CHAPTER 18: DEFICITS, SURPLUSES AND THE PUBLIC DEBT

DEFICITS, SURPLUSES AND DEBT: DEFINITIONS

Budget Deficit – is the amount by which government expenditures exceed government revenues in a given year.

Budget Surplus – is the amount by which government revenues exceed government expenditures in a given year.

Public debt – is essentially the total accumulation of the deficits the Federal government has incurred through time.

BUDGET PHILOSOPHIES

• Annually Balanced Budget – is not economically neutral; the pursuit of such a policy may intensify the business cycle, not dampen it.

• Cyclically Balanced Budget – The equality of government expenditures and net tax collections over the course of a business cycle; deficits incurred during periods of recession are effect by surpluses obtained during periods of prosperity.

•  Functional Finance – the use of fiscal policy to achieve a noninflationary gross domestic product without regard to the effect on the public debt.

THE PUBLIC DEBT: FACTS AND FIGURES

• Causes

·         Wars

·         Recessions

·         Lack of Fiscal Discipline

• Quantitative Aspects

·         Debt and GDP

·         International Comparisons

·         Interest Charges

·         Ownership

• Social Security Considerations

Social Security – is basically a “pay-as-you-go” plan which the mandated benefits paid out each year are financed by the payroll tax revenues received each year.

FALSE CONCERNS

• Bankruptcy

There are two main reasons:

·         Refinancing

·         Taxation

SUBSTANTIVE ISSUES

·         Income Distribution

·         Incentives

·         Foreign-owned Public Debt

• Crowding Out and the Stock of Capital

2 Factors that reduce the net economic burden shifted to future generations:

·         Public Investment

·         Public-private complementarities

• What To Do With The Surpluses?

·         Pay down the public debt

·         Cut taxes

·         Increase federal expenditures

CHAPTER 17: ECONOMIC GROWTH

INGREDIENTS OF GROWTH

• Supply Factors – changes in the physical and technical agents of production – enable an economy to expand it potential GDP.

·         Increases in the quantity and quality of natural resources

·         Increases in the quantity and quality of human resources

·         Increases in supply of capital goods

·         Improvements in technology

• Demand factor – fifth ingredient of economic growth.

·         To achieve the higher production potential created by supply factors, households, businesses and government must purchase the economy’s expanding output of goods and services.

• Efficiency Factor – sixth ingredient of economic growth.

·         To reach its production potential, an economy must achieve an economic efficiency as well as full employment. The economy must use its resources in the least costly way to produce the specific unit of goods and services that maximizes people’s well being.

• Production Possibilities Analysis

·         Growth and Production Possibilities

It indicates the various maximum combinations of products an economy can produce with its fixed quantity and quality of natural, human and capital resources and its stock of technological knowledge. An improvement in any of the supply factors will push the production possibilities curve outward.

“best allocation” – is determined by expanding production of each good until its marginal benefit equals its marginal cost.

·         Labor and Productivity

REAL GDP = hours of work x labor productivity

-Hours of work – hours of labor input depend on the size of the employed labor force and the length of the average workweek. Labor force size depends on the size of the working-age population and the labor-force participation rate – the percentage of the working-age population actually in the labor force.

-Labor productivity – is determined by technological process, the quantity of capital goods available to workers, the quality of the labor itself, and the efficiency with which inputs are allocated, combined and managed.

•  Growth in the AD-AS Model

·         Production Possibilities and Aggregate Supply

The supply factors that shift the production possibilities curve outward also shift its long-run aggregate supply curve rightward.

·         Extended AD-AS Model

It is used to depict the economic growth process. It is extended to include the distinction between short- and long-run aggregate supply.

U.S. ECONOMIC GROWTH RATE

Over the full 50 years, real GDP grew by about 3.5% annually, whereas real GDP per capita grew by about 2.3% annually.

ACCOUNTING FOR GROWTH

Growth Accounting – bookkeeping of the supply side elements that contribute to changes in real GDP – to assess the factors underlying economic growth.

2 main categories:

·         Increases in hours of work

·         Increases in labor productivity

• Labor inputs versus Productivity

Both increases in the quantity of labor and rises in labor productivity are important source of economic growth.

• Technological Advance

It includes not only innovative production techniques but new managerial methods and new forms of business organization that improve the process of production.

• Quantity of Capital

Increased capital explains roughly 30% of productivity growth.

• Education and Training

Contribute to a worker’s stock of human capital – the knowledge and skills that make a productive worker.

•  Economies of Scale and Resource Allocation

·         Economies of Scale – reductions in per-unit cost that result in the size of markets and firms.

·         Improved Resource Allocation – means that workers over time have moved from low-productivity employment to high-productivity employment.

