Chapter 16: Economic Policy

Chapter 16

Economic Policy

Chapter Summary

Good Times, Bad Times

Like any economy that is fundamentally capitalistic, the U.S. economy experiences ups and down. Two key issues that influence these ups and down are unemployment and inflation. See Figure 16-1 and Figure 16-2for a look at historic levels of unemployment and inflation. These ups and downs are usually referred to as business cycles. See Figure 16-3for a look at national business activity.

Fiscal Policy

One of the government policy options to smooth out the economy is fiscal policy. Changes in taxes are sometimes part of an overall fiscal policy change. A fiscal policy is the use of government spending or taxation to alter the national economy. One approach to fiscal policy is to use government funds to stimulate economic activity in a recession by increasing expenditures and decreasing taxes. Known as Keynesian economics, this policy grew out of the theories of the English economist John Maynard Keynes. Conversely, during inflation, the government should reduce spending and increase taxes to balance the economy. Until the late 1990s, the federal government ran a deficit in every year except two since 1960. A deficit results from spending more than revenues allow and issuing U.S. treasury bonds to borrow the difference.

The accumulation of all past deficits is known as the national debt or public debt and has been a major policy issue. While the government cannot go bankrupt as long as it makes interest payments, public debt financing by selling bonds can “crowd out” private borrowing and slow the rate of economic growth. See Figure 16-4 for a look at public debt as a percentage of national output. See Table 16-1for net public debt totals. In 2001, the economy was beginning a recession, when terrorists attacked the Pentagon and the WorldTradeCenter towers. Government expenditures increased dramatically and federal government deficits returned.

Monetary Policy

Monetary policy is also used to alter the economy by controlling the amount of money in circulation, which can affect interest rates, credit, inflation, and employment. Monetary policy works in a similar way to fiscal policy. In times of recession, the economy is stimulated by a greater supply of money and credit. With inflation, the money supply, and hence credit, is reduced to bring down the level of economic activity. The Federal Reserve System, sometimes called the Fed and created in 1913, largely carries out monetary policy. The chairperson of the system usually speaks for the entire board. The Fed and its Federal Open Market Committee (FOMC) make decisions about monetary policy eight times a year. Although monetary policy can be implemented much quicker than fiscal policy, it still seems to take over a year to affect the economy. In recent years the Fed’s record has been mixed at best, as some actions seem to have affected the economy in an adverse way.

World Trade

In recent years world trade has become an important economic issue in the United States. In recent decades Japan, the European Union, and other nations of the Pacific Rim have challenged U.S. dominance in the global marketplace. The protection of American jobs against “slave” wages in developing countries is a key issue. See Figure 16-5for the growth of world trade. The creation of the World Trade Organization in 1997 has intensified the concern about the globalization of trade. The large balance of trade deficit of the U.S. adds to these concerns. See Figure 16-6for a look at the balance of trade deficit since 1960.In the late 1990s many of the Asian and European economies were stagnating. Clearly, the United States remains among the premier world economic powers but can no longer take this position for granted.

The Politics of Taxes

Americans pay a variety of different taxes. See Figure 16-7on how the U.S. ranks with other countries in the percent of taxes. Individuals and corporations facing high taxes will have a big incentive to find or add loopholes to the tax laws. See Table 16-2for 2006 tax rates. Tax cuts have been a major part of President Bush’s plan to stimulate the economy. See Table 16-3for the progressive or regressive nature of different taxes.

The Social Security Problem

The question of taxes in America always raises a discussion of the Social Security tax. The tax on employees and employers is a regressive tax in which people with higher incomes pay lower tax rates than people with lower incomes. The program is basically a pay-as-you-go transfer system in which those who are working pay benefits to those who are retired. The number of people working is declining relative to the number of people retiring and the large numbers of the baby boom generation will bankrupt the current system when they retire in the twenty-first century. See Figure 16-8on the number of workers per retiree. Numerous proposals to save the Social Security system have focused on allowing individuals to make private investments of social security taxes. George W. Bush’s plan to partly privatize Social Security floundered as the public expressed its distrust and dissatisfaction. No policy decision has been made, but a decision must be made, as nothing can be done to stop the aging of the population.

Key Terms

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Chapter 16: Economic Policy

balance of trade

budget deficit

Federal Reserve System

fiscal policy

gross domestic product

inflation

Keynesian economics

monetary policy

net public debt

progressive tax

regressive tax

tariffs

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Chapter 16: Economic Policy

OTHER RESOURCES

A number of valuable supplements are available to students using the Schmidt, Shelley, and Bardes text. The full list of the supplements is in the preface to this study guide. Ask your instructor how to obtain these resources. One supplement is highlighted here, the INFOTRAC Online Library.

INFOTRAC EXERCISES

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“Bush Bilks the Elderly”

The premise of this article is that President Bush’s spending proposals will provide a tax cut for the wealthy and seriously damage Social Security and Medicare.

