Test 2 Study Guide
Test 2 Study Guide ECON 2105 080
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This 12 page Study Guide was uploaded by Nihar Desai on Thursday February 18, 2016. The Study Guide belongs to ECON 2105 080 at Georgia State University taught by Jardon Apperson in Winter 2016. Since its upload, it has received 95 views. For similar materials see PRINCIPLES OF MACROECONOMICS in Economcs at Georgia State University.
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Econ Test 2 Study Guide Chapter 15 How Does the Government Spend? Two sides to a budget: the sources of funds (income or revenue) and the uses of funds (spending or outlays). Transfer payments: payments made to groups or individuals when no good or service is received in return. -the government transfers funds from one group in society to another. These include income assistance (welfare) and Social Security payments to retired or disabled persons. Government outlays: the part of the government budget that includes both spending and transfer payments. Outlays 1. Mandatory outlays: constitute government spending that is determined by ongoing programs like Social Security and Medicare. -These programs are mandatory because existing laws mandate government funding for them. -Entitlement programs: citizens who meet certain requirements are then entitled to benefits under current laws. 2. Discretionary outlays: comprise government spending that can be altered when the government is setting its annual budget. - Examples of discretionary spending include monies for bridges and roads, payments to government workers, and defense spending. 3. Interest Payments: payments made to current owners of U.S. Treasury bonds. – -Such payments are not easy to alter, given a certain level of debt, so they are also essentially mandatory payments. Social Security and Medicare Social Security: a government-administered retirement funding program. Medicare: a mandated federal program that funds health care for retired persons. Demographics 1.)people are living longer today than ever before, which means that they draw post-retirement benefits for longer periods 2.)Those who paid into the programs for many years are now retired and drawing benefits. To be eligible for Social Security and Medicare payments, workers have to pay taxes out of their earnings while they work. 3.)The baby boomers are retiring How to fix Social Security and Medicare funding? Increase retirement age to 67-70. (People are living longer) Adjusting the benefits computation to the consumer price index. Means-testing for Medicare and Social Security benefits. (decrease the amount of benefits to wealthier recipients) Spending and Current Fiscal Issues Increased spending on Social Security and Medicare Defense spending in the wake of the terrorist attacks of September 11, 2001. Government responses to the Great Recession, beginning with fiscal policy in 2008 How does Government Tax? Tax Revenue Sources of Tax Revenue 1.)Individual Income Taxes 2.)Social Insurance (Social Security and Medicare taxes) Payroll Taxes: taxes are deducted from workers’ paychecks. Progressive income tax system: people with higher incomes pay a larger percentage of their income in taxes than people with lower incomes do. Marginal tax rate: the tax rate paid on an individual’s next dollar of income. Average tax rate: the total tax paid divided by the amount of taxable income. Budget Deficits Budget deficit: occurs when government outlays exceed revenue. (Spend more than what they bring in) Budget surplus: occurs when revenue exceeds outlays. (bring in more than what they spend) *When the budget is in deficit, the balance is negative; when the budget is in surplus, the balance is positive.* Debt Debt: the total of all accumulated and unpaid deficits. (money that must be paid back) Austerity: involves strict budget regulations aimed at debt reduction. Chapter 16 Fiscal Policy Monetary policy: the use of the money supply to influence the economy. Fiscal policy: the use of government spending and taxes to influence the economy. Expansionary fiscal policy: occurs when the government increases spending or decreases taxes to stimulate the economy toward expansion. Contractionary fiscal policy: occurs when the government decreases spending or increases taxes to slow economic expansion. Countercyclical fiscal policy: the use of fiscal policy to counteract business-cycle fluctuations. - It consists of using expansionary policy during economic downturns and contractionary policy during economic expansions. Multipliers Marginal propensity to consume (MPC): the portion of additional income that is spent on consumption. Spending multiplier (ms): tells us the total impact on spending from an initial change of a given amount. * The multiplier depends on the marginal propensity to consume: the greater the marginal propensity to consume, the greater the spending multiplier.* Shortcomings of Fiscal Policy Time Lags 1.)Recognition Lag: In the real world, it is difficult to determine when the economy is turning up or down. GDP data is released quarterly, and the final estimate is not known until three months after the period in question. Unemployment rate data tends to lag even further behind. In addition, growth is not constant: one bad quarter does not always signal a recession, and one good quarter is not always the beginning of an expansion. All these factors make it very difficult to recognize when expansion or contraction starts. 