Unit 6


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Unit 6

  1. 1. Unit 6: What Are Taxes? <ul><li>Tax: A required payment to a local, state, or national government. </li></ul><ul><li>Revenue: Income received by a government from taxes and non-tax sources. </li></ul><ul><li>Tax and Revenue: Taxes and revenue allow a government to provide goods and services. </li></ul>
  2. 2. The Power to Collect Taxes <ul><li>In the United States was granted by Article 1, Section 8, Clause 1 of the Constitution. </li></ul><ul><li>The tax must be collected for the common defense and general welfare of the people of the United States. </li></ul>
  3. 3. Limits: <ul><li>Federal taxes must be the same in every state. </li></ul><ul><li>Church services are exempt under the First Amendment. </li></ul><ul><li>Exports can not be taxed but imports can be. </li></ul><ul><li>Taxes originally were divided equally based on population but with the Sixteenth Amendment income tax was created. </li></ul>16
  4. 4. The Tax Base <ul><li>The income, property, goods, and services that are subject to taxation. </li></ul><ul><li>Individual Income Tax: Taxation on individual earnings. </li></ul><ul><li>Sales Tax: Taxation on the dollar value of goods and services being sold. </li></ul><ul><li>Property Tax: Tax on the value of property. </li></ul><ul><li>Corporate Income Tax: Taxation on company profits. </li></ul>
  5. 5. Tax Structures <ul><li>Proportional Tax: Taxation is based on a certain percentage of income and is the same for all income levels. </li></ul><ul><li>Often called a flat tax. </li></ul>
  6. 6. <ul><li>Progressive Tax: Taxation in which the percentage of income paid is increased as income increases. </li></ul><ul><li>The United States has as progressive system with exemptions and that averages around 30% today. </li></ul>
  7. 7. <ul><li>Regressive Tax: Taxation in which the percentage of income paid is lowered as income increases. </li></ul><ul><li>The theory behind this is that the higher the income the more revenue collected via sales tax because individuals with wealth will spend it if they have it. </li></ul><ul><li>This has been called voodoo economics in the past. </li></ul>
  8. 8. Characteristics of a Good Tax <ul><li>Economists agree for a good and successful tax system a tax should have four key characteristics. </li></ul>
  9. 9. <ul><li>1. Simplicity </li></ul><ul><li>2. Efficiency </li></ul><ul><li>3. Certainty </li></ul><ul><li>4. Equity: Two theories to gauge fairness </li></ul><ul><li>Benefits Received </li></ul><ul><li>Ability to Pay </li></ul><ul><li>A good tax will generate enough revenue but not too much! </li></ul>
  10. 10. The Incidence of a Tax <ul><li>The final burden of tax and who bears it. </li></ul><ul><li>Policy makers must consider this. In many cases producers can “pass on” the burden. </li></ul><ul><li>A lack of consumer sensitivity to prices and inelastic demand results in consumers bearing the burden. </li></ul><ul><li>Sensitivity to prices and elastic demand results in producers and sellers bearing the burden. </li></ul>
  11. 11. Federal Taxes <ul><li>The US federal government has six major sources of tax revenue. </li></ul><ul><li>Individual Income Tax </li></ul><ul><li>Corporate Income Tax </li></ul><ul><li>Social Insurance Tax </li></ul><ul><li>Excise Tax </li></ul><ul><li>Estate Tax </li></ul><ul><li>Gift Tax </li></ul>
  12. 12. Individual Income Tax <ul><li>Tax levied on an individual’s income. </li></ul>
  13. 13. <ul><li>Pay As You Earn: Most citizens pay taxes throughout the year and either pay any additional taxes owed at the end of the or receive a return in mid April. </li></ul><ul><li>Withholding: Tax payments withheld from an individual’s pay. </li></ul><ul><li>Tax Return: Form used to file income taxes. </li></ul>
  14. 14. <ul><li>Taxable Income: Income on which tax must be paid. </li></ul><ul><li>It is taken from the total income minus exemptions and deductions. </li></ul><ul><li>Personal Exemptions: The amount subtracted from gross income for yourself, your spouse, and any dependents. </li></ul><ul><li>Gross Income: Total income. </li></ul>
  15. 15. <ul><li>Net Income: Income after taxes, exemptions, and deductions. </li></ul><ul><li>Deductions: Variable amounts that you can subtract or deduct from your gross income for such items as donations, mortgages, medical expenses, and state or local payments. </li></ul><ul><li>Tax Bracket: Since the US system is a progressive system the tax rate is the tax bracket an individual falls into based on income. </li></ul>
  16. 16. Corporate Income Tax <ul><li>Tax levied on a company’s profit and income. </li></ul><ul><li>Deductions: Variable amounts that can be subtracted or deducted from profit for such items as health insurance for employees. </li></ul><ul><li>Progressive Tax: Like personal income tax corporate tax is progressive. </li></ul>
