Private economies are subject to a variety of fluctuations in inflation and employment. Can the government, through policies termed fiscal or monetary, help to smooth these out or mitigate their negative impact on citizens? Can government help move the economy toward low inflation and high unemployment?
This issue was dramatically demonstrated in 2008 when confidence in financial institutions was badly shaken. To offset the Great Recession, the government passed the Recovery Act, which permitted tax cuts (tax reduction), spending by the Federal government (increasing government purchasing), and assistance to local and state governments (transfer payments).
Debate surrounded what is termed the multiplier effect:
- are they higher for tax cuts or government spending,
- the differences in multiplier effect from different tax cuts,
- Incentive impact from tax cuts.
Tax cuts shift the actual money available to people for purchases – termed disposable income — increases in taxes shifts GDP to the right and down, and vice versa.
The multiplier effect works through the chain of spending – one person’s income is another person’s expenditure. The formula (much simplified) IS 1/ (1-MPC). This probably overstates the multiplier by ignoring variation in imports, price changes, and income taxes.
The book asserts that tax cuts have a smaller multiplier than government spending because there is no assurance that every dollar of a tax cut will be laid out in purchases (or, although this is not mentioned, within the reporting period). If people are remitting a portion of income in taxes (Page 218 seems to be missing).
To shift potential GDP, it is necessary to know or guess at the multiplier, so you know how much the government needs to spend to get the growth that is desired.
In past years, for example, in 1999, the challenge is to reduce aggregate demand, and the procedure was carried out in reverse of the above.
As long as the combination of spending and tax cuts generates the same aggregate demand curve, the outcome will be the same in terms of real GDP and prices. How much emphasis is placed on government spending versus tax cuts ends up depending on political perspective? Conservatives prefer personal actions and spending, while liberals accept government spending and action to accomplish the desired objectives.
The effectiveness of all governmental interventions is impaired by several items. These include changing circumstances, inaccuracy in estimation of the multiplier, and inaccuracy in employment statistics, the long lag time between implementing something and its effect in the economy, and the fact that these changes are being suggested by politicians rather than economic experts (for whatever they are worth!).
Reagan-era economists proposed that supply-side personal income tax cuts would increase working, saving, and making investments back into the economy. This does not always take into account the demand-side effects. People spend more when they have more money. Supply-side policies can increase inequality, and they certainly decrease tax revenues. Also, the timing of impacts may be uncertain and delayed.
Monetary : one way that the government can affect the economy is through interest rates and money supply. The Federal Reserve is largely involved in such policies. This was founded after the economic panic of 1907, in 1914, to prevent a recurrence.
It is intended to operate independently of political pressure, which is why the leadership is appointed for 14 years – long enough to outlast most politicians. However, some accuse it of being undemocratic. Meeting 8 x per year, the Federal Open Market Committee decides what actions to take (or not) to achieve 1.5-2% inflation.
It is important to understand the difference between money and income. Money is measured at one point. Income is received over some time.
The Federal Reserve can increase or decrease the amount banks must keep in reserves, thereby increasing or decreasing the money supply. To lower interest rates, the Fed buys Treasury bills from banks or individuals, and thus increases their money on hand.
The supply curve for bank reserves is upward sloping, and the demand curve is downwards sloping. The demand curve for reserves depends on the demand for transaction deposits, the real GDP, and the price level — interest rate: federal funds rate. The federal funds rate is critical; it is the interest rate charged and paid between banks ( not the public).
It is, with the Treasury Bill rate of return, the only interest rate that the Fed can control. When the Fed purchases T-Bills on the open market, this raises money supply and lowers interest rates. When the Fed sells T-Bills, this reduces the money supply and lowers T-Bill prices. Interest rates on credit cards, loans, mortgages, and corporate bonds balances are out of the Fed’s control. A crisis in the economy occurs when interest rates move at wildly different rates or directions.
Interest rates should reflect the risk of default. They range from T-bills to banks borrowing from banks, to the lending of reserves, to Fortune 500 corporate debt, to smaller or weaker corporate debt (junk bonds). The interest premium for risky borrowers (whether nations or individuals or firms) is spread over various Treasuries. The risk spread widens when the perception of default risk increases, and vice versa.