary Policy Monetary policy affects interest rates and the available quantity of loanable funds, which in turn affects several components of aggregate demand. Tight or contractionary monetary policy that leads to higher interest rates and a reduced quantity of loanable funds will reduce two components of aggregate demand; Investment and Consumption. Business investment will decline because it is less attractive for rms to borrow money, and even firms that have money will notice that, with higher interest rates, it is relatively more attractive to put those funds in a financial investment than to make an investment in physical capital. In addition, higher interest rates will discourage consumer borrowing for big-ticket items like houses and ca rs. Conversely, loose or expansionary monetary policy that leads to lower interest rates and a higher quantity of loanable funds will tend to increase business investment and consumer borrowing for big-ticket items. If the economy is suffering a recession and high unemployment, with output below potential GDP, expansionary monetary policy can help the economy return to potential GDP by shifting AD to the right and closing the recessionary gap. Conversely, if an economy is producing at a quantity of output above its potential GDP, a contractionary monetary policy can reduce the inflationary pressures for a rising price level by shifting AD to the left and closing the inflationary gap. We will learn much more about monetary policy next unit. Automatic Stabilizers The millions of unemployed in 20082009 could collect unemployment insurance benefits to replace some of their salaries. Federal fiscal policies include discretionary fiscal policy, when the government passes a new law that explicitly changes tax or spending levels. The 2009 stimulus package is an example. Changes in tax and spending levels can also occur automatically, due to automatic stabilizers, such as unemployment insurance and food stamps, which are programs that are already laws that stimulate aggregate demand in a recession and hold down aggregate demand in a potentially inflationary boom. Counterbalancing Recession and Boom Consider first the situation where aggregate demand has risen sharply, causing the equilibrium to occur at a level of output above potential GDP. This situation will increase inflationary pressure in the economy. The policy prescription in this setting would be a dose of contractionary fiscal policy, implemented through some combination of higher taxes and lower spending. To some extent, both changes happen automatically. 0n the tax side, a rise in aggregate demand means that workers and firms throughout the economy earn more. Because taxes are based on personal income and corporate profits, a rise in aggregate demand automatically increases tax payments. On the spending side, stronger aggregate demand typically means lower unemployment and fewer layoffs, and so there is less need for government spending on unemployment benefits, welfare, Medicaid, and other programs in the social safety net. The process works in reverse, too. If aggregate demand were to fall sharply so that a recession occurs, then the prescription would be for expansionary fiscal policysome mix of tax cuts and spending increases. The lower level of aggregate demand and higher unemployment will tend to pull down personal incomes and corporate profits, an effect that will reduce the amount of taxes owed automatically. Higher unemployment and a weaker economy should lead to increased government spending on unemployment benefits, welfare, and other similar domestic programs. In 2009, the stimulus package included an extension in the time allowed to collect unemployment insurance. In addition, the automatic stabilizers react to a weakening of aggregate demand with expansionary fiscal policy and react to a strengthening of aggregate demand with contractionary fiscal policy, just as the AD/AS analysis suggests. Access for free at httpszl/openslax.org/books/principles-economics-Ze/pages/iintroduction 4 Files 12:39 PM Mon May 16 Insert Draw Layout Review View Unit SMacroeconomic Policy Fiscal Policy Fiscal policy is the use of government spending and tax policy to influence the path ofthe economy over time. Expansionary fiscal policy increases the level of spending in the economy, through either increases in government spending or reductions in tax rates. Expansionary policy can do this by (1) increasing consumption by raising disposable income through cuts in personal income taxes or payroll taxes; (2) increasing investment spending by raising after-tax profits through cuts in business taxes; and (3) increasing government purchases through increased federal government spending on final goods and services and raising federal grants to state and local governments to increase their expenditures on final goods and services. Consider first the situation in Figure 3011, which is similar to the US. economy during the 2008-2009 recession. The intersection of aggregate demand (ADO) and aggregate supply (SRASO) is occurring below the level of potential GDP as the LRAS curve indicates--a recessionary gap. At the equilibrium (E0), a recession occurs and unemployment rises. In this case, expansionary fiscal policy using tax cuts or increases in government spending can shift aggregate demand to AD1, closer to the full-employment level of output. In addition, the price level would rise back to the level P1 associated with potential GDP. LRAS Price Level Real GDP Figure 30.11 Expansionary Fiscal Policy The original equilibrium (E0) represents a recession, occurring at a quantity of output ( Y0) below potential GDP. However, a shift of aggregate demand from ADO to ADI, enacted through an expansionary fiscal policy, can move the economy to a new equilibrium output of 1 at the level of potential GDP which the LRAS curve shows. Since the economy was originally producing below potential GDP, any inationary increase in the price level from P0 to P1 that results should be relatively small. Contractionary fiscal policy does the reverse: it decreases the level of spending in the economy by decreasing consumption, decreasing investment, and decreasing government spending, either through cuts in government spending or increases in taxes. As Figure 30.12 shows, the intersection of aggregate demand (ADO) and aggregate supply (SRASO) occurs at equilibrium E0, which is an output level above potential GDP--an inflationary gap. Economists sometimes