  17. 17. Social Insurance Tax <ul><li>Taxes authorized for services that fall under the Federal Insurance Contributions Act (FICA). </li></ul>
  18. 18. Social Security <ul><li>Old age, survivor, and disability insurance. </li></ul><ul><li>Established in 1935 it was created as a retirement fund to provide supplement benefits and was expanded to aid surviving family members and the disabled. </li></ul>
  19. 19. Medicare <ul><li>National health insurance program for individuals over 65 or with certain disabilities. </li></ul>
  20. 20. Unemployment Taxes <ul><li>Collected from businesses this tax aids workers who are jobless through no fault of their own and are actively looking for work. </li></ul>
  21. 21. Excise Tax <ul><li>Tax on the sale or manufacture of a good. </li></ul><ul><li>Items such as cable television, gas, and telephone services fall under excise tax. </li></ul>
  22. 22. <ul><li>A form of excise tax is Sin Tax. </li></ul><ul><li>It is a tax on goods such as alcohol and cigarettes that have what are considered to negative impacts on society. </li></ul>
  23. 23. Estate Tax <ul><li>Tax on the estate of an individual who has died and willed the money to others. </li></ul><ul><li>It is based on the total value of all money and property of the deceased. </li></ul>
  24. 24. Gift Tax <ul><li>Tax on money or property one living person gives to another. </li></ul>
  25. 25. Other Issues <ul><li>Tariffs: Tax on imported goods. </li></ul><ul><li>Tax Incentive: Use of taxation to encourage or discourage certain behaviors or ventures. </li></ul><ul><li>Value Added Taxes (VAT): A VAT taxes each step of production and the tax is added into the final price of a good. </li></ul><ul><li>Many European countries use VAT systems. </li></ul>
  26. 26. Federal Spending <ul><li>The goods and services the government spends your taxes on. </li></ul>
  27. 27. Mandatory Spending <ul><li>Spending on payment of the national debt, social insurance, and certain entitlement programs that is mandated or required by existing laws. </li></ul><ul><li>Entitlement programs are social welfare programs that certain people are entitled to if they meet certain requirements. </li></ul><ul><li>All citizens receive benefits from social insurance but not all will receive entitlements. </li></ul>
  28. 28. <ul><li>Social Security: Falls under social insurance taxation. </li></ul><ul><li>Medicare: Falls under social insurance taxation. </li></ul><ul><li>Medicaid: Medical benefits and assistance for people and families with low incomes. </li></ul><ul><li>Falls under entitlements. </li></ul><ul><li>Unemployment Tax: Falls under social insurance. </li></ul><ul><li>Other mandatory spending includes food stamps, Supplemental Security Income (SSI), child nutrition, retirement benefits and insurance for federal workers, and veteran pensions and benefits. </li></ul>
  29. 29. Discretionary Spending <ul><li>Spending about which government planners can make decisions and choices. </li></ul>
  30. 30. <ul><li>Defense and law enforcement </li></ul><ul><li>Education and training (includes student loans for example) </li></ul><ul><li>Research (science and tech) </li></ul><ul><li>National parks and monuments </li></ul><ul><li>Housing and land management </li></ul><ul><li>Aid to state and local governments </li></ul><ul><li>Environment and disaster clean up and aid </li></ul><ul><li>Farm subsidies </li></ul><ul><li>Foreign aid and loans </li></ul><ul><li>Transportation </li></ul>
  31. 31. State and Local Government Taxation and Spending <ul><li>Like the federal government state and local governments use revenue to pay for a variety of programs and services. </li></ul><ul><li>In general states spend the largest amounts on grants to local governments, education, and public welfare. </li></ul>
  32. 32. State Budgets <ul><li>The federal government has just one budget for all kinds of spending but states have two budgets. </li></ul><ul><li>They are operating and capital budgets. </li></ul>
  33. 33. Operating Budget <ul><li>Budget for day to day expenses. </li></ul><ul><li>These expenses included the salaries of state employees, supplies, and the maintenance of facilities and parks. </li></ul>
  34. 34. Capital Budget <ul><li>for major capital or investment expenditures. </li></ul><ul><li>Most of the money for this budget comes from bonds and borrowing. </li></ul>
  35. 35. Balanced Budget <ul><li>Unlike the federal government states have laws that require a balanced budget, or a budget in which the revenues are equal to spending. </li></ul><ul><li>For every dollar the state spends it must take in a dollar in revenue. </li></ul>
