Fiscal Policy and Policy Making
Fiscal policy is the use of government revenue collection (taxation) and expenditure (spending) to influence the economy.
Identify the central elements of fiscal policy
- The two main instruments of fiscal policy are government taxation and expenditure.
- There are three main stances in fiscal policy: neutral, expansionary, and contractionary.
- Even with no changes in spending or tax laws at all, cyclic fluctuations of the economy cause cyclic fluctuations of tax revenues and of some types of government spending, which alters the deficit situation; these are not considered fiscal policy changes.
- taxation: The act of imposing taxes and the fact of being taxed
- expenditure: Act of expending or paying out.
- fiscal policy: Government policy that attempts to influence the direction of the economy through changes in government spending or taxes.
In economics and political science, fiscal policy is the use of government budget or revenue collection (taxation) and expenditure (spending) to influence economic. The two main instruments of fiscal policy are government taxation and expenditure. Changes in the level and composition of taxation and government spending can impact the following variables in the economy: (1) aggregate demand and the level of economic activity; (2) the pattern of resource allocation; and (3) the distribution of income.
The three main stances of fiscal policy are:
- Neutral fiscal policy, usually undertaken when an economy is in equilibrium. Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.
- Expansionary fiscal policy, which involves government spending exceeding tax revenue, and is usually undertaken during recessions.
- Contractionary fiscal policy, which occurs when government spending is lower than tax revenue, and is usually undertaken to pay down government debt.
These definitions can be misleading however. Even with no changes in spending or tax laws at all, cyclic fluctuations of the economy cause cyclic fluctuations of tax revenues and of some types of government spending, which alters the deficit situation; these are not considered to be policy changes. Therefore, for purposes of the above definitions, “government spending” and “tax revenue” are normally replaced by “cyclically adjusted government spending” and “cyclically adjusted tax revenue”. Thus, for example, a government budget that is balanced over the course of the business cycle is considered to represent a neutral fiscal policy stance.
Methods of Funding
Governments spend money on a wide variety of things, from the military and police to services like education and healthcare, as well as transfer payments such as welfare benefits. This expenditure can be funded in a number of different ways:
- Seigniorage, the benefit from printing money
- Borrowing money from the population or from abroad
- Consumption of fiscal reservesSale of fixed assets (e.g., land)
- Borrowing: A fiscal deficit is often funded by issuing bonds, like treasury bills or consols and gilt-edged securities. These pay interest, either for a fixed period or indefinitely. If the interest and capital requirements are too large, a nation may default on its debts, usually to foreign creditors. Public debt or borrowing: it refers to the government borrowing from the public.
- Consuming prior surpluses: A fiscal surplus is often saved for future use, and may be invested in either local currency or any financial instrument that may be traded later once resources are needed; additional debt is not needed. For this to happen, the marginal propensity to save needs to be strictly positive.
Deficit Spending, the Public Debt, and Policy Making
Deficit spending and public debt are controversial issues within economic policy debates.
Describe government debt and how it is formed
- Whereas, public debt refers to debt owed by a central government, deficit spending refers to spending done by a government in excess of tax receipts is known as deficit spending.
- As the government draws its income from much of the population, government debt is an indirect debt of the taxpayers.
- Deficit spending may, however, be consistent with public debt remaining stable as a proportion of GDP, depending on the level of GDP growth.
- The mainstream economics position is that deficit spending is desirable and necessary as part of counter-cyclical fiscal policy, but that there should not be a structural deficit.
- The mainstream position is attacked from both sides – advocates of sound finance argue that deficit spending is always bad policy, while some Post-Keynesian economists, particularly Chartalists, argue that deficit spending is necessary, and not only for fiscal stimulus.
- financing: A transaction that provides funds for a business.
- debt: The state or condition of owing something to another.
- deficit: A situation wherein, or amount whereby, spending exceeds government revenue.
