Ch. 13/14: Monetary and Fiscal Policy Study Guide

CHAPTER 13

Q1. What is the federal budget and what are its two purposes? What is fiscal policy and who makes it? What is a typical timeline for the federal budget process and what are the roles of the president and the Congress in creating it? What is the framework in which fiscal policy operates? What is the role of the Council of Economic Advisers?

Topic: Fiscal Policy and Federal Budget

Key Terms:

• Federal Budget: an annual statement of the outlays and receipts of the US Gov't , together with the laws and regulations that approve and support them

  • 1. finance government activities

  • 2. achieve macroeconomic objectives (such as full employment, sustained economic growth and price level stability). <-- fiscal policy

  • The federal budget process

    • Annual Timeline

      • Feb: President submits budget request to congress

      • Mar-Sep: Congressional review; debates and amends, enacts a budget before start of fiscal year on Oct. 1

      • President signs or vetoes ENTIRE bill (all or nothing)

      • Throughout fiscal year, congress may pass supplementary budget law

      • Ends Sept 30 of following year

        • Accounts of fiscal year are prepared; Outlays, receipts, and the budget : are reported

• Fiscal Policy: The use of government spending and taxation to influence the economy --> made by congress and the president

• Council of Economic Advisers: A group that was created to monitor the economy and keep the president and public informed about its current state and future forecasts. Advises the President on economic policy.

  • Consists of a chairperson and 2 other members

  • appointed by the President

Q2. What are the components of the federal budget? What are the four sources of federal budget receipts? What are the three categories of federal budget outlays? What is the government budget balance? When does the government have a budget deficit? What about a budget surplus? What is government debt?

Topic: Federal Budget Structure and Government Finances

Key Terms and Formulas:

• Receipts: Government income

  • Personal Income taxes (largest source)

  • Social Security taxes

  • Corporate income taxes

  • Indirect taxes/other receipts (sales of gas, alcohol...)

• Outlays: Government spending

  • Transfer payments

    • payments to individuals, businesses, and other levels of govt/world

      • includes SS benefits, medicare/aid, unemployment checks, welfare, farm subsidies, grants to state/local gov'ts, international agencies

  • Expenditure on goods and services

    • expenditure on final goods/services

      • includes national defense, homeland security, research, IRS supplies, govt vehicles, federal hwys

  • Debt interest

    • interest on the gov't debt

    • when in a budget deficit, gov't needs to borrow.

  • Government Debt: total amount that the gov't has borrowed.

    • Sum of past budget deficits - sum of past budget surpluses

    • persistent deficits lead to increase borrowing --> larger interest payments --> larger deficit

• Budget Balance: $\text{Budget Balance} = \text{Receipts} - \text{Outlays}$

  • Surplus = receipts > outlays. makes loan repayments

  • Deficit = outlays > receipts. borrows

  • Balanced budget = Receipts = outlays

• Percentage of GDP: allows us to see how large gov't is relative to the size of the economy. Helps us study changes in. thescale of gov't over time

Q3. What are the effects of income taxes in the labor market and on potential GDP? What is a tax wedge? What are the effects of income taxes in the loanable funds market? How do we calculate the real after-tax interest rate? What is the Laffer Curve and what does it show?

Background

Topic: Income Taxes and Economic Incentives

Key Terms and Formulas:

• Income Taxes...

  • reduce incentives to work and invest, lowering potential GDP.

  • decreases real after-tax interest rate, discouraging saving and investment, decreasing the supply of loanable funds, raising interest rates, decreasing investment, decreasing growth rate of real GDP

  • no effect on demand for labor. only on SUPPLY

• Tax Wedge: gap b/w gross and net income due to taxes

• Real After-Tax Interest Rate: $\text{Real After-Tax Interest Rate} = \text{Nominal Interest Rate} \times (1 - \text{Tax Rate}) - \text{Inflation Rate}$

• Laffer Curve: Shows the relationship between the tax rate and tax revenue collected

  • higher tax rates does NOT = higher revenues

  • revenue increases as the rate goes up but only to a certain point. There will be a level that starts to decrease as higher rates discourage economic activity

Q4. What is generational accounting? What is fiscal imbalance and generational imbalance?

