Understanding Fiscal Policy and its Impact on Potential Output and Debt

1. Chapter 15 Fiscal Policy,Deficit, and Debt

2. Potential output • Is the economy’s maximum sustainable output in the long run, given the supply of resources, the state of technology, and the rules of the game that nurture production and exchange. • Potential output referred to the full-employment output.

3. continued • GDP of $12 trillion potential output is real GDP of $12 trillion. • In theory, fiscal policy can be used to ensure the economy achieves its potential, w/ full employment and price stability. • Natural rate of unemployment- the unemployment rate when the economy is producing its potential level of output.

4. USA • Natural rate of unemployment are in the range of 4 to 5 % of the labor force. • 2008 rate is 7.2% • Contractionary gap- the amount by which short-run output falls below the economy’s potential output. • If output is below the economy’s potential, policy makers often decide to reduce taxes or increase government spending. (idea is to stimulate aggregate demand is a way of increasing output to its potential.)

5. Expansionary gap • The amount by which actual output in the short run exceeds the economy’s potential output. • Production creates inflationary pressure in the economy. • Production exceeding the economy’s potential is not sustainable in the long run.

6. Normal production capacity • Studying. Same pace through out the year. Nearing exams students study more. • Producers, too can exceed their normal capacity in the short run to push output beyond the economy’s potential. • Long run , the economy does not exceed its potential, just as you don’ t boost your study effort permanently. • Output in the long run gravitates back to the economy’s potential.

7. Classical economists. • Prior to great depression, public policy was shaped by the vies of classical economists. • They advocated laissez faire. • Laissez-faire, the belief that free markets w/o govn’t intervention were the best way to achieve the economy’s potential output. • Didn’t deny depressions or high unemployment. Due to wars, tax increases, poor growing season,

8. Classical economists • Believed, that natural forces such as declining prices, wages, and interest rates, would end any recession in a relatively short time by encouraging people and businesses to spend more. • Classical economists argued.

9. Annually balanced budget • Matching annual spending w/ annual revenue, except during war years; approach to the federal budget prior to the Great Depression. • Great Depression 25% unemployed. • John Maynard Keynes (Cambridge University 1936).

10. Multplier effect • Any change in fiscal policy affects aggregate demand by more than the original change in spending or taxing

11. Chapter 15.2 • Discretionary fiscal policy- Congressional changes in spending or taxing to promote macroeconomics goals. • Automatic stabilizers- Government spending and taxing programs that year after year automatically reduce fluctuations in disposable income, and thus in consumption, over the business cycle.

12. Problems w/ Discretionary Fiscal Policy • Stagflation • Calculating the natural rate of unemployment. Not easy. • (4 to 5% unemployment rate) • The Problem of Lags • Recognition lag- the time needed to identify a macroeconomic problem

13. continued • Decision making lag- the time needed to decide what to do once the problem has been identified. • Implementation lag- the time needed to execute a change in policy. • Effectiveness lag- the time needed to change in policy to affect the economy.

14. Chapter 15.3 • Federal Deficits and Federal Debt • 2008-2009 1.3 trillion dollars debt • Federal reserve has printed only $900 billion. • More than half the money is unaccounted.

15. Budget Deficit • Measures the amount by which total federal spending exceeds total federal revenues. • Why is the budget usually a deficit? • Congress is not required to balance the budget. Spending wins people’s votes and taxing loses people’s votes. • The Surplus of 1998-2001. Bill Clinton and his administration balance the budget. George W. Bush’s administration spent 1.3 trillion on 2 wars and natural disasters such as Katrina, and other natural disasters through out the nation. • Federal Reserve kept interest rates low to prevent inflation. Housing boom, deregulation in the loans, and predator lenders. Hike in interest rates.

16. Deficit and Interest rate • Crowding in- government spending stimulates private investment in an otherwise stagnant economy. • Crowding out- private investment falls when higher government deficits drive up interest rates.

17. Chapter 16 sec. 1Money and Banking • Barter-A system of exchange in which products are traded directly for other products. • Money- functions medium of exchange, a unit of account, and a store of value. • Medium of exchange- Anything generally accepted by all parties in payment for goods or services. • Commodity money- Anything that serves both as money and as a commodity, such as gold.