Government debt is the debt owed by a central government. In the United States and other federal states, government debt may also refer to the debt of a state or provincial government, municipal or local government. By contrast, the annual government deficit refers to the difference between government receipts and government spending in a single year, that is, the increase in debt over a particular year. Government debt is one method of financing government operations, but it is not the only method. Governments can also create money to monetize their debts, thereby eliminating the need to pay interest. Doing this, however, simply reduces government interest costs, rather than truly fixing the government debt. Governments usually borrow by issuing securities, government bonds, and bills. Less creditworthy countries sometimes borrow directly from a supranational organization, like the World Bank, or international financial institutions.
Because the government draws its income from much of the population, government debt is an indirect debt of the taxpayers. Government debt can be categorized as internal debt (owed to lenders within the country) and external debt (owed to foreign lenders). Sovereign debt usually refers to government debt that has been issued in a foreign currency. Government debt can also be categorized by duration until repayment is due. For instance, short term debt is generally considered to last for one year or less, while long term debt is for more than ten years. Medium term debt falls between these two boundaries. A broader definition of government debt may consider all government liabilities, including future pension payments and payments for goods and services the government has contracted, but not yet paid.
Government deficit, on the other hand, refers to a situation when the government’s expenses, including its purchases of goods and services, its transfers (grants) to individuals and corporations, and its net interest payments, exceed its tax revenues. Deficit spending occurs when government spending exceeds tax receipts. Governments usually issue bonds to match their deficits. Bonds can be bought by the Central Bank through quantitative easing. Otherwise the debt issuance can increase the level of (i) public debt, (ii) private sector net worth, (iii) debt service (interest payments) and (iv) interest rates. Deficit spending may, however, be consistent with public debt, remaining stable as a proportion of GDP, depending on the level of GDP growth.
Deficit Reduction Debate: Differences between the two Parties
In the United States, taxes are imposed on net income of individuals and corporations by the federal, most state, and some local governments. One of the largest budget expenditures for state governments is Medicaid. The United States public debt is the outstanding amount owed by the federal government of the United States from the issue of securities by the Treasury and other federal government agencies. US public debt consists of two components:
- Debt held by the public includes Treasury securities held by investors outside the federal government, including that held by individuals, corporations, the Federal Reserve System and foreign, state and local governments.
- Debt held by government accounts or intragovernmental debt includes non-marketable Treasury securities held in accounts administered by the federal government that are owed to program beneficiaries, such as the Social Security Trust Fund. Debt held by government accounts represents the cumulative surpluses, including interest earnings, of these accounts that have been invested in Treasury securities.
Democrats and Republicans mean very different things when they talk about tax reform. Democrats argue for the wealthy to pay more via higher income tax rates, while Republicans focus on lowering income tax rates. While both parties discuss reducing tax expenditures (i.e., exemptions and deductions), Republicans focus on preserving lower tax rates for capital gains and dividends, while Democrats prefer educational credits and capping deductions. Political realities make it unlikely that more than $150 billion per year in individual tax expenditures could be eliminated. One area with more common ground is corporate tax rates, where both parties have generally agreed that lower rates and fewer tax expenditures would align the U.S. more directly with foreign competitioIn addition to policies regarding revenue and spending, policies that encourage economic growth are the third major way to reduce deficits. Economic growth offers the “win-win” scenario of higher employment, which increases tax revenue while reducing safety net expenditures for such things as unemployment compensation and food stamps. Other deficit proposals related to spending or revenue tend to take money or benefits from one constituency and give it to others, a “win-lose” scenario. Democrats typically advocate Keynesian economics, which involves additional government spending during an economic downturn. Republicans typically advocate Supply-side economics, which involves tax cuts and deregulation to encourage the private sector to increase its spending and investment.
Monetary policy is the process by which a country controls the supply of money in order to promote economic growth and stability.
Recognize the importance of monetary policy for addressing common economic problems
- The official goals of monetary policy usually include relatively stable prices and low unemployment.
- A policy is referred to as ” contractionary ” if it reduces the size of the money supply, increases money supply slowly, or if it raises the interest rate.
- An expansionary policy increases the size of the money supply more rapidly or decreases the interest rate.
- Within almost all modern nations, special institutions exist that have the task of executing the monetary policy, often independently of the executive.
- contractionary: Tending to reduce the size of the money supply.
- expansionary: Tending to increase the total supply of money in the economy.