  36. 36. Where State and Local Government Taxes are Spent <ul><li>Education </li></ul><ul><li>Public Safety and Law Enforcement </li></ul><ul><li>Highways and Transportation </li></ul><ul><li>Public Welfare and Works </li></ul><ul><li>Arts and Recreation </li></ul><ul><li>Administration, Elections, and Record Keeping </li></ul>
  37. 37. Tax Exempt <ul><li>The federal Constitution and state constitutions limit taxation. </li></ul><ul><li>Many things are exempt from taxation. </li></ul><ul><li>For example states can not tax federal property, imports, exports, goods sent between states, nonprofit organizations, religious groups, and charities. </li></ul>
  38. 38. Sources of Revenue for States and Local Governments <ul><li>Sales Tax: Tax on the sale of goods and services and the number one source of state revenue. </li></ul><ul><li>State Income Tax: Some states tax income. </li></ul><ul><li>Corporate Tax: Most states and local governments tax business profit and income. </li></ul>
  39. 39. <ul><li>Property Tax: Taxation on property by states and local governments. </li></ul><ul><ul><li>Real Property: Physical property such as land and buildings. </li></ul></ul><ul><ul><li>Personal Property: Possessions such as jewelry, furniture, and boats. </li></ul></ul><ul><ul><li>Tax Assessor: Official who determines the value of property. </li></ul></ul><ul><li>License Fees </li></ul><ul><li>Transfer Tax: Tax on the transfer on documents and stock certificates. </li></ul>
  40. 40. <ul><li>Severance Tax: Tax on natural resources and resource use. </li></ul><ul><li>State Estate and Inheritance Tax </li></ul><ul><li>Payroll Taxes: Taxes taken out of payrolls for services in a city by a local government. </li></ul><ul><li>Individuals might work in one city and have payroll tax taken out of wages and live in another city causing controversy </li></ul><ul><li>Tourist and Traveler Tax </li></ul>
  41. 41. Fiscal Policy <ul><li>The federal government takes in money for the budget through taxation and borrowing. </li></ul><ul><li>The decisions the government makes about taxing and spending can have a powerful impact on the overall economy. </li></ul><ul><li>This unit will look at fiscal policy and this impact. </li></ul>
  42. 42. <ul><li>Fiscal policy is the use of government spending and revenue collecting to influence the economy. </li></ul><ul><li>Fiscal policy is a tool used by the government to try and achieve economic growth, full employment, and price stability and the flow of cash into and out of the economy. </li></ul><ul><li>Fiscal policy has a large impact on aggregate demand and supply. </li></ul><ul><li>These decisions are made each year during the creation of the federal budget. </li></ul>
  43. 43. Federal Budget <ul><li>A plan for the federal government’s revenues and spending for the coming fiscal year. </li></ul><ul><li>It lists expected income and shows exactly how the money will be spent. </li></ul>
  44. 44. Fiscal Year <ul><li>A twelve month period that can begin on any date. </li></ul><ul><li>The government’s economic fiscal year is from October 1 through September 30. </li></ul>
  45. 45. The Process of the Federal Budget <ul><li>Each federal agency writes a detailed estimate on how much it plans to spend in a coming fiscal year. </li></ul>
  46. 46. <ul><li>The proposals are sent to the executive branch and the Office of Management and Budget (OMB) prepares the budget. </li></ul>
  47. 47. <ul><li>The President presents the budget to congress in January or February. </li></ul>
  48. 48. <ul><li>The Congressional Budget Office (CBO) reviews the budget and collects economic data. </li></ul>
  49. 49. <ul><li>The House and Senate Budget Committee’s then review and work on the budget. </li></ul><ul><li>Budget resolutions, spending limits, and changes are presented by May 15 for a first draft. </li></ul><ul><li>A second round of review and work begins and results are due by September 15. </li></ul>
  50. 50. <ul><li>Appropriation Committee’s in both the House and Senate begin to submit bills to authorize specific spending. </li></ul><ul><li>Appropriation bills setting money aside for specific spending with limits are created and must be passed by September 30. </li></ul>
  51. 51. <ul><li>If Congress can not finish the work by September 30 short term emergency “stop gap funding” will be passed to keep the government running and special sessions will be set up. </li></ul>
  52. 52. <ul><li>Once the bills are complete they are sent to the President for approval or veto. </li></ul><ul><li>If a veto occurs Congress can attempt to override the veto through a voting process. </li></ul>
