- The most important sources of Federal Government
Funds are (1) personal income taxes and (2) social security
Income security programs account for the largest
amount of Federal Government expenditures. These programs include
social security, health care programs, etc.
State and Local Governments receive their funds from
a wide variety of taxes and sources. The Federal Government is
an important source of funds for State Governments.
- State and Local Governments spend a large part
of their money on education.
It is not easy to decide how the Federal Government
should spent its money. Here is an estimate of projected spending.
If you were making the decisions, what changes would you make
- Total government expenditures as a percent of
GNP rose from:
22 % in 1950 to
35 % in 1990
Limits to Taxation
On the average, U.S. citizens feel that they should
not have to pay more than 25% of their income to support government
- "Schumpeter's Law": Tax payers resistance
precludes any government from collecting taxes greater than 27
% of people's income.
- Fiscal policy is the use of government spending
and financing powers to affect aggregate demand and aggregate
- Changes in government purchases and transfer
payments may cause even larger changes in aggregate demand.
This is the "chain reaction" effect. If
the government purchases cars, auto workers have more income to
purchase boats, vacations, homes, etc.
- Higher taxes reduce disposable income and consumption
spending. This shifts the aggregate demand curve to the left.
Personal Income Taxes are taxes paid by individuals
on their labor and capital incomes. These taxes have averaged
about 9 % of GNP for the past 20 years.
Corporate Income Taxes are taxes that companies
pay on their profits. These averaged about 4 % of GNP in the
1960s. They represented only 2 % of GNP by the middle 1980s.
Indirect Taxes are taxes on the goods and services
that we buy and included customs duties. These were about 1.5
% of GNP in the middle 1980's.
Social Security Taxes are taxes paid by employees
and employers to finance the social security programs. These
taxes increased from 3.5 % of GNP in the 1960s to over 8 % of
GNP in the late 1980s.
Defense purchases accounted for about 9 % of GNP
during the Vietnam War. They fell during the 1970s and increased
again during the 1980s.
- Other goods and services purchases have amounted
to about 2 % of GNP.
Transfer payments are the largest element of spending.
They have increased sharply from 5 % of GNP in the 1960's to
over 10 % of GNP in the late 1980s.
Interest payments were about 1 % of GNP in 1970.
By the 1980s, the federal government's interest payments were
over 3 % of GNP.
- The Government can attempt to change AE by changing
- Autonomous taxes are taxes that do not vary directly
with real GNP. (Examples: property taxes and estate taxes.)
- Induced taxes are taxes which vary directly with
real GNP. (Examples: sales taxes and income taxes.)
Tax Multiplier (Cont.)
- The autonomous tax multiplier is the change in
income caused by a change in autonomous taxes.
KT = ²Y/ ²Ta = 1 - (1/ MPS)
Suppose MPC = 0.8, then the tax multiplier is
1 - (1/0.2) = - 4
If autonomous taxes increase by $1000, the equilibrium
income level will fall by $4000.
The tax multiplier is less than the simple Keynesian
multiplier because part of taxes come from a reduction in savings.
Q. If taxes increase by $ 10,000,000. What
will happen to the equilibrium level of real GNP ?
Ans. It will FALL by $ 40,000,000
Automatic stabilizers are tax structures and government
spending programs that cause budget deficits to grow automatically
during recessions and surpluses to grow during expansions.
- Progressive income taxes.
- Unemploymnet compensation.
- Social Security Payments
Induced taxes serve as a shock absorber which tend
to dampen changes in income. Assume that we have a closed economy
with no imports or exports.
ITEM Case # 1 Case
Marginal tax rate 0.2
² in GDP = ²Y $ 1000
² in taxes = ²T $ 200
² in disposal income $ 800 $
MPC from ²Yd 0.8
² in C = ²C $
640 $ 480
When per capita income is growing progressive income
taxes result in a larger portion of total income being transferred
to the Government. The higher tax revenues slow down economic
growth. This is called fiscal drag.
