A review of fiscal policy issues

1. A review of fiscal policy issues

2. Problems with Fiscal Policy • Cutting taxes and increasing spending is politically easy • Raising taxes and decreasing spending is politically difficult • Increasing AD can cause inflation (see graph)

3. Deficits and the Nat’l Debt • A deficit occurs when the gov’t spends more than it collects in taxes in one year • Add up all the deficits, you get the National Debt • Current National Debt

4. Is the National Debt EVIL? • No • We used to just owe this money to each other • Where’s the National Asset Clock? • Yes • China holds a huge part of this debt, which will drain money from future generations to pay them off, and it gives the Chinese huge power over the US

5. National Budget • The current administration has run up huge deficits and added trillions to the National Debt in the past 7 years. • Could you do better? Try your hand at balancing the Federal Budget by playing the Budget Game at National Budget Simulation

6. National Budget Simulation • After trying the Budget Simulation, describe the results of your budget. This one page essay is due July 27. Include the print out of the results of your budget changes.

7. Taxes • Oliver Wendell Holmes said that “Taxes are the price we pay for civilization”

8. Taxes • Progressive tax • Takes a higher % from those people with higher incomes. Example: Income tax • Delores earns $300,000 in income and pays $93,000 in taxes (31%) • Marcus earns $30,000 in income and pays $4,500 (15%) • Fair? Utility of the lower or higher income

9. Regressive tax • Regressive tax • Takes a higher % from those with lower incomes. Example: 10% sales tax on clothes • Mary earns $2,000,000 and spends $20,000 on clothes; she pays $2,000 in sales tax, or 0.1% • Tim earns $30,000 and spends $5,000 on clothes; paying $500 in taxes or 1.6%

10. “Flat Tax” • Flat tax • Takes the same % from all • Some people think Social Security is a flat tax, but no FICA taxes are taken from income over about $102,000

11. “Fair Tax” • A National Sales Tax is being proposed by some of the candidates for president • Advocates of the so-called "FairTax" claimed a 23 percent national sales tax can replace both the federal income tax and Social Security taxes. • Some opponents claim the actual rate would have to be at least 34 percent even if it fell on new homes, mortgage interest and a host of other products and services not usually subject to state or local sales taxes.

12. Is a Fair Tax really Fair? • Richie Rich earns $1,000,000 in a year. He spends $200,000 of his income subject to the 24% “Fair” tax for a tax total of $48,000, or 4.8% of his income • Average Joe earns $50,000 in a year. He spends $40,000 subject to the “Fair” tax, which is $9,600, or 19% of his income. • Is this fair or just regressive?

13. Review of Classical Economics • Based on three basic ideas • Say’s Law • Equation of exchange • Self-regulating markets

14. Say’s Law • Supply creates its own Demand. • The act of producing a product generates the income to buy that product

15. Equation of Exchange • MS x V = P x Y • MS is the money supply • V is Velocity of money • P is Price • Y is Output

16. Equation of Exchange (2) • If you increase the MS and V is constant then P X Y must go up. Usually it’s just Price increases though.

17. Self-Regulating Markets • Markets tend to settle at equilibrium and so government should stay out! • Laissez-faire

18. Keynesian Economics • Rejects those three beliefs • Demand creates supply • Velocity isn’t stable • Markets can settle into a Great Depression

19. Criticisms of Keynesian fiscal policy • Can result in deficits and increase the National Debt

20. Keynesian Monetary Policy • In addition to Fiscal Policy, Keynesian economics also had another tool that might be used to fine tune the economy: • Monetary Policy • To understand Monetary Policy, we first have to understand Money

21. Money and Banking

22. What is Money? • 1. Medium of Exchange • 2. A Store of Wealth • 3. A Unit of Account to compare value or price

23. What has been used as Money? • 1. Large stones in So. Pacific

24. What has been used as Money? • 1. Large stones in So. Pacific • 2. Shells in West Africa • 3. Commodity money like gold • 4. Cigarettes in POW camps

25. Measures of Money • Transaction money called M1 • currency+demand deposits+traveler’s checks • Broad Money M2 includes M1 + savings accounts and money market accounts

26. Short History of Banks • Goldsmiths in the Middle Ages • Banks printed their own money • US government printed greenbacks during the civil war

