Macroeconomics: Understanding the Difference between Fiscal Policy and Monetary Policy SSEMA2 Students will explain the role and function of the Federal Reserve System

Fiscal Policy Fiscal Policy- refers to governments taxing and spending policy, and how it affects the economy. 1. Expansionary Fiscal Policy (BAD TIMES)- government spends more money on goods and services- hopefully leads to more jobs a. Cut Taxes- lower taxes puts more money in consumers hands to spend and invest. b. Disposable Income- the income earned minus taxes can only spend what’s available c. Savings- unspent money 2. Contractionary Policy (GOOD TIMES)- government spends less, leads to slower GDP growth. a. Raise Taxes- raising taxes reduces income for businesses and consumers, slows GDP.

How Taxes Work Taxes- used by the federal government to pay for services and goods for Americans 1. Tax base- is the income, property, good, or service that is subject to a tax. Three Types of Taxes 1. Proportional tax- is a tax for which the percentage of income paid in taxes remains the same for all income levels. (SALES TAX) 2. Progressive tax- is a tax for which the percent of income paid in taxes increases as income increases. (INCOME TAX) 3. Regressive tax- is a tax for which the percentage of income paid in taxes decreases as income increases. (SOCIAL SECURITY/MEDICARE)

Impact of Fiscal Policies Limits to Fiscal Policy- 1. Difficulty of Changing Spending- small part of the budget 2. Predicting the Future- nobody understands the economy and its hard to react at the right time 3. Delayed Results- takes time for change to be felt 4. Political Pressure- Voters put pressure on representatives to reduce taxes and cut spending 5. Government Coordination- the different branches and services need to work together to implement good fiscal policies (IMPOSSIBLE)

The Federal Budget Budget Surplus- when the government taxes exceed government expenditures (costs). Balanced Budget- when taxes collected equal to government expenditures. Budget Deficit- When the government collects less taxes than its spends.

National Debt How does a government pay for Budget Deficits? 1. Borrow- government borrows money to pay for the deficit. 2. Sells: Government Securities known as: Treasury Bonds, Savings Bonds, etc… National Debt- is the total money owed by the government to anyone who owns a Treasury Bond or Savings Bonds. 1. Payback- We owe 11 trillion dollars and the interest we owe must be paid first and cuts out on the goods or services the government can provide. (education, defense, health care, etc…) Difference between National Debt and Budget Deficit- a deficit is one year, and the national debt is the total amount owed by the country.

Federal Reserve System Chaos- Before 1913 every bank could print its own money, which meant at anytime there could be lots of money or very little money available for businesses and people. Federal Reserve- established in 1913 to regulate the amount of money available in the economy. The Federal Reserve System Organization 1. Board of Governors- 7 member group that oversees the Federal Reserve and set monetary policy in the FMOC a. Chairman of the Federal Reserve- Ben Bernanke

Federal Reserve System 2. Federal Reserve Districts- 12 Federal Banks throughout the country that monitor and report on economic activity 3. Member Banks- all nationally chartered banks join the Federal Reserve and are partners allowing it to operate independently of the government. 4. FOMC- Federal Open Market Committee is composed of the Board of Governors and 12 District Banks

Structure of the Federal Reserve System 12 District Reserve Banks Federal Open Market Committee 4,000 member banks and 25,000 other depository institutions Board of Governors

The Federal Reserve as a server Federal Reserve serving the Government 1. Bonds- The Fed sells all U.S. bonds 2. Currency- The Fed prints all paper money Federal Reserve serving Banks 1. Checks- all checks are cleared through the Fed 2. Bank reserves- ensures that banks maintain 10% of all deposits to cover their customers. 3. Lender of Last Resort- in case of emergency (2008) the Fed will lend money to commercial banks to keep them afloat. 4. Problems- the Fed can force banks to sell risky investments if they are too exposed to too much liability

The Fed regulates the money supply MONETARY POLICY- changes in the supply of money and credit offered by the Federal Reserve. What affects the money supply? 1. Money- allows for easier transactions 2. Higher prices- as prices rise so does the demand for cash 3. Interest Rates- The price charged to borrow money, High Interest=decrease demand for cash. Low Interest=increase demand for cash 4. Home Income- as income rises so does the demand for more cash 5. Watching- The Fed watches the supply of money and the demand for money to keep inflation low.

