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Chapter 26- Fiscal Policy: Congress

In this chapter you will learn about the importance of fiscal policy- the spending, borrowing, and taxation decisions taken by governments. In the United States, Congress handles fiscal policy. Fiscal policy is used to stabilize an economy and to lessen the negative or excessively positive economic fluctuations that can weaken an economy, like employment, inflation, or real GDP that is too high or too low. Fiscal policy is referred to as supply-side policy because it focuses on increasing long-term economic growth of aggregate supply (AS)/potential GDP. The primary tools that Congress uses to influence aggregate supply/potential GDP (AS/GDP) are 1) government spending/expenditures and 2) taxes.

When the U.S. economy is in a recession/in contraction, Congress can use expansionary fiscal policy to increase real GDP/economic output by increasing government (G) spending/expenditures and/or lowering taxes to increase the money supply and build up the economy. When the U.S. economy is in expansion/with inflation, Congress can use contractionary fiscal policy to decrease real GDP/economic output by decreasing government (G) spending/expenditures and/or increasing taxes to decrease the money supply and slow down the economy. Expansionary and contractionary fiscal policy are countercyclical fiscal policies because they help the economy meet its potential output and minimize economic fluctuations. The cyclical movements in the economy are being "countered," or offset, by changes in government spending/expenditures or taxes.

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The first lesson about fiscal policy is "do no harm," but fiscal policy can go terribly wrong. Poorly determined increases or decreases in government purchases (G) or taxes can negatively impact potential GDP. Crowding out of the private sector (C, I, and X) can also occur. A decline in C, I, & X spending/investment due to an increase in government purchases/expenditures is called crowding out because C, I, & X spending/investment is “crowded out” by government purchases/expenditures. Because the government is borrowing money, it leaves less money for C, I, & X thus raising interest rates.

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Taxes to pay for spending programs are included in the budget. As part of the budget, the President may propose an increase or a decrease in taxes. Tax revenues are the total dollar amount the government receives from taxpayers each year. When tax revenues are exactly equal to government spending, there is a balanced budget. When tax revenues are greater than spending, there is a budget surplus. When spending is greater than tax revenues, there is a budget deficit and the government must borrow to pay the difference, which raises nominal interest rates. A budget deficit is the number one problem of fiscal policy. The federal debt is the total amount of outstanding loans that the federal government owes. If the government runs a surplus, the debt comes down by the amount of the surplus. If there is a deficit, like during deficit spending, governments spend while they are in debt, the debt goes up, the nominal interest rate increases, and net exports decrease. The national debt, on the other hand, is the cumulative amount of money that the federal government has borrowed to make up for all those deficits in previous years.

The budget the President submits is only a proposal. After the fiscal year has begun (Oct. 1) and the budget has been enacted, various supplementals are proposed and passed. A supplemental is a change in a spending program or a change in the tax law that affects a country's budget in the current fiscal year. Recessions and booms always affect tax revenues and spending to some degree. Because the whole budget cycle from a budget's beginning to becoming a reality takes over two years to finish, at any one-time discussions about three budgets are taking place.

Discretionary fiscal policy refers to specific changes in laws or administrative procedures, such as a change in an existing program to speed up spending, the creation of a program (such as a new welfare program), or a change in the tax system (such as lower tax rates). These changes in the law are discretionary changes because they require action on the part of the Congress or the President. Congress creates a new bill that is designed to change aggregate demand (AD) through government spending (G) or taxation. The problem is the time lag between bill creation and approval due to bureaucracy. It takes time for Congress to act.

Many of the very large changes in government taxes and spending are automatic. Unemployment compensation, Social Security payments, and welfare payments all rise in a recession. These automatic tax and spending changes are called automatic stabilizers or non-discretionary fiscal policy because they tend to stabilize the fluctuations of real GDP. For example, tax revenue decreasing when an economy is contracting and increasing when expanding.

For many years economists have debated the usefulness of discretionary and automatic fiscal policy. Proponents of discretionary fiscal policy argue that the automatic stabilizers would not be large enough or well-timed enough to bring the economy out of a recession quickly. Critics of discretionary policy, like Nobel Prize winner Milton Friedman, emphasize that the effect of a policy is uncertain and that there are long lags in the impact of policy. By the time spending increases and taxes are cut, a recession could be over. Three types of lags are particularly problematic for discretionary fiscal policy: a recognition lag (the time between the need for the policy and the recognition of the need), an implementation lag (the time between the recognition of the need for the policy and its implementation), and an impact lag (the time between the implementation of the policy and its impact on real GDP).

