Why Government Is Involved in the
Economy And Social Welfare
1. Economic management
– a. Governments in all modern capitalist societies
play a substantial role in the management and
direction of their economies.
– b. Government responsibility for the national
economy is so widely accepted that national
elections are often decided by the voters’
judgment of how well the party in power is
carrying out this duty.
– c. Keynesian economic policy - The management
of aggregate demand.
Tools of Macroeconomic Policy
• Monetary policy — government policy to
influence interest rates and control the
supply of money in circulation, primarily
accomplished through the operations of
the Federal Reserve Board
• Fiscal policy — altering government
finances by raising or lowering
government spending, raising or lowering
taxes, and raising or lowering government
– Fiscal tools are not easy to use.
– Many issues come into play in setting
• Federal spending cannot be easily adjusted
up or down.
• Tax rates cannot be easily adjusted.
• Changes in spending and taxes take so long
to accomplish that there is danger that the
policies will be inappropriate by the time
they filter into the economy.
I. Fiscal Policy (Taxing and Spending)
A. Spending Policy
• In 2000: Defense (19%), Social Security
(21%), Medicare spending (13%), medicaid
(8%) and interest payments (13%) on past
borrowing. This makes 74% of the total
budget; the remaining 26% is allotted to
such things as housing, foreign aid, etc. (4
billion for housing and services for the
B. Taxation Policy
• 95% of the total, are individual
income taxes (46%), Corporate
income taxes (12%), payroll taxes for
Social Security and Medicare (34%),
and excise taxes on gasoline,
cigarettes and alcohol (3%). The
remaining 5% of taxes includes such
things as estate taxes, custom fees,
Death and Taxes
• Corporate taxes have been reduced to half of
what they were in 1960. Excise taxes have
reduced to a third and social insurance/payroll
taxes have doubled.
• 1. Progressive taxation
Taxpayers by 1993 adjusted share of Share of
income gross income AGI income
top 1% above $185,791 13.8% 28%
Top 5% above $87,154 27.8 47.3
top 10% above $66,196 39.1 58.8
top 25% above $41,192 62.5 79.2
top 50% above $21,158 85.1 95.2
bottom 50% below $21,158 14.9 4.8
Taxpayers by 2008 adjusted share of Share of
income gross income AGI AGI income
top 1% above $380,354 20% 38%
Top 5% above $159,619 34.7 58.7
top 10% above $113,799 45.8 70
top 25% above $67,280 67.4 86.3
top 50% above $33,04 87.3 97.3
bottom 50% below $33,04 12.8 2.7
2. Flat taxation - Would benefit the rich by far. Would
increase middle class tax rate. Unless all loopholes
3. Regressive taxation - lower-income earners pay
higher percentage (e.g. Payroll Taxes - Social
Security; sales taxes; some state income taxes)
“Who Pays? A Distributional Analysis of the Tax
Systems in All 50 States.” WA, FL, TN, SD, TX, IL,
MI, PA, NV& AL—states where families in the
bottom 20% of the income scale pay almost six times
as much of their earnings in taxes as do the wealthy.
4. Excise Taxes
5. Corporate Taxes - easy target for liberals
6. Loopholes for the wealthy and corporations (and
Tax Receipts as a % of GDP
The Federal Budget and Fiscal Policy
• Government spending
• Federal government spending in 1999
– Fourfold increase since 1960 in constant
– Expansion of federal outlays as a
proportion of GDP from 18% to about 19%
• 2010 federal outlays are 25% of GDP
The Deficit and the National Debt
• The budget deficit is the annual
shortfall between what the government
spends and what it takes in.
• The national debt refers to the total of
what the government owes.
C. Deficit and the National Debt
• The accumulated debt as a % of GDP in
1946 as 114%. This number fell to 46% in
1960 and to 26% by 1980. Deficits usually
were small when they accrued until a
reversal occurred, and the number rose to
37% in 1985 and to 52% in 1995. Then it
began to decline but went up during the
Afghan and Iraq war and continues to rise
during the recession and Obama’s stimulus
• Is debt bad?: Yes, No, Maybe
II. Monetary Policy - the value of currency
• The FED controls monetary policy, which refers broadly to
money, the interrelationship of money with the banking
system, and interest rates.
A. The Federal Reserve Board (FED)
• Quasi-public corporation - Chairman. Appointed - 4 year
term. Other members: 7 of the 12 Board of Governors are
appointed for one 14 year term; 5 are selected from the
regional Federal Reserve Banks
• Actions by the Fed affect how much money is available to
businesses and individuals in financial institutions.
• It influences interest rates and the money supply.
• How the Fed sets monetary policy
• Open market operations
• Discount rate
• Reserve requirements
B. Control of the money supply
1. First - What is money?:
– Economic Definitions of Money:
• M1: currency, traveler's checks,
checking accounts. Called narrow
money - 1/8 of GDP
• M2: Includes everything in M1, plus
savings accounts and money market
mutual funds. M2 = about 1/2 of the
• M3: Includes everything in M2, plus
cds and other deposits.
C. FED Tools to affect money supply
• 1. Reserve requirement: every bank is required to
keep some of its deposits on reserve at the central
bank; they do not receive interest on these
deposits. If this reserve requirement is raised, then
banks have less money to lend out and interest
rates will rise.
• 2. the discount rate: if a bank has loaned most of its
funds, it may not have enough on hand to deposit
wit the central bank to meet the reserve
requirement. If a bank needs or wished to borrow
from the central bank, then the interest rate that it
is charged is called the discount rate.
• 3. Open Market Operations: involve buying/selling
government securities and Treasury bonds. If the
Fed sells bonds to banks, then banks have the
bonds, but they also have less money (type M1) to
lend and will charge higher rates.
• 4. Movement of Checks: Fed is responsible for the
physical movement of checks through the clearing
D. Effects of Monetary Policy
• 1. Expansion of monetary supply will reduce
interest rates, stimulate aggregate demand in the
economy, create jobs and thus reduce cyclical
• 2. tighter monetary policy that reduces the money
supply will raise interest rates, reduce aggregate
demand, and reduce inflation.
• 3. Low and stable interest rates proved a good
framework for long-term investment decisions and
sustained economic growth
The FED and Democracy:
• The Fed has great power over the U.S.
economy, even over the world economy, yet
it is run by presidential appointees and
bankers, and its policy decisions are not
voted on by Congress or other publicly
elected officials. Although there are
plausible reasons for this lack of direct
democratic accountability, it is an ongoing
source of controversy.
• Why do we give the Fed authority it has?
Alternatives to an Appointed FED
• Democratic vote on monetary policy: no nation uses a
democratic, legislative vote to make monetary policy
decisions. The fear is that elected representatives
would find it nearly impossible to vote for higher
• Fixed rules: fixed rules as to when the money supply
would be allowed to grow (in accordance with the rate
in growth of the economy). But new financial
innovations (e.g., credit cards) have somewhat
scrambled the relationship between money & GDP, so
these rules look less reliable.
• Price stability: Congress or an elected body sets an
inflation target for the Fed or some other central bank
to meet. The central bank focuses only on the
inflation target and uses its tools to try and meet the
target. If I doesn't, its leaders can be dismissed.