6. Why is inflation bad: Some things are indexed for inflation. Adjustable rate mortgage, cost of living adjustments. unpredictability. Lending money becomes precarious. Less incentive to save money in the bank. Affects the economy by limiting the amount of capital out there to invest and borrow. Decreases productivity.

7. Hyper inflation: Germany 1920s – led to National Socialist German Workers’ Party. Argentina, Israel, Boliva in the 1980s. 400% inflation; 14% a month.

Why Government Is Involved in the Economy And Social Welfare

1. Economic management– a. Governments in all modern capitalist societies

play a substantial role in the management and direction of their economies.

– b. Government responsibility for the national economy is so widely accepted that national elections are often decided by the voters’ judgment of how well the party in power is carrying out this duty.

– c. Keynesian economic policy - The management of aggregate demand : when unemployment is high and demand is low government should increase spending and lower taxes. When demand is high, inflation is high, government should cut spending and increase taxes.

2. Minimizing "Diseconomies"• the environment• workplace safety• food safety/product safety

3. Promote Public Goods/solve collection action problems

• managing the federal government's natural resources

– a. the National Forests– b. the National Parks

• Support scientific research

4. Interest Group Pressure• corporate subsidies

– a. agriculture - Farmers, Campbell soup, Pet foods

– b. research and development grants

5. Promote Growth• military spending - military Keynesianism• human capital - education/health• physical resources (public works projects)• increase savings via incentives

6. Promote Stability• Criminal Justice System• Federal Judicial System

7. Promote Values• progressive tax• tax sinful products• $100 million to promote health marriages

Tools of Macroeconomic Policy

• Monetary policy — government policy to influence interest rates and control the supply of money in circulation, primarily accomplished through the operations of the Federal Reserve Board

• Fiscal policy — altering government finances by raising or lowering government spending, raising or lowering taxes, and raising or lowering government borrowing

– Fiscal tools are not easy to use.– Many issues come into play in setting

fiscal policy.• Federal spending cannot be easily

adjusted up or down.• Tax rates cannot be easily adjusted.• Changes in spending and taxes take so

long to accomplish that there is danger that the policies will be inappropriate by the time they filter into the economy.

I. Fiscal Policy (Taxing and Spending)

A. Spending Policy

• Defense (19%), Social Security (21%), Medicare spending (13%), medicaid (8%) and interest payments (13%) on past borrowing. This makes 74% of the total budget; the remaining 26% is allotted to such things as housing, foreign aid, etc. (4 billion for housing and services for the homeless)

B. Taxation Policy

• 95% of the total, are individual income taxes (46%), Corporate income taxes (12%), payroll taxes for Social Security and Medicare (34%), and excise taxes on gasoline, cigarettes and alcohol (3%). The remaining 5% of taxes includes such things as estate taxes, custom fees, etc.

Death and Taxes• Corporate taxes have been reduced to half of

what they were in 1960. Excise taxes have reduced to a third and social insurance/payroll taxes have doubled. Individual contributions have remained about the same.

• 1. Progressive taxation

Taxpayers by income

1993 adjusted gross income

AGI

share of AGI

Share of income taxes

top 1% above $185,791 13.8% 28% Top 5% above $87,154 27.8 47.3 top 10% above $66,196 39.1 58.8 top 25% above $41,192 62.5 79.2 top 50% above $21,158 85.1 95.2 bottom 50% below $21,158 14.9 4.8

2. Flat taxation - Would benefit the rich by far. Would increase middle class tax rate. Unless all loopholes are closed.

3. Regressive taxation - lower-income earners pay higher percentage

4. Payroll Taxes - Social Security

5. Excise Taxes

6. Corporate Taxes - easy target for liberals

7. Loopholes for the wealthy and corporations (and middle class)

8. An Assessment: Progressive, Flat, or Regressive?

Tax Receipts as a % of GDP

The Federal Budget and Fiscal Policy

• Government spending• Federal government spending in

1999– Fourfold increase since 1960 in constant

dollars– Expansion of federal outlays as a

proportion of GDP from 18% to about 19%

The Deficit and the National Debt

• The budget deficit is the annual shortfall between what the government spends and what it takes in.

• The national debt refers to the total of what the government owes.

C. Deficit and the National Debt

• The accumulated debt as a % of GDP in 1946 as 114%. This number fell to 46% in 1960 and to 26% by 1980. Deficits usually were small when they accrued until a reversal occurred, and the number rose to 37% in 1985 and to 52% in 1995,though more recently has started to level out

• Is it Bad?: MAYBE, MAYBE NOT

II. Monetary Policy - the value of currency

• The FED controls monetary policy, which refers broadly to money, the interrelationship of money with the banking system, and interest rates.

A. The Federal Reserve Board (FED)

• Quasi-public corporation - Chairman. Appointed - 4 year term.

• Other members: 7 of the 12 Board of Governors are appointed for one 14 year term; 5 are selected from the regional Federal Reserve Banks

• Actions by the Fed affect how much money is available to businesses and individuals in banks, savings and loans, and credit unions.

• It influences interest rates and the money supply.

• How the Fed sets monetary policy• Open market operations• Discount rate• Reserve requirements

B. Control of the money supply

1. First - What is money?: – Economic Definitions of Money:

•M1: currency, traveler's checks, checking accounts. Called narrow money - 1/8 of GDP

•M2: Includes everything in M1, plus savings accounts and money market mutual funds. M2 = about 1/2 of the GDP

•M3: Includes everything in M2, plus cds and other deposits.

C. FED Tools to affect money supply

• 1. Reserve requirement: every bank is required to keep some of its deposits on reserve at the central bank; they do not receive interest on these deposits. If this reserve requirement is raised, then banks have less money to lend out and interest rates will rise.

• 2. the discount rate: if a bank has loaned most of its funds, it may not have enough on hand to deposit wit the central bank to meet the reserve requirement. If a bank needs or wished to borrow from the central bank, then the interest rate that it is charged is called the discount rate.

• 3. Open Market Operations: involve buying/selling government securities and Treasury bonds. If the Fed sells bonds to banks, then banks have the bonds, but they also have less money (type M1) to lend and will charge higher rates.

• 4. Movement of Checks: Fed is responsible for the physical movement of checks through the clearing system

D. Effects of Monetary Policy

• 1. Expansion of monetary supply will reduce interest rates, stimulate aggregate demand in the economy, create jobs and thus reduce cyclical unemployment.

• 2. tighter monetary policy that reduces the money supply will raise interest rates, reduce aggregate demand, and reduce inflation.

• 3. Low and stable interest rates proved a good framework for long-term investment decisions and sustained economic growth

The FED and Democracy:

• The Fed has great power over the U.S. economy, even over the world economy, yet it is run by presidential appointees and bankers, and its policy decisions are not voted on by Congress or other publicly elected officials. Although there are plausible reasons for this lack of direct democratic accountability, it is an ongoing source of controversy.

• Why do we give the Fed authority it has?

Alternatives to an Appointed FED

• Democratic vote on monetary policy: no nation uses a democratic, legislative vote to make monetary policy decisions. The fear is that elected representatives would find it nearly impossible to vote for higher interest rates, and the result would be that the economy had a bias toward letting inflation get established.

• Fixed rules: fixed rules as to when the money supply would be allowed to grow (in accordance with the rate in growth of the economy). But new financial innovations (e.g., credit cards) have somewhat scrambled the relationship between money and GDP, so these rules look less reliable now.

• Price stability: Congress or an elected body sets an inflation target for the Fed or some other central bank to meet. The central bank focuses only on the inflation target and uses its tools to try and meet the target. If I doesn't, its leaders can be dismissed.