call this an \"overheating economy\" where demand is so high that there is upward pressure on wages and prices, causing inflation. In this situation, contractionary fiscal policy involving federal spending cuts or tax increases can help to reduce the upward pressure on the price level by shifting aggregate demand to the left, to AD1, and causing the new equilibrium E1 to be at potential GDP, where aggregate demand intersects the LRAS curve. Access for free at httpszliopensiax.org/books/principles-economics-Ze/pages/t-intr0duction 4 Files 12:39 PM Mon May 16 Insert Draw Layout Review View Unit SMacroeconomic Policy Price Level Figure 30.12 A Contractionary Fiscal Policy The economy starts at the equilibrium quantity of output Y0, which is above potential GDP. The extremely high level of aggregate demand will generate inflationary increases in the price level. A contractionary fiscal policy can shift aggregate demand down from ADO to ADI, leading to a new equilibrium output E1, which occurs at potential GDP, where ADI intersects the [RAE curve. Again, the ADAS model does not dictate how the government should carry out this contractionary fiscal policy. Some may prefer spending cuts; others may prefer tax increases; still others may say that it depends on the specific situation. The model only argues that, in this situation, the government needs to reduce aggregate demand. Should the government use tax cuts or spending increases, or a mix of the two, to carry out expansionary fiscal policy? During the 2008-2009 Great Recession (which started, actually, in late 2007), the US. economy suffered a 3.1% cumulative loss of GDP. That may not sound like much, but it's more than one year's average growth rate of GDP. Over that time frame, the unemployment rate doubled from 5% to 10%. The consensus view is that this was possibly the worst economic downturn in US. history since the 1930's Great Depression. The choice between whether to use tax or spending tools often has a political tinge. As a general statement, conservatives and Republicans prefer to see expansionary fiscal policy carried out by tax cuts, while liberals and Democrats prefer that the government implement expansionary fiscal policy through spending increases. In a bipartisan effort to address the extreme situation, the Obama administration and Congress passed an $830 billion expansionary policy in early 2009 involving both tax cuts and increases in government spending. At the same time, however, the federal stimulus was partially offset when state and local governments, whose budgets were hard hit by the recession, began cutting their spending. The conflict over which policy tool to use can be frustrating to those who want to categorize economics as \"liberal" or \"conservative," or who want to use economic models to argue against their political opponents. Ultimately, decisions about whether to use tax or spending mechanisms to implement macroeconomic policy is a political decision rather than a purely economic one. Access for free at httpszllopenstax.org/books/principles-economics-Ze/pages/'lintroduction 4 Files 12:39 PM Mon May 16 Insert Draw Layout Review View Unit SMacroeconomic Policy Spending and Taxes Total US. Government Spending Government spending covers a range of services that the federal, state, and local governments provide. When the federal government spends more money than it receives in taxes in a given year, it runs a budget decit. Conversely, when the government receives more money in taxes than it spends in a year, it runs a budget surplus. If government spending and taxes are equal, it has a balanced budget. For example, in 2009, the U.S. government experienced its largest budget deficit ever, as the federal government spent $1.4 trillion more than it collected in taxes. This deficit was about 10% of the size of the U.S. GDP in 2009, making it by far the largest budget deficit relative to GDP since the mammoth borrowing the government used to finance World War II. Federal spending in nominal dollars (that is, dollars not adjusted for inflation) has grown by a multiple of more than 38 over the last four decades, from $93.4 billion in 1960 to $3.9 trillion in 2014. Comparing spending over time in nominal dollars is misleading because it does not take into account inflation or growth in population and the real economy. A more useful method of comparison is to examine government spending as a percent of GDP over time. The top line in Figure 30.2 shows the federal spending level since 1960, expressed as a share of GDP. Despite a widespread sense among many Americans that the federal government has been growing steadily larger, the graph shows that federal spending has hovered in a range from 18% to 22% of GDP most of the time since 1960. The other lines in Figure 30.2 show the major federal spending categories: national defense, Social Security, health programs, and interest payments. From the graph, we see that national defense spending as a share of GDP has generally declined since the 19605, although there were some upward bumps in the 19805 buildup under President Ronald Reagan and in the aftermath of the terrorist attacks on September 11, 2001. In contrast, Social Security and healthcare have grown steadily as a percent of GDP. Healthcare expenditures include both payments for senior citizens (Medicare), and payments for low-income Americans (Medicaid). State governments also partially fund Medicaid. Interest payments are the final main category of government spending in Figure 30.2. 