In case, real GDP is lower than potential GPD expansionary policies are implemented in correcting contraction of business cycle. Expansionary Fiscal policy leads to increases in purchases by government, tax rate decrease and transfer payment increase to overcome contracting business cycle. Expansionary fiscal policy closes gap of recession, stimulates economy and decreases rate of unemployment.
Fiscal policy tools to stimulate economy are:
Expenditures done by government sector for services and final goods come under Government purchases. Government purchases are part of GDP bought by the government. Government purchases include heavy cost expenses like highway construction and aircraft clips carriers to smaller expenses like paper clips and traffic lights. Government purchases often lead to bigger government sector and thus policy makers prefer to use for Taxes as tool.
Taxes are one of the tools of fiscal policy and to help boost the economy. Government charges payments which are involuntary to generate revenue which they can use for public goods and performing government functions. Under expansionary fiscal policy government decreases the income tax rate or provides rebate of taxes paid in past in one-time payment. Tax reduction creates disposable income which in turn leads to increase in expenditures which enhances employment and production which leads to increase in income.
Transfer payment is another tool of fiscal policy. Government sector undertake transfer payments by making payments to households without any expectation of any productive activity from it. Benefits of Social security for disable and elders, compensation for unemployment and Welfare of poor constitutes transfer payments. An increase in transfer payment or one lump-sum payment to eligible population creates additional income for consumption which increases production and employment opportunities to further increase income.
In case, real GDP is lower than potential GPD expansionary policies are implemented in correcting contraction of business cycle. Increasing money supply and decreased interest rates constitutes expansionary monetary policy. Tools for Monetary policy which help in simulation of growth are:
Open Market Operations
Open market operations involve purchasing and selling securities of US Treasury for the purpose of having control over money supply, bank reserves and rate of interest. Under expansionary monetary policy Federal Reserve purchases Securities of US Treasury via open market and pays through bank reserves which increase total reserves at helm of banks. With extra money in the reserves banks can now lend this money at lower rates and this increases money supply and deposits.
Interest rate at which Federal Reserve charges commercial banks an interest for loans from reserve is called discount rate. With expansionary monetary policy Federal Reserve lowers the rate of discount at which banks borrow. With additional reserves saved from lower interest rate banks can now offer loans at lesser interest rates to customers and increase money supply and deposits.
Tools of Contractionary Fiscal Policy
Contractionary fiscal policy is implemented by decreasing funds to government agencies. These agencies due to reduction in funds allotted to them reduce their own expenses leading to decrease in income, production and inflation rate.
Contractionary fiscal policy includes either a surcharge deducted one-time or increasing the taxation rate. Increase in tax leads to reduction on income for disposing leading to decrease in employment, production and income which decreases rate of inflation.
Contractionary fiscal policy includes either a payment reduction across all the eligible population or decreasing schedule of payment by one or more times. A reduction in income of population will lead to reduction in disposable income of households and this leading to less expenditure, production and employment which leads to reduction in inflation rate.
Tools of Contractionary Monetary Policy
Open Market Operations
Contractionary monetary policy involves Federal Reserve selling US Treasury securities via open market. The Federal Reserve sells and collects treasury security payment through bank reserves which lowers the reserves with banks. Banks are now bound to increase the rate of interest on loans which decreases the deposits and money supply.
Contractionary monetary policy involves Federal Reserve increasing the discount rate. With higher discount rates banks find it tough to borrow from the Federal Reserve. This leads to reduced bank reserves and higher rate of interest on bank loans leading to lesser deposits and lower money supply.
3. Kind of Lags
There is always time lag between on set of any economic problem to impact of policy to overturn it. The main reason why these lag to arise is due to the fact of government actions not being instantaneous. There are two divisions of Policy Lags: Inside and Outside.
Time between onset of problem and launch of corrective measure is part of Inside Lag. Government actions usually take their time and this leads to development of time lag. Inside lag is subdivided into 3 parts:
Recognition Lag: For this lag to take place an actual problem should exist. To recognize an actual problem collection and evaluation of data is required and thus time lag takes place.
Decision Lag: As soon as Government identify a problem the next step to take a decision to solve the problem. To decide on suitable corrective measure another lag is added which is called decision lag.
Implementation Lag: After selection of policy which will serve as corrective measure for the problem. It is highly important that the implementation is done correctly on each level and for this government agencies are needed to be informed. Inside Lag generally take about months to come to fruition.