In 1964 tax rates were lowered in order to reduce
fiscal drag. The result was increased growth of income and more
A structural deficit is an estimate of the budget
deficit that tax and spending structures would yield if the economy
was at full employment.
Tax Revenue is the product of the tax rate and the
tax base. A Tax Rate is the percentage rate of tax levied on
a particular activity. The Tax Base is the activity on which
a tax is levied.
- To understand this paradox we use the
We can increase tax revenues if by cutting the tax
rate by x-percent we are able to increase the tax base by a larger
Suppose the above curve represents the response of
tax revenues to a change in taxes on gasoline. At first, as
the tax increases so do revenues. After the tax reaches 40 percent
of the gasoline price, however, quantity purchased falls by a
larger percentage than the percentage increase in the tax. As
a result, tax revenues fall.
Fiscal Policy History
- Tax Increase of 1932
- The tax increases were intended to raise enough
funds to balance the budget.
- Instead, they reduced GDP and made the economic
- Tax Cut of 1964
- Designed to reduce fiscal drag.
- Resulted in higher income and more tax revenue.
- Tax Cuts of 1981 & 1983
- Increases in GDP were far short of the supply-side
- Hugh deficits stimulated the economy.
- Deficit Reduction Plans of the 1990s
Key Concepts: Ch. 11
- The Tax Multiplier
- Balanced Budget Multiplier
- Automatic Stabilizers
- Structural Deficit (Surplus)
- Cyclical Deficit (Surplus)
- The Laffer Curve
- Deficit vs. Debt
- Money is a medium of exchange. In other words,
anything that is generally acceptable in exchange for goods and
- Medium of Exchange. Any commodity or asset
that serves as a generally acceptable medium of exchange is money.
- Unit of Account is an agreed upon measure for
stating the prices of goods and services.
- Standard of Deferred Payment is an agreed upon
measure that enables contracts to be written for future receipts
- Store of Value is any commodity that can be
held and exchanged later for some other commodity or service.
- Commodity Money is a physical commodity valued
in its own right and also used as a medium of exchange.
- Its advantage is that it can be used in ways
other than as a medium of exchange. (Example: Gold)
- The disadvantages of commodity money are:
- 1. There is a temptation to debase the money.
2. Commodity money has an opportunity
cost because it can be used for something other than money.
Thus there is an incentive to find alternatives to the commodity
which can serve as money and which have lower opportunity costs.
- Necessary Characteristics
- 1. Acceptability
- 2.. Durability
- 3. Divisibility
- 4. Homogeneity
- 5. Portability
- 6. Relative stability of supply
- 7. Optimal scarcity
- 9. Hard to counterfeit
- Consider some alternatives:
- Ice Cream
Convertible Paper Money is a paper claim to a commodity
that circulates as a medium of exchange. This form of money
goes back to the 14th century. The U.S. had convertibility
of the dollar until 1971.
There is an opportunity cost associated with holding
the commodity. Thus, nations try to minimize the amount of the
commodity held to back the convertible paper money. The least
expensive alternative is to eliminate the convertibility.
- L includes M3 plus holdings of U.S. savings bonds,
short-term Treasury securities, commercial paper and similar liquid
- L is a broad measure of liquid assets.
- Demand Deposit: can be converted into currency
- NOW Account: Negotiable Order of Withdrawal
Account -- these are check like accounts that pay interest.
ATS Account: Automatic-Transfer Saving Account --
surplus funds are automatically transferred between checking and
- Time Deposit: Has a fixed time to maturity.
- Large Time Deposits: A time deposit of $100,000
- Eurodollars: U.S. dollar bank accounts overseas
-- primarily in Western Europe.
- Mutual Fund: Financial funds that sell shares
and use the proceeds to buy stocks and bonds.
Money Market Mutual Fund: A financial
institution that issues shares redeemable at a fixed price by
writing a check.
Note that more money is held in large time deposits
and institutional money market mutual fund shares than the entire
value of M 1.
Definitions & Concepts of what is money have
changed over time -- and will continue to change. Financial
institutions can be very innovative at times in finding new ways
to create money -- and avoid regulations.
