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Money and Banking.

Please read the following topic and answer those three questions below at the bottom

MONEY & BANKING

The Congressional Budget Office (CBO) on August 25, 2009 estimated that the accumulated deficit from 2010-19 will approximate $7.137 trillion.
Fiscal deficit in 2010 is estimated at $1.3 trillion or a post-War II record of almost 10.0 percent of the GDP. In this year federal spending rose by 22 percent to 24.7 percent of GDP. The U.S. currently borrows 40 percent of every dollar it spends.

The CBO 2012 report estimated annual spending over the Obama era to have climbed to a projected $3.6 trillion in fiscal year 2012 from $2.9 trillion in fiscal 2008 or more than 20 percent. Published debt will climb in 2012 to 72.5 percent of the economy from 40.3 percent in 2008.

The 18 member bipartisan National Commission on Fiscal Responsibility estimated that by 2025 tax revenues will be sufficient to finance only interest payments (which are projected to soar from a current $200 billion to more than $1,0000billion) and entitlement programs with no room for anything else. Every other expenditure-including defense- will have to be paid with borrowed funds. By 2035 this rising debt could reduce gross domestic product per capita by as much as 15 percent. Deficits are projected to be 6 percent of GDP in 2020; 15 percent in 2035. Such deficits are not sustainable as investors will revolt. The Commission recommends $3,900 billion in deficit reductions by 2020, with a 3 to 1 ratio of spending cuts to tax increases. Other proposals: raising the pension age; curbing healthcare and limiting tax breaks such as deducting interest paid on mortgages.

There have been three "stimuli measures". One, by the Bush administration in February 2008 when a package of federal spending and temporary tax rebates totaling $168 billion were agreed with the Democratic controlled House. Two, the Obama administration's $814 billion combination of one-time tax rebates and spending (mostly on social programs) and three, the "cash -for-clunkers, the $8,000 home-buyer's tax credit, mortgage payment relief, and jobless pay up to 99 weeks.

The deal extending Bush-era tax cuts and unemployment benefits in December 2010 added $858 billion to the long term deficits.

The off balance sheet obligations associated with Social Security and Medicare are estimated by the former head of the GAO, David Walker, at $56 trillion.

The CBO estimates the Obama administration will over the period 2009-11 borrow an estimated $3.7 trillion. By 2019, the interest payments on this debt will be larger than the budget for: Education, roads, and all other nondefense discretionary spending.

During the period 2008-10 the Federal Reserve cut its benchmark interest rate to near zero and expanded its balance sheet by more than $2 trillion by purchasing mortgage-backed securities and other assets.

QUESTION:

A) After stating your assumptions concerning the means of the respective Congresses and administrations over the next ten years responding to deficits (formal and off balance sheet), and the timing of the federal reserve board's removal of reserves from the banking system, outline what you expect to be the movement in: interest rates in the short and long run and in the average price level in the short and long run. Explain how these adjustments are likely to come about; by changes in interest rates caused primarily by shifts in the demand and supply of bonds and or by changes in the money supply?

B) Given your analysis and expectations as to the movement of interest rates, state what you expect to be the consequences for investment in the private sector. State the conditions in which private sector investment could be crowded out.

The Commerce Department released data that showed that the four years after the recession began the real gross domestic product per person was down $1,112 while 5.8 million fewer Americans are working than when the recession started. Never before in postwar America has either real per capita GDP or employment still been lower four years after a recession began.

C) Compare and contrast the Keynesian from the Austrian explanation for this protracted recession. Then outline your explanation for the protracted recession.

Solution Preview

This is a very good resource on deficit spending:
http://research.stlouisfed.org/publications/review/88/11/Deficit_Nov_Dec1988.pdf

This one is older, but he basic concepts still apply:
http://www.cbo.gov/sites/default/files/cbofiles/ftpdocs/67xx/doc6744/10-13-long-termeffects_brief.pdf

also

http://www.econlib.org/library/Enc/GovernmentDebtandDeficits.html

These ideas can be applied to all three questions (since they are all overlapping anyway):

The basic supply side argument:
Deficits hurt both consumer spending and investor confidence.
High taxes do NOT help with balancing budgets. They depress economic activity.
So the general answer is that ?
High taxes lead to LESS revenue over time.
This is because, as taxes go up, investor confidence goes down.

This is made much worse in a globalized economy, since companies can utilize overseas labor.
This means that interest rates will rise in BOTH the long and short run.
If the money supply is increased at times of higher taxes, then inflation is the result.
Remember ? supply side economics holds that demand will take care of itself if the incentive structure encourages investments. To encourage investments, budgets have to be balanced and taxes kept low.
The problem is that any economic recovery will have to increase consumer spending. The topic you included says nothing about consumer debt, which is far higher than government debt. Hence, recovery is a huge problem at any level. The savings money is just not there.

The other significant concept of the supply side argument is that deficits (and debts) always cause inflation. This is because money is being printed that
a) goes to unproductive (government) causes, and
b) is not, therefore, going to economic production.
In the supply side mentality, every dollar that does NOT go to private sector production is wasted. It goes to inflate the currency. Governments, in this mindset, do not create anything and hence, any money they spend is inherently unproductive.

The more a government borrows, the higher rates will go. The higher the rate, the slower the economy. Everything must be focused on the suppliers of products to create the proper incentives to hire and produce.

The demand side (Keynesian) argument is a bit different.

For them, deficit depending is OK. Demand needs to be provoked through the stimulus measures you have mentioned.
The basic demand side approach says that demand must be created through concessions to the consumer ? NOT the producer. This is the case (in their view) because prices do not respond quickly to stimulus incentives (like lower taxes).
Therefore, lower taxes might not spur production or lower prices. Prices might stay ...

Solution Summary

Money and banking for the congressional budget office is examined.

$2.19