Overall, the U.S. economy tends to grow at an annual rate of about 3%. When economists talk about a growing economy, they mean it is expanding the measure of the output of goods and services produced, which is the Gross Domestic Product, or GDP. You may also hear of another similar measure called Gross National Product (GNP) but there is very little difference between the two measures for the United States. Regardless, just think of either number as a measure of the value of the goods and services produced over the course of a year; it’s the nation's income.
People are given incentives to produce. If you produce something of value, you will be rewarded with profits and higher profits mean you get more things; that is, you are wealthier. It is a basic belief in economics that people generally prefer more things than less, so choose to work. When people choose to work, they also have demands for other goods and services because of the income they are earning. However, this buying pressure does not necessarily lead to inflation as when we assumed the government prints money to make people wealthier.
In order for you to demand goods or services, you must produce an equivalent amount. This is known as Say's Law, which states supply creates its own demand. Therefore, in the long run, you cannot have a surplus or shortage of goods. If producers have a surplus, they will lower prices until that surplus is sold. In doing so, they have just lowered their profits which lowers the goods and services they can demand. Likewise, if producers have a shortage of goods, they will raise prices to reduce the number of buyers, thus increasing profits. With higher profits, the producers can now demand more goods and services. As long as there is sufficient demand, production and incomes will increase.
Besides the proper incentives to produce, economies must have the proper resources, one of which is the efficient formation of capital and is the very reason behind the U.S. capital markets. For example, you are much more likely to invest in shares of stock if there is an actively traded secondary market, such as the NYSE or Nasdaq where you can immediately sell them. If there weren't such a market, it would mean a higher risk and cost to hold the shares and you would bid correspondingly lower for new issues. The capital markets thus means cheaper borrowing costs to firms and thus greater incentives for entrepreneurs to take risk by investing in factories and equipment for profit.
When an asset is created, such as factories or equipment, that can be used over and over to generate money, economists call it investment spending.
If Intel constructs a new building, it is an investment. This is probably different from the way most people think of investments such as stocks and bonds. Economists consider those as savings. Investment spending raises the average level of capital per worker so helps to increase productivity. Investment capital can also lead to greater technological developments that produce even greater economic growth, such as with the steam engine and computers and why many companies invest heavily in research and development.
The same laws that apply to producers (employers) also apply to labor (employees). If there is an undersupply of labor, wages and salaries will increase to give people incentive to work. If there is an oversupply of labor, wages will come down which either gives people the disincentive to work (be unemployed) or the incentive for employers to hire them since profits can now be made at the lower wages. The theoretical result is that there should never be unemployment.
However, wages are typically fixed by minimum wage laws and not allowed to float as with a true market. By now you should understand that when the government creates price restrictions, in this case called a price floor, that supply and demand cannot be equal and the market cannot be cleared. Because wages are fixed and cannot fall below that minimum level if they should need to, there always tends to be a surplus of labor. In essence, it is nearly impossible to have no unemployment. If you're not sure why, think about it this way: If there are excess workers, the price of labor (wages) should continue to fall until the last worker is hired. However, if the wage is allowed to only fall so far, then they cannot fall low enough to hire that last worker. The result is unemployment.
If you are unemployed, not only are you not working but also you're not spending. There tends to be less demand for goods and services and, consequently, producers lower their prices. The lower prices bring in more buyers, which strengthens demand. The higher profits and higher demand forces firms to hire more people.
Eventually the economy brightens and people start to expect corporate earnings to rise in the coming quarters or years. Once consumer confidence is up, people will spend ahead of their incomes, which means they typically spend expected earnings. This is sometimes difficult to understand but can easily be demonstrated with a simple example.
Assume you just won your state's lottery and are due $200,000 per year for the next 20 years. Do you wait for the money to arrive before spending it? If you are like most people, you probably will spend ahead of your expected earnings and spend now even before the first check arrives. So once the economy's outlook is bright, people start spending ahead of anticipated incomes. This creates higher demand and forces firms to respond with more products and services. This, in turn, requires firms to hire more people and raise the wages in order to get them into the workforce. The higher demand for products and services coupled with the higher wages paid by firms results in an inflationary environment. People are spending for goods that haven't even been produced yet.
The result is that the economy is in a constant battle between inflation and unemployment, which is often depicted in a downward sloping graph called the Philips Curve as shown in Figure 3. The Phillips Curve simply shows the historical fact that as unemployment increases (more people are out of work) there is a tendency for interest rates to fall and vice versa:
Figure 3
By now you should see the connection between unemployment and inflation. It is up to the government and the Fed to create the proper balance between these two undesired conditions.