Background

Topic: Long-Term Fiscal Policy and Intergenerational Equity

Key Terms:

• Generational Accounting: an accounting system thats measures the lifetime tax burden and benefits of each generation

  • Present values compares todays dollars to value of future dollars to assess the magnitude of the govts debts to older americans in the form and pensions and medical benefits

• Fiscal Imbalance: present value of the govts commitments to pay benefits minus the present value of its tax revenues. An attempt to measure the scale of the govt's true liabilities.

• Generational Imbalance: the division of the fiscal imbalance between the current and future generations, assuming that the current generation will enjoy the existing levels of taxes and benefits

  • a fiscal imbalance must eventually be corrected, and when it is, people either pay higher taxes or receive lower benefits....the concept of generational imbalance tells us who will pay

Q5. What is a fiscal stimulus? What is automatic fiscal policy? What is discretionary fiscal policy?

Background

Topic: Types of Fiscal Policy

Key Terms:

• Fiscal Stimulus: use of fiscal policy to increase production and employment

  • Automatic Fiscal Policy: a fiscal policy action that is triggered by the state of the economy with no action by government

    • Tax Revenues: tax dollars paid depends on tax rates and incomes. Incomes vary with gdp

      • expansion: when real GDP increases in a business cycle, wages and profits rise, tax revenue from these incomes rise.

      • Recession: when real GDP decreases, wages and profits fall, tax revenues fall

    • Needs-tested spending: spending on programs that pay benefits to qualified people and businesses , resulting in transfer payments that depend on the economic state of citizens and businesses.

      • Expansion: unemployment falls, number of people in hardship decreases, needs-tested spending decreases

      • Recession: unemployment is high, people in hardhip increases, needs-tested spending on unemployment beneifts and food stamps increase

    • Automatic Stimulus: budget provides automatic stimulus that helps shrink the recessionary/inflationary gap

      • expansion: receipts rise, outlays decrease - auto stimulus shrinks inflationary gap

      • recession: outlays rise, receipts fall - auto stimulus shrinks recessionary gap

    • Cyclical and Structural Budget Balances - to identify the gov't budget deficit that arises from the business cycle, we distinguish b/w -->

      • Structural Surplus/Deficit: Due to policy. the budget balance that would occur if the economy were at full employment.

        • Structural Deficit: outlays > receipts. When potential GDP is less than GDP would be at equilibrium

        • Structural Surplus: receipts > outlays. When potential GDP is greater than what GDP would be at equilibrium

      • Cyclical Surplus/Deficit: due to economic fluctuations. The actual surplus/deficit minus the structural suplus/deficit

        • Cyclical Deficit: outlays > receipts. Real GDP < Potential GDP

        • Cyclical Surplus: receipts > outlays. Real GDP > Potential GDP

  • Discretionary Fiscal Policy: a fiscal policy action initiated by an act of congress. requires a change in a spending program or in a tax law

Q6. What is a discretionary fiscal stimulus? What is the government expenditure multiplier and what is the tax multiplier? What are the three time lags that influence discretionary fiscal stimulus actions?

Background

Topic: Fiscal Policy Effects and Timing

Key Terms and Formulas:

Discretionary Fiscal Stimulus: occurs when policies like unemployment benefits increase during a recession. It is deliberate action by the gov't.

• Government Expenditure Multiplier: measures the effect of a change in gov't spending on GDP

  • $\text{Multiplier} = \frac{\Delta \text{GDP}}{\Delta \text{Government Spending}}$

  • the crowding out effect is strong enough to make this multiplier less than 1

• Tax Multiplier: measures the effect of a change in taxes on GDP

  • $\text{Multiplier} = \frac{\Delta \text{GDP}}{\Delta \text{Taxes}}$

• Three Time Lags:

  • Recognition lag - time it takes to figure out that action is needed

  • Decision (law-making) lag- time it takes Congress to pass the laws needed to change taxes or spending

  • Implementation (impact) lag - time it takes from passing a tax/spending change to its effects on real GDP being felt. These changes could be spread out over a number of quarters or years.

CHAPTER 14

Q7. What are the objectives of monetary policy and what are the Fed’s policy goals? What do we call the Fed’s dual mandate? What are two measures of inflation that the Fed is monitoring? What is the core inflation rate and why is the Fed focusing on it? Who is responsible for monetary policy in the US?

Topic: Monetary Policy Objectives and Measures

Key Terms:

• Monetary Policy: Central bank actions to influence money supply and interest rates.