Time between selection of policy and implementation and when the policy starts to showcase constitutes of outside lag. This process takes its own time to show its results and it constitutes of only one lag called Impact Lag.
Impact Lag: Time it takes for any policy to have an impact over the economy i9s called impact lag.
Lag and Monetary Policy
In case of monetary policy decision lag seems to be shorter as most decision is made by Federal Reserve System which constitutes of its chairman and its members (12 members). Monetary policy serves as their primary task and all members meet in every six-week or earlier which leads to faster decision making and reducing Lag time. Implementation Lag is further short as once a choice is made the implementation is done immediately.
Lag and Fiscal Policy
In case of Fiscal policy decision Lag is usually longer as most decisions are made by President and involves many steps. Since Congress consists of members with different interests, coming to a consensus usually takes its time. Implementation Lag is also longer as all changes are ran through government agencies and bureaucrats involved before any act of implementation.
4. National Debt and Deficit
“In 2012, the United States federal government spent $3.54 trillion on everything in its budget, including defense, (the largest chunk of discretionary spending at $670 billion),Social Security (the largest of the mandatory expenses at $767 billion), Medicare and Medicaid, scientific research, grants for college students and much, much more. Unfortunately, the government only took in $2.45 trillion in taxes, fees and other revenue. That leaves a budget shortfall of more than $1 trillion, and that trillion dollars is called the deficit” (Roos).
“The national debt represents the total amount of money that the federal government has borrowed to cover its annual budget deficits. As of March 2013, the national debt stood at $16.7 trillion. Technically the U.S. doesn't owe that entire amount to its creditors. Around $4.8 trillion is held by various government trust funds, so only $11.9 trillion is considered debt held by the public” (Roos).
Statistical Significance of National Debt and Federal Deficit
If things don’t change in coming 20 years, Social Security Trust will not be able to cover for retirement benefits. Higher tax rates since high Debt ensures no more loans from foreign countries.
“As of September 2012 (most recent data), foreigners held $5.455 trillion, or roughly one third of total U.S. debt. China holds $1.155 trillion and Japan owns $1.131 trillion. The oil exporting countries are the third largest holders, at $267 billion, with Brazil next at $251 billion. The Caribbean Banking Centers are fifth, holding $240 billion. The Bureau of International Settlements suspects that much of the holdings of the Caribbean centers, as well as Luxembourg (holding $148 billion) and Belgium ($134 billion) are fronts for the oil-exporting countries or hedge funds that do not wish to be identified. The next largest holders Taiwan, Switzerland, Russia, United Kingdom, and Hong Kong own between $135-$191 billion each” (Amadeo).
Causes of Deficits and National Debt
Six factors that have caused an up stir in national debt and deficit:
1. The Bush tax cutsIn between 2001-2003 no tax deductions under President Bush lead to addition of $1.6 million to national debt.
2. Health care entitlements
Medicaid and entitlements have added $1.1 trillion to government spending which is 900 million above required inflation amount.
3. Medicare prescription drug benefitBush’s Medicare prescription drug benefit increased national debt by $300 Billion.
4. The wars in Iraq and AfghanistanWar against Afghanistan and Iraq cost more than $1.3 trillion to the national debt.
5. Obama's economic stimulusStimulus package of 2009 cost about $800 Billion and Tax-cut compromise of 2010 cost additional $400 Billion and bailout for financial giants in 2008 added another $200 Billion to the
6. The Great RecessionOne of the biggest factors which has influenced the national debt has been the great recession which crippled the economy. With billions lost in tax revenues due to loss of income and expenditure.
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Rogers, S. US debt: how big is it and who owns it?. Retrieved from. http://www.theguardian.com/news/datablog/2011/jul/15/us-debt-how-big-who-owns
Amadeo, K. The U.S. Debt and How It Got So Big. Retrieved from. http://useconomy.about.com/od/fiscalpolicy/p/US_Debt.htm
Boccia, R. How the United States’ High Debt Will Weaken the Economy and Hurt Americans. Retrieved from. http://www.heritage.org/research/reports/2013/02/how-the-united-states-high-debt-will-weaken-the-economy-and-hurt-americans
Blodget, H. The Truth About Who's Responsible For Our Massive Budget Deficit. Retrieved From. http://www.businessinsider.com/us-budget-deficit-2011-7#ixzz2iPCbJwsU