2.)Implementation lag: It takes time to implement fiscal policy. In most nations, one or more governing bodies must approve tax and spending legislation. In the United States, such legislation must pass both houses of Congress and receive presidential approval before becoming law. For this reason, fiscal policy takes much longer to implement than monetary policy does. For example, as we discussed earlier in this chapter, the Economic Stimulus Act of 2008 entailed sending tax rebate checks to U.S. taxpayers. The act passed in early February, yet most checks did not go out until about six months later. This delay occurred even though the recipients were known ahead of time—that’s about as “shovel-ready” as a project can get. 3.)Impact lag: it takes time for the complete effects of fiscal or monetary policy to materialize. The multiplier makes fiscal policy powerful, but it takes time to ripple through the economy. Automatic Stabilizers Automatic stabilizers: government programs that automatically implement countercyclical fiscal policy in response to economic conditions. Progressive income tax rates guarantee that individual tax bills fall when incomes fall (during recessions) and rise when incomes rise (during expansions). ■ Taxes on corporate profits lower total tax bills when profits are lower (during contractions) and raise tax bills when profits are higher (typically during expansions). ■ Unemployment compensation increases government spending automatically when the number of unemployed people rises and decreases government spending when fewer people are unemployed. ■ Welfare programs also increase government spending during downturns and decrease government spending when the economy is doing better. Crowding-Out Crowding-out: occurs when private spending falls in response to increases in government spending. Savings Shifts New classical critique of fiscal policy: asserts that increases in government spending and decreases in taxes are largely offset by increases in savings, because people know they’ll have to pay higher taxes eventually. But if savings increases, then consumption falls, and this outcome mitigates the effects of the government spending. Supply side of Fiscal Policy Supply-side fiscal policy: involves the use of government spending and taxes to affect the supply, or production, side of the economy. Fiscal policy initiatives that focus on the supply side of the economy 1. Research and development (R&D) tax credits. Reduced taxes are available for firms that spend resources to develop new technology. 2. Policies that focus on education. Subsidies or tax breaks for education expenses create incentives to invest in education. One example is the Pell grant, which helps to pay for college expenses. Eventually, education and training increase effective labor resources and thus increase aggregate supply. 3. Lower corporate profit tax rates. Lower taxes increase the incentives for corporations to undertake activities that generate more profit. 4. Lower marginal income tax rates. Lower income tax rates create incentives for individuals to work harder and produce more, since they get to keep a larger share of their income. We will discuss this further below. First, they increase the incentives for productive activities. Second, each initiative takes time to affect aggregate supply. For example, education subsidies may encourage people to go to college and learn skills that will help them to succeed in the workplace. But the full impact of that education won’t be felt until after the education is completed. For this reason, supply- side proposals are generally emphasized as long-run solutions to growth problems. The Laffer Curve income tax revenue = tax rate × income ↑ income tax revenue = ↑tax rate × income ↓ income tax revenue = ↑tax rate × ↓↓income Chapter 17 What is Money? Currency: the paper bills and coins that are used to buy goods and services. Three Functions of Money 1.)Medium of Exchange: what people trade for goods and services. Barter: involves individuals trading some good or service they already have for something else that they want. Double coincidence of wants: each party in an exchange transaction happens to have what the other party desires. Commodity money: involves the use of an actual good in place of money. (Gold and Silver) Commodity-backed money: money that can be exchanged for a commodity at a fixed rate. Fiat money: money that has no value except as the medium of exchange; there is no inherent or intrinsic value to the currency. (Paper dollars) 2.)Unit of Account: the measure in which prices are quoted. 