  53. 53. Types of Fiscal Policies <ul><li>Expansionary Policies: Policies that encourage economic growth. </li></ul><ul><li>Often higher spending and tax cuts are used. </li></ul><ul><li>Contractionary Policies: Policies that encourage reduced growth and economic slow down. </li></ul><ul><li>Often higher taxes and lower spending are used. </li></ul>
  54. 54. Limits of Fiscal Policies <ul><li>Fiscal policy is not a cure all and they can be difficult to put into practice. </li></ul>
  55. 55. <ul><li>Spending level changes are often met by major resistance by consumers of the federal budget. </li></ul><ul><li>Nobody wants a decrease in what they get and everybody tends to want more. </li></ul><ul><li>Predicting the future is impossible and decisions are based on past performance and every year’s performance is different. </li></ul>
  56. 56. <ul><li>Results are delayed and it can take years to feel the impact from a fiscal policy change. </li></ul><ul><li>Political pressure and partisanship make the process difficult. </li></ul><ul><li>Coordination and getting all levels of government and the states to work together is difficult. </li></ul>
  57. 57. Fiscal Policy Options and the Theories That Create Them <ul><li>Economists use economic theories to help create fiscal policies. </li></ul><ul><li>Several schools of economic thought are often suggested and put into practice in the United States. </li></ul>
  58. 58. Classical Economics <ul><li>The idea that free markets can regulate themselves. </li></ul>
  59. 59. <ul><li>Adam Smith, David Ricardo, and Thomas Malthus are the main economists whose works are the basis of classical economic theory. </li></ul>
  60. 60. <ul><li>Smith wrote “Wealth of Nations” in 1776 promoting the laissez faire approach that governments should not interfere in the market and the market will reach equilibrium on its own. </li></ul>
  61. 61. <ul><li>Classical economists also focused on how to encourage savings and investment in order to increase growth over the long term. </li></ul><ul><li>Many economists began to explore other options and this theory fell out of favor with the Great Depression. </li></ul><ul><li>The long run was considered too long and people and the government wanted a quicker return to prosperity. </li></ul>
  62. 62. Keynesian Economics <ul><li>John Maynard Keynes published “The General Theory of Employment, Interest, and Money” in 1936. </li></ul>
  63. 63. <ul><li>Keynes felt classical theory was failing in the era of the Great Depression and felt you could not wait around for the economy to fix itself in the long run. He stated “in the long run we are all dead.” </li></ul>
  64. 64. <ul><li>He focused on short run issues and felt the classical view only worked when the economy was running at full potential and at productive capacity. </li></ul><ul><li>He felt when the economy was in a rut the government must take an active role in encouraging aggregate demand by increase spending or decreasing taxes to jump start the economy. </li></ul><ul><li>When things improve a shift back to classical approaches could be acceptable but he viewed the economy and markets as inherently unstable and still favored government involvement. </li></ul>
  65. 65. <ul><li>He believed the “Paradox of Thrift” resulted in saving not equaling investment. </li></ul><ul><li>He felt many firms reduced investment plans in problem times or when the possibility of problems existed and would simply hold onto money. </li></ul><ul><li>This would result in decreased production and the government needed to provide incentives that would cause firms to increase activity. </li></ul><ul><li>This led to demand side economics and the idea that government spending and tax cuts help an economy and raise demand. </li></ul>
  66. 66. <ul><li>Keynes also felt his theories could be used to combat recession and inflation. </li></ul><ul><li>The multiplier effect, or the idea that every dollar of government spending creates more than one dollar of economic activity, is key to the Keynesian view and automatic stabilizers, or government programs that change automatically depending on GDP and personal income, are key tools. </li></ul>
  67. 67. Supply Side Economics and the Trickle Down Effect <ul><li>Supply Side Economists favor aggregate supply growth over Keynesian aggregate demand growth. </li></ul><ul><li>The focus is on tax cuts only and government spending should not be used as a tool. </li></ul>
  68. 68. <ul><li>Tax cuts are viewed to raise demand because businesses keep more money and do more. </li></ul><ul><li>High taxes are considered discouraging and historically when taxes are low more revenue is collected by the government. </li></ul>
  69. 69. Arthur Laffer used the Laffer Curve to illustrate this concept.
