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Economics discussion: state of the economy, recent monetary policy, the Fed

A. Characterize the state of the economy.
b. Is the Federal Reserve more concerned about high inflation or the possibility of a recession? Or, is the Federal Reserve more concerned about other issues? If so, what are they?
c. What is the stated direction of recent monetary policy? What policy actions have the Federal Reserve taken to confirm that direction?

I tried to answer these questions, by going to the Federal Reserve Web site http://www.federalreserve.gov

I located the sections for Testimony and Speeches and the section for Monetary Policy Report to the Congress.

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CHARACTERIZE THE STATE OF THE US ECONOMY

The state of the US economy depends to a great extent on the role of the government. The role of government in the American economy extends far beyond its activities as a regulator of specific industries. The government also manages the overall pace of economic activity, seeking to maintain high levels of employment and stable prices. It has two main tools for achieving these objectives: fiscal policy, through which it determines the appropriate level of taxes and spending; and monetary policy, through which it manages the supply of money.

Much of the history of economic policy in the United States since the Great Depression of the 1930s has involved a continuing effort by the government to find a mix of fiscal and monetary policies that will allow sustained growth and stable prices. That is no easy task, and there have been notable failures along the way.

But the government has gotten better at promoting sustainable growth. From 1854 through 1919, the American economy spent almost as much time contracting as it did growing: the average economic expansion (defined as an increase in output of goods and services) lasted 27 months, while the average recession (a period of declining output) lasted 22 months. From 1919 to 1945, the record improved, with the average expansion lasting 35 months and the average recession lasting 18 months. And from 1945 to 1991, things got even better, with the average expansion lasting 50 months and the average recession lasting just 11 months.

Inflation, however, has proven more intractable. Prices were remarkably stable prior to World War II; the consumer price level in 1940, for instance, was no higher than the price level in 1778. But 40 years later, in 1980, the price level was 400 percent above the 1940 level.

In part, the government's relatively poor record on inflation reflects the fact that it put more stress on fighting recessions (and resulting increases in unemployment) during much of the early post-war period. Beginning in 1979, however, the government began paying more attention to inflation, and its record on that score has improved markedly. By the late 1990s, the nation was experiencing a gratifying combination of strong growth, low unemployment, and slow inflation. But while policy-makers were generally optimistic about the future, they admitted to some uncertainties about what the new century would bring.

The state of the US economy depends to a great deal on the budget and taxes:

The growth of government since the 1930s has been accompanied by steady increases in government spending. In 1930, the federal government accounted for just 3.3 percent of the nation's gross domestic product, or total output of goods and services excluding imports and exports. That figure rose to almost 44 percent of GDP in 1944, at the height of World War II, before falling back to 11.6 percent in 1948. But government spending generally rose as a share of GDP in subsequent years, reaching almost 24 percent in 1983 before falling back somewhat. In 1999 it stood at about 21 percent.

The development of fiscal policy is an elaborate process. Each year, the president proposes a budget, or spending plan, to Congress. Lawmakers consider the president's proposals in several steps. First, they decide on the overall level of spending and taxes. Next, they divide that overall figure into separate categories -- for national defense, health and human services, and transportation, for instance. Finally, Congress considers individual appropriations bills spelling out exactly how the money in each category will be spent. Each appropriations bill ultimately must be signed by the president in order to take effect. This budget process often takes an entire session of Congress; the president presents his proposals in early February, and Congress often does not finish its work on appropriations bills until September (and sometimes even later).

The federal government's chief source of funds to cover its expenses is the income tax on individuals, which in 1999 brought in about 48 percent of total federal revenues. Payroll taxes, which finance the Social Security and Medicare programs, have become increasingly important as those programs have grown. In 1998, payroll taxes accounted for one-third of all federal revenues; employers and workers each had to pay an amount equal to 7.65 percent of their wages up to $68,400 a year. The federal government raises another 10 percent of its revenue from a tax on corporate profits, while miscellaneous other taxes account for the remainder of its income. (Local governments, in contrast, generally collect most of their tax revenues from property taxes. State governments traditionally have depended on sales and excise taxes, but state income taxes have grown more important since World War II.)