Chapter 27- Monetary Policy: The Federal Reserve

In this chapter we will explain why central banks that are independent from the government may bring about better economic performance, like the Federal Reserve System (FED) in America. We will examine the complexity of the decisions facing the monetary policymakers who are given the independence to make policy decisions and also consider the three tools policymakers have at their disposal.

Governments are interested in implementing policies to either help to resist recessions or minimize the impact of them.  Monetary policymakers prefer to implement policies that minimize fluctuations in real GDP (Y), thus lessening the chance of a recession occurring. Like fiscal policy, monetary policy is used to stabilize an economy and to lessen the negative or excessively positive economic fluctuations that can weaken an economy, like employment, inflation, or real GDP that is too high or too low. Monetary policy is referred to as demand-side policy because it focuses on increasing long-term economic growth of aggregate demand/real GDP (AD/Y). The primary tools that the FED uses to influence aggregate demand/real GDP are 1) bonds/securities, 2) the discount rate, and 3) the required reserve rate.

When the U.S. economy is in a recession/in contraction, the FED can use expansionary monetary policy to increase real GDP/real output by buying government bonds/securities from banks and/or decreasing the discount rate or required reserve rate. These will increase the money supply, decrease interest rates, and build up the economy. Expansionary monetary policy increases the price level (PL) and real GDP(Y). When the U.S. economy is in expansion/with inflation, the FED can use contractionary monetary policy to decrease real GDP/real output by selling government bonds/securities to banks and/or increasing the discount rate or required reserve rate. These will decrease the money supply, increase interest rates, and slow down the economy. Contractionary monetary policy decreases the price level and real GDP.

Governments, usually through a central bank, control the money supply.  A central bank is the main bank to other banks in a country. America's central bank is the Federal Reserve, nicknamed the "FED."  The FED was established as the central bank for the U.S. in 1913 and has over 15,000 employees spread all over the country.  Those who direct the FED are referred to as the Federal Reserve Board, or Board of Governors.

The most important feature of a central bank is the degree of independence from the government that the law gives it. Like Supreme Court justices in the United States, FED officials develop an independence from governmental influence. The main rationale for central bank independence is that an independent central bank can prevent the government in power from using monetary policy in ways that appear beneficial in the short-run but that can harm the economy in the long-run.

A commercial bank, such as Bank of America or Chase, is a firm that channels funds from individual savers to investors by accepting deposits and making loans.  The desire for loans is determined by the real interest rate. The lower the real interest rate, the more loans that will be requested by interest-sensitive customers (C, I, and X). Banks are commonly referred to as financial intermediaries.  Banks accept deposits and then lend the funds to others and earn profits by charging interest. Commercial banks, like Chase or TD, deposit funds at the central bank, and the central bank in turn makes loans to other commercial banks, like Bank of America.

The FED makes decisions about the money supply through a committee called the Federal Open Market Committee (FOMC).   The FOMC meets in Washington eight times a year to decide how to implement monetary policy, such as deciding whether to raise, lower, or keep the nominal interest rate steady. When journalists in the press run a story about the FED, they usually talk as if the chair has complete power over FED decisions.  Some view the chair of the FED as the most powerful person in America, after the President.

The FED regulates the money supply by changing any one of the following: 1) open market operations by buying or selling government bonds (short-term loans) from/to banks, 2) lending money to banks at a higher or lower discount rate, and 3) setting the required reserve or reserve ratio higher or lower for banks.

The FED's primary monetary tool is used when either the FED buys government bonds/securities from banks or sells government bonds/securities to banks.  This is referred to as open market operations. Think of all rates like a wall in your way; ↑ is bad and ↓ is good. When the U.S. economy is in a recession/in contraction, the goal of the FED is to increase the money supply.  More money= more chance to spend money. To do this, the FED buys government bonds/securities from banks (buy= bigger).  The FED then electronically pays the bank by increasing their reserves at the FED.  Banks then have more money to loan to borrowers which influences banks to decrease the federal funds rate (the short-term interest rate that banks charge one another on overnight loans).  This ultimately decreases the nominal interest rate (the interest rate when inflation is taken into account).  Interest-sensitive spending by C, I, and X increases and so does aggregate demand/real GDP (AD/Y).