  70. 70. <ul><li>Tax cuts also were theorized to result in workers putting in more hours because they get to keep more of their money. </li></ul><ul><li>In the 1980’s under President Regan this theory was pushed to fight an economic recession. </li></ul><ul><li>The economy did recover but the problem was government spending increased with Regan, Bush, and Clinton. In fact federal debt grew. </li></ul>
  71. 71. <ul><li>Historically Keynesian policies have worked the best. </li></ul>
  72. 72. Debt and Deficit Defined <ul><li>Balanced Budget: A budget in which revenues are equal to spending. </li></ul><ul><li>Budget Surplus: A situation in which the government takes in more than it spends. </li></ul><ul><li>Budget Deficit: A situation in which the government spends more than it takes in. </li></ul><ul><li>Hyperinflation: Very high inflation. </li></ul>
  73. 73. <ul><li>National Debt: All the government owes to bondholders. </li></ul>
  74. 74. The Debt vs. Deficit <ul><li>The debt is the sum of all borrowing and the total of all deficits and surpluses over the years. </li></ul><ul><li>The deficits and surpluses are yearly accounts. </li></ul><ul><li>Currently we have a large debt and carry a deficit. </li></ul><ul><li>A few years ago we had a large debt but ended up with surpluses in several fiscal years. </li></ul><ul><li>These surpluses were used to counter 9/11 and to fund the war on terrorism. </li></ul><ul><li>The debt is in the trillions now. </li></ul>
  75. 75. Problems with the Debt <ul><li>Overall Keynesians do not view debt as a major problem provided it is not carried too long and does not spiral out of control. </li></ul><ul><li>The current fear is that this is where we are heading. </li></ul>
  76. 76. Other Problems with Debt <ul><li>Crowding out effect: The loss of funds for private investment due to government borrowing. </li></ul><ul><li>Less money is available. </li></ul><ul><li>Servicing the debt: Interest payments are becoming too large and it is eating up available money. </li></ul>
  77. 77. The Fed <ul><li>The Federal Reserve System was created by the Federal Reserve Act of 1913 in response to the central bank debate discussed in chapter 10 section </li></ul>
  78. 78. <ul><li>In 1913 President Wilson’s Federal Reserve Act created the Federal Reserve System. This became the nation’s central banking system. A central bank could lend money to banks in times of need to try and keep them from failing and help build confidence and trust in banks. In other words it was a banker’s bank and a lender of last resort . </li></ul>
  79. 79. Issues: <ul><li>12 regional Federal Reserve Banks were created throughout the country to help bring about organization and stability. </li></ul><ul><li>A Federal Reserve Board of Governors appointed by the President runs the system. There are seven governors who serve staggered non renewable turns where every two years a member rotates out. (14 year terms) </li></ul>
  80. 80. <ul><li>Each bank can issue short-term loans to banks in need. </li></ul><ul><li>The Fed controls the amounts of currency in circulation and can up it and lower it as needed. </li></ul><ul><li>They impact the money supply greatly. </li></ul><ul><li>The Federal Open Market Committee (FOMC) is made up of the seven board of governor members and five of the presidents selected from the twelve banks. </li></ul><ul><li>Four of the presidents rotate out and the New York President is always on the committee because of Wall Street. (This is the key policymaking body of the Fed) </li></ul>
  81. 81. <ul><li>The research arm of the Fed is the Federal Advisory Council (FAC). </li></ul><ul><li>Information about the economy and its health is then presented to the Board of Governors which meets by law four times a year. </li></ul>4
  82. 82. <ul><li>Members from the Board of Governors who sit on the FOMC will present data and advice and decisions are made about what actions should be taken by the Fed. </li></ul><ul><li>These decisions deal with the money supply and interest rates. </li></ul><ul><li>The FOMC meets around eight times a year. </li></ul>
  83. 83. <ul><li>The chair of the Board of Governors will announce the decisions and conclusions reached by the Fed. </li></ul>