- Are checks money ?
- Are credit cards money ?
No! Why ?
They serve as the mechanism by which money is
transferred but they themselves are not recognized as mediums
of exchange. Nor do they provide the other functions of money.
A financial intermediary is a firm that takes deposits
from households and firms and transfers them to others. The
major types are:
Savings & Loan Associations
Balance Sheet of All Commercial Banks --
Assets (Billions $)
Reserves with FED.
Liabilities ( Billions $ )
- Until 1980, there was a reasonably sharp distinction
between commercial banks and other deposit-taking financial institutions.
In 1980, Congress passed the Depository Institutions'
Deregulation and Monetary Control Act. This act allowed setting
up of NOW and ATS accounts at all deposit-taking financial institutions.
In addition, in the early 1980s, Congress dropped
Regulation Q which placed a ceiling on interest rates that financial
institutions could pay on deposits. One result was the growth
of money market mutual funds.
The deregulation of financial institutions set the
stage for substantial changes in the forms that people hold their
money. Another was the failure of many banks and savings and
loan institutions. It also allowed the development of the junk
bond market which led to the most massive merger movement in U.S.
- Financial intermediaries provide four services:
Minimizing the cost of obtaining funds.
Minimizing the cost of monitoring borrowers.
- Banks are able to "create money " because
only a fraction of a bank's total deposits have to be held in
The desired reserve ratio is the ratio of reserves
to deposits that banks regard as necessary in order to be able
to conduct their business.
- The difference between actual reserves and desired
reserves are excess reserves.
The Federal Reserve can help keep the required
reserves low by being willing to:
1. Lend banks money.
2. Buy securities from banks.
Initial Commercial Bank Balance Sheet
Cash and Reserves 200
The New Balance Sheet
Cash and Reserves 300
The Balance Sheet
Cash and Reserve 200
Total 1100 1600
The reasons why a bank may not increase its loans
to utilize its excess reserves include:
1. The available potential loans may be too
2. The bank may believe that interest rates
will go up shortly. If so, it would be wise to delay
making loans until rates increased.
Real World Money Multipliers are usually less than
the simple money multiplier because not all the loans made by
banks return to banks in the form of reserves. Part of the loans
are held in the form of currency and not re-deposited in banks.
Money Multipliers: 2
The potential money multiplier, Mp , indicates the
total demand deposits that can be generated from a new bank deposit
that is "fully loaned out," if people keep all of their
currency in the bank.
Money Multipliers: 3
- The actual money multiplier, Ma , expresses the
relationship between the money supply, MS, and the monetary base,
If you held $50,000 in the 1st World Bank of Ames
and I told you that it was expected to fail within the week, would
you be very concerned about the safety of your money ?
- The FED was created by the Federal Reserve Act
The Federal Reserve System has three key elements:
1. Board of Governors
2. Regional Federal Reserve Banks
3. Federal Open Market Committee.
The minimum reserves that a bank is permitted to
hold are called required reserves. (These average about 3 %
of a bank's deposits.) By increasing required reserve ratios,
the FED can create a shortage of reserves for the banking system
and reduce the amount of bank leading. This will push up interest
rates and reduce the money supply.
Changes in required reserves are not used as an active
tool for achieving short-run variations in interest rates and
the money supply. They are more commonly used to achieve long-term
By lowering the discount rate, the FED can encourage
banks to borrow more reserves. This will push interest rates
down and increase the money supply.
Changes in the discount rate will only have an
effect if the banking system is short of reserves. Increases
in the discount rate signal that the FED wants to tighten up on
the money supply. Reductions in the discount rate signal that
the FED wants to increase the money supply.
Changes in the Discount Rate signal the direction
the FED plans to go. Changing the Discount Rate alone will
have limited impact on the money supply and interest rates.
Open market operations are the KEY monetary tool
available to the FED.
They can have a rapid and significant impact
on the money supply and interest rates.