30- 25 Total federal spending 20 7 15- Federal Spending (as percentage of GDP) \"\\T_ 1960 1970 1980 1990 2000 2010 2020 Year Access for free at httpszllopensiax.org/books/principles-economics-Ze/pages/'l-intr0duction 4 Files 12:39 PM Mon May 16 Insert Draw Layout Review View Unit SMacroeconomic Policy Figure 30.2 Federal Spending, 19602014 Since 1960, total federal spending has ranged from about 18% to 22% of GDP, although it climbed above that level in 2009, but quickly dropped back down to that level by 2013. The share that the government has spent on national defense has generally declined, while the share it has spent on Social Security and on healthcare expenses (mainly Medicare and Medicaid) has increased. (Source: Economic Report of the President, Tables 3-2 and 3-22, http://www.gpo.gov/fdsys/pkg/ERP-2014/content-detai|.htm|) Each year, the government borrows funds from U.S. citizens and foreigners to cover its budget deficits. It does this by selling securities (Treasury bonds, notes, and bills)in essence borrowing from the public and promising to repay with interest in the future. From 1961 to 1997, the US. government has run budget deficits, and thus borrowed funds, in almost every year. It had budget surpluses from 1998 to 2001, and then returned to deficits. The interest payments on past federal government borrowing were typically 12% of GDP in the 19605 and 19705 but then climbed above 3% of GDP in the 19805 and stayed there until the late 19905. The government was able to repay some of its past borrowing by running surpluses from 1998 to 2001 and, with help from low interest rates, the interest payments on past federal government borrowing had fallen back to 1.4% of GDP by 2012. The deficit is not the debt. The difference between the deficit and the debt lies in the time frame. The government deficit (or surplus) refers to what happens with the federal government budget each year. The government debt is accumulated over time. It is the sum of all past deficits and surpluses. If you borrow $10,000 per year for each of the four years of college, you might say that your annual deficit was $10,000, but your accumulated debt over the four years is $40,000. Four categoriesnational defense, Social Security, healthcare, and interest paymentsaccount for roughly 73% of all federal spending, as Figure 30.3 shows. The remaining 27% wedge of the pie chart covers all other categories of federal government spending: international affairs; science and technology; natural resources and the environment; transportation; housing; education; income support for the poor; community and regional development; law enforcement and the judicial system; and the administrative costs of running the government. Net interest (5%) All other spending (29%) Healthcare (including Medicare and Medicaid) (24%) National defense (1 9%) Social Security (22%) Figure 30.3 Slices ofFederai Spending, 2014 About 73% of government spending goes tofour major areas: national defense, Social Security, healthcare, and interest payments on past borrowing. This leaves about 29% of federal spending for all other functions of the U.S. government. (Source: https://www. whitehouse.gov/omb/budget/Historicals/) Access for free at httpszllopenstax.org/books/principles-economics-Ze/pages/t-introduction 4 Files 12:39 PM Mon May 16 Insert Draw Layout Review View Unit SMacroeconomic Policy Federal Taxes Just as many Americans erroneously think that federal spending has grown considerably, many also believe that taxes have increased substantially. The top line of Figure 30.5 shows total federal taxes as a share of GDP since 1960. Although the line rises and falls, it typically remains within the range of 17% to 20% of GDP, except for 2009, when taxes fell substantially below this level, due to recession. 25 N D Total federal tax receipts \\ 15 Payroll taxes Individual income tax \\ 10 ,..1 Federal Ta xes (as percentage of GD P) 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Year Figure 30.5 Federal Taxes, 19602014 Federal tax revenues have been about 1720% of GDP during most periods in recent decades. The primary sources of federal taxes are individual income taxes and the payroll taxes that nance Social Security and Medicare. Corporate income taxes and social insurance taxes provide smaller shares of revenue. (Source: Economic Report ofthe President, 2015. Table 3-21, https://obamawhitehouse.archives.gov/sites/default/files/docs/cea_2015_erp_comp|ete.pdf) Figure 30.5 also shows the taxation patterns for the main categories that the federal government taxes: individual income taxes, corporate income taxes, and social insurance and retirement receipts. When most people think of federal government taxes, the first tax that comes to mind is the individual income tax that is due every year on April 15 (or the first business day after). The personal income tax is the largest single source of federal government revenue, but it still represents less than half of federal tax revenue. The second largest source of federal revenue is the payroll tax (captured in social insurance and retirement receipts), which provides funds for Social Security and Medicare. Payroll taxes have increased steadily over time. Together, the personal income tax and the payroll tax accounted for about 80% of federal tax revenues in 2014. Although personal income tax revenues account for more total revenue than the payroll tax, nearly three-quarters of households pay more in payroll taxes than in income taxes. Access for free at httpszllopenstax.org/books/principles-economics-Ze/pages/t-introduction 4 Files 12:39 PM Mon May 16 Insert Draw Layout Review View Unit SMacroeconomic Policy The income tax is a progressive tax, which means that the tax rates increase as a household's income increases. Taxes also vary with marital status, family size, and other factors. The marginal tax rates (the tax due on all yearly income) for a single taxpayer range from 10% to 35%, depending on income. How does the marginal rate work? Suppose that a single taxpayer's income is $35,000 per year. Also suppose that income from $0 to $9,075 is taxed at 10%, income from $9,075 to $36,900 is taxed at 15%, and, finally, income from $36,900 and beyond is taxed at 25%. Since this person earns $35,000, their marginal tax rate is 15%. The key fact here is that the federal income tax is designed so that tax rates increase as income increases, up to a certain level. The payroll taxes that support Social Security and Medicare are designed in a different way. First, the payroll taxes for Social Security are imposed at a rate of 12.4% up to a certain wage limit, set at $118,500 in 2015. Medicare, on the other hand, pays for elderly healthcare, and is fixed at 2.9%, with no upper ceiling. In both cases, the employer and the employee split the payroll taxes. An employee only sees 6.2% deducted from his or her paycheck for Social Security, and 1.45% from Medicare. However, as economists are quick to point out, the employer's half of the taxes are probably passed along to the employees in the form of lower wages, so in reality, the worker pays all of the payroll taxes. We also call the Medicare payroll tax a proportional tax; that is, a flat percentage of all wages earned. The Social Security payroll tax is proportional up to the wage limit, but above that level it becomes a regressive tax, meaning that people with higher incomes pay a smaller share