- monetary policy: The process by which the government, central bank, or monetary authority manages the supply of money or trading in foreign exchange markets.
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment. Monetary theory provides insight into how to craft optimal monetary policy. It is referred to as either being expansionary or contractionary. An expansionary policy increases the total supply of money in the economy more rapidly than usual. A contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses to expand. Contractionary policy is intended to slow inflation in hopes of avoiding the resulting distortions and deterioration of asset values.
Monetary policy differs from fiscal policy. Fiscal policy refers to taxation, government spending, and associated borrowing.
Monetary policy uses a variety of tools to influence outcomes like economic growth, inflation, exchange rates with other currencies and to control unemployment. When currency is under a monopoly of issuance or when there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and therefore influence the interest rate (to achieve policy goals). The beginning of monetary policy was introduced in the late 19th century, where it was used to maintain the gold standard.
A policy is referred to as “contractionary” if it reduces the size of the money supply, increases the money supply slowly, or if it raises the interest rate. An expansionary policy increases the size of the money supply more rapidly or decreases the interest rate. Furthermore, monetary policies are described as “accommodative” if the interest rate set by the central monetary authority is intended to create economic growth. Policies are referred to as “neutral” if it is intended neither to create growth nor combat inflation. Policies are called “tight” if they are intended to reduce inflation.
There are several monetary policy tools available to achieve these ends including increasing interest rates by fiat, reducing the monetary base, and increasing reserve requirements. All of the tools have the effect of contracting the money supply and, if reversed, expanding the money supply. Since the 1970’s, monetary policy has generally been formed separately from fiscal policy. Even prior to the 1970’s, the Bretton Woods system still ensured that most nations would form the two policies separately.
Within most modern nations, special institutions (such as the Federal Reserve System in the United States, the Bank of England, the European Central Bank, the People’s Bank of China, the Reserve bank of India, and the Bank of Japan) exist which have the task of executing the monetary policy, often independently of the executive. In general, these institutions are called central banks and usually have other responsibilities such as supervising the smooth operation of the financial system.
The primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various financial instruments, such as treasury bills, company bonds, or foreign currencies. All of these purchases or sales result in more or less base currency entering or leaving market circulation.
Usually, the short term goal of open market operations is to achieve a specific short term interest rate target. In other instances, monetary policy might entail the targeting of a specific exchange rate relative to some foreign currency or gold. For example, in the case of the United States, the Federal Reserve targets the federal funds rate, which is the rate at which member banks lend to one another overnight. However, the monetary policy of China is to target the exchange rate between the Chinese renminbi and a basket of foreign currencies.
The other primary means of conducting monetary policy include: (i) Discount window lending (lender of last resort); (ii) Fractional deposit lending (changes in the reserve requirement); (iii) Moral suasion (cajoling certain market players to achieve specified outcomes); (iv) “Open mouth operations” (talking monetary policy with the market).
Income Security Policy and Policy Making
Income security policy is designed to provide a population with income at times when they are unable to care for themselves.
Define income security policy in the United States
- Income maintenance is based on a combination of five main types of program: social insurance, means-tested benefits, non-contributory benefits, discretionary benefits, and universal or categorical benefits.
- The fact that a compulsory government program, not the private market, provides unemployment insurance can be explained using the concepts of adverse selection and moral hazard.
- The amount of support is enough to cover basic needs, and eligibility is often subject to a comprehensive and complex assessment of an applicant’s social and financial situation.
- discretion: The freedom to make one’s own judgements
- demogrants: Non-contributory benefits given to whole sections of the population without a test of means or need.
Income Security Policy is usually applied through various programs designed to provide a population with income at times when they are unable to care for themselves. Income maintenance is based in a combination of five main types of program
- Social insurance.
- Means-tested benefits. This is financial assistance provided for those who are unable to cover basic needs (such as food, clothing, and housing) due to poverty or lack of income because of unemployment, sickness, disability, or caring for children. While assistance is often in the form of financial payments, those eligible for social welfare can usually access health and educational services free of charge. The amount of support is enough to cover basic needs and eligibility is often subject to a comprehensive and complex assessment of an applicant’s social and financial situation.