Gold & Foreign Exchange
U.S. Government Securities 232.7
Federal Reserve Notes
FED's Monetary Base
FED buys $ 100 in U.S. Government Securities
Fed's Balance Sheet Changes
Assets -- U.S. Govt. Securities increase by
Liabilities -- Banks' Reserves at FED increase
by $ 100.
Commercial Banks Balance Sheet Changes
Assets -- U.S. Govt. Securities decrease by
Assets -- Banks' Reserves with FED increase
by $ 100.
Liabilities -- no changes.
1. FED buys U.S. Government Securities.
2. Commercial Banks have excess reserves.
3. Banks make new loans.
4. New loans are used to purchase products.
5. Households' & firms' receipts increase.
6. Part of receipts are held as currency.
7. Part of receipts are deposited in banks.
8. Banks reserves go up by amount of
9. Desired reserves increase.
10. Excess reserves decrease.
11. Money supply increases by amount of
currency drain ( #6 above ) and the increase
in bank deposits.
Let MB = the Monetary Base
M 1 / MB = 3
M 2 / MB = 12
M 3 / MB = 14
Money Multipliers change over time but usually
do not change very rapidly. They are fairly stable because:
1. The currency holdings of households and
firms as a fraction of total deposits do not change
very much over time.
2. The reserve holdings of banks as a fraction
of total deposits do not change much.
1. Interest Rates
2. Quantity of Money ( M 1 & M 2 )
Both the FED and the U.S. Treasury are concerned
about the U.S. balance of payments and international flows of
funds. If U.S. interest rates are low relative to interest rates
elsewhere the result will be a flow of funds out of the U.S.
The FED, in particular, wants to avoid rapid movements of international
The FED controls the supply of money. Households
and firms determine the demand for money. This is the primary
reason why the FED can't control both interest rates and the money
Alternatively, the FED can set the quantity of open
market sales or purchases of U.S. securities. In this case the
rate of interest changes as the price of securities is allowed
to adjust to clear the market. This is referred to as base control
because the FED is viewing the monetary base as the primary
1951 -- 1969
The FED tried to control interest rates, keeping
in mind that it wanted to exercise some control over the money
1970 -- 1990
The FED gave more attention to regulating the
money supply and less to the control of interest rates. In the
early 1980's, the FED made absolutely no effort to control interest
For the 1960 -- 1990 period to observe:
1. The rate of monetary expansion
has shown major short-term swings.
2. There has been a strong upward, long-term
trend in the rate of growth of the money supply.
3. Monetary policies have tended to be
"jerky." Monetary expansion frequently has
varied from full-halt to full-speed.
Suppose that unemployment was projected to be
8 % next year. What actions would you expect the FED to take
? How would the anticipated actions of the FED affect your decision:
to purchase a home ?
to switch money in your checking account
to a three year CD.
Paul Volcker was Chairman of the Federal Reserve
System from August, 1979 until August, 1987.
One of his first actions was to tighten up on
the money supply. Real interest rates were very low ( and at
times even negative ) in the 1970's. Volcker was determined to
change that and to bring an end to high rates of inflation.
He achieved this by slowing down the rate of growth of the money
supply. The equation for achieving this was very simple.
Outline the FED's structure.
What are the main monetary policy tools the FED
uses to influence interest rates ?
Explain what happens the balance sheet of commercial
banks when the FED purchases U.S. securities on the open market.
Show how to calculate the money multiplier for
What factors influence the aggregate quantity
of money demanded ? Explain the relationships between these
factors and the demand for money.
You should be able to:
Explain what money is.
Distinguish between the various types of money.
Define "Excess Reserves."
Explain the Quantity Theory of Money.
Calculate the Simple Money Multiplier.
Be able to place items on a bank's balance sheet.
And be able to answer the following:
What are the functions of money ?
How do banks create money ?
What is the significance of Gresham's Law ?
Are bank loans an asset or a liability ?
During the 1980's, there were several occasions when
the FED tried to reduce the value of the dollar in terms of foreign
currency. Why ?
The main motive for holding money is to be able
to undertake transactions and to minimize the cost of transactions.