  84. 84. <ul><li>The most well known chair in recent history was Alan Greenspan who took office in 1987. </li></ul><ul><li>He served both Democrat and Republican administrations through the longest period of economic growth in US history. </li></ul><ul><li>He raised interest rates in the 1980’s to halt high inflation and managed small rate adjustments to drive the course of the economy throughout his career. </li></ul>
  85. 85. <ul><li>The current chair of the Fed is Ben Bernake. </li></ul>
  86. 86. <ul><li>The day to day operating centers of the Fed are the 12 regional banks located in: </li></ul>
  87. 87. <ul><li>Boston </li></ul><ul><li>New York </li></ul><ul><li>Philadelphia </li></ul><ul><li>Cleveland </li></ul><ul><li>Richmond </li></ul><ul><li>Atlanta </li></ul><ul><li>Chicago </li></ul><ul><li>St. Louis </li></ul><ul><li>Minneapolis </li></ul><ul><li>Kansas City </li></ul><ul><li>Dallas </li></ul><ul><li>San Francisco </li></ul>
  88. 88. <ul><li>More districts are located east of the Mississippi River due to the distribution of the population when the system was created. </li></ul>
  89. 89. The Functions of the Fed <ul><li>Provides banking and fiscal services to the federal government. </li></ul>
  90. 90. <ul><li>It is the US government’s banker and maintains the checking account for the Treasury Department. </li></ul><ul><li>It acts as the financial agent for the Treasury Department selling, transferring, and redeeming government bonds. </li></ul><ul><li>It also makes interest payments on these securities. </li></ul><ul><li>It is the only legal body that can issue money through the United States Mint run by the Treasury Department. Money is designed and printed at the bureau of Engraving. </li></ul>
  91. 91. Provides banking services to member and nonmember banks. <ul><li>Check Clearing: The process by which banks record whose account gives up money and whose account receives money when a customer writes a check. </li></ul>
  92. 92. <ul><li>It supervises lending practices and financial activities of banks and studies proposed mergers and other activities. </li></ul><ul><li>It also regulates banks and bank holding companies, or companies that own more than one bank. </li></ul><ul><li>It protects consumers by enforcing truth in lending and through consumer education. </li></ul>
  93. 93. <ul><li>It is a lender of last resort that allows other banks to borrow funds in times of need. </li></ul><ul><li>The discount rate is the amount of interest the Fed charges for these loans. </li></ul><ul><li>When banks loan each other money they charge a federal fund rate, only the fed charges a discount rate. </li></ul>
  94. 94. The Fed regulates the banking industry. <ul><li>Banks are required under the fractional reserves system to hold funds in reserve and must continually report this information to the Fed. </li></ul><ul><li>The Fed conducts regular bank examinations and financial reviews to makes sure banks are following the law. </li></ul><ul><li>The Fed does this by conducting surprise visits and examining records and books. </li></ul><ul><li>The net worth, or total assets minus total liabilities, will be calculated and examined. </li></ul>
  95. 95. <ul><li>The Fed regulates the money supply and sets interest rates. </li></ul>
  96. 96. The Goal of the Fed <ul><li>To regulate the money supply, keep banks honest and in business, stabilize the economy, and promote full employment and economic growth. </li></ul>
  97. 97. Monetary Policy Tools of the Fed: What do they do and how does it work.
  98. 98. Money Creation <ul><li>The process by which money enters into circulation. </li></ul><ul><li>*This does not mean printing money; it is how it gets out in the economy and does its thing! </li></ul><ul><li>We are talking about the expansion of credit and debt and deposit creation. </li></ul>
  99. 99. <ul><li>Money creation occurs because banks go about their business. </li></ul><ul><li>They take in deposits and keep some of them based of the required reserve ratio (RRR) dictated by the Fed. </li></ul>RRR!
  100. 100. <ul><li>The RRR is the money held onto by banks to cover withdraw needs. </li></ul><ul><li>The rest of the money is loaned out creating economic activity. </li></ul><ul><li>If you only were dealing with one deposit the amounts you could loan from it would be small, but multiple deposits are put together and loaned out. </li></ul>RRR!
