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

2. Deficit and Debt

3. 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.

4. 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.

5. 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.

6. 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.

7. 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.

8. 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.

9. 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.

10. 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.

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

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

13. 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.

14. 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.

15. 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.

16. 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.

17. 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.

18. 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

19. 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.

20. 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.*

21. The central bank and the monetary transmission

22. 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.

23. 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.

24. 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.

25. 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.

26. 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.

27. 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.

28. 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.

29. 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.

30. 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

31. 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

32. 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.

33. 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.

34. 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.

35. 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.

36. 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

37. 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

38. 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.

39. 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.

40. 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