( Suppose you put everything you earned in CDs as soon as you
were paid. Would it be expensive for you to go shopping ? )
Households' and firms' demand for money is influenced
- 1. Prices.
- 2. Real Expenditures.
- 3. The opportunity cost of holding money.
These influences translate into three macroeconomic
variables that influence the aggregate quantity of money demanded.
- 1. The Price Level.
- 2. Real GDP.
- 3. The Interest Rate.
- The quantity of money measured in constant dollars
is called Real Money.
- The quantity of real money demanded is independent
of the price level.
Real GNP is an important determinant of the quantity
of real money demanded. As Real GNP increases, the demand for
real money increases.
The Demand for Real Money is the relationship between
the quantity of real money demanded and the interest rate, holding
constant all other influences on the amount of money that people
wish to hold.
The growth of real income in the United States
has resulted in an increase in the demand for real money. On
the other hand, financial innovation has:
created new ways to hold money.
made it easier for us to move between
various types of money.
increased the velocity of existing
money, which in turn decreased the
demand for real money holdings.
The Quantity Theory of Money states that:
M V = P Y
V = Y / ( M / P )
In other words, the velocity of circulation is
equal to the ratio of real GNP to the real money supply, ( M
/ P ).
Classical Quantity Theory
- The Classical viewpoint is:
- V is constant
- Y is always at full employment
- Therefore the money supply determines the price
M V = P Yf
If the money supply increases, prices go up. There
is a direct relationship between the rate of change in the money
supply and the rate of change in prices.
²M / M = ² P / P
Suppose the current interest rate is 5 % and
the perpetuity pays $ 10 a year.
The perpetuity is therefore worth:
P = $ 10 / 0.05 = $ 200
If the interest rate increases to 10 % annually,
the value of the perpetuity falls to:
P = $ 10 / 0.10 = $ 100
A flow equilibrium is a situation in which the
quantity of goods or services supplied per unit of time equals
the quantity demanded per unit of time.
Market interest rates are determined by the supply
of and demand for money.
The FED and commercial banks determine the supply
Households and firms determine the demand for
- If monetary policy makers are not aware of what
is happening they can make serious mistakes.
For example, growth of money market mutual funds
in the 1970's was overlooked. The FED increased the supply of
conventional money and thereby caused inflation to increase.
In other words, the Transmission Mechanism describes:
1. The link between monetary equilibrium
(Ms = Md) and the interest rate (r).
2. The link between the interest rate (r)
and investment (I).
3. The link between investment (I) and
aggregate demand (AD).
As interest rates fall; investment increases.
The relationship between the interest rate and investment is
MARGINAL EFFICIENCY OF INVESTMENT.
- The increase in the money supply results in a
lower interest rate and a higher level of investment.
As Aggregate Expenditures increase, the Aggregate
Demand curve shifts to the right and income (Y) increases.
1. The steeper the LP function, the greater
the effect of a change in the money supply on interest rates.
2. The flatter the MEI function, the greater
effect a change in the rate of interest will have on investment
expenditure and hence on aggregate demand.
The degree of sensitivity of investment to interest
rates depends on how willing people are to vary the timing of
their investments. If investments are easily postponed, then
the MEI of investment function will be very flat. i.e. Investment
will be very sensitive to changes in interest rates. A small
change in interest rates will result in a large change in investment.
When the LP function is steep and the MEI function
is flat, a small change in the money supply will result in a large
change in investment -- and therefore in national income. In
this case, monetary policy works very well.
When the LP function is flat and the MEI function
is steep, a very large change in the money supply will result
in only a small change in the level of investment. In this case
monetary policy does not work very well.
Autonomous Expenditure Lag
Investment is an "autonomous" variable
in aggregate expenditure. Changes in interest rates affect investment
plans over a period of time. Some investment decisions are very
responsive to interest rate changes. Others are not. Thus there
is a lag in the effect of interest rate changes on autonomous
Price Adjustment Lag
This lag occurs if a change in equilibrium expenditure
changes prices. In the "intermediate" range of the
aggregate supply curve, an increase in aggregate demand will begin
to push up prices. After a period of time, the higher prices
will result in higher production costs and the short-run aggregate
supply curve will move upward. This price adjustment process
takes place over a period of time -- i.e. with a lag.