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Remember, think of all rates like a wall in your way; ↑ is bad and ↓ is good. When the U.S. economy is in expansion/with inflation, the goal of the FED is to decrease the money supply. Less money= less chance to spend money.  To do this, the FED sells government bonds/securities to banks (sell =smaller). The FED then electronically receives payment from the banks by decreasing their reserves at the FED.  Banks then have less money to loan to borrowers which influences banks to increase the federal funds rate.  This ultimately increases the nominal interest rate and the real interest rate that borrowers pay.  Interest-sensitive spending decreases and so does aggregate demand/real GDP (AD/Y).

The 2nd instrument the FED uses to impact monetary policy is the discount rate. This is the interest rate that the FED charges commercial banks when loaning them money. For example, if Bank of America needs $10 million, BOA could borrow it from the U.S. Treasury (which the FED controls), but Bank of America must pay the loan back with interest. Remember, think of all rates like a wall in your way; ↑ is bad and ↓ is good. To increase the money supply and bulk up the economy, the FED decreases the discount rate, making it cheaper for banks to borrow money from them. To decrease the money supply and slow down the economy, the FED increases the discount rate to make it more expensive for banks to borrow from them. Remember,: more money= more chance to spend money and less money= less chance to spend money.

The 3rd and last instrument the FED uses to impact the money supply is the required reserve or reserve ratio. This is the percent of customer deposits that banks must hold in reserve at the FED and cannot loan out. The FED sets the amount, the ratio, that banks must hold. Remember, think of all rates like a wall in your way; ↑ is bad and ↓ is good. If you have a bank account, where is your money? Only a small percent of your money is held in reserve. The rest of your money can be loaned out. This is called "Fractional Reserve Banking." When the FED wants to increase the money supply, the FED decreases the reserve requirement. Banks then loan out the excess reserves to make money. Excess reserves are simply extra bank reserves at the FED. This is also what happens when deposits are made at a bank.

When the FED wants to decrease the money supply, the FED increases the required reserve. Banks then have less to loan out to borrowers. This is also what happens when withdrawals are made at a bank. Remember,: more money= more chance to spend money and less money= less chance to spend money.

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As more money flows into an economy and into banks, those banks are now able to make additional loans. Interest rates decrease due to the increase in the money supply and aggregate demand/real GDP (AD/Y) increases. This positive ripple effect on the economy is called the money multiplier, and it is the expansion or contraction of a country's money supply that results from banks being able to lend or having to keep more money in their banks. This is also what happens when deposits or withdrawals are made at a bank.

For example, if a $1 million increase in required reserves by the FED is combined with a 10% (.1) reserve ratio, the money multiplier is 10 and we get a $10 million increase in demand deposits and the money supply.  A $1 million increase in reserves by the FED ultimately leads to a $10 million increase in available funds in the economy, funds that will available for banks to loan to customers.

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The money multiplier can also be harmful to an economy. As fewer loans are created, less money flows into the economy and into other banks preventing those banks from making additional loans. Interest rates increase due to the decrease in the money supply and aggregate demand/real GDP (AD/Y) decreases. This ripple effect is negative. This is also what happens when withdrawals are made at a bank. For example, if a $1 million decrease in required reserves by the FED is combined with a 10% (.1) reserve ratio, the money multiplier is 10 and we get a $10 million decrease in demand deposits and the money supply. $10 million is now no longer available for banks to loan.

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When using the money multiplier, the two determinations that have to be made are 1) is the impact on the economy a positive or negative one and 2) is the money being referred to that will impact the economy already in the money supply or not? For example, if a person deposits $100 in cash in their bank, the money they are depositing is already in the money supply, and we won't count it all twice. So, if a person deposits $100 in cash in their bank and the required reserve is 20%, the money multiplier would be 5. But, the 5 would be multiplied by only $80 since $20 of the $100 (money already in the money supply) has to remain in reserve. Only $80 can be loaned out. If a person withdrew $100, there would be a decrease in loans and the money supply.

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