• Other Factors

·         Reliance on the market system

·         A stable political system

·         A social philosophy that embraces material progress

·         An abundant supply of willing workers and entrepreneurs

·         Free-trade policies

THE PRODUCTIVITY ACCELERATION: ANEW ECONOMY?

New economy – one with a higher projected trend rate of productivity growth and therefore greater potential economic growth than the 1973-1995 period.

• Reasons for the Productivity Acceleration

·         The Microchip and Information Technology

Microchip – it has helped create a wide array of the products and services and new ways of doing business.

Information Technology – connect all parts of the world.

·         New Firms and Increasing Returns

Start-up Firms – advanced various aspects of the new information technology.

Increasing Returns – occur when a firm’s output increases by a larger percentage than the increase in its inputs. There are a number of sources of increasing returns and economies of scale for emerging firms:

-More specialized inputs

-Spreading of development costs

-Simultaneous consumption

-Network effects

-Learning by doing

·         Global Competition

• Macroeconomic Implications

·         More rapid economic growth

The productivity speedup allows the economy to achieve a higher rate of economic growth.

·         Law Natural Rate of Unemployment

A law natural rate of unemployment (NRU) such that of 1995-2000 (4-5%) may also be consisted with the new economy.

·         Growing Tax Revenue

The faster economic growth enabled by the productivity speedup produces larger increases in personal income and, given tax rates, larger increases in government tax revenues.

• Skepticism about Performance

Skeptics of the New Economy urge a wait-and-sec approach. They point out that surges in productivity and real GDP growth rate have previously occurred during vigorous economic expansions but do not necessarily represent long-lived trends.

IS GROWTH DESIRABLE AND SUSTAINABLE?

• The Antigrowth View

Critics of rapid growth say that it adds to environmental degradation, increases human stress, and exhausts the earth’s finite supply of natural resources.

CHAPTER 16: ExTENDING THE ANALYSES OF AGGREGATE SUPPLY

• From Short Run to Long Run

Short Run – period in which nominal wages do not respond to price-level changes

• Short-Run Aggregate Supply

Its curve has a positive slope because nominal wages are unresponsive to the price-level changes.

• Long-Run Aggregate Supply

Its curve is vertical, because nominal wages eventually change by the same relative amount in the price level.

• Equilibrium in the Extended AD-AS Model

It occur at the intersection of the aggregate demand curve, the long run aggregate supply curve, and the short run aggregate supply curve.

APPLYING THE ExTENDED AD-AS MODEL

•  Demand-Pull Inflation in the Extended AD-AS Model

In the short run, demand-pull inflation raises both the price level and real output; in the long run, nominal wages rise. The short run aggregate supply curve shifts to the left, and only the price level increases.

• Cost Push Inflation in the Extended AD_AS Model

Cost push inflation creates a policy dilemma for the government. If it engages in an expansionary policy to increase output, an inflationary spiral occur; if it does nothing recession will occur.

• Recession and the Extended AD-AS Model

In the short run, a decline in aggregate demand reduces real output; in the long run, prices and nominal wages presumably fall, the short run aggregate supply curve shifts to the right, and real output returns to its full-employment level.

THE INFLATION-UNEMPLOYMENT RELATIONSHIP

·         Under normal circumstances, there is a short-run tradeoff between the rate of inflation and the rate of unemployment.

·         Aggregate supply shocks can occur both higher rates of inflation and higher rates of unemployment.

·         There is no significant tradeoff between inflation and unemployment over long periods of time.

• The Philipps Curve – a curve showing the relationship between the unemployment rate and the annual rate of increase in the price level.

• Disinflation – reductions in inflation rate from year to year.

TAxATION AND AGGREGATE SUPPLY

Supply-side economics – active force in determining the levels of inflation, unemployment and economic growth.

• Laffer curve – a curve relating government tax rates and tax revenues on which a particular tax rate maximizes tax rates.

• Criticisms on the Laffer Curve

·         Taxes, Incentives and Time

·         Inflation or Higher Real Interest Rates

·         Position on the Curve

CHAPTER 15: MONETARY POLICY

MONETARY POLICY – A central bank’s changing of the money supply to influence interest rates and assist the economy in achieving price stability, full employment and economic growth.

CONSOLIDATED BALANCE SHEET OF THE FEDERAL RESERVE BANK

• Assets – anything of monetary value owned by a firm or individual.

The two main assets of the Federal Reserve Banks are:

·         Securities – They consist largely of Treasury bills, Treasury rates and Treasury bonds issued by the U.S. government to finance past budget deficits. These are part of the public debt – the money borrowed by the Federal government.

·         Loans to Commercial Banks – They are assets to the Fed because they are claims against the commercial banks. Through borrowing in this way, commercial banks can increases their reserves.