In addition to the "interest rate"
transmission mechanism, there are three other important transmission
mechanisms of monetary policy. These are the:
Real Balance Effect.
Exchange Rate Effect.
Sequence of events:
1. Money supply increases.
2. With prices constant, real money holdings
3. People convert part of their real money holdings
to other types of assets.
4. As a result, investment increases.
5. As investment increases, real GNP goes up.
Sequence of events:
1. Money supply increases.
2. People use the money to buy stock.
3. As stock prices go up people become wealthier.
4. As wealth increases, people spend more on
5. As consumption increases, real GNP goes up.
Sequence of events:
1. Money supply increases lower interest rates.
2. As U.S. interest rate fall, investors purchase
higher yielding foreign assets.
3. In the process they sell U.S. dollars and
buy foreign currency.
4. This lowers the value of the U.S. dollar
relative to the values of foreign currency .
5. As the exchange rate falls foreigners buy
more U.S. goods. The increase in exports results in an
increase in real GNP.
When the government increases its purchases of
goods and services, autonomous expenditure increases and the increased
equilibrium expenditure brought about by the subsequent multiplier
process increases real GNP.
This increase in real GNP leads to an increase
in the demand for real money.
As a result, interest rates go up and private
In other words, the increase in government purchases
of goods and services crowds out private investment.
Keynesians believe that the Crowding -- Out Effect
is small. Fiscal policy works well -- at least when there is
a large GNP gap.
Monetarists believe that the Crowding - Effect
is large. Fiscal policy does not work well.
The FED favors keeping Government purchases
down and taxes high enough to avoid a deficit. This would take
the pressure off the FED to keep interest rates low and to help
finance the Government's deficit.
Congress, on the other hand, wants the FED to
steadily expand the money supply and thereby keep interest rates
as low as possible.
Neither wants to dance to the other's music.
In the 1980's, the Government deficit increased very
rapidly. This resulted in higher real interest rates which in
turn attracted foreign funds to help finance the deficit. The
inflow of foreign funds helped keep the inflation rate down.
On the other hand, the dollar remained relatively strong -- which
resulted in lower exports and higher imports. Thus the U.S. trade
deficit increased substantially.
It takes time to:
1. Identify changes in GNP and prices.
2. Analyze what needs to be done.
3. Make a decision.
4. Implement the decision.
5. See the results.
6. Adjust the policies.
Keynesians are macroeconomists who's views about
the economy are based on the theories of John Maynard Keynes.
( Keynes's " General Theory ... : 1936 ") Keynesians
regard the economy as inherently unstable and as requiring active
government intervention to achieve stability.
An economy is in a Liquidity Trap if the demand
curve for real money is horizontal. In this situation, a change
in the quantity of money affects only the amount of money held.
It does not affect interest rates. Thus, even if investment
responds to interest rate changes, monetary policy would not be
effective. Extreme Keynesians believe that liquidity traps exist.
An extreme monetarist believes that a change
in Government purchases or taxes has no effect on GNP -- and that
a change in the money supply has a large and predictable effect
on GNP. This could happen if:
the investment demand curve was horizontal.
the demand curve for money was vertical.
The Intermediate Position is that both monetary
and fiscal policy affect aggregate demand.
Crowding out is not complete.
There is no liquidity trap.
Investment does respond to interest rate changes.
Money demand responds to interest rate changes.
The IS curve shows combinations of real GNP and
interest rate at which aggregate planned expenditure equals real
GNP. In other words, the IS curve shows combinations of the
interest rate and real GNP at which there is an expenditure equilibrium.
( The Hicks' IS Curve was for a closed economy in which investment,
I, was equal to savings, S. )
Each of the equilibrium points relating AE and
real income are associated with a different interest rate.