of their income in tax. The third-largest source of federal tax revenue, as Figure 30.5 shows is the corporate income tax. The common name for corporate income is "profits." Over time, corporate income tax receipts have declined as a share of GDP, from about 4% in the 19605 to an average of 1% to 2% of GDP in the first decade of the 20005. The federal government has a few other, smaller sources of revenue. It imposes an excise taxthat is, a tax on a particular goodon gasoline, tobacco, and alcohol. As a share of GDP, the amount the government collects from these taxes has stayed nearly constant over time, from about 2% of GDP in the 19605 to roughly 3% by 2014, according to the nonpartisan Congressional Budget Office. The government also imposes an estate and gift tax on people who pass large amounts of assets to the next generationeither after death or during life in the form of gifts. These estate and gift taxes collected about 0.2% of GDP in the first decade of the 20005. By a quirk of legislation, the government repealed the estate and gift tax in 2010, but reinstated it in 2011. Other federal taxes, which are also relatively small in magnitude, include tariffs the government collects on imported goods and charges for inspections of goods entering the country. Access for free at httpszllopenstax.org/books/principles-economics-Ze/pages/t-introduction 4 Files 12:40 PM Mon May 16 Insert Draw Layout Review View Unit SMacroeconomic Policy Deficits and Debt Debt/GDP Ratio A useful way to view the budget deficit is through the prism of accumulated debt rather than annual decits. The national debt refers to the total amount that the government has borrowed over time. In contrast, the budget deficit refers to how much the government has borrowed in one particular year. Figure 30.8 shows the ratio of debt/GDP since 1940. Until the 19705, the debt/GDP ratio revealed a fairly clear pattern of federal borrowing. The government ran up large deficits and raised the debt/GDP ratio in World War II, but from the 19505 to the 19705 the government ran either surpluses or relatively small deficits, and so the debt/GDP ratio drifted down. Large deficits in the 19805 and early 19905 caused the ratio to rise sharply. When budget surpluses arrived from 1998 to 2001, the debt/GDP ratio declined substantially. The budget deficits starting in 2002 then tugged the debt/GDP ratio higherwith a bigjump when the recession took hold in 20082009. 120 100 [ll 1 80 l .0 {i ll / 20 Federal Debt (as percentage of GDP) 0 I l I I I l l l 1940 1950 1960 1970 1980 1990 2000 2010 2020 Year Figure 30.8 Federal Debt as a Percentage of GDP, 19422014 Federal debt is the sum of annual budget deficits and surpluses. Annual deficits do not always mean that the debt/GDP ratio is rising. During the 19605 and 19705, the government often run small decits, but since the debt was growing more slowly than the economy, the debt/GDP ratio was declining over this time. in the 20082009 recession, the debt/GDP ratio rose sharply. (Source: Economic Report of the President, Table 8-20, http://www.gpo.gov/fdsys/pkg/ERP-ZOI5/content-detail.html) What is the national debt? One year's federal budget deficit causes the federal government to sell Treasury bonds to make up the difference between spending programs and tax revenues. The dollar value of all the outstanding Treasury bonds on which the federal government owes money is equal to the national debt. The Path from Deficits to Surpluses to Deficits Why did the budget deficits suddenly turn to surpluses from 1998 to 2001 and why did the surpluses return to deficits in 2002? Why did the deficit become so large after 2007? Figure 30.9 suggests some answers. The graph combines the information on total federal spending and taxes in a single graph, but focuses on the federal budget since 1990. Access for free at httpszllopenstax.org/books/principles-economics-2e/pages/1-introduction 4 Files 12:40 PM Mon May 16 Insert Draw Layout Review View Unit SMacroeconomic Policy 26 24 R 22 /\\\\ f '- Tolal spenly 18 ,_ _ Tax recalprs 20 l6 l4 Total Government Spending and Taxes [as percentage of GDP) 12 'lO l I l l ISQD 1995 2000 2005 2010 2015 Year Figure 30.9 Total Government Spending and Taxes as a Shore of GDP, 19902014 When government spending exceeds taxes, the gap is the budget deficit. When taxes exceed spending, the gap is a budget surplus. The recessionary period starting in late 2007 saw higher spending and lower taxes, combining to create a large decit in 2009. (Source: Economic Report of the President, Tables 8-21 and 3-1, "http://www.gpo.gov/fdsys/pkg/ERP- 2015/content-detail. html) Government spending as a share of GDP declined steadily through the 19905. The biggest single reason was that defense spending declined from 5.2% of GDP in 1990 to 3.0% in 2000, but interest payments by the federal government also fell by about 1.0% of GDP. However, federal tax collections increased substantially in the later 19905, jumping from 18.1% of GDP in 1994 to 20.8% in 2000. Powerful economic growth in the late 19905 fueled the boom in taxes. Personal income taxes rise as income goes up; payroll taxes rise as jobs and payrolls go up; corporate income taxes rise as profits go up. At the same time, government spending on transfer payments such as unemployment benefits, foods stamps, and welfare declined with more people working. This sharp increase in tax revenues and decrease in expenditures on transfer payments was largely unexpected even by experienced budget analysts, and so budget surpluses came as a surprise. However, in the early 20005, many of these factors started running in reverse. Tax revenues sagged, due largely to the recession that started in March 2001, which reduced revenues. Congress enacted a series of tax cuts and President George W. Bush signed them into law, starting in 2001. In addition, government spending swelled due to increases in defense, healthcare, education, Social Security, and support programs for those who were hurt by the recession and the slow growth that followed. Deficits returned. When the severe recession hit in late 2007, spending climbed and tax collections fell to historically unusual levels, resulting in enormous deficits. Longer-term U.S. budget forecasts, a decade or more into the future, predict enormous deficits. The higher deficits during the 2008-2009 recession have repercussions, and the demographics will be challenging. The primary reason is the \"baby boom\"the exceptionally high birthrates that began in 1946, right after World War II, and lasted for about two decades. Starting in 2010, the front edge of the baby boom generation began to reach age 65, and in the next two decades, the proportion of Americans over the age of 65 will increase substantially. The current level of the payroll taxes that support Social Security and Medicare will fall well short of the projected expenses of these programs, as the following Clear It Up feature shows; thus, the forecast is for large budget deficits. A decision to collect more revenue to support these programs or to decrease benet levels would alter this long-term forecast. 