18. Unit of account • A standard on which to base prices. • Shoes, made out of leather (hide), or pots may be measured by bushels of corn. • Corn becomes the common denominator, a yardstick, for measuring the value of all goods and services. • Buyers and sellers could price everything using a common measure, such as corn. Store of value- Anything that retains its purchasing power over time.

19. Commodity Money • Limitations of Commodity Money. • The ideal money is durable, portable, divisible, of uniform quality, has a low opportunity cost, does not fluctuate wildly in value, and is in limited supply.

20. continued • Durable- last long, unlike corn that is perishable (rotten). • Portable- carry around easily. • Divisible-$1.00, $2.00, $5.00. $10.00, $20.00, $50.00, $100 • Coins pennies, nickels, dimes, quarter, fifty cents, dollar coins. • Uniform Quality- similar embossed images.

21. continued • Low Opportunity Cost-Commodity money usually tied up as valuable resources, so it has high opportunity cost compared with paper money. • Ex. Corn that is used for money cannot at the same time be used as food. The ideal money has a low opportunity cost.

22. continued • Supply or Demand Must Not Fluctuate Erratically • Supply and Demand of commodity money determine the prices of all other goods. • A record harvest would increase the supply of corn. An increase in the popularity of corn as food would increase the demand of corn. Each would alter the price level measured in corn. • Erratic fluctuations in the supply or demand for corn limit its usefulness as money, particularly as a unit of account and as a store of value.

23. continued • Limited Supply- value of money depends on its limited supply, anything that can be gathered or produced easily would not serve well as commodity money. • Ideal money should be in limited supply

24. Coins • Bushel of corn, rock salt cut into block used as money. • Silver & Gold were used as money. • Used cheaper metals, quantity & quality was solved by coining silver & gold. • Coinage determined both the amount & quality of the metal. • Coins-durable, easy to carry, precious metals

25. Coin • Table on which money was counted during this era came to be called the counter. • The power to coin was vested in the feudal lord or seignior. • If the exchange value of the coin exceeds the cost of making it, minting coins became a source of revenue to the seignior. • Token money is money whose exchange value exceeds the cost of production.

26. Ch. 16 s. 2 Origins of Banking and the Federal Reserve System • Gold coins on deposit w/ a goldsmith. • Pay & deposit w/ goldsmith. • Bank Checks • Checks-A written order instructing the bank to pay someone from an amount deposited. • Bank Loans-The goldsmith could extend a loan by creating an account against which the borrower could write checks. In this way goldsmiths, or banks, were able to create a medium of exchange- “create money”. Goldsmith shop

27. Check by Wells, Fargo & Co 1868

28. Bank loan • This money, based only on an entry in the banks ledger, was accepted because of the public’s confidence that the bank would honor these checks.

29. Fractional reserve banking system • Only a portion of bank deposits is backed by reserve. • In this system, the goldsmith’s reserves amounted to just a fraction of the claims by depositors. • The reserve ratio measures bank reserves as a share of deposits. Ex. If the goldsmith had gold reserve valued at $40,000 but deposits totaling $100,000, the reserve ration would be 40%.

30. Bank Notes • Bank notes were pieces of paper promising the bearer a specific amount of gold or silver when the notes were redeemed at the issuing bank. • Checks could be redeemed for gold only if endorsed by the payee. Bank notes, however, could be redeemed for gold by anyone who presented them to issuing bank. • Paper money is portable. • Representative money-Bank notes that exchange for a specific commodity, such as gold.

31. Fiat money- Money not redeemable for anything of intrinsic value; declared money by government decree. Ex. Currency issued by the U.S. government & nearly all other governments throughout world today is fiat money. Fiat Money

32. Fiat Money • Requires only some paper and a printing press.

33. Depository Institutions • Accept deposits from the public and make loans from these deposits. • Commercial Banks: Depository institutions that make loans primarily to businesses than to households. • Until 1980 commerical banks were the only depository institutions that offered demand deposits, or checking accounts.

34. Commercial banks • Demand deposits are so named because a depositor with such an account can write a check demanding those deposits.