The LM curve shows the combinations of real
GNP and interest rate at which the quantity of real money demanded
equals the quantity of real money supplied. ( The Hicks' LM
Curve was for a closed economy in which the liquidity preference,
L, was equal to the supply of money, M. )
As the equilibrium level of real GNP increases,
the money demand curve ( Md ) shifts upward to the right. As
a result, the supply of money is equal to the demand for money
at a higher interest rate. The LM Curve shows the combinations
of interest rates and real GNP which are consistent with equilibrium
in the money market. We note that there are a large number of
combinations of interest rates and real GNP which are consistent
with equilibrium in the money market.
Suppose the market interest rate is above the
equilibrium interest rate. What will happen ?
Investment will begin to fall. This will reduce
GNP. As a result, the demand for money falls. This results in
a lower interest rate. The process continues until we reach a
combination of interest rate and real GNP which is consistent
with equilibrium in the money market and in the product market.
The FED determines the money supply in current
dollars. The higher the price level, the lower is the real value
of those dollars. Because the price level affects the quantity
of real money supplied, it also affect the LM curve. As prices
fall, the Ms curve shifts to the right. This results in lower
interest rates and higher real GNP. As a result, the LM Curve
moves to the right.
We can derive the Aggregate Demand Curve from
the IS and LM Curves. There is a different LM Curve for each
All of the points on the Aggregate Demand Curve
are consistent with equilibrium in the money market and equilibrium
in the product market.
We introduce the Aggregate Supply Curve to determine
the equilibrium price level.
Key Concepts: Ch. 14
- Demand for Money
- Transactions Demand
- Precautionary Demand
- Speculative Demand
- Quantity Theory of Money
- Velocity of Money
- ² in Money Supply & Inflation
- Keynes vs. Classical Viewpoints
- Transmission Mechanism
- Liquidity Trap
We need to distinguish between the Government
Debt and the Deficit.
The Deficit is a flow.
Surplus/Deficit = Taxes -- Govt. Expenditures
The Government Debt is the total amount of
borrowing the Government has undertaken over a period of years.
It is a stock.
The federal government's deficit was usually less
than 1 % of GNP during the 1960s. It began to grow in the early
1970s and by 1975 exceeded 4 % of GNP. Then it declined until
1980. During the 1980s the deficit averaged about 4 % of GNP.
- The Department of Commerce formula for determining
the effect of the business cycle on the deficit has two key elements:
Each 1 % point increase in the unemployment
rate increases the deficit by $30 billion.
Each $100 billion decrease in current dollar
GNP increases the deficit by $35 billion.
Because of inflation, the Government's deficit is
not really as big as it appears. When we look at the Real Deficit,
we find that it was usually positive during the 1960s and 1970s.
Only when inflation declined in the 1980s, while interest rates
remained high, did a large and persistent real deficit emerge.
- To finance its deficit, the Government sells
bonds. The effects of the bond sales depends on who buys the
- Money Financing: If the bonds are purchased
by the FED, they increase the money supply.
Debt Financing: If the bonds are purchased by
firms, households, or others rather than the FED, they do not
bring a change in the money supply.
This would be similar to an individual borrowing
money to purchase a home and then never paying anything on the
principal and borrowing more money each year to pay the interest
on the loan. For a $100,000 home loan at 10 % interest, you would
owe the bank $121,000 at the end of the second year. Your bank
loans would add up to $417,724 at the end of 15 years. Of this
amount, $100,000 would be your original "deficit" and
$317,724 would be the interest on the initial loan plus the interest
on the interest, on the interest, on the interest.
Thus, money financing benefits the Government
but it causes inflationary problems for everyone else.
Furthermore, with a progressive income tax structure,
inflation results in everyone paying a higher percentage of their
real income to the Government. This benefits the Government but
hurts everyone else.