- Non-contributory benefits. Several countries have special schemes, administered with no requirement for contributions and no means test, for people in certain categories of need (for example, veterans of armed forces, people with disabilities, and very old people).
- Discretionary benefits. Some schemes are based on the discretion of an official, such as a social worker.
- Universal or categorical benefits, also known as demogrants. These are non-contributory benefits given to whole sections of the population without a test of means or need, such as family allowances or the public pension in New Zealand (known as New Zealand Superannuation).
That a compulsory government program, not the private market, provides unemployment insurance can be explained using the concepts of adverse selection and moral hazard.
Adverse selection refers to the fact that “workers who have the highest probability of becoming unemployed have the highest demand for unemployment insurance.” Adverse selection causes profit maximizing private insurance agencies to set high premiums for the insurance because there is a high likelihood they will have to make payments to the policyholder. High premiums exclude many individuals who otherwise might purchase the insurance. “A compulsory government program avoids the adverse selection problem. Hence, government provision of UI has the potential to increase efficiency. However, government provision does not eliminate moral hazard.”
“At the same time, those workers who managed to obtain insurance might experience more unemployment other than what would have been the case.” The private insurance company would have to determine whether the employee is unemployed through no fault of their own, which is difficult to determine. Incorrect determinations could result in the payout of significant amounts for fraudulent claims, or alternately failure to pay legitimate claims. This leads to the rationale that if the government could solve either problem, then government intervention would increase efficiency.
The Changing Federal Role in the Economy
The role of the federal government in the economy has been a central debate among economists and political scientists for two centuries.
Explain the role and the historical origins of the Federal Reserve System in the early 20th century
- In the United States, the Federal Reserve System (also known as the Federal Reserve, and informally as the Fed) serves as the central mechanism for understanding federal intervention (and de-entanglement) with the economy.
- Over time, the roles and responsibilities of the Federal Reserve System have expanded and its structure has evolved.
- Events such as the Great Depression were major factors leading to changes in the system.
- monetary policy: The process by which the government, central bank, or monetary authority manages the supply of money or trading in foreign exchange markets.
- bank regulation: Bank regulations are a form of government regulation which subject banks to certain requirements, restrictions and guidelines.
The role of the federal government in the economy has been a central debate among economists and political scientists for over two centuries. Classic liberalism and Right-libertarian arguments argue for limited or no role for the federal government in the economy, while welfare economics argue for an increased role of the federal government.
In the United States, the Federal Reserve System (also known as the Federal Reserve, and informally as the Fed) serves as the central mechanism for understanding federal intervention (and de-entanglement) with the economy. The central banking system of the United States, the Fed was created on December 23, 1913, with the enactment of the Federal Reserve Act. This was largely in response to a series of financial panics, particularly a severe panic in 1907. Over time, the roles and responsibilities of the Federal Reserve System have expanded, and its structure has evolved. Events such as the Great Depression were major factors leading to changes in the system.
The Congress established three key objectives for monetary policy —maximum employment, stable prices, and moderate long-term interest rates—in the Federal Reserve Act. The first two objectives are sometimes referred to as the Federal Reserve’s dual mandate. Its duties have expanded over the years, and today, according to official Federal Reserve documentation, include conducting the nation’s monetary policy, bank regulation, maintaining the stability of the financial system and providing financial services to depository institutions, the U.S. government, and foreign official institutions. The Fed also conducts research into the economy and releases numerous publications, such as the Beige Book.
Politics and the Great Recession of 2008
Global political instability is rising fast due to the global financial crisis and is creating new challenges that need to be managed.
Explain the causes and consequences of the 2008-2012 Global Recession
- Economic weakness could lead to political instability in many developing nations.
- Globally, mass protest movements have arisen in many countries as a response to the economic crisis.
- The bursting of the U.S. housing bubble, which peaked in 2006, caused the values of securities tied to U.S. real estate pricing to plummet, damaging financial institutions globally.
- The U.S. Senate ‘s Levin–Coburn Report asserted that the crisis was the result of “high risk, complex financial products; undisclosed conflicts of interest; the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street.
