Transcript Money and Banking - Elkhorn Public Schools

A review of fiscal policy issues
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)
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
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
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
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.
Taxes
• Oliver Wendell Holmes said that “Taxes are
the price we pay for civilization”
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
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%
“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
“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.
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?
Review of Classical Economics
• Based on three basic ideas
–Say’s Law
–Equation of exchange
–Self-regulating markets
Say’s Law
• Supply creates its own Demand.
• The act of producing a product generates the
income to buy that product
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
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.
Self-Regulating Markets
• Markets tend to settle at
equilibrium and so government
should stay out!
• Laissez-faire
Keynesian Economics
• Rejects those three beliefs
– Demand creates supply
– Velocity isn’t stable
– Markets can settle into a Great Depression
Criticisms of Keynesian fiscal policy
• Can result in deficits and increase the National
Debt
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
Money and Banking
What is Money?
• 1. Medium of Exchange
• 2. A Store of Wealth
• 3. A Unit of Account to compare value or price
What has been used as Money?
• 1. Large stones in
So. Pacific
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
Measures of Money
• Transaction money called M1
• currency+demand deposits+traveler’s checks
• Broad Money M2 includes M1 + savings
accounts and money market accounts
Short History of Banks
• Goldsmiths in the Middle Ages
• Banks printed their own money
• US government printed greenbacks during
the civil war
The FED, the banks’ bank
• Today’s banks are required to belong to the
FED or the Federal Reserve Bank
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
12 Fed Branches
Three tools of the Fed
• 1. The Reserve Ratio
• 2. Discount rate and Federal Funds rate
• 3. Open market operations
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
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%
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
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
A Simple Banking Example
•
•
•
•
•
•
•
Steve’s Bank
Assets
$500
$450
$950
$400
$1,350
Liabilities
$500
initial deposit
$450
loan
$950
total cash
$400 another loan
$1,350 total cash
Monetary Policy
• Series of actions 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
Rube Goldberg
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
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
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
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.
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.
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?
More Slippages
• 3. What if MEI is not greater than the interest
rate?
• 4. What if Investment doesn’t occur, just
transfer of wealth?
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
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
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
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
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
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
Monetary Rule
• The Monetarists’ believed
– fiscal and monetary policies create inflation
– government intervention in the economy creates
instability
– Greed was better than government
• Milton Friedman
• This led them to advocate for a monetary rule:
steady, predictable growth in the money
supply, of about 4%
Rational Expectations
• This economic theory suggested that fiscal
and monetary policy would be ineffective
because you can’t fool all the people all the
time
• According to this theory, people make rational
economic decisions after considering all the
available information
Rational Expectations (cont’d)
• A criticism of this theory centers on the ability
of people to adjust their decisions as
conditions change. People can’t renegotiate
their mortgage or labor contract every time
the economy changes.
• Gathering this information takes knowledge,
time and money that many people don’t have
Supply Side Economics
• A new economic theory became popular in
the 1980’s; Supply Side Economics
• The basic premise was to shift the AS curve
out, creating more output at lower prices
• Supply-siders felt that lowering taxes and
removing government regulations would allow
the AS curve to shift out
Supply Side Economics (cont’d)
• The Laffer Curve suggested that tax rates
could be cut and tax revenue would increase
at the lower rate, because economic activity
would increase
• Taxes were cut by about 25%
• Government expenditures also increased
during this time, driving up deficits and
doubling the national debt
Supply Side Economics (cont’d)
• Some argued that cutting taxes and increasing
spending was really a double dose of
Keynesian economics
• The deregulation of some businesses resulted
in crises in some industries, including the
savings and loan industry
Deregulation
• This trend toward more deregulation may
have led to problems in the energy sector and
the financial sector in recent years
• Even Alan Greenspan said he may have
overestimated the ability of self-regulating
markets to protect the economy
• Alan Greenspan "I was wrong"