10 Access for free at httpszllopenstax.org/books/principles-economics-Ze/pages/t-introduction 4 Files 12:40 PM Mon May 16 Insert Draw Layout Review View Unit SMacroeconomic Policy Money Barter and the Double Coincidence of Wants Money for the sake of money is not an end in itself. You cannot eat dollar bills or wear your bank account. Ultimately, the usefulness of money rests in exchanging it for goods or services (that is why economists consider opportunity cost the true cost). As the American writer and humorist Ambrose Bierce (18421914) wrote in 1911, money is a \"blessing that is of no advantage to us excepting when we part with it.\" Money is what people regularly use when purchasing or selling goods and services, and thus both buyers and sellers must widely accept money. This concept of money is intentionally flexible, because money has taken a wide variety of forms in different cultures. To understand the usefulness of money, we must consider what the world would be like without money. How would people exchange goods and services? Economies without money typically engage in the barter system. Barterliterally trading one good or service for anotheris highly inefficient for trying to coordinate the trades in a modern advanced economy. In an economy without money, an exchange between two people would involve a double coincidence of wants, a situation in which two people each want some good or service that the other person can provide. For example, if an accountant wants a pair of shoes, this accountant must find someone who has a pair of shoes in the correct size and who is willing to exchange the shoes for some hours of accounting services. Such a trade is likely to be difficult to arrange. Think about the complexity of such trades in a modern economy, with its extensive division of labor that involves thousands upon thousands of different jobs and goods. Another problem with the barter system is that it does not allow us to easily enter into future contracts for purchasing many goods and services. For example, ifthe goods are perishable it may be difcult to exchange them for other goods in the future. Imagine a farmer wanting to buy a tractor in six months using a fresh crop of strawberries. Additionally, while the barter system might work adequately in small economies, it will keep these economies from growing. The time that individuals would otherwise spend producing goods and services and enjoying leisure time they spend bartering. Functions for Money Money solves the problems that the barter system creates. (We will get to its definition soon.) First, money serves as a medium of exchange, which means that money acts as an intermediary between the buyer and the seller. Instead of exchanging accounting services for shoes, the accountant now exchanges accounting services for money. The accountant then uses this money to buy shoes. To serve as a medium of exchange, people must widely accept money as a method of payment in the markets for goods, labor, and financial capital. Second, money must serve as a store of value. In a barter system, we saw the example of the shoemaker trading shoes for accounting services. However, she risks having her shoes go out of style, especially if she keeps them in a warehouse for future usetheir value will decrease with each season. Shoes are not a good store of value. Holding money is a much easier way of storing value. You know that you do not need to spend it immediately because it will still hold its value the next day, or the next year. This function of money does not require that money is a perfect store of value. In an economy with inflation, money loses some buying power each year, but it remains money. 11 Access for free at httpszllopenstax.org/books/principles-economics-Ze/pages/'I-introduction 4 Files 12:40 PM Mon May 16 Insert Draw Layout Review View Unit SMacroeconomic Policy Third, money serves as a unit of account, which means that it is the ruler by which we measure values. For example, an accountant may charge $100 to file your tax return. That $100 can purchase two pair of shoes at $50 a pair. Money acts as a common denominator, an accounting method that simplifies thinking about trade-offs. Commodity versus Fiat Money Money has taken a wide variety of forms in different cultures. People have used gold, silver, cowrie shells, cigarettes, and even cocoa beans as money. These items are commodity money, they also have a value from use as something other than money. For example, people have used gold throughout the ages as money although today we do not use it as money but rather value it for its other attributes. Gold is a good conductor of electricity and the electronics and aerospace industry use it. Other industries use gold too, such as to manufacture energy efficient reflective glass for skyscrapers and is used in the medical industry as well. Of course, gold also has value because of its beauty and malleability in creating jewelry. As commodity money, gold has historically served its purpose as a medium of exchange, a store of value, and as a unit of account. Commodity-backed currencies are dollar bills or other currencies with values backed up by gold or other commodities held at a bank. During much of its history, gold and silver backed the money supply in the United States. Interestingly, antique dollars dated as late as 1957, have \"Silver Certificate" printed over the portrait of George Washington, as Figure 27.2 shows. This meant that the holder could take the bill to the appropriate bank and exchange it for a dollar's worth of silver. Figure 27.2 A Silver Certificate and a Modern U.S. Bill Until 1958, silver certificates were commodity-backed moneybacked by silver, as indicated by the words "Silver Certificate\" printed on the bill. Today, The Federal Reserve backs U.S. bills, but as fiat money (inconvertible paper money made legal tender by a government decree). (Credit: '"I'he.Comedian"/Flickr Creative Commons) Havens\" humu . As economies grew and became more global in nature, the use of commodity monies became more cumbersome. Countries moved towards the use of fiat money. Fiat money has no intrinsic value, but is declared by a government to be a country's legal tender. The United States' paper money, for example, carries the statement: "THIS NOTE IS LEGAL TENDER FOR ALL DEBTS, PUBLIC AND PRIVATE.