- The 1999 repeal of the Glass–Steagall Act effectively removed the separation between investment banks and depository banks in the United States.
- Most governments in Europe, including Greece, Spain, Italy, have faced austerity measures that include reduced government spending, elimination of social programs in education and health, and the deregulation of short-term and long-term capital markets.
- secession: Secession (derived from the Latin term secessio) is the act of withdrawing from an organization, union, or especially a political entity. Threats of secession also can be a strategy for achieving more limited goals.
- recession: A period of reduced economic activity
- financial crisis: A period of economic slowdown characterised by declining productivity and devaluing of financial institutions often due to reckless and unsustainable money lending.
The Global Recession
The 2008–2012 global recession is a massive global economic decline that began in December 2007 and took a particularly sharp downward turn in September 2008. No economic recession since The Great Depression of the 1930s has affected economic input, production and circulation of capital like the current global recession. The global recession affected the entire world economy, hitting some countries more than others. It is a major global recession characterized by various systemic imbalances sparked by the outbreak of the Financial crisis of 2007–2008. shows the trend in international trade that reflects the recession in 2008.
Beginning February 26, 2009 an Economic Intelligence Briefing was added to the daily intelligence briefings prepared for the President of the United States. This addition reflects the assessment of United States intelligence agencies that the global financial crisis presents a serious threat to international stability.
The bursting of the U.S. housing bubble, which peaked in 2006, caused the values of securities tied to U.S. real estate prices to plummet, damaging financial institutions globally. The financial crisis was triggered by a complex interplay of government policies that encouraged home ownership, providing easier access to loans for subprime borrowers, overvaluation of bundled sub-prime mortgages based on the theory that housing prices would continue to escalate, questionable trading practices on behalf of both buyers and sellers, compensation structures that prioritize short-term deal flow over long-term value creation, and a lack of adequate capital holdings from banks and insurance companies to back the financial commitments they were making.
Several causes of the financial crisis have been proposed, with varying weights assigned by experts. The U.S. Senate’s Levin–Coburn Report asserted that the crisis was the result of “high risk, complex financial products; undisclosed conflicts of interest; the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street. ” The 1999 repeal of the Glass–Steagall Act effectively removed the separation between investment banks and depository banks in the United States. Critics argued that credit rating agencies and investors failed to accurately price the risk involved with mortgage-related financial products, and that governments did not adjust their regulatory practices to address 21st-century financial markets. Research into the causes of the financial crisis has also focused on the role of interest rate spreads.
In March 2009, Business Week stated that global political instability is rising fast due to the global financial crisis and is creating new challenges that needed to be addressed. The Associated Press reported in March 2009 that: United States “Director of National Intelligence Dennis Blair has said the economic weakness could lead to political instability in many developing nations. ” Even some developed countries are experiencing political instability. NPR reports that David Gordon, a former intelligence officer who now leads research at the Eurasia Group, said: “Many, if not most, of the big countries out there have room to accommodate economic downturns without having large-scale political instability if we’re in a recession of normal length. If you’re in a much longer-run downturn, then all bets are off.”
In January 2009, the government leaders of Iceland were forced to call elections two years early after the people of Iceland staged mass protests and clashed with the police due to the government’s handling of the economy. Hundreds of thousands protested in France against President Sarkozy’s economic policies. Prompted by the financial crisis in Latvia, the opposition and trade unions there organized a rally against the cabinet of premier Ivars Godmanis. The rally gathered some 10-20 thousand people. In the evening the rally turned into a Riot. The crowd moved to the building of the parliament and attempted to force their way into it, but were repelled by the state’s police. In late February many Greeks took part in a massive general strike to protest the economic situation and they shut down schools, airports, and many other services in Greece. Communists in Moscow also rallied to protest the Russian government’s economic plans. Protests have also occurred in China as demands from the west for exports have been dramatically reduced and unemployment increased. Beyond these initial protests, the protest movement has grown and continued in 2011. In late 2011, the Occupy Wall Street protest took place in the United States, spawning several offshoots that came to be known as the Occupy movement.