  101. 101. <ul><li>Example: Tommy deposits $1000 into Greedy National Bank. </li></ul><ul><li>The RRR is 10%. </li></ul><ul><li>Greedy National Bank keeps $100 in reserve. </li></ul><ul><li>Greedy National Bank loans Peter $900. </li></ul><ul><li>Peter buys a $900 engine for his car from Bart. </li></ul><ul><li>Bart deposits the money in Fleece Bank. </li></ul><ul><li>Fleece Bank keeps $90 in reserve. </li></ul><ul><li>Fleece loans Gomer $810 for a scuba suit. </li></ul><ul><li>The $900 loan and the $810 loan combined equal $1710. </li></ul><ul><li>The money supply overall was increase by $1710 through this process. </li></ul>RRR!
  102. 102. <ul><li>Money Multiplier Formula: The amount of new money that will be created with each demand deposit is calculated as 1/RRR </li></ul>1/ RRR
  103. 103. <ul><li>Increase in Money Supply Formula: </li></ul><ul><li>Increase in Money Supply = initial cash deposit x 1/RRR </li></ul><ul><li>Excess Reserves: Many banks will hold more money than is required by Fed. </li></ul>RRR 1/ x cash &quot;D&quot; = &quot;MS&quot;
  104. 104. <ul><li>RRR Requirement Changes: </li></ul><ul><li>Reducing the RRR increases the money supply. </li></ul><ul><li>Increasing the RRR decreases the money supply. </li></ul>
  105. 105. <ul><li>Discount Rate Changes: The discount rate is the interest rate the Fed charges banks. Changes in this rate will also impact the prime rate banks charge. </li></ul><ul><li>A prime rate is a discounted interest rate a bank will charge on short term loans to its best customers (usually a large business). </li></ul><ul><li>Reducing the Discount Rate increases the money supply. </li></ul><ul><li>Increasing the Discount Rate decreases the money supply. </li></ul>
  106. 106. Open Market Operation <ul><li>The buying and selling of government securities by the Fed. </li></ul>
  107. 107. <ul><li>If the Fed purchases bonds off the open market the money supply will increase because bond sellers will be putting deposits into banks. </li></ul>
  108. 108. <ul><li>If the Fed sells bond on the open market the money supply will decrease because money is going out of banks to buy the bonds and is out of circulation and out of reserve. </li></ul>
  109. 109. This is the most used tool for money creation.
  110. 110. Monetary Policy and Macroeconomic Stabilizers <ul><li>When is it time for the Fed to act? </li></ul>
  111. 111. Monetarism <ul><li>The belief that the money supply is the most important factor in macroeconomic performance. </li></ul>
  112. 112. Easy Money Policy <ul><li>Policy that increases the money supply with the goal of stimulation or expanding of the economy in times of contraction. </li></ul><ul><li>This tends to lead to lower interest rates and increased investment spending. </li></ul><ul><li>The danger inherent to this policy is that it can encourage over borrowing and over investment followed by a layoffs and cutbacks. </li></ul><ul><li>A successful policy will result in an increase in aggregate demand and real GDP. </li></ul>
  113. 113. Tight Money Policy <ul><li>Policy that decreases the money supply with the goal of slowing down the economy in times of inflation. </li></ul><ul><li>This tends to lead to higher interest rates and reduced investment spending. </li></ul><ul><li>The danger inherent to this policy is that it can cause as drop in real GDP and decreased aggregate demand. </li></ul>
  114. 114. Timing <ul><li>These policies must be carefully timed to help the macro economy. </li></ul><ul><li>Good timing will result in stabilization and a smoothing of the economy. </li></ul><ul><li>Bad timing will make the bad worse and longer. </li></ul><ul><li>Inside Lag: A delay in implementing a monetary policy. </li></ul><ul><li>Outside Lag: The time it takes monetary policy to work. </li></ul><ul><li>Traditional Self Correction View: Traditional laissez faire economists will prefer to allow for self correction. </li></ul>
  115. 115. The Bottom Line <ul><li>Expansionary Tools: Increased government spending, cutting taxes, open market operations bond purchasing, decreased discount rates, decreased RRR. </li></ul><ul><li>Contractionary Tools: Decreased government spending, raising taxes, open market operation bond sales, increased discount rates, and increased RRR. </li></ul>