\" In other words, by government decree, if you owe a debt, then legally speaking, you can pay that debt with the U.S. currency, even though it is not backed by a commodity. The only backing of our money is universal faith and trust that the currency has value, and nothing more. 12 Access for free at httpszllopenstax.org/books/principIes-economics-Ze/pages/'I-introduction 4 Files 12:40 PM Mon May 16 Insert Draw Layout Review View Unit SMacroeconomic Policy The Federal Reserve and Banking Structure/Organization of the Federal Reserve The Federal Reserve is the central bank of the United States. It is semi-decentralized, mixing government appointees with representation from private-sector banks. At the national level, it is run by a Board of Governors, consisting of seven members appointed by the President of the United States and confirmed by the Senate. Appointments are for 14-year terms and they are arranged so that one term expires January 31 of every even-numbered year. The purpose of the long and staggered terms is to insulate the Board of Governors as much as possible from political pressure so that governors can make policy decisions based only on their economic merits. Additionally, except when filling an unfinished term, each member only serves one term, further insulating decision-making from politics. The Fed's policy decisions do not require congressional approval, and the President cannot ask for a Federal Reserve Governor to resign as the President can with cabinet positions. One member of the Board of Governors is designated as the Chair. For example, from 1987 until early 2006, the Chair was Alan Greenspan. From 2006 until 2014, Ben Bernanke held the post. From 2014 to 2018, Janet Yellen was the Chair. The current Chair is Jerome Powell. The Fed Chair is first among equals on the Board of Governors. While he or she has only one vote, the Chair controls the agenda, and m Fed's public voice, so he or she has more power and influence than one might expect. The Federal Reserve is more than the Board of Governors. The Fed also includes 12 regional Federal Reserve banks, each of which is responsible for supporting the commercial banks and economy generally in its district. Figure 28.3 shows the Federal Reserve districts and the cities where their regional headquarters are located. The commercial banks in each district elect a Board of Directors for each regional Federal Reserve bank, and that board chooses a president for each regional Federal Reserve district. Thus, the Federal Reserve System includes both federally and private-sector appointed leaders. Board of Governors Alaska and Hawaii ' are part of the San Francisco a a District, ~ Figure 28.3 The Twelve Federal Reserve Districts There are twelve regional Federal Reserve banks, each with its district. 13 Access for free at httpszl/openstax.org/books/principles-economics-Ee/pageslt -introduction 4 Files 12:40 PM Mon May 16 Insert Draw Layout Review View Unit SMacroeconomic Policy What Does a Central Bank Do? The Federal Reserve, like most central banks, is designed to perform three important functions: 1. To conduct monetary policy 2. To promote stability of the financial system 3. To provide banking services to commercial banks and other depository institutions, and to provide banking services to the federal government. The Federal Reserve provides many of the same services to banks as banks provide to their customers. For example, all commercial banks have an account at the Fed where they deposit reserves. Similarly, banks can obtain loans from the Fed through the \"discount window\" facility, which we will discuss in more detail later. The Fed is also responsible for check processing. When you write a check, for example, to buy groceries, the grocery store deposits the check in its bank account. Then, the grocery store's bank returns the physical check (or an image of that actual check) to your bank, after which it transfers funds from your bank account to the grocery store's account. The Fed is responsible for each of these actions. On a more mundane level, the Federal Reserve ensures that enough currency and coins are circulating through the financial system to meet public demands. For example, each year the Fed increases the amount of currency available in banks around the Christmas shopping season and reduces it again in January. Finally, the Fed is responsible for assuring that banks are in compliance with a wide variety of consumer protection laws. For example, banks are forbidden from discriminating on the basis of age, race, sex, or marital status. Banks are also required to disclose publicly information about the loans they make for buying houses and how they distribute the loans geographically, as well as by sex and race of the loan applicants. Banks as Financial Intermediaries Banks and money are intertwined. It is notjust that most money is in the form of bank accounts. The banking system can literally create money through the process of making loans. An "intermediary\" is one who stands between two other parties. Banks are a financial intermediarythat is, an institution that operates between a saver who deposits money in a bank and a borrower who receives a loan from that bank. Financial intermediaries include other institutions in the financial market such as insurance companies and pension funds, but we will not include them in this discussion because they are not depository institutions, which are institutions that accept money deposits and then use these to make loans. All the deposited funds mingle in one big pool, which the financial institution then lends. Figure 27.4 illustrates the position of banks as nancial intermediaries, with deposits flowing into a bank and loans flowing out. Of course, when banks make loans to firms, the banks will try to funnel nancial capital to healthy businesses that have good prospects for repaying the loans, not to firms that are suffering losses and may be unable to repay. 