In 2012 the economic difficulties in Spain have caused support for secession movements to increase. In Catalonia support for the secession movement exceeded 50%, up from 25% in 2010. On September 11, a pro-independence march, which in the past had never drawn more than 50,000 people, pulled in a crowd estimated by city police at 1.5 million..
Business and Labor in the Economy
The relationship between business and labor has been at the center of economic and political theory for the last two centuries.
Explain the relationship between labor and business in the economy
- The late nineteenth century saw many governments starting to address questions surrounding the relationship between business and labor, primarily through labor law or employment law.
- Labor law is the body of laws, administrative rulings, and precedents which address the legal rights of, and restrictions on, working people and their organizations.
- Labor law arose due to the demand for workers to have better conditions, the right to organize, or, alternatively, the right to work without joining a labor union, and the simultaneous demands of employers to restrict the powers of workers’ many organizations and to keep labor costs low.
- Workers’ organizations, such as trade unions, can also transcend purely industrial disputes, and gain political power. The state of labor law at any one time is therefore both the product of, and a component of, struggles between different interests in society.
- Commercial law is the body of law that applies to the rights, relations, and conduct of persons and businesses engaged in commerce, merchandising, trade, and sales. It is often considered to be a branch of civil law and deals with issues of both private law and public law.
- labor union: A continuous association of wage earners for the purpose of maintaining or improving the conditions of their employment; a trade union.
- capitalism: A socio-economic system based on private property rights, including the private ownership of resources or capital, with economic decisions made largely through the operation of a market unregulated by the state.
- labor law: This is the body of laws, administrative rulings, and precedents which address the legal rights of, and restrictions on, working people and their organizations.
The relationship between business and labor has been at the center of some of the major economic and political theories about capitalism over the last two centuries. In his 1867 work, Das Kapital, Karl Marx argued that business and labor were inherently at odds under capitalism, because the motivating force of capitalism is in the exploitation of labor, whose unpaid work is the ultimate source of profit and surplus value. In order for this tension to be resolved, the workers had to take ownership over the means of the production, and, therefore, their own labor–a process that Marx explained in his other major work, The Communist Manifesto.
The late nineteenth century saw many governments starting to address questions surrounding the relationship between business and labor, primarily through labor law or employment law. Labor law is the body of laws, administrative rulings, and precedents which address the legal rights of, and restrictions on, working people and their organizations. As such, it mediates many aspects of the relationship between trade unions, employers, and employees.
Labor law arose due to the demand for workers to have better conditions, the right to organize, or, alternatively, the right to work without joining a labor union, and the simultaneous demands of employers to restrict the powers of the many organizations of workers and to keep labor costs low. Employers’ costs can increase due to workers organizing to achieve higher wages, or by laws imposing costly requirements, such as health and safety or restrictions on their free choice of whom to hire. Workers’ organizations, such as trade unions, can also transcend purely industrial disputes and gain political power. The state of labor law at any one time is, therefore, both the product of, and a component of, struggles between different interests in society.
The Fair Labor Standards Act of 1938 set the maximum standard work week to 44 hours and in 1950, this was reduced to 40 hours. A green card entitles legal immigrants to work just like U.S. citizens, without requirement of work permits. Despite the 40-hour standard maximum work week, some lines of work require more than 40 hours to complete the tasks of the job. For example, if you prepare agricultural products for market, you can work over 72 hours a week, if you want to, but you cannot be required to work these many hours. If you harvest products you must get a period of 24 hours off after working up to 72 hours in a seven-day period. There are exceptions to the 24-hour break period for certain harvesting employees, such as those involved in harvesting grapes, tree fruits, and cotton. Professionals, clerical (administrative assistants), technical, and mechanical employees cannot be terminated for refusing to work more than 72 hours in a work week. These high-hour ceilings, combined with a competitive job market, often motivate American workers to work more hours than required. American workers consistently take fewer vacation days than their European counterparts and on average, take the fewest days off of any developed country.
Commercial law is the body of law that applies to the rights, relations, and conduct of persons and businesses engaged in commerce, merchandising, trade, and sales. It is often considered to be a branch of civil law and deals with issues of both private law and public law.