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Barbulean
STAGES OF INFLATION
• 1. CREEPING INFLATION (0%-3%)
DM*
Qm1 Qm*
Money Supply
“The
Disco
unt W
indow
”
• Discount Rate:
the interest rate the Fed charges banking
institutions for borrowed funds.
– An increase in the discount rate decreases the
money supply (restrictive) because it discourages
banks from borrowing from the Federal Reserve to
extend new loans.
– A reduction in the discount rate increases the
money supply (expansionary) because it makes
borrowing from the Federal Reserve less costly.
The 3 Tools the Fed Uses
to Control the Money Supply
Monetary Policy Tools
REVIEW: TOOLS OF MONETARY POLICY
Open-Market Operations
The Reserve Ratio
The Discount Rate
What will happen to the money
Examples: supply in the following situations?
•Buy securities •Sell Securities
MONEY INCREASES MONEY DECREASES
•Increase Reserve Ratio •Decrease Reserve Ratio
MONEY DECREASES MONEY INCREASES
•Raise Discount Rate •Lower Discount Rate
MONEY DECREASES MONEY INCREASES
How Banks Create Money
by Extending Loans
Fractional Reserve Banking
• The U.S. banking system is a fractional
reserve system where banks maintain only a
fraction of their assets as reserves to meet
the requirements of depositors.
• Under a fractional reserve system, an
increase in reserves (excess reserves) will
permit banks to extend additional loans and
thereby expand the money supply (by
creating additional checking deposits).
Creating Money from New Reserves
New cash Potential demand
deposits: New deposits created by
Bank Actual Reserves Required Reserves extending new loans
Initial deposit (bank A) $1,000.00 $200.00 $800.00
Second stage (bank B) 800.00 160.00 640.00
Third stage (bank C) 640.00 128.00 512.00
Fourth stage (bank D) 512.00 102.40 409.60
Fifth stage (bank E) 409.60 81.92 327.68
Sixth stage (bank F) 327.68 65.54 262.14
Seventh stage (bank G) 262.14 52.43 209.71
All others (other banks) 1,048.58 209.71 838.87
Total $5,000.00 $1,000.00 $4,000.00
http://www.economicsonline.co.uk/Managing
_the_economy/Supply_side_shocks.html
The Golden Age of Keynesian Fiscal
Policy to Stagflation
• The Early 1960s provided support for Keynesian theories
– In particular, President Kennedy’s 1964 income tax cut did much to
boost the economy and reduce unemployment
• However, the 1970s were marked by significant supply-side
shocks (increases in oil prices in addition to crop failures)
– The economic ills brought about by these supply-side shocks to the
economy could not be remedied by demand-side Keynesian
economic theories
Supply side shocks cause cyclical instability by shifting short-run aggregate supply (SRAS)
although they are unlikely to have any major impact on the long-run productive potential of
the economy. A negative supply-side shock might be caused by a rise in world oil prices - over
the last thirty years there have been several occasions when the international price of crude oil
has moved sharply higher causing major effects on the economies of countries across the
global economy. The rise in oil prices has causes an increase in the variable costs of firms for
whom oil is an essential input into the production process. For this reason firms may seek to
raise their prices to protect their profit margins
Lags in Fiscal Policy
• The time required to approve and implement fiscal
legislation may hamper its effectiveness and weaken fiscal
policy as a tool of economic stabilization
• In the case of an oncoming recession, it may take time to
– Recognize the coming recession
– Implement the policy
– Let the policy have its impact
Discretionary Policy and
Permanent Income
• Permanent income is
income that individuals
expect to receive on
average over the long run
• To the extent that
consumers base spending
decisions on their
permanent income,
attempts to fine-tune the
economy through
discretionary fiscal policy
will be less effective
Budgets, Deficits,
and Public Policy
The Government Budget
• A plan for government
expenditures and
revenues for a specified
period, usually a year
The Federal Budget
• The federal budget is the budget of the
federal government.
• The difference between the federal
government’s receipts and its expenditures is
the federal surplus (+) or deficit (-).
The Federal Budget
There is one tax here that you probably do not know…. Be honest….
Excise tax
Tobacco, alcohol and gasoline
These are the three main targets of excise taxation in most countries around the world. They
are everyday items of mass usage (even, arguably, "necessity") which bring huge profits for
governments. The first two are considered to be legal drugs, which are a cause of many
illnesses, which are used by large swathes of the population, with tobacco being widely
recognized as addictive. Gasoline (or petrol), as well as diesel and other fuels, meanwhile,
despite being indispensable to modern life, have excise tax imposed on them mainly because
they pollute the environment.
Narcotics
Many US states tax illegal drugs.
Gambling
Gambling licences are subject to excise in many countries; however, gambling itself was for a
time also subject to taxation, in the form of stamp duty, whereby a revenue stamp had to be
placed on the ace of spades in every pack of cards to demonstrate that the duty had been
paid.