14 Access for free at httpszl/openstax.org/books/principles-economics-Ze/pages/iintroduction 4 Files 12:40 PM Mon May 16 Insert Draw Layout Review View Unit SMacroeconomic Policy name Loans Figure 27.4 Banks as Financial Intermediaries Banks act as financial intermediaries because they stand between savers and borrowers. Savers place deposits with banks, and then receive interest payments wmgwah '13:;an and withdraw money. Borrowers receive loans from banks and repay the loans with interest. In Emanuel; Inleres1payments Interestpaymenls turn, banks return money to savers in the form of withdrawals, which also include interest payments from banks to savers. Money Creation by Banks Start with a hypothetical bank called Singleton Bank. The bank has $10 million in deposits from savers. At this stage, Singleton Bank is simply storing money for depositors and is using these deposits to make loans. In this simplified example, Singleton Bank cannot earn any interest income from these loans and cannot pay its depositors an interest rate either. The Federal Reserve requires Singleton Bank to keep $1 million on reserve (10% of total deposits). It will loan out the remaining $9 million. By loaning out the $9 million and charging interest, it will be able to make interest payments to depositors and earn interest income for Singleton Bank. Instead of becoming just a storage place for deposits, Singleton Bank can become a financial intermediary between savers and borrowers. Singleton Bank lends $9 million to Hank's Auto Supply. This loan is an asset, because it will generate interest income for the bank. Of course, the loan officer will not allow let Hank to walk out of the bank with $9 million in cash. The bank issues Hank's Auto Supply a cashier's check for the $9 million. Hank deposits the loan in his regular checking account with First National. The deposits at First National rise by $9 million and its reserves also rise by $9 million. First National must hold 10% of additional deposits as required reserves but is free to loan out the rest. Making loans that are deposited into a demand deposit account increases the money supply. The money supply is now $19 million: $10 million in deposits in Singleton bank and $9 million in deposits at First National. Obviously as Hank's Auto Supply writes checks to pay its bills the deposits will draw down. However, the bigger picture is that a bank must hold enough money in reserves to meet its liabilities. The rest the bank loans out. In this example so far, bank lending has expanded the money supply by $9 million. As this cycle of loaning and deposits continues the money supply increases with each step. Money and BanksBenefits and Dangers Money and banks are marvelous social inventions that help a modern economy to function. Compared with the alternative of barter, money makes market exchanges vastly easier in goods, labor, and financial markets. Banking makes money still more effective in facilitating exchanges in goods and labor markets. Moreover, the process of banks making loans in financial capital markets is intimately tied to the creation of money. However, the extraordinary economic gains that are possible through money and banking also suggest some possible corresponding dangers. If banks are not working well, it sets off a decline in convenience and safety of transactions throughout the economy. If the banks are under financial stress, because of a widespread decline in the value of their assets, loans may become far less available, which can deal a crushing blow to sectors of the economy that depend on borrowed money like business investment, home construction, and car manufacturing. The 20082009 Great Recession illustrated this pattern. 15 Access for free at httpszllopenstax.org/books/principles-economics-Ze/pagesH-introduction 4 Files 12:40 PM Mon May 16 Insert Draw Layout Review View Unit SMacroeconomic Policy The Fed and Monetary Policy The Federal Reserve's most important function is to conduct the nation's monetary policy. Article |, Section 8 of the US. Constitution gives Congress the power "to coin money\" and \"to regulate the value thereof.\" As part of the 1913 legislation that created the Federal Reserve, Congress delegated these powers to the Fed. Monetary policy involves managing interest rates and credit conditions, which influences the level of economic activity, as we describe in more detail below. A monetary policy that lowers interest rates and stimulates borrowing is an expansionary monetary policy or loose monetary policy. Conversely, a monetary policy that raises interest rates and reduces borrowing in the economy is a contractionary monetary policy or tight monetary policy. A central bank has three traditional tools to implement monetary policy in the economy: 1. Open market operations 2. Changing reserve requirements 3. Changing the discount rate In discussing how these three tools work, it is useful to think of the central bank as a "bank for banks\" that is, each private-sector bank has its own account at the central bank. We will discuss each of these monetary policy tools in the sections below. Open Market Operations The most common monetary policy tool in the U.S. is open market operations. These take place when the central bank sells or buys U.S. Treasury bonds in order to influence the quantity of bank reserves and the level of interest rates. The specific interest rate targeted in open market operations is the federal funds rate. The name is a bit of a misnomer since the federal funds rate is the interest rate that commercial banks charge making overnight loans to other banks. As such, it is a very short term interest rate, but one that reflects credit conditions in financial markets very well. The Federal Open Market Committee (FOMC) makes the decisions regarding these open market operations. The FOMC comprises seven members of the Federal Reserve's Board of Governors. It also includes five voting members who the Board draws, on a rotating basis, from the regional Federal Reserve Banks. The New York district president is a permanent FOMC voting member and the Board fills other four spots on a rotating, annual basis, from the other 11 districts. The FOMC typically meets every six weeks, but it can meet more frequently if necessary. The FOMC tries to act by consensus; however, the Federal Reserve's chairman has traditionally played a very powerful role in defining and shaping that consensus. For the Federal Reserve, and