Chapter 18
Economic
Policy
Government’s role in
the economy
TWO KEY QUESTIONS
• HOW MUCH RESPONSIBILITY DOES THE
GOVERNMENT HAVE TO KEEP OUR ECONOMY
HEALTHY?
• HOW MUCH POWER DOES THE
GOVERNMENT HAVE TO KEEP THE ECONOMY
HEALTHY?
Copyright © 2011 Cengage
U.S. Government and the
Economy: A Brief History
The Framers of the Constitution
wanted the government to have the
power to:
• promote free trade
• protect patents, copyrights and trademarks
• enforce contracts between individuals and
businesses
• build the infrastructure (roads, bridges,
canals, etc.) necessary to allow economic
growth.
Copyright © 2011 Cengage
U.S. Government and the
Economy: A Brief History
Constitutional provisions (Article I, Section 8)
• Lay and collect taxes and duties.
• Regulate interstate commerce.
• Coin money and regulate its value.
• Establish post offices and post roads.
• “Promote science and useful arts” by issuing
copyrights and patents.
Copyright © 2011 Cengage
U.S. Government and the
Economy: A Brief History
• Until the late 19th Century the U.S. the government
had a laissez-faire policy with no government
intervention.
• The government moved to break up monopolies in
the late 19th Century.
• The Great Depression resulted in a huge shift in
thinking about the relationship between government
and the economy.
• Roosevelt’s New Deal saw the federal government
take on responsibility for managing the economy.
Copyright © 2011 Cengage
The Business Cycle
•
The peaks and troughs of the business cycle
are normal but undesirable.
• What can/should the government do to
prevent highs and lows?
CARTER
REAGAN
BUSH 41
Copyright © 2011 Cengage
CLINTON
BUSH 43
Recession of 2007-2009
• Obama becomes president
• Congress passes stimulus
On the edge
of the abyss
Recession
begins
U.S. GDP growth 2008-2012
Obama
stimulus
Federal government deficit
1982-2012
Copyright © 2011 Cengage
Economic Policy
•
The Great Depression was the biggest
recession the U.S. has ever had.
• Recession (def): A period of reduced
production and increased unemployment.
• Since the Depression, the government has
tried two basic ways to avoid recessions and
prevent inflation.
Copyright © 2011 Cengage
Fiscal Policy
• The government attempts to
regulate the economy through
taxing and spending.
• The plan for taxing and spending
is the federal budget.
Copyright © 2011 Cengage
Fiscal Policy
• John Maynard Keynes was a
British economist who was
most influential during the
1930s.
• Basic idea: The government
assures the “right amount”
of demand in the economy.
• To stimulate the economy,
the government should
increase demand for goods
and services by spending
money on projects.
• His theories are called
Keynesian economics.
Economic downturn
Government should take
action
(“Stimulus” spending)
Increase in demand for all
goods and services.
Jobs created.
John Maynard Keynes
British Economist
1883-1946
Fiscal Policy
FDR’s New Deal was
an application of
Keynesian economics.
Fiscal Policy
The Obama stimulus plan was a 21st Century
application of Keynesian theory.
Supply side
economics
• Relies more on market
forces to stimulate
economy.
• Attempts to stimulate
the economy by cutting
taxes.
• High tax rates slow economic growth. People
and businesses work less, spend less, save
less, invest less.
• Cutting tax rates for the highest income
earners is most important.
Supply side
economics
Tax cuts for the wealthy.
The wealthy invest their
disposable income.
Businesses can expand, hire
more workers, increase
production.
Economy begins to grow.
More economic
activity = more tax
revenues.
Monetary
Policy
• The Federal Reserve is the “bank of banks.”
It is part of the federal government but is not
controlled by the President or Congress.
• The “Fed” controls the money supply by
raising and lowering interest rates.
• The “Fed” controls the money supply in
order to avoid recession and inflation.
Copyright © 2011 Cengage
Monetary
Policy
• The government tries to steer a course between
recession and inflation by controlling interest rates,
and thus the money supply.
• When interest rates are lowered, people borrow more
and banks lend more, the money supply increases and
the economy is stimulated.
• When interest rates are raised, the opposite happens.
• Ideally, the money supply grows at the same rate as
GDP.
Copyright © 2011 Cengage
The Machinery of Economic Policy
Making: The Executive Branch
COUNCIL OF ECONOMIC ADVISORS (CEA)
• Theoretically: three impartial professional
economists chosen by the president.
• Forecast economic trends, analyze economic
issues, prepare President’s economic report for
Congress.
• Tend to favor reliance on market forces.
Copyright © 2011 Cengage
The Machinery of Economic Policy
Making: The Executive Branch
OFFICE OF MANAGEMENT AND BUDGET (OMB)
• Chief function: prepare spending estimates of
federal departments and agencies.
• Also: ensure that the legislative proposals for
departments are in keeping with president’s
policy programs.
Copyright © 2011 Cengage
The Machinery of Economic Policy
Making: The Executive Branch
Jacob Lew
SECRETARY OF THE TREASURY
• Usually someone from the world of business of
finance.
• Expected to offer perspective of the private
financial sector.
• Provides estimates of federal tax revenues and
predicts impact of changes in tax policy.
Copyright © 2011 Cengage
The basic functions of the Department of the
Treasury include:
• Managing Federal finances
• Collecting taxes, duties and monies due to the U.S.
• Paying all bills of the U.S. government
• Currency and coinage
• Managing Government accounts and the public debt
• Supervising national banks and thrift institutions
• Advising the President and Congress on financial, monetary,
economic, trade and tax policy
• Enforcing Federal finance and tax laws
• Investigating and prosecuting tax evaders, counterfeiters, and
forgers
The Machinery of Economic
Policy Making: The Fed
• Board of Governors: Seven
members appointed by president to
14-year non-renewable terms.
• Chairman serves four-year,
renewable term.
Ben Bernanke, Chairman of the
Federal Reserve, speaks to a
congressional committee.
• Professional economists or bankers.
• Independent of president and
Congress.
• Regulates economy by controlling
the money supply (interest rates).
Copyright © 2011 Cengage
The Machinery of Economic Policy
Making: Congress
• Most important player in economic policy
making.
• Approves all taxes and almost all spending.
• Can alter powers of the Fed by passing laws.
• Especially influential to economic policy:




House and Senate Budget Committees
House and Senate Appropriations Committees
House Ways and Means Committee
Senate Finance Committee
The Machinery of Economic Policy
Making
CONGRESS
FEDERAL
RESERVE
PRESIDENT
Why is it important that the Federal Reserve be
independent of Congress and the President?
Copyright © 2011 Cengage
The Budget: Vocabulary




Budget – The government’s plan for raising
and spending money.
Fiscal Year – October 1 through the
following September 30 (federal)
Budget resolution – A congressional
decision that states the maximum amount of
money the government should spend
Entitlements - A claim for government funds
that cannot be changed without violating
the rights of the claimant
Copyright © 2011 Cengage
The Budget: Vocabulary



Mandatory spending – spending that is
required under law. Examples: entitlement
programs, veterans benefits, unemployment.
Discretionary spending – spending that must
be authorized each year. Examples: highway
construction, federal court system, scientific
research
Appropriations – money set aside for specific
purposes.
The Budget: Vocabulary


Deficit spending – when the government
spends more than it collects in revenues (in a
given fiscal year).
Federal debt – the total amount of money
owed by the federal government.
Federal Income Tax
Progressive tax: The higher the income and
ability to pay, the higher the tax rate.
Figure 18.5 Federal Taxes on Income,
Top Percentage Rates 1913-2002
Source: Updated from Congressional Quarterly Weekly Report (September 18, 1993), 2488.
Copyright © 2011 Cengage
Figure 18.4 Tax
Burdens in
Democratic Nations
(Taxes as a
Percentage of
Income of a Family
with Two Children)
Source: Statistical Abstract of the United
States, 2003, Table 1344.
Copyright © 2011 Cengage
The Federal Budget Process

Process could be:
1. How much money will we have?
2. How can we divide that much money on the
programs we need?

Instead, it is:
1. What programs do we need?
2. How do we get that much money?
The Federal Budget Process
President gives
instructions to
agencies after
consulting with
OMB.
Spring
Agencies work on
their budgets.
Executive Action
Summer
OMB begins
review of agency
proposals.
September
OMB prepares
final budget for
president.
December
The Federal Budget Process
President
submits budget
proposal to
Congress.
January
Congress adopts
budget
resolution.
April
Congressional Action
Congress
completes work
on appropriations
bills.
September
New fiscal year
begins.
October 1
FY 2015 Federal Budget

March 4: President Obama submits his
budget to Congress.
• $1 trillion in tax increases.
• Increase in spending on social programs.
• $0.4 billion less for military spending vs. 2014.
 April 1: House Budget Committee Chairman
Paul Ryan unveils Republican plan.
•
•
•
•

No tax increases.
Cuts in social programs.
Increase military spending.
Repeals Affordable Care Act.
April 27: House defeats Obama budget
413-2.
Figure 18.1 Federal Budget Deficit
(or Surplus)
Source: Budget of the U.S. Government, FY 2009 updated by OMB’s Mid-Session Review, July 2009 © 2003, AAAS.
Reprinted with permission
Copyright © 2011 Cengage
Figure 18.1 Federal Budget Deficit
Public support for deficit reduction proposals
The Politics of Economic Prosperity




Economic health creates majoritarian politics:
everyone wants a healthy economy.
Before an election, politicians worry about
pocketbook issues (economic conditions)
Lower income people worry about
unemployment; higher income people worry
about inflation.
Voting behavior and economic conditions are
strongly related. Voters care about the
national economy.
Copyright © 2011 Cengage
The Politics of Economic Prosperity


Politicians are motivated to take short-term
view of economic prosperity.
Ideally, they want to create low
unemployment and rising incomes before an
election.
Copyright © 2011 Cengage
The Politics of Economic
Prosperity
During the 1992 presidential race, Clinton
campaign director James Carville posted this
now famous sign in “the war room” to keep his
staff focused on the most important issue.