The federal income tax is levied on the worldwide income of U.S. citizens and resident aliens and on certain U.S. income of non-residents. The first U.S. income tax law was enacted in 1862 to support the Civil War. The 1862 tax law also established the Office of the Commissioner of Internal Revenue to collect taxes and enforce tax laws either by seizing the property and income of non-payers or through prosecution. The commissioner's powers and authority remain much the same today.

The income tax was declared unconstitutional by the Supreme Court in 1895 because it was not apportioned among the states in conformity with the Constitution. It was not until the 16th Amendment to the Constitution was adopted in 1913 that Congress was authorized to levy an income tax without apportionment. Still, except during World War I, the income tax system remained a relatively minor source of federal revenue until the 1930s. During World War II, the modern system for managing federal income taxes was introduced, income tax rates were raised to very high levels, and the levy became the principal sources of federal revenue. Beginning in 1943, the government required employers to collect income taxes from workers by withholding certain sums from their paychecks, a policy that streamlined collection and significantly increased the number of taxpayers.

Most debates about the income tax today revolve around three issues: the appropriate overall level of taxation; how graduated or "progressive" the tax should be; and the extent to which the tax should be used to promote social objectives.

The overall level of taxation is decided through budget negotiations. Although Americans allowed the government to run up deficits, spending more than it collected in taxes during the 1970s, 1980s, and the part of the 1990s, they generally believe budgets should be balanced. Most Democrats, however, are willing to tolerate a higher level of taxes to support a more active government, while Republicans generally favor lower taxes and smaller government.

From the outset, the income tax has been a progressive levy, meaning that rates are higher for people with more income. Most Democrats favor a high degree of progressivity, arguing that it is only fair to make people with more income pay more in taxes. Many Republicans, however, believe a steeply progressive rate structure discourages people from working and investing, and therefore hurts the overall economy. Accordingly, many Republicans argue for a more uniform rate structure. Some even suggest a uniform, or "flat," tax rate for everybody. (Some economists -- both Democrats and Republicans -- have suggested that the economy would fare better if the government would eliminate the income tax altogether and replace it with a consumption tax, taxing people on what they spend rather than what they earn. Proponents argue that would encourage saving and investment. But as of the end of the 1990s, the idea had not gained enough support to be given much chance of being enacted.)

Over the years, lawmakers have carved out various exemptions and deductions from the income tax to encourage specific kinds of economic activity. Most notably, taxpayers are allowed to subtract from their taxable income any interest they must pay on loans used to buy homes. Similarly, the government allows lower- and middle-income taxpayers to shelter from taxation certain amounts of money that they save in special Individual Retirement Accounts (IRAs) to meet their retirement expenses and to pay for their children's college education.

The Tax Reform Act of 1986, perhaps the most substantial reform of the U.S. tax system since the beginning of the income tax, reduced income tax rates while cutting back many popular income tax deductions (the home mortgage deduction and IRA deductions were preserved, however). The Tax Reform Act replaced the previous law's 15 tax brackets, which had a top tax rate of 50 percent, with a system that had only two tax brackets -- 15 percent and 28 percent. Other provisions reduced, or eliminated, income taxes for millions of low-income Americans.

The state of the US economy has been affected by Fiscal Policy and Economic Stabilization

In the 1930s, with the United States reeling from the Great Depression, the government began to use fiscal policy not just to support itself or pursue social policies but to promote overall economic growth and stability as well. Policy-makers were influenced by John Maynard Keynes, an English economist who argued in The General Theory of Employment, Interest, and Money (1936) that the rampant joblessness of his time resulted from inadequate demand for goods and services. According to Keynes, people did not have enough income to buy everything the economy could produce, so prices fell and companies lost money or went bankrupt. Without government intervention, Keynes said, this could become a vicious cycle. As more companies went bankrupt, he argued, more people would lose their jobs, making income fall further and leading yet more companies to fail in a frightening downward spiral. Keynes argued that government could halt the decline by increasing spending on its own or by cutting taxes. Either way, incomes would rise, people would spend more, and the economy could start growing again. If the government had to run up a deficit to achieve this purpose, so be it, Keynes said. In his view, the alternative -- deepening economic decline -- would be worse.