3.)Store of value: a means for holding wealth. M1 and M2 Checkable deposits: deposits in bank accounts from which depositors may make withdrawals by writing checks. M1 is the money supply measure that is composed of currency and checkable deposits. M2 includes everything in M1 plus savings deposits. M2 also includes two other types of deposits: money market mutual funds and small- denomination time deposits (certificates of deposit). *money supply (M) = currency + deposits* Actual data for both M1 and M2 is regularly published by the Federal Reserve. How do Banks Create Money Balance sheet: an accounting statement that summarizes a firm’s key financial information. Liabilities: the financial obligations the firm owes to others. Owner’s equity: the difference between the firm’s assets and its liabilities. Reserves: are the portion of bank deposits that are set aside and not lent out. Fractional reserve banking: occurs when banks hold only a fraction of deposits on reserve. Banks hold reserves for two reasons. First, they must accommodate withdrawals by their depositors. Second, banks are legally bound to hold a fraction of their deposits on reserve. Required reserve ratio (rr): the portion of deposits that banks are required to keep on reserve. *required reserves = rr × deposits* *excess reserves = total reserves - required reserves* Moral hazard: occurs when a party that is protected from risk behaves differently from the way it would behave if it were fully exposed to the risk. Simple money multiplier: the rate at which banks multiply money when all currency is deposited into banks and they hold no excess reserves. How Does the Federal Reserve Control the Money Supply? The Fed’s primary responsibilities are threefold: 1. Monetary policy: The Fed controls the U.S. money supply and is charged with regulating it to offset macroeconomic fluctuations. 2. Central banking: The Fed serves as a bank for banks, holding their deposits and extending loans to them. 3. Bank regulation: The Fed is one of the primary entities charged with ensuring the financial stability of banks, including the determination of reserve requirements. Federal funds: are deposits that private banks hold on reserve at the Fed. The interest rate on such interbank loans is known as the federal funds rate. The loans from the Fed to the private banks are known as discount loans. Discount rate is the interest rate on the discount loans made from the Fed to private banks. Monetary Policy Tools Open market operations: involve the purchase or sale of bonds by a central bank. When the Fed wants to increase the money supply, it buys securities; in contrast, when it wishes to decrease the money supply, it sells securities. The Fed buys and sells Treasury securities for two reasons. First, the Fed’s goal is to get the funds directly into the market for loanable funds. In this way, financial institutions begin lending the new money, and it quickly moves into the economy. Second, a typical day’s worth of open market operations might entail as much as $20 billion worth of purchases from the Fed. Reserve Requirements and Discount Rates Reserve requirements: 1. The Fed sets the ratio of deposits that banks must hold on reserve. This ratio is the required reserve ratio. 2. The simple money multiplier (mm) depends on the required reserve ratio (rr) Chapter 18 Effect of Monetary Policy in the Short-run Two types of monetary policy: Expansionary monetary policy: occurs when a central bank acts to increase the money supply in an effort to stimulate the economy. - It typically expands the money supply through open market purchases: it buys bonds. - When the Fed buys bonds from financial institutions, new money moves directly into the loanable funds market. - Since investment is a component of aggregate demand, an increase in the quantity of investment demand also increases aggregate demand. - Aggregate demand derives from four sources: C, I, G, and X - In the short run, expansionary monetary policy reduces unemployment (u) and increases real GDP (Y). In addition, the overall price level (P) rises somewhat as flexible prices increase in the short run. Contractionary monetary policy: occurs when a central bank takes action that reduces the money supply in the economy. - A central bank often undertakes contractionary monetary policy when the economy is expanding rapidly and the bank fears inflation. - The central bank reduces the money supply via open market operations: it sells bonds in the loanable funds market. - Selling the bonds takes funds out of the loanable funds market because the banks buy the bonds from the central bank with money they might otherwise lend out Why Doesn’t Monetary Policy Always work? The idea that the money supply does not affect real economic variables is known as monetary neutrality. Unexpected inflation harms workers and other resource suppliers who have fixed prices in the short run. Short-run aggregate supply shifts back when workers and resource suppliers expect higher future prices, since they do not want their real prices to fall. Phillips Curve Short-run inverse relationship between inflation and unemployment rates became known as the Phillips curve. Theory behind the Phillips curve relationship: monetary expansion stimulates the economy, and this outcome reduces the unemployment rate. Monetary policy can push the unemployment rate down, but only in the short run. Expansionary monetary policy can stimulate the economy and reduce unemployment—but only if it is unexpected.
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