Economics for serious beginners Luxembourg 17 – 19 November 2014 CONTRACTOR IS ACTING UNDER A FRAMEWORK CONTRACT CONCLUDED WITH THE EUROPEAN COMMISSION

Deficit and Debt

Discretionary vs Automatic Rules governing taxes and some transfers act as automatic stabilizers, reducing the size of the multiplier and automatically reducing the size of fluctuations in the business cycle. In contrast, discretionary fiscal policy arises from deliberate actions by policy makers rather than from the business cycle.

Discretionary Fiscal Policy Making the Automatic Stabilizers More Effective Public Works The main fiscal policy to end the Depression was public works Transfer Payments The government could extend the benefit period for unemployment compensation and increase welfare payments, Social Security, and veteran’s pensions.

Discretionary Fiscal Policy Making the Automatic Stabilizers More Effective Changes in Tax Rates To fight inflation, the government can raise taxes To fight recession, the government can cut taxes Corporate incomes taxes can be raised during periods of inflation and lowered when recessions occur Using tax rate changes as a counter cyclical policy tool provides a quick fix, however, temporary tax cuts carried out during recessions should not become permanent.

Discretionary Fiscal Policy Making the Automatic Stabilizers More Effective Changes in Government Spending The government increases spending and cuts taxes to fight recessions The government decreases spending and raises taxes to fight inflation In brief, we fight recessions with budget deficits and inflation with budget surpluses.

The Deficit Dilemma Deficits, Surpluses, and the Balanced Budget When government spending is greater than tax revenue, we have a budget deficit The government borrows to make up the difference Deficits are prescribed to fight recession When the budget is in a surplus position, tax revenue is greater than government spending Budget surpluses are prescribed to fight inflation We have a balanced budget when government expenditures are equal to tax revenue We’ve never had an exactly balanced budget.

Why Are Large Deficits So Bad? Large deficits raise interest rates, which, in turn, discourages investment The government has become increasingly dependent on foreign savers to finance the deficit On the positive side, budget deficits stimulate the economy  John Maynard Keynes advocated running surpluses and paying off the debt during periods of prosperity.

Will We Be Able to Balance Future Budgets? A recession, a decline in stock prices, a tax cut, or an increase in government spending programs can easily eliminate any surpluses and replace them with deficits.

Should the Budget be Balanced? Most economists don’t believe the government should be forced to run a balanced budget every year because this would undermine the role of taxes and transfers as automatic stabilizers. Yet policy makers concerned about excessive deficits sometimes feel that rigid rules prohibiting—or at least setting an upper limit on—deficits are necessary.

Defining Surpluses and Debt A surplus is an excess of revenues over payments. A deficit is a shortfall of revenues over payments.

The Definition of Debt and Assets Debt is accumulated deficits minus accumulated surpluses. Deficits and surpluses are flow concepts. Debt is a stock concept.

Long-Run Implications Government budget accounting is calculated on the basis of fiscal years. Persistent budget deficits have long-run consequences because they lead to an increase in public debt.

The Public Debt Differentiating between the Deficit and the Debt The deficit occurs when government spending is greater than tax revenue The debt is the cumulative total of all the budget deficits less any surpluses.

Debt Burden Is the national debt a burden that will have to borne by future generations? As long as we owe it to ourselves, the answer is no If we did owe it mainly to foreigners, and if they wanted it paid off, it could be a great burden.

Difference Between Individual and Government Debt Paying interest on the internal debt involves a redistribution among citizens of the country. It does not involve a net reduction in income of the average citizen.

Difference Between Individual and Government Debt External debt – government debt owed to individuals in foreign countries. External debt is more like an individual’s debt.

Debt and Our Children In the future, even if we never pay back one penny of the debt, our children and our grandchildren will have to pay hundreds of billions of dollars in interest At least to that degree, the public debt will be a burden to future generations

Interest Rates and Debt Burden The interest rate determines annual debt service. The annual debt service is the interest rate on debt times the total debt.

Interest Rates and Debt Burden Interest payments on the debt is government revenue that cannot be spent on defense or welfare. That is what people mean when they say a deficit is burdening future generations.*

The central bank and the monetary transmission

The central bank acts as banker to the commercial banks in a country and is responsible for setting interest rates. Two key tasks: to issue coins and bank-notes to act as banker to the banking system and the government See the introduction to Chapter 23 and Section 23-1 of the main text.

Three ways in which the central bank MAY influence money supply: Reserve requirements The central bank sets a minimum ratio of cash reserves to deposits that commercial banks must meet Discount rate The interest rate that the central bank charges when the commercial banks want to borrow Setting this at a penalty rate may encourage commercial banks to hold more excess reserves Open market operations Actions to alter the monetary base by buying or selling financial securities in the open market See Section 23-2 of the main text.

