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Economic Policy


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Title: Economic Policy

Economic Policy
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

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
  • 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)

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

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

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

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

Fiscal and Monetary Policy
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
  • Active use of fiscal policy was popular with
    governments from the 1950s to mid-1970s.

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?

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
  • Aim of this type of counter-cyclical fiscal
    policy is to ensure low unemployment.

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.

Using Fiscal Policy
  • What is the final effect on the economy of an
    increase in government spending of 10 billion
  • 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.

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

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

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

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

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)

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.

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

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

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.

Central Banking and Federal Reserve System
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.

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.

How Banks Create Money - the Fractional Banking
  • 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

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

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.

The Federal Reserve
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

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
  • Through Reserve Requirements
  • The amount of money member banks must keep on
  • 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

Budgeting Taxing and Spending
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

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.

Federal Budgeting
Federal Budgeting
  • This makes for 73 of the total budget the
    remaining 27 is allotted to such things as
    housing, foreign aid, transportation, education,
  • 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
  • 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)

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.

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
  • Excise taxes on gasoline, cigarettes and alcohol
  • The remaining 4 of taxes includes such things as
    estate taxes, customs fees, etc.

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

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

Government spending as a GDP
  • 1960 2000
  • France 35 48
  • Germany 33 44
  • Japan 17 32
  • USA 27 33
  • EU 32 50

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
  • 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.

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

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
  • 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.

Debt and Deficits
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

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

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)

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

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

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

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

Goals of Fiscal Policy
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.

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
  • 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.

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

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).

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.

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
  • The better the approval ratings, the greater the
    chance that the President will be re-elected (or
    get Congressional approval of his economic
  • Every President will attempt to manipulate fiscal
    policy in order to help himself and his political

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
  • 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).

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
  • 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.

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.

Review Questions
  • What policies does the government use to
    encourage and/or discourage private sector
  • 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?

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
  • Is the Social Security system sound does it
    need reform of some sort?