Study Questions

  1. What is President Bush’s plan for Medicare?
  2. What is the current situation with Social Security?

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Chapter 16: Economic Policy

Practice Exam

(Answers appear at the end of this chapter.)

Fill-in-the-Blank Supply the missing word(s) or term(s) to complete the sentence.

  1. The maintenance of ______is one of the most important government functions.
  2. The ups and downs of the economy are called the ______.
  3. The use of taxation and spending by the government is called ______.
  4. The economic theory associated with using fiscal policy to alter national economic variables is

called ______.

5. Federal Reserve monetary policy is made through the Federal ______.

6.When the federal government incurs a budget deficit, it issues debt instruments in the form of

______.

7.The organization created to lessen trade barriers throughout the world is the ______.

8. The difference between the value of a nation’s exports and imports is called the ______

______.

9. The Social Security system is a pay-as-you-go transfer system in which those who are ______

pay benefits to those who are ______.

10.Today roughly ______workers now provide for each retiree’s Social Security.

True/False Circle the appropriate letter to indicate if the statement is true or false.

TF1.Today five percent unemployment is considered full employment.

TF2.The business cycle refers to periods of economic prosperity.

TF3.Fiscal policy is primarily the responsibility of the president and Congress rather than the Federal Reserve Board.

TF4.When the economy is in a recession, the Federal Reserve Board will usually increase the amount of money in circulation.

TF5.Monetary policy can be more quickly implemented than fiscal policy.

TF6.Polls indicate that most Americans want a slowdown in international trade.

TF7.Recent talks involving the World Trade Organization (WTO) have ended with controversy between developed and developing nations.

TF8. Individuals and corporations facing high taxes will react by making concerted efforts to get Congress to insert loopholes in new tax laws.

TF9.One proposal to fix Social Security is to raise the payroll tax rate.

TF10.As long as the people use money, monetary policy will directly affect the people.

Multiple-Choice Circle the correct response.

  1. The use of fiscal policy to alter economic variables is the underlying premise for
  2. supply and demand.
  3. Keynesian economics.
  4. Marxist economic theory.
  5. the global economy.
  6. monetary theory.
  1. Regulating government spending or taxes to alter national economic variables is part of a
  2. stagflation.
  3. monetary policy.
  4. real assessed economic policy.
  5. fiscal policy.
  6. budgeting policy.
  1. To pay for a budget deficit, the federal government
  2. will usually sell off public land holdings.
  3. will almost always increase taxes.
  4. issues debt instruments in the form of U.S. Treasury bonds.
  5. increases the amount of money in circulation.
  6. will borrow money from other nations.
  1. Policies regulating the amount of money in circulation are part of
  2. a fiscal policy.
  3. national economizing.
  4. a monetary policy.
  5. zero sum budgeting.
  6. a debt payment plan.
  1. Monetary policy is primarily made by the
  2. president.
  3. Congress.
  4. Federal Reserve.
  5. treasury secretary.
  6. federal mint.
  1. Monetary policy does not suffer from the same lengthy time lags as fiscal policy does because
  2. monetary policy does not have an immediate effect upon consumers.
  3. the president can act more quickly than Congress to implement monetary policy.
  4. the Federal Reserve can, within a very short time, put its policy into effect.
  5. Congress can act quickly when needed to solve economic problems.
  6. money can be printed quickly.
  1. A typical strategy for overcoming a recession would be to
  2. decrease the supply of money in circulation.
  3. increase the supply of money in circulation.
  4. increase the tax base within the economy.
  5. cut government spending.
  6. raise taxes.
  1. A tax on imported goods is
  2. a tariff.
  3. advocated by the World Trade Organization.
  4. part of the European Union strategy.
  5. necessary to pay for the global Internet.
  6. an import quota

  1. A major concern about the World Trade Organization is that it will
  2. strengthen multi-national corporations.
  3. eliminate unionization of workers in developing nations.
  4. increase tariffs on goods from non-member countries.

d. lack the power to regulate trade.

e. weaken environmental, health and safety laws.