35. Thrifts • Thrift institutions, or thrifts, include savings and loan associations, mutual savings banks, and credit unions. • Historically, savings & loans associations and mutual savings banks specialized in making home mortgage loans. • Credit unions, which tend to be small, account for most thrifts. Extend loans to “members” to finance homes or other consumer purchases.

36. Dual Banking System • Before 1863, banks were chartered called state banks. • Goldsmiths made different notes. • Thousand’s of different notes circulated at the same time, & nearly all redeemable for gold. • The National Banking Act of 1863 & other acts created news system of Chartered banks called National Banks.

37. Federal Reserve System (Fed) • Established in 1913 as the central bank and monetary authority of the United States. • Other industrialized countries established central banks; Bundesbank in Germany, the Bank of Japan, and the Bank of England. • America’s suspicion of monopolies initially led to the establishment of 12 separate banks in the Federal Reserve districts around the country.

38. Federal Reserve System • Named after the cities in which they were located. • Federal Reserve Banks of • Boston • New York • Chicago • San Francisco • Philadelphia • Richmond • Cleveland • St. Louis • Kansas City • Minneapolis • Dallas

39. The Twelve Federal Reserve Districts (www.federalreserve.gov)

40. Federal Reserve System • Federal Reserve Board of Governors “to exercise general supervision” over the Federal Reserve System to ensure sufficient money and credit in the banking system. The power to issue banks notes was taken away from national banks and turned over the Federal Reserve.

41. Take a look at paper currency and you will read “Federal Reserve Note” across the top • These notes actually are printed by the U.S. Bureau of Printing and Engraving, which is part of the U.S. Treasury. • The Treasury prints the notes but the Fed has responsibility for putting them into circulation.

42. Federal Reserve • It does not deal w/ the public directly. • Bankers’ bank. • Banks hold deposits for member banks, just as commercial banks and thrifts hold deposits for the public. • The name “Reserve Banks” comes from the responsibility to hold member- bank reserves on deposits.

43. Reserves • Consist of cash that banks have on hand in their vaults or on deposit with Reserve banks. • Bank can clear a check written by a depositor at one bank, such as Bank of America and deposited in another bank, such as your bank.

44. Reserves • Reserve Banks also extend loans to member banks. • The interest rate charged for these loans is called the discount rate. • By making loans to banks, the fed can increase reserves in the banking system.

45. Directing Monetary Policy • The Federal Reserve’s Board of Governors is responsible for setting and carrying out the nation’s monetary policy. • Monetary Policy is the regulation of the economy’s money supply and interest rates to promote macroeconomic objectives such as full employment, price stability, and economic growth.

46. Board of Governors • MembersSince 1913 • Ben S. Bernanke, Chairman | Donald L. Kohn, Vice Chairman | Kevin M. Warsh | Elizabeth A. Duke | Daniel K. Tarullo • The seven members of the Board of Governors of the Federal Reserve System are nominated by the President and confirmed by the Senate. A full term is fourteen years. One term begins every two years, on February 1 of even-numbered years. A member who serves a full term may not be reappointed. A member who completes an unexpired portion of a term may be reappointed. All terms end on their statutory date regardless of the date on which the member is sworn into office. • The Chairman and the Vice Chairman of the Board are named by the President from among the members and are confirmed by the Senate. They serve a term of four years. A member's term on the Board is not affected by his or her status as Chairman or Vice Chairman.

47. Board Membership • Relatively stable b/c a new U.S. President can be sure of appointing or reappointing only two members in a presidential term. • The Board structure is designed to insulate monetary authorities from pressure by elected officials.

48. Federal Open Market Committee • Originally , the power of the Federal Reserve System was vested in each of the 12 Reserve Banks. • (FOMC) to consolidate decisions regarding the most important tool of monetary policy-open-market operation.

49. Open-Market operations • Consist of buying or selling U.S. government securities to influence the money supply and interest rates in the economy.

50. President appoints, Senate confirms Federal Advisory Committee Federal Open Market Communittee Board of Governors 12 Federal Reserve Banks National banking system: Commercial banks, Savings, & loan associations, Mutual savings banks, Credit Union