First tool of the Federal Reserve The First Tool- Required Reserve Ratio 1. Required Reserve Ratio- the amount of money a bank must keep on hand and not loan out, set by the FED. 2. Reducing the RRR- lowering it allows banks to lend out more money. (MONEY SUPPLY INCREASES) 3. Increasing the RRR- raising it causes banks to keep more money on hand. (MONEY SUPPLY DECREASES)

Second Tool of the Federal Reserve The Second Tool- Discount Rate 1. Discount Rate- the interest rate banks pay to borrow money from The Fed. 2. Reducing the Discount Rate- makes it easier for banks to loan out money by making it cheaper for banks to borrow. (MONEY SUPPLY INCREASES) 3. Increasing the Discount Rate- makes it harder for banks to borrow money by making it more expensive to borrow money. (MONEY SUPPLY DECREASES)

Third Tool of the Federal Reserve The Third Tool- Open Market Operations 1. Open Market Operations- the buying and selling of government securities to alter the money supply. 2. Bond Purchaser- the Fed buys securities. (MONEY SUPPLY INCREASES) 3. Bond Seller- the Fed sells securities. (MONEY SUPPLY DECREASES)

Why does the Federal Reserve watch money? Money and Business Cycles- 1. EASY MONEY POLICY- During a bad economy The Fed will relax interest rates to increase spending, this EXPANDS the ECONOMY 2. TIGHT MONEY POLICY- The Fed will raise interest rates, to decrease spending and lower the money supply. This is to CUT OFF INFLATION 3. Timing- a. Right- the economy will go through peaks and contractions quickly and easily. b. Bad- The economy will go through extreme cycles of Expansions and Contractions

American Banking System Financial System- this is a system that transfers money between savers and borrowers Financial Middlemen 1. Banks- Take in deposits from savers and then lend some of these funds to various businesses. 2. Finance Company- Make loans to consumers and small businesses, but charge borrowers higher fees and interest rates to cover possible losses. 3. Mutual Funds- Pool the savings of many individuals and invest this money in a variety of stocks and bonds. 4. Life Insurance Companies- Provide financial protection for Life, Auto, Home, Disability. 5. Pension Funds- Are set up by employers to collect deposits and distribute payments to retirees

Savers make deposits to… Financial Institutions that make loans to… Financial Intermediaries Savers make deposits to… Commercial banks Savings & loan associations Savings banks Mutual savings banks Credit unions Financial Institutions that make loans to… Life insurance companies Mutual funds Pension funds Finance companies Investors

Services offered by Financial Institutions Savings- placed directly in an account with a bank it earns a little interest. 1. Safe- very safe since banks must keep a certain amount of RRR to pay on savings accounts. 2. Federal Deposit Insurance Company (FDIC)- government agency that insures up to 250k on all savings accounts. Interest- money banks pay on your savings accounts. 1. Interest Earned- amount paid on a bond, savings account, CD or stocks. 2. Interest Charged- amount you are charged by a bank when you borrow money for a car, house, student loan. THIS IS HOW BANKS MAKE MONEY.

Services cont’d… Certificate of Deposit (CD)- you deposit a fixed amount for a certain period of time, in exchange for a higher interest rate. 1. Safe- very safe no risks Bonds- are IOU’s that you buy from a corporation, organization or government. 1. Payment- the borrower pays you periodically interest on the loan and then repays you the entire loan on the due date, usually years later. 2. How are Bonds used? - Government uses them to pay other debts or public good projects. Corporations use them for capital investments. 3. Safe- very safe no risks

Services cont’d… Stocks- offer the biggest payouts but the highest risks 1. Safe- Very Risky can lose all your money 2. Capital Gains- if you sell your stocks at a profit you pay these taxes on the stocks sold. Mutual Funds- pools of money from many different investors to buy a large variety of stocks in a PORTFOLIO. 1. Safe- a combination of both High Risk and Low Risk stocks- Makes this safe 2. Why Buy- because of the mix investors almost never lose all their money

Becoming Creditworthy Are you creditworthy? 1. Work 2. Income 3. Savings 4. Current Expenses 5. How many people depend on you for their needs 6. Debt 7. Collateral- something the bank can take from you if you fail to repay your loan 8. Credit History- shows if you pay your bills 9. Credit Score- Higher it is the more likely a bank will lend you money and vice versa

$1,000 loan with 10% interest rate for a year= Interest Rates Annual Percentage Rate- the amount charged annually Fixed Interest Rates- never changes Variable Interest Rates- can go up at any time Simple Interest Rates- you are charged interest only on the original amount of the loan. $1,000 loan with 10% interest rate for a year= 1,000 + (.10 x 1000)= $1,000 + 100= $1,100 Let’s try another: $1,000 @ 10% interest for 2 years, remember to add a (.10 x 1000 for each year).

$1,000 loan with 10% interest rate for 2 years= Interest Rates Compound Interest Rates: interests is charged not only on the original amount you borrowed, but also on the amount you still owe. $1,000 loan with 10% interest rate for 2 years= 1st year: $1,000+ (.10 x 1,000)= $1,000 + 100= $1,100 2nd year: $1,000+ (.10 x 1,100)= $1,100 + $110= $1,210 Credit cards: use compounded interest rates but monthly, which causes people to owe more and more each month.