Taxes & Government Spending
• Entitlement Programs:
– Entitlements – social welfare programs that
people are “entitled to” if they meet certain
eligibility requirements. i.e. age or income
– Mandatory spending increases as more and more
people qualify for the money.
– Some of the entitlement programs are “means-
tested”, that means people with higher
incomes may receive lower benefits or no
benefit at all.
Taxes & Government Spending
– Entitlements are a largely unchanging part of
government spending.
– Once Congress has set the requirements, it cannot
control how many people become eligible
for each king of benefit.
– Congress can change the eligibility requirements
or reduce the amount of the benefits.
Taxes & Government Spending
• Social Security
– This is the largest category of federal spending.
– More than 50 million retired or disabled people
and their families and survivors receive
monthly payments.
Taxes & Government Spending
• Medicare
– Medicare serves about 40 million people, most of
them over the age of 65.
– This program pays for hospital care and for the
costs of the physicians and medical
services.
– Also pays for disabled people and those suffering
from certain diseases.
– It is funded by taxes withheld from your paycheck
Taxes & Government Spending
• Medicaid
– It benefits low-income families, some people with
disabilities, and elderly people in nursing
homes.
– It is the largest source of funds for medical and
health-related services for America’s
poorest people.
Taxes & Government Spending
• Other Mandatory Spending Programs
– These include
• Food Stamps
• Supplemental Security Income (SSI)
• Child Nutrition
Taxes & Government Spending
• Future of Entitlement Spending
– Spending for both Social Security and Medicare
have increased enormously.
– It is expected to increase even more in the future
as the “baby-boomers” began to collect.
Entitlement spending
http://www.youtube.com/watch?
v=JsTbkB9hOuw
The Presidential Role in the Budget
Process
• Early in this century, the president had very little
involvement in the development of the federal budget
• By the mid-1970s the president had been given the
resources to translate policy into a budget proposal to be
presented to Congress
– Office of Management and Budget (1921)
– Employment Act of 1946 (Council of Economic Advisers)
The Presidential Role in the
Budget Process (continued)
• The development of the
president’s budget begins a
year before it is submitted to
Congress
– The presidents proposed
budget (The Budget of the
United States Government) is
supported by the Economic
Report of the President
• The budget is submitted in
January for the upcoming fiscal
year October 1-September 30
The Congressional Role in the Budget
Process
• House and Senate budget committees review the
president’s budget proposal
• An overall budget outline is approved by Congress (budget
resolution) and given to the various congressional
committees and subcommittees which authorize federal
spending
Budget Deficits and Surpluses
• When budgeted
expenditures exceed
projected tax revenues, the
budget is projected to be in
deficit
• When projected tax
revenues exceed budgeted
expenditures, the budget is
projected to be in surplus
Suggestions for Budget Reform
• Biennial budget
• The elimination of line item
details before Congress
– Congress would consider
only the overall budget for
a given agency, rather that
detailed line items
Rationale for Budget Deficits
• Large capital projects (highways, etc.)
– The benefits from these project will benefit more than current taxpayers,
so deficit financing is appropriate
• Major Wars
• Keynesian economics points to the use of deficits to stimulate the
economy during periods of economic slowdown
• Automatic stabilizers tend to increase deficits, since during times of
recession, taxes are reduced while unemployment insurance and
welfare payments are increased
Budget Philosophies
• Annually balanced budget—Budget philosophy prior to the
Great Depression; aimed at equating revenues with
expenditures, except during times of war
• Cyclically balanced budget—Budget philosophy calling for
budget deficits during recessions to be financed by budget
surpluses during expansions
• Functional Finance—A budget philosophy aiming fiscal
policy at achieving potential GDP rather than balancing
budgets either annually or over the business cycle
Crowding Out and Crowding In
• Crowding out--When the government undertakes
expansionary fiscal policy, interest rates increase due to
competition for borrowed funds and increased transactions
demand for money
– As a result, private investment is “crowded out” due to increases in
public investment
• Crowding in—If expansionary fiscal policy raises the general
level of prosperity in the economy, private investors may
expect greater investment-related profits, causing private
investment to increase
The Federal Deficit Versus the National
Debt
• The federal deficit is a flow variable measuring the amount
by which expenditures exceed revenues in a particular year
• The national debt is a stock variable measuring the
accumulation of past deficits
• In the U.S., it took 200 years for the national debt to reach
$1 trillion
– After the debt reached this level, it took only 15 years for the debt
to reach the $5 trillion level
The Debt and Problems
• http://www.brillig.com/debt_clock/
• Arguments about the Debt
– We have to pay it back
– We owe it to ourselves (much less so than years
ago).
Size of Government
Reducing the Deficit
• Line-item veto (signed into law
in April 1996 struck by the
Supreme Court in 1998)
– A provision to allow the
president to reject particular
portions of the budget rather
than simply accept or reject
the entire budget
• Balanced budget amendment
– Proposed amendment to the
U.S. Constitution requiring a
balanced federal budget
Five Debates over
Macroeconomic Policy
Chapter 34
Five Debates over Macroeconomic Policy