1 Year 2
Inflation rate 10 %
Nominal Income $ 25,000
Real Income $ 25,000
Nominal Taxes $ 2,500
Real Taxes $ 2,500
Taxes as % of Income 10 %
- It has been suggested that debt financing is
more inflationary than money financing because:
With continued debt financing, the deficit becomes
larger and larger. At some point, the Government debt outstanding
will have grown so large that the interest burden on it will be
larger than the Government is willing to pay. At that point,
the Government will switch to money financing. The result will
be rapid inflation. When that happens interest rates will go
up and the value of the bonds that households and firms purchased
earlier will lose value rapidly. Hence, Government bonds must
carry an increasingly higher interest rate to encourage people
to buy them. -- This results in even greater deficits. Furthermore,
if people expect the value of money to fall, they will begin to
switch into real goods, aggregate demand will increase and even
more inflation will occur.
In summary, money financing is certainly inflationary.
Debt financing could eventually become inflationary if people
begin to expect that the Government will increasingly turn to
Deficits are not inevitably inflationary. But the
larger the deficit and the longer it persists, the greater the
pressures and temptations to cover the deficit by creating money,
thereby generating inflation.
Govt. Budget Constraint
- Govt. expenditures (G) must come from taxes (T),
borrowing (²B), or printing money (²MB).
G = T + ²B + ²MB
Deficit = G - T = ²B + ²MB
If (G - T) > 0 then the government must
borrow ²B > 0 or create money ²MB > 0.
One view is that the nation must increase taxes on
future generations in order to pay the interest on the debt.
Those who pay the taxes are not necessarily the same as those
who receive the interest. The taxes tend to be on middle class
wage and salary earners. The interest tends to be paid to be
upper middle class, wealthy individuals and large companies.
Foreign lenders are also helping to finance a larger portion
of the national debt. Thus a large debt is likely to result in
some re-distribution of income.
Real interest rates in the U.S. in the 1980s were
higher than at any time in history. Furthermore, there is a general
tendency for real interest rates and the real deficit to fluctuation
together. i.e. The recent data tends to support those economists
who believe in the crowding out effect of higher deficits.
- The budget deficit is related to the trade deficit.
G + I + X = S + T + M
(G - T) = (S - I) + (M - X)
If S = I and (G - T) > 0, then we have (M
- X) > 0
In other words, we can not solve our balance
of payments problem until we solve our federal deficit problem.
- The Reagan Administration cut taxes in the first
part of the 1980s.
- Republicans have pushed for a balanced budget
- Annually Balanced Budget proposals are aimed
at two problems.
- 1. To avoid the alleged inflationary consequences
of chronic budget deficits.
- 2. To prevent stabilization policy from leading
to a continual increase in the size of the Government sector.
- A Non-Keynesian View
- a. Deficits have important harmful effects.
- b. Government employees and special interest
groups want to spend money for their own purposes -- not for
c. When an economy is near full
employment a deficit causes inflation which hurts
purchasing power and the balance of trade.
Remeasuring Public Debt
- Some feel that debt figures would be more useful
- were converted to real values.
- adjusted for interest rate changes. (Reported
on a market value basis rather than on a par value basis.)
revised to conform to Generally Accepted Accounting
Principles. (This would take into account the government's assets
as well as its debts.)
- Making these adjustments usually reduces both
debt and deficit values.
Many elements of Government expenditure have a built-in
tendency to increase. This is particularly true for income security
and health care expenditures. Only by removing from the
public domain certain responsibilities can the Government's share
of GNP be effectively contained. Congress frequently tries to
move some items "off-line " or to privatize them.
There is little scope for significant cuts in Government
expenditure as long as we maintain our global defense obligations
and our obligations under social security and other programs such
as welfare, unemployment, Medicare, etc.
- Gramm-Rudman Act (1985)
- Federal deficit was to be reduced to zero by
- Most "uncontrollable" expenditures
- Congress easily found ways to avoid it.
- Deficit Reduction Act (1990)
- Combined tax increases & spending cuts.
- Focused on controlling some aspects of federal
- Deficit Reduction Act (1993)
- Was primarily a very large tax increase.
The feasible alternatives available to a nation depend
partly on the form of government and the size, wealth and technology
of the nation.
- The U.S. has frequently proceeded to capture
resources from other nations.
- Peru has allowed rapid inflation to make debt
- Many developing nations rely on defaulting on