The repo market A gilt repo is a sale and repurchase agreement e.g. a bank sells you a gilt with a simultaneous agreement to buy it back at a specified price at a specified future date. this uses the outstanding stock of long-term assets (gilts) as backing for new short-term loans See Box 23-1 in the main text.

Other functions of the Bank of England Lender of last resort the bank stands ready to lend to banks and other financial institutions when financial panic threatens Banker to the government the bank ensures that the government can meet its payments when running a budget deficit Setting monetary policy to control inflation See Section 23-2 and 23-3 in the main text.

The demand for money The opportunity cost of holding money is the interest given up by holding money rather than bonds. People will only hold money if there is a benefit to offset that opportunity cost. See Section 23-4 in the main text.

Motives for holding money Transactions payments and receipts are not perfectly synchronised: so money is held to finance known transactions depends upon income and payment arrangements Precautionary because of uncertainty: people hold money to meet unforeseen contingencies depends upon the (nominal) interest rate See Section 23-4 in the main text.

Motives for holding money (2) Asset people dislike risk so may hold money as a low-risk component of a mixed portfolio depends upon opportunity cost (the nominal interest rate) Speculative people may hold money rather than bonds if bond prices are expected to fall i.e. the interest rate is expected to rise depends upon the rate of interest and on expectations about bond prices See Section 23-4 in the main text. The speculative motive does not appear in the main text, but may be useful later in discussing the liquidity trap. NB Japan.

The demand for money: summary The demand for money is a demand for real money balances It depends upon: real income nominal interest rate (the opportunity cost of holding money) the price level (currently assumed fixed) expectations about future interest rates See Section 23-4 in the main text.

Money market equilibrium When money supply is L0, money market equilibrium occurs when the rate of interest is at r0. L0 r0 LL Interest rate See Section 23-4 in the main text, and Figure 24-2. Real money holdings

Monetary control LL L0 Given the money demand schedule: The central bank can ... Interest rate EITHER set the interest rate at r0 and allow money supply to adjust to L0 r0 OR set money supply at L0 and allow the market rate of interest adjust to r0 LL See Section 23-5 in the main text and Figure 23-3. L0 BUT cannot set both money supply and interest rate independently. Real money holdings

Monetary control – some provisos Monetary control cannot be precise unless the authorities know the shape and position of money demand and can easily manipulate the money multiplier. Controlling money supply is especially problematic this involves fixing the interest rate and accepting (ie supplying) the equilibrium level of money See Section 23-5 in the main text.

Targets and instruments of monetary policy Monetary instrument: the variable over which the central bank exercises day to day control e.g. interest rate Intermediate target the key indicator used as an input to frequent decisions about when to set interest rates The financial revolution has reduced the reliability of money supply as an indicator and central banks increasingly use inflation forecasts as the intermediate target See Section 23-6 in the main text.

The transmission mechanism … is the channel through which monetary policy affects output and employment. In a closed economy, monetary policy works through the impact on interest rates on consumption and investment demand. See Section 23-7 in the main text.

Consumption demand A simple version of the consumption function is: C = a + bYd monetary policy can affect a household wealth this is called a wealth effect the wealth effect occurs in two ways: See Section 23-7 in the main text and Section 20.1 of Ch 20.

Consumption demand - the wealth effect The wealth effect occurs in two ways: directly, through an increase in the real money supply (part of wealth is kept in the form of money) indirectly, through the effect of interest rates on share prices: as interest rates fall, the price of bonds and shares rises making stock holders feel wealthier. See Section 23-7 in the main text

Consumption demand - consumer credit and durable goods Consumption is affected by two aspects of consumer credit the quantity of credit: an increase in the quantity of credit increases a and vice versa the cost of credit: households will borrow less at higher interest rates thus reducing a and vice versa. See Section 23-7 in the main text

Investment demand Investment spending includes: fixed capital Transport equipment Machinery & other equipment Dwellings Other buildings Intangibles working capital stocks (inventories) work in progress See Section 23-7 in the main text. "Intangibles" includes investment in computer software etc.

The demand for fixed investment Investment entails present sacrifice for future gains firms incur costs in the short run but reap gains in the long run Expected returns must outweigh the opportunity cost if a project is to be undertaken so at relatively high interest rates, less investment projects are viable. See Section 23-7 in the main text.

The credit channel of monetary policy An emphasis of recent research has been on how the credit channel affects the real value of collateral and hence the supply of credit. There are two credit channels: changes in goods prices alter the real value of nominal assets policy induced changes in the interest rate alter the market value of assets which may be used as collateral. See Section 23-7 and Box 23-5 in the main text