A Simple Model for Understanding the Economy
One of the easiest ways to understand the role of the government and Fed and the tradeoff between inflation and unemployment is with the following analogy, which economists often call "models." One of the simplest is the "water bucket" analogy often presented in basic economics courses.
Assume you have a bucket filled part way with water. At the top of the bucket, you have two faucets and, at the bottom, two drains. The left faucet is called "government spending" and the right is "investment spending" while the left drain is "taxes" and the right is "interest rates" which are shown in Figure 4 below:
Figure 4
The level of the water represents economic activity, or GDP. If you want to raise the level of economic activity (economic growth), there are four basic ways to do it. Looking at the above diagram, how would you increase the water level? You can either increase government spending or investment spending. Remember that investment spending is the creation of new assets that have recurring uses and not stocks and bonds. How would you get Intel to invest in a new factory? You simply lower interest rates. If Intel can make an 8% return by building a factory, the prevailing interest rate will drive their decision. If rates are 10%, Intel will not build the factory since it will be losing 2% on the deal (borrowing at 10% and earning 8%). However, if rates dropped below 10%, Intel will accept the project and spend the money.
Notice how the money flowing into the economy is not escaping through the drains. Taxes were not raised and interest rates were lowered, which means there is a net inflow into the economy. The lower interest rates give firms an incentive to invest and, at the same time, give investors the disincentive to save (take money out the economy).
Likewise, you could increase the water level by controlling the drains and reduce taxes or decrease interest rates to raise the water level. Reducing taxes was part of President Reagan's "supply side" economic policy. By lowering taxes, it gave entrepreneurs the incentive to produce or "supply" more and we know from Say's law that supply creates its own demand.
Any of these four actions (or combinations) will increase the economic level of activity:
1. Increase government spending
2. Increase investment spending
3. Decrease taxes
4. Decrease interest rates
Notice how decreasing interest rates are tied to investment spending. The lower the rates, the less people save and the more firms will invest. Similarly, but in the opposite direction, raising taxes lowers economic activity but gives the government and incentive to spend.
What if the government wants to slow down the level of economic activity (the water level is rising too fast) and inflation is imminent? You should now understand the opposite actions will decrease the rate of growth. Reducing government or investment spending or increasing taxes or interest rates (or any combination) will do the trick.
Raising interest rates makes it more desirable to save (putting money in an interest bearing account or stocks and bonds)and less desirable for firms to borrow that money. The money goes out and doesn't come back in or at least comes back at a slower rate. The net effect is a slowing economy.
The Roles of the Government and the Fed
Notice how the above economic model can be divided vertically into a left and right half. On the left is government spending and taxes, which are controlled by the government through fiscal policy. How much should the government spend? What is the optimal tax rate? These are questions for fiscal policy. The right half is investment spending and interest rates, which are controlled by the Fed through monetary policy. Monetary policy, as we have learned, is the controlling of the money supply to stimulate or hold back growth.
Fiscal policy is aimed at finding the right level of taxes and government spending for optimal production (GDP). The government raises the money it spends through taxes. If the government charges no taxes, then no spending can occur, which is obviously bad for the country as a whole. Likewise, if the government assessed a 100% tax, then nobody would work and the government would still have no revenue, just as it would under a zero tax policy. So as the tax is increased above zero percent, tax revenues rise but will start to fall as tax rates approach 100%. Obviously, there must be some optimal amount of tax. In economics, the Laffer curve (after economist Arthur Laffer) demonstrates this description of an optimal tax rate as shown in Figure 5:
Figure 5
In the Laffer curve above, it's easy to see that point A is the tax rate that maximizes government revenues. However, that is really a theoretical point and there is no way to determine if you're on it or not. If we assume that we're not at the optimal tax rate, should the government raise or lower taxes?
If the nation is at point B, then raising taxes will increase revenues. However, if the nation is at point C, the lowering taxes will increase revenues. The problem for the government is that there is no way to know which side of the peak (point A) the nation is on, which makes fiscal policy a truly difficult job. To make things more difficult, imagine that the curve is not drawn for the entire nation but for individuals. If the government has people taxed at rate C (high income individuals) and some at rate B (lower income), then lowering taxes will increase revenues from C and reduce taxes from B while raising taxes will have the opposite effect. Which is the best policy for the nation? It's nearly impossible to say.