Keynes's ideas were only partially accepted during the 1930s, but the huge boom in military spending during World War II seemed to confirm his theories. As government spending surged, people's incomes rose, factories again operated at full capacity, and the hardships of the Depression faded into memory. After the war, the economy continued to be fueled by pent-up demand from families who had deferred buying homes and starting families.

By the 1960s, policy-makers seemed wedded to Keynesian theories. But in retrospect, most Americans agree, the government then made a series of mistakes in the economic policy arena that eventually led to a reexamination of fiscal policy. After enacting a tax cut in 1964 to stimulate economic growth and reduce unemployment, President Lyndon B. Johnson (1963-1969) and Congress launched a series of expensive domestic spending programs designed to alleviate poverty. Johnson also increased military spending to pay for American involvement in the Vietnam War. These large government programs, combined with strong consumer spending, pushed the demand for goods and services beyond what the economy could produce. Wages and prices started rising. Soon, rising wages and prices fed each other in an ever-rising cycle. Such an overall increase in prices is known as inflation.

Keynes had argued that during such periods of excess demand, the government should reduce spending or raise taxes to avert inflation. But anti-inflation fiscal policies are difficult to sell politically, and the government resisted shifting to them. Then, in the early 1970s, the nation was hit by a sharp rise in international oil and food prices. This posed an acute dilemma for policy-makers. The conventional anti-inflation strategy would be to restrain demand by cutting federal spending or raising taxes. But this would have drained income from an economy already suffering from higher oil prices. The result would have been a sharp rise in unemployment. If policy-makers chose to counter the loss of income caused by rising oil prices, however, they would have had to increase spending or cut taxes. Since neither policy could increase the supply of oil or food, however, boosting demand without changing supply would merely mean higher prices.

President Jimmy Carter (1973-1977) sought to resolve the dilemma with a two-pronged strategy. He geared fiscal policy toward fighting unemployment, allowing the federal deficit to swell and establishing countercyclical jobs programs for the unemployed. To fight inflation, he established a program of voluntary wage and price controls. Neither element of this strategy worked well. By the end of the 1970s, the nation suffered both high unemployment and high inflation.

While many Americans saw this "stagflation" as evidence that Keynesian economics did not work, another factor further reduced the government's ability to use fiscal policy to manage the economy. Deficits now seemed to be a permanent part of the fiscal scene. Deficits had emerged as a concern during the stagnant 1970s. Then, in the 1980s, they grew further as President Ronald Reagan (1981-1989) pursued a program of tax cuts and increased military spending. By 1986, the deficit had swelled to $221,000 million, or more than 22 percent of total federal spending. Now, even if the government wanted to pursue spending or tax policies to bolster demand, the deficit made such a strategy unthinkable.

Beginning in the late 1980s, reducing the deficit became the predominant goal of fiscal policy. With foreign trade opportunities expanding rapidly and technology spinning off new products, there seemed to be little need for government policies to stimulate growth. Instead, officials argued, a lower deficit would reduce government borrowing and help bring down interest rates, making it easier for businesses to acquire capital to finance expansion. The government budget finally returned to surplus in 1998. This led to calls for new tax cuts, but some of the enthusiasm for lower taxes was tempered by the realization that the government would face major budget challenges early in the new century as the enormous post-war baby-boom generation reached retirement and started collecting retirement checks from the Social Security system and medical benefits from the Medicare program.

By the late 1990s, policy-makers were far less likely than their predecessors to use fiscal policy to achieve broad economic goals. Instead, they focused on narrower policy changes designed to strengthen the economy at the margins. President Reagan and his successor, George Bush (1989-1993), sought to reduce taxes on capital gains -- that is, increases in wealth resulting from the appreciation in the value of assets such as property or stocks. They said such a change would increase incentives to save and invest. Democrats resisted, arguing that such a change would overwhelmingly benefit the rich. But as the budget deficit shrank, President Clinton (1993-2001) acquiesced, and the maximum capital gains rate was trimmed to 20 percent from 28 percent in 1996. Clinton, meanwhile, also sought to affect the economy by promoting various education and job-training programs designed to develop a highly skilled -- and hence, more productive and competitive -- labor ...

Solution Summary

In a 9806 word solution, the state of the economy is thoroughly discussed.

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