• Liabilities – A debt with a monetary value; an amount owed by the firm or an individual.

3 items on the liability side of the Fed’s consolidated balance sheet:

·         Reserves of Commercial Banks – They are assets on the books of the commercial banks, which still own them even though they are deposited at the Federal Reserve Banks.

·         Treasury Deposits – To the Treasury these deposits are assets, to the Federal Banks they are liabilities. Treasury creates and replenishes theses deposits by depositing tax receipts and money borrowed from the public or from the commercial banks through the sale of bonds.

·         Federal Reserve Notes Outstanding – When this money is circulating outside the Federal Reserve Banks, it constitutes claims against the asset of the Federal Reserve Banks. The Fed thus treats this notes as a liability.

TOOLS OF MONETARY POLICY

• Open-Market Operations – consist of the buying of government bonds from, or the selling of government bonds to, commercial banks and the general bank.

·         Buying Securities

From Commercial Banks

a)      Commercial banks give up part of their holdings of securities to the Federal Reserve Banks

b)      The Federal Reserve Banks, in paying for those securities, increase the reserve of the commercial banks by the amount of purchase

                           From the Public

a)      Gristly gives up securities to the Federal Reserve Banks and gets in payment a check drawn by the Federal Reserve Banks on themselves

b)      Gristly promptly deposits the check in its account with the Wahoo bank

c)      The Wahoo bank sends this check against the Federal Reserve Banks to a Federal Reserve Bank for collection

·         Selling Securities

To Commercial Banks

a)      The Federal Reserve Banks give up securities that the commercial banks acquire

b)      The commercial banks pay for those securities by drawing checks against their deposits – that is, against their reserves – in Federal Reserve Banks

                           To the Public

a)      The Federal Reserve Banks sell government bonds to Gristly, which pays with a check drawn on the Wahoo bank

b)      The Federal Reserve Banks clear this check against the Wahoo bank by reducing Wahoo’s reserves

c)      The Wahoo bank returns check to Gristly, reducing Gristly’s checkable deposit accordingly

• The Reserve Ratio – ability to lend

·         Raising the reserve ratio

·         Lowering the reserve ratio

Reserve ratio affects the money-creating ability of the banking system in two ways:

·         It changes the amount of excess reserves

·         It changes the size of the monetary multiplier

• The Discount Rate – The interest rate that the Federal Reserve Banks change on the loans they make to commercial banks and thrift institutions.

• Easy Money and Tight Money

·         Easy money policy/ Expansionary monetary policy – Federal Reserve System actions to increase the money supply to lower interest rates and expand real GDP.

-Buy securities

-Lower the reserve ratio

-Lower the discount rate

·         Tight money policy/ Restrictive money policy – Federal Reserve System actions that contracts, or restrict the growth of the nation’s money supply for the purpose of reducing or eliminating inflation.

-Sell securities

-Increase the reserve ratio

-Raise the discount rate

• Relative Importance

Of the three instruments of monetary control, buying and selling securities in the open market is the most important.

MONETARY POLICY, REAL GDP AND THE PRICE LEVEL

• Cause-Effect Chain

-Money market – demand curve for money and the supply curve of money are brought together.

-Equilibrium interest rate – is the rate at which the amount of money demanded and the amount supplied are equal.

-Investment – this curve shows the relationship between the interest rate –the cost of borrowing to invest – and the amount of investment spending.

-Equilibrium GDP – shows the impact of our three interest rates and corresponding levels of investment spending on aggregate demand.

• Effects of an Easy Money Policy – the economy must be experiencing substantial and unemployment.

• Effects of a Tight Money Policy – the higher interest rate will discourage investment, lowering aggregate demand and restraining demand-pull inflation.

MONETARY POLICY IN ACTION

It has two key advantages:

·         Speed and flexibility

·         Isolation and political pressure

• Focus on the Federal Funds Rate – it is the interest rate that banks charge one another to overnight loans of reserves hold at the Federal Reserve Banks.

• Problems and Complications

·         Lags – monetary policy is hindered by a recognition lag and operation lag

·         Changes in velocity

Velocity of money – the number of times per year the average dollar is spent on goods and services.

·         Cyclical Asymmetry

•  “Artful Management” or “Inflation Targeting”?

Inflation Targeting – the annual statement of a target, say 1 to 2 percent, for the economy over some period, say 2 years.

• Monetary Policy and the International Economy

• ·         Net Export Effect – the idea that the impact of a change in monetary policy or fiscal policy will be strengthened or weakened by the consequent change in exports.
•  Macro Stability and the Trade Balance

The easy money policy, which is appropriate for the alleviation of unemployment and sugglish growth, is compatible with the goal of correcting a balance-of-trade deficit.