27. The FED, the banks’ bank • Today’s banks are required to belong to the FED or the Federal Reserve Bank

28. The FED • Created in Dec. 1913 • 12 branch banks • Clears checks between banks, hold reserves, provides cash, provides loans for member banks • Chairman and a Board of Governors, Ben Bernancke current FED chairman

29. 12 Fed Branches

30. Three tools of the Fed • 1. The Reserve Ratio • 2. Discount rate and Federal Funds rate • 3. Open market operations

31. Reserve Ratio • The percent of demand deposits required to be held with the FED as reserves or cash in the bank • Currently between 3% and 10% • Changed infrequently, updated one a year in December or January

32. Discount and Fed Funds Rate • The Discount rate is the interest rate that the FED charges banks on short term loans • The Federal Funds rate is the interest rate, set by the FED, that banks can charge each other for short term loans of reserves • Currently 5.25%

33. Discount and Fed Funds Rate • These have been reviewed every 2-3 months recently • If the rate increases, M1 decreases • If the rate decreases, M1 should increase

34. Open Market Operations • Occur every day when the FED buys or sells government bonds • If the FED buys bonds, it puts money into the banks’ excess reserves, and increases the Money Supply • If the FED sells bonds, banks give the FED excess reserves, reducing the Money Supply

35. A Simple Banking Example • Steve’s Bank • Assets Liabilities • $500 $500 initial deposit • $450 $450 loan • $950 $950 total cash • $400 $400 another loan • $1,350 $1,350 total cash

36. Monetary Policy • Series ofactions that might result in an increase of Aggregate Demand • This series is similar to the gears on a standard shift car, and so is sometimes called the Transmission Mechanism

37. Rube Goldberg

38. Transmission Mechanism:First Gear (little honda) • First Gear: • The FED identifies a recession • so the board of governors shifts policy and decides to BUY Government Bonds, putting money into banks’ excess reserves, • or the FED lowers the discount rate or the federal funds rate, which allows banks to increase their excess reserves by short-term borrowing

39. Second Gear • The banks see that they have extra reserves so the banks can… • Loan that money to investors • To attract loan customers, banks should … interest rates • Lower interest rates

40. Third Gear • Investors see that interest rates have gone down. They re-examine investment options, and determine the potential profit of the investment, known as the Marginal Efficiency of Investment or MEI

41. Third Gear Cont’d • If the MEI is greater than the interest rate then investors will borrow and invest. • If the MEI is less than the interest rate, then borrowing the money to invest would cause a loss so investment would not occur.

42. Fourth Gear • Firms borrow money to invest. As Investment increases, so does Aggregate Demand. • As the impact of investment ripples then AD increases even more and Output (Y) increases as well, ending the recession.

43. Slippages • Keynes pointed to potential problems in moving between the “gears”, problems he called slippages • 1. What if the FED tries to buy bonds but nobody is selling? • 2. What if banks sell bonds, but just sit on their reserves and don’t loan them out?

44. More Slippages • 3. What if MEI is not greater than the interest rate? • 4. What if Investment doesn’t occur, just transfer of wealth?

45. Monetary Policy plusses and minuses • The recognition lag for monetary and fiscal policies are the same • The implementation lag for monetary policy can be one day. The fed can change from buying to selling bonds overnight, and can change interest rates almost as fast • The impact lag is difficult to predict because of the slippages mentioned previously

46. More monetary analysis • Some critics feel that fighting inflation by raising interest rates is like trying to fight a fever by raising your temperature. • When the Fed fights inflation with high interest rates, some sectors of the economy are impacted; housing, construction and automotive industries are particularly prone to downturns when interest rates increase

47. Monetarists • A new school of economic thought developed, led by Milton Friedman • Monetarists based their theories on three basic principals: • Permanent Income Hypothesis • Equation of Exchange • Monetary Rule

48. Permanent Income Hypothesis • The Monetarists believe that consumers make choices based on their past, present and future income. • A change in income from a temporary fiscal policy will not have a permanent economic impact

49. Equation of Exchange • Any change in monetary or fiscal policy will only result in inflation • Ms x V = P x Y • If velocity and output are fixed, any increase in the money supply will just drive up prices

50. Equation of Exchange (cont’d) • If AD increases, that causes a temporary increase in Y, but also creates “demand pull” inflation • AS reacts to this price level increase with “cost push” inflation, as their costs go up, they shift AS back • The monetarist Long Run Aggregate Supply Curve is straight up and down