for most central banks, open market operations have, over the last few decades, been the most commonly used tool of monetary policy. Where does the Federal Reserve get the money that it uses to purchase the bonds? A central bank has the power to create money. In practical terms, the Federal Reserve would write a check to a bank, so that the bank can have that money credited to its bank account at the Federal Reserve. In truth, the Federal Reserve created the money to purchase the bonds out of thin airor with a few clicks on some computer keys. 16 Access for free at httpszllopenstax.org/books/principles-economics-Ze/pages/'l-intr0duction 4 Files 12:40 PM Mon May 16 Insert Draw Layout Review View Unit SMacroeconomic Policy Changing Reserve Requirements A second method of conducting monetary policy is for the central bank to raise or lower the reserve requirement, which is the percentage of each bank's deposits that it is legally required to hold either as cash in their vault or on deposit with the central bank. If banks are required to hold a greater amount in reserves, they have less money available to lend out. If banks are allowed to hold a smaller amount in reserves, they will have a greater amount of money available to lend out. In early 2015, the Federal Reserve required banks to hold reserves equal to 0% of the first $14.5 million in deposits, then to hold reserves equal to 3% of the deposits up to $103.6 million, and 10% of any amount above $103.6 million. The Fed makes small changes in the reserve requirements almost every year. For example, the $103.6 million dividing line is sometimes bumped up or down by a few million dollars. In practice, the Fed rarely uses large changes in reserve requirements to execute monetary policy. A sudden demand that all banks increase their reserves would be extremely disruptive and difficult for them to comply, while loosening requirements too much would create a danger of banks inability to meet withdrawal demands. Changing the Discount Rate The Federal Reserve was founded in the aftermath of the 1907 Financial Panic when many banks failed as a result of bank runs. As mentioned earlier, since banks make profits by lending out their deposits, no bank, even those that are not bankrupt, can withstand a bank run. As a result ofthe Panic, the Federal Reserve was founded to be the \"lender of last resort.\" In the event of a bank run, sound banks, (banks that were not bankrupt) could borrow as much cash as they needed from the Fed's discount "window" to quell the bank run. We call the interest rate banks pay for such loans the discount rate. (They are so named because the bank makes loans against its outstanding loans \"at a discount" of their face value.) Once depositors became convinced that the bank would be able to honor their withdrawals, they no longer had a reason to make a run on the bank. In short, the Federal Reserve was originally intended to provide credit passively, but in the years since its founding, the Fed has taken on a more active role with monetary policy. The third traditional method for conducting monetary policy is to raise or lower the discount rate. If the central bank raises the discount rate, then commercial banks will reduce their borrowing of reserves from the Fed, and instead call in loans to replace those reserves. Since fewer loans are available, the money supply falls and market interest rates rise. If the central bank lowers the discount rate it charges to banks, the process works in reverse. How Monetary Policy Impacts the Economy If the economy is suffering a recession and high unemployment, with output below potential GDP, expansionary monetary policy can help the economy return to potential GDP. Figure 28.8 (a) illustrates this situation. The original equilibrium during a recession of E0 occurs at an output level of 600. An expansionary monetary policy will reduce interest rates and stimulate investment and consumption spending, causing the original aggregate demand curve (ADO) to shift right to AD1, so that the new equilibrium (E1) occurs at the potential GDP level of 700. Conversely, if an economy is producing at a quantity of output above its potential GDP, a contractionary monetary policy can reduce the inflationary pressures for a rising price level. In Figure 28.8 (b), the 17 Access for free at httpszl/openstax.org/books/principles-economics-Ze/pages/i-introduction 4 Files 12:40 PM Mon May 16 Insert Draw Layout Review View Unit SMacroeconomic Policy original equilibrium (E0) occurs at an output of 750, which is above potential GDP. A contractionary monetary policy will raise interest rates, discourage borrowing for investment and consumption spending, and cause the original demand curve (ADO) to shift left to AM, so that the new equilibrium (E1) occurs at the potential GDP level of 700. L RAS SRAS 8' 2 u '3 )5 O 0) ll! 9; E > 0 _l O 2 E2 80 - l l r l 400 500 600 700 800 Real Output (constant dollars) (a) Expansionary monetary policy Price Level (base year = 100) LRAS 120 - 110 ----------------------- ' 1004 90- i 80 1 i i r l l 400 500 600 700 800 Real Output (constant dollars) (1)) Contractionary monetary policy Figure 28.8 Expansionary or Contractionary Monetary Policy (a) The economy is originally in a recession with the equilibrium output and price shown at E0. Expansionary monetary policy will reduce interest rates and shift aggregate demand to the rightfrom ADO to ADI, leading to the new equilibrium (E1) at the potential GDP level of output with a relatively small rise in the price level. (b) The economy is originally producing above the potential GDP level of output at the equilibrium E0 and is experiencing pressures for an inationary rise in the price level. Contractionary monetary policy will Shift aggregate demand to the left from ADD to ADI, thus leading to a new equilibrium (E1) at the potential GDP level of output. Policies Expansionary Policies that lower interest rates (to fight unemployment Lower Discount Rate during a recessionary gap) Contractionary Policies that raise interest rates (to fight inflation during an inflationary gap) Raise Discount Rate The Federal Reserve's Monetary Buy securities on open market Lower Reserve Requirement Sell securities on open market Raise Reserve Requirement Congress and the President's Fiscal Policies Lower Taxes Raise Government Spending Raise Taxes Lower Government Spending 18 Access for free at httpszllopenslax.org/books/principles-economics-Ze/pagesH-introduction