  1. The only nation with a lower total amount of taxes collected than the U.S. is
  2. Sweden.
  3. Germany.
  4. Great Britain.
  5. Spain.
  6. Japan.
  1. Under a regressive tax proposal,
  2. people with high incomes pay a lower percentage in taxes than people with low incomes.
  3. people pay according to their ability to pay.
  4. low income groups are treated fairly.
  5. the national debt is adversely affected.
  6. an income tax is required.
  1. Which of the following taxes are progressive taxes?
  2. federal income tax
  3. Social Security tax
  4. state sales tax
  5. local real estate taxes
  6. Medicare tax
  1. Social Security taxes are
  2. based upon the Consumer Price Index.
  3. actually paid by the government.
  4. progressive taxes.
  5. regressive taxes.
  6. the same as the Medicare tax.
  1. The Social Security system is in crisis because
  2. the pension fund lost money in the stock market.
  3. the government spend the money on homeland security.
  4. people receiving benefits are greedy.
  5. the government didn’t budget enough money for the program.
  6. the large number of baby boomers will retire, and fewer workers will pay for the program.
  1. Another serious crisis related to the Social Security problem is
  2. the national debt.
  3. the balance of trade.
  4. funding the war in Iraq.
  5. funding the Medicare program.
  6. increasing the market return for the money invested.
  1. President Bush has proposed which of the following to solve the Social Security problem?
  2. raise the payroll tax
  3. eliminate the cap on the level of wages taxed
  4. increase the age for full benefits to 70
  5. privatizeSocial Security
  6. draft older Americans to fight in Iraq
  1. The concept of the current account balance is
  2. the same as the balance of trade.
  3. the amount of money currently in the Social Security fund.
  4. the amount of money currently in the Medicare fund.
  5. the amount of the public debt.
  6. a wider concept of the balance of trade, including services and other items.
  1. Which of the following is a free trade area?
  2. The WTO
  3. provisions of the Smoot-Hawley Act
  4. the European Union
  5. the World Banana Board
  6. the Panama Canal
  1. U.S. exports compared to other countries are
  2. one of the highest in the world.
  3. in the top 10%.
  4. in the middle range.
  5. relatively small.
  6. unable to be determined because of globalization and security.
  1. Legal methods in the tax code of avoiding taxes are referred to as
  2. justifications.
  3. hidden benefits.
  4. loopholes.
  5. give-backs.
  6. regressive taxes.

Short Essay Questions Briefly address the major concepts raised by the following questions.

  1. Identify the difference between fiscal policy and monetary policy.

2. Identify the differences between the federal deficit and the national debt.

3. Explain the world trade position of the United States in the global economy of today.

4. Explain the issues related to Social Security.

Answers to the Practice Exam

Fill-in-the-Blank

1.economic stability

2.business cycle

  1. fiscal policy
  2. Keynesian economics
  3. Open Market Committee
  4. U.S. treasury bonds
  5. World Trade Organization
  6. balance of trade
  7. working, retired
  8. three

True/False

1. T3. T5. T7. T9. T

2. F4. T6. T8. T10. T

Multiple-Choice

1.b6.c11.a 16. d

2.d7.b12.a 17.e

3.c8.a13.d18.c

4.c9.e 14.e 19.d

5.c10.e15.d20.c

Short Essay Answers

1. Identify the difference between fiscal policy and monetary policy.

  • Fiscal policy is the change in government spending or taxation to alter national economic variables.
  • Fiscal policy is under the control of Congress and the president.
  • In a recession, which is a period of rising unemployment, the government will stimulate the economy by increasing government expenditures and by decreasing taxes. During inflation, which is rapid increases in employment and rising prices, the government will “cool off” the economy by reducing expenditures and increasing taxes.
  • Monetary policy is the change in the amount of money in circulation to alter national economic variables.
  • Monetary policy is under the control of the Federal Reserve System, or the Fed.
  • In a recession, the Fed will stimulate the economy by expanding the rate of growth of the money supply. During inflation, the Fed will “cool off” the economy by reducing the rate of growth of the amount of money in circulation.

2. Identify the differences between the federal deficit and the national debt. How does the government deal with national debt?

  • The federal deficit occurs when the federal government spends more money in a year than it receives.
  • From 1960 to 1998, the federal government usually operated at a deficit.
  • The national debt is the total amount of debt carried by the federal government from all yearly deficits.
  • Public debt financing is a process of issuing or selling U.S. Treasury bonds. The government can never go bankrupt as long as it can make interest payments.
  • Public debt financing can affect the economy by “crowding out” private borrowing.
  • The federal deficit was ended in 1998 by the increase in taxes.
  • In 2001, President Bush persuaded Congress to pass huge tax cuts while also funding the war on terrorism and the invasion of Iraq, leading to some of the largest deficits in U.S. history.

3. Explain the world trade position of the United States in the global economy of today.

  • World trade has become a very controversial topic.
  • The United States has used two key tools to protect our economy from unfair trade. These are import quotas and tariffs.
  • The United States faces a major problem of a deficit in its balance of trade, which reached record levels in 1998 and continues to be quite large. A more troubling problem is the current account balance, which is related to the loss of American jobs overseas. See Figure 16-6.
  • The United States and other nations have been very concerned about the activity of the World Trade Organization (WTO) and its attempts to lessen trade barriers, which might weaken environmental, health, and consumer safety laws.

4. Explain the issues related to Social Security.

  • The viability of the Social Security system is an issue concerning more and more individuals.
  • The system is a pay-as-you-go transfer system in which those who are working are paying benefits to those who are retired.
  • Today there are about three workers to provide for each retiree’s Social Security and Medicare. With the imminent retirement of a huge group of baby boomers, the ratio will drop to two workers in 2030.
  • A variety of solutions have been proposed, such as raising the Social Security payroll tax, eliminating the current cap on the level of wages to tax, increasing the age to receive full benefits to 70, and allowing immigrants to qualify for benefits.
  • President Bush has proposed the privatization of the system to allow individuals to invest in the financial markets, although the American people are dubious about this plan.

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