• Dual Mandate: a mandate to achieve stable prices and full employment (and moderate long-term interest rates)

• Headline Inflation:

• Core Inflation Rate: Inflation excluding food and energy prices

Operational "Stable Prices" Goal: "flexible average inflation targeting"

• Price Level Measure:

  • Fed measures price level by using the Personal Consumption Expenditure Price Index (PCEPI)

    • monthly chain-linked index calculated by using the current and previous months baskets of goods/services

    • free from bias of CPI

  • Target Inflation Rate:

    • The Fed's stable-prices target is an inflation rate of 2% (NOT per month)

    • Measured by the annual change in the PCEPI

  • Time Period over which Inflation is Averaged:

    • Inflation rate averaged over a period of time

      • after a period of below 2% inflation, the fed will permit a period above 2% inflation (so long as the higher rate does not increase expected inflation rate)

Final Answer:

The objectives of monetary policy are price stability and maximum employment, known as the Fed's dual mandate. The Fed monitors headline inflation and core inflation rates. The core inflation rate excludes volatile food and energy prices, providing a clearer view of underlying inflation trends. The Federal Reserve is responsible for monetary policy in the US.

Q8. What is a monetary policy instrument? What is the Fed using as monetary policy instruments? Recall what the federal funds rate is. Who makes decisions about it?

Background

Topic: Monetary Policy Tools

This question tests your understanding of the instruments used by the Fed to implement monetary policy.

Key Terms:

• Monetary Policy Instrument: A tool used to influence the economy (e.g., interest rates).

• Federal Funds Rate: The interest rate at which banks lend to each other overnight.

Final Answer:

A monetary policy instrument is a tool used to influence economic activity, such as the federal funds rate. The Fed uses the federal funds rate, reserve requirements, and open market operations. The federal funds rate is the overnight lending rate between banks, and decisions about it are made by the Federal Open Market Committee (FOMC).

Q9. How does a change in the federal funds rate transmit throughout the economy?

Background

Topic: Monetary Policy Transmission Mechanism

This question tests your understanding of how changes in monetary policy affect the broader economy.

Key Terms:

• Transmission Mechanism: The process by which monetary policy affects economic variables.

• Federal Funds Rate: Central to the transmission mechanism.

Final Answer:

A change in the federal funds rate affects other interest rates, influencing borrowing and spending. Lower rates stimulate investment and consumption, increasing aggregate demand and GDP. Higher rates have the opposite effect. The transmission mechanism involves time lags before the full impact is felt.

Q10. How does the Fed fight recession and what are the effects in the money market, loanable funds market and on real GDP? How does the Fed fight inflation and what are the effects in the money market, loanable funds market and on real GDP?

Background

Topic: Monetary Policy Actions and Economic Effects

This question tests your understanding of how the Fed uses monetary policy to address recession and inflation, and the effects on key markets and GDP.

Key Terms:

• Money Market: Where money supply and demand interact.

• Loanable Funds Market: Where savings and investment interact.

• Real GDP: Total output adjusted for inflation.

Final Answer:

To fight recession, the Fed lowers interest rates, increasing money supply and stimulating investment and spending, which raises real GDP. To fight inflation, the Fed raises interest rates, reducing money supply and curbing investment and spending, which lowers real GDP. These actions affect both the money market and loanable funds market.

Q11. What are two alternative approaches in terms of monetary policy strategy?

Background

Topic: Monetary Policy Strategies

This question tests your understanding of different approaches to setting monetary policy.

Key Terms:

• Monetary Policy Strategy: The framework for making policy decisions.

• Rules-based vs. Discretionary Policy: Two main approaches.

Final Answer:

The two alternative approaches are rules-based policy (such as following the Taylor Rule) and discretionary policy (making decisions case-by-case). Rules-based policy provides predictability, while discretionary policy allows flexibility.

Q12. What happens during a financial crisis (what are the events that can put a bank at risk)? What was the Fed’s and Congress’ policy responses to the financial crisis of 2007-2008?

Background

Topic: Financial Crises and Policy Responses

This question tests your understanding of the causes of financial crises and the policy responses to them.

Key Terms:

• Financial Crisis: A period of severe disruption in financial markets.

• Bank Risk: Factors that threaten bank stability.

• Policy Response: Actions taken by the Fed and Congress.

Final Answer:

During a financial crisis, banks face risks from falling asset values, liquidity shortages, and loss of confidence. In 2007-2008, the Fed lowered interest rates, provided emergency lending, and Congress passed stimulus and bailout measures to stabilize the financial system.