Government Spending
Government spending is necessary to effectively run a nation. One of the main reasons government is important is for the purchase of "public" goods. A public good is one that can be used by many people simultaneously, such as military defense, roads, hospitals, public schools and transportation. Without a government, these assets would never be bid up to their proper value and there is no incentive for individuals to produce them.
For example, if you could elect to contribute money for military defense spending, you would have a very strong incentive to not do so. That's because the military cannot pick and choose whom it protects; it protects the entire country. As long as you are in the country, you receive the same benefits as someone who may have paid. So, why not keep the money and enjoy the same benefits?
Notice how public goods are different from private goods. Private goods such as cars, houses, clothes or computers cannot benefit multiple people at the same time. If you buy a car, someone else cannot buy that very same car.
There are many heated debates about government spending and whether the funds are being used "correctly" or whether they are wasted. Whether they are used in the best interest for all is a matter for the art side of economics; however, there are many misconceptions about government spending that you should be aware of.
First, if the government spends a billion dollars to design a fighter jet and the project is a flop, are these dollars wasted? The answer is no, and that's because somebody gets those dollars. The government doesn't necessarily waste dollars; they merely redirect it to certain groups of people. The billion dollars spent on a scrapped fighter jet project means that a billion dollars went to an engineering firm as well as others involved in the design and building of the plane. The dollars are not lost to the economy; they are just redistributed. Now, it certainly could be argued that the use of the funds could have been better chosen, but that does not mean the dollars were burned either.
Second, the source of the funds is another area of controversy. If the government spends additional money without raising taxes, it spends more money than it receives, but not more money than it has. How does it get the additional money? The same way you would if you were trying to buy something that requires more funds than you immediately have. They get a loan through selling bonds as a way to generate cash. Is it better to pay cash or to borrow? Again, that is a matter of great debate but it should be recognized that the act of financing by itself does not make one bit of difference.
For example, assume you are going to buy an item costing $1,000. You can pay cash, finance it for a year, or finance it indefinitely. Which is best? Many will tell you to pay cash so you can save all of the interest expense. However, that's only half the story. If you pay cash, there is an opportunity cost since you also have less cash to earn interest with. Let's run through the three scenarios and see which is truly best. Assume you have $2,000 in the bank, interest rates are 5%, and you can borrow or lend at the same rate.
If you pay cash, you spend $1,000 today leaving $1,000 in your account. At the end of the year, your account will have grown to $1,050.
If you finance the item for one year, you not pay anything now so will have $2,100 in your account at the end of the year. At that time, you will pay $1,050 ($1,000 plus $50 interest), which leaves you with $1,050 at the end of the year.
If you finance indefinitely, you will have to set aside an amount that generates a perpetual $50 interest payment each year, which is $1,000. Once you withdraw that $1,000 today and set it aside, you are left with $1,000, which again is worth $1,050 at the end of the year.
You can see from the above scenarios that it doesn't really doesn't matter how the government finances its decisions. Rather, the question is how should it be spending those dollars? Now, you may argue that the above doesn't hold true for individuals since lending and borrowing rates different. However, because government bonds are backed by the full faith and credit of the government, the government is the risk-free rate and can borrow and lend at that rate.
The U.S. Department of the Treasury handles the financing needs of the government. If bonds come due, the Treasury will refinance them. If the government wants to increase spending (deficit spending), the Treasury will issue new bonds; if the government runs a surplus, the Treasury can use some of the cash to buy back the bonds and close out the loans.
Although we've stated that the government and the Fed operate separate halves of the simple model we have presented, they are actually interconnected. Assume the economy is sinking and the government want to pursue and expansionary policy, which it can do by either lowering taxes or increasing spending. If it increases spending, it must sell bonds in the open market, which drives their prices down and interest rates up.
Now the government may have more cash to pump into the economy, but the interest rates are now higher too, which keeps private companies from investing! In effect, the government's actions to expand the economy are contracting it from the private side. This is called crowding out, which just means that the governments actions crowds out private investment so that the net result is no change in the economy. If the government's actions exactly counter private investments (such as Intel buying a new factory), then the only way for an expansionary policy to work is if there is an increase in the money supply too.
Here's how the government can prevent "crowding out." If the government wants an expansionary policy, it will sell bonds in the open market, which normally would drive up the interest rates. However, the Fed can buy the bonds in the open market (the Fed is prevented from purchasing bonds directly from the Treasury), which is an expansionary monetary policy. If so, there's no need for the interest rates to rise since the Fed is holding the bonds. In other words, the crowding out effect has been offset by an expansionary monetary policy.