Introduction to Economics

Egor Sidorov

Economic policy deals with …

─ economic growth─ price stability ─ interest rates─ foreign exchange rate ─ employment

─ Policy can either be expansive or restrictive

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1. Fiscal policy

2. Monetary policy

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Private and Public sectors

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Public expenditures

─ Current expenditures for:─ goods and services,─ interest payments,─ subsidies,─ transfers.

─ Capital expenditures.

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Macro-economic aspects of public expenditures

─ Public expenditures are important part of total incomes and expenses.

─ Public expenditures on goods and services (G) is an important part of AD.─ AD (aggregate Demand) = Aggregate Expenditure =

C + IG + G + NX

─ G influences employment and production in the economy.

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Growth of public expenditures

─ demographic factors:─ militant affairs,─ inflation trends (higher costs for goods and

services),─ technological changes (increased labour

productivity),─ production volumes growth – increase of taxes,─ political and social influences,─ etc.

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System of public budgets

─ State budget,─ Local budgets (regional, municipal),─ Special centralized funds

─ i.e. in CR – National Property Fund, Land Fund, Environmental Fund etc.

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State budget

─ Passes in a Parliament as a law. ─ The fact of approval law implies confidence in government

and its policy.

─ Budget is being approved for a Fiscal year ─ USA: September – September,─ Japan: March – March,─ UK: April –April.

─ Any budget has 2 parts:─ Revenue side─ Expenditure side

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Income of the State budget

─ Direct taxes: ─ taxes on persons or property,

─ individual income tax,

─ employee social insurance tax,

─ corporate tax,

─ property tax,

─ Indirect taxes:─ taxes on events or transactions,

─ employer payroll tax,

─ sales tax (including excise and value-added).

─ Other incomes for state budget:─ Customs duties,

─ loans from abroad,

─ incomes from public offerings of state bonds

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Principles of taxation

─ Fairness, efficiency, purpose.─ The benefits principle is the idea that people should

pay taxes based on the benefits they receive from government services. (I.e. gasoline tax: revenues from a gasoline tax are used to finance the highway system).

─ The ability-to-pay principle is the idea that taxes should be levied on a person according to how well that person can shoulder the burden: ─ Vertical equity (progressive and regressive system).─ Horizontal equity (equal conditions).

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State budget: Result of the fiscal year

─ Balanced budget─ Surplus budget ─ Deficit budget

─ Two types of deficits exist:─ Cyclical deficit – related to the business cycle.─ Structural (active) deficit – related to the measures of the

economic policy (taxation, volume of expenditures…).

─ State budget deficit compensation measures: ─ State bonds sale,─ Loans from abroad.

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Fiscal Policy: Objectives and Tools

─ Main objectives:─ Balancing the budget (Pre-Great Depression)─ Promoting full employment with price stability (Post

Keynes and WWII) ─ Eliminating critical points of economic cycles─ Economical growth promotion

─ General tools:─ Discretionary Fiscal Policy ─ Automatic Stabilizers

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Tools of Discretionary Fiscal Policy

─ Government purchases─ Transfer payments─ Taxes and Borrowing

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AD1

AD2

The government increases its purchases. The aggregate demand function shifts up.► Increased government purchases increase real GDP. ► Increased real GDP increases disposable income. ► Increased disposable income increases consumption.► Increased consumption increases real GDP (The cycle continues).

Automatic Stabilizers

─ Automatic Stabilizers stimulate AD during periods of recession and dampen AD during periods of expansion.

─ They do not require yearly congressional action to operate.

─ Examples of automatic stabilizers:─ progressive income tax with its increasing marginal income tax

rates,─ unemployment insurance,─ welfare spending.

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1. Fiscal policy

2. Monetary policy

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Money

─ Three main functions of money. ─ Accounting unit.

─ Everything in economic life can be measured by money.

─ Store of value. ─ You can hold your wealth as money.

─ Medium of exchange. ─ Money allows us to carry on purchasing transactions.

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What is money?

─ Money = everything used as a tool for exchange─ Historical development:

─ Natural exchange. ─ Commodity money:

─ Many things have been money over the centuries: cattle, stones, beads, iron, copper, zinc, cigarettes, silver and gold, ...

─ Gold and silver hold a place of special importance because they─ are relatively scarce,─ have a high value for unit of mass,─ are easily divisible,─ are durable and easily worked,─ are considered rather valuable themselves.

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Gold standard

─ Up until quite recently, gold was money. ─ 1933 - the United States went off the domestic gold

standard. Gold was stored in government vaults, and in it's place people were issued paper money which was "backed" by gold or silver on a one for one basis.

─ 1973 - the U.S. left off the international gold standard. ─ This meant that gold and silver no longer had any

monetary role whatever. They became (and remain) „normal” industrial commodities.

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Money aggregates

─ Transaction money M1: ─ Currency (paper bills and coins) is obviously the

most liquid of all assets. ─ Checking accounts (current accounts) are nearly

as liquid as currency (think of debit cards).

─ Broad money M2: ─ M1 (currency and checking accounts) ─ + deposits in saving accounts (short time)

─ Aggregate M3: ─ M2 + shares of money market, deposits in saving

accounts (long time) …, etc.

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Low

High

Liquidity

Monetary Policy

─ Main participant: Central Bank ─ Czech National Bank, Federal Reserve Bank, the Bank of

Canada, State Bank of Namibia…)

─ Functions:─ Fights against inflation.─ Promotes the efficiency of finance system.─ Ensures financial system stability.

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Main Central Bank’s clients:

─ Commercial banks:─ Transaction execution between banks.─ Control of their assets and their performance.

─ The government:─ Keeps it’s accounts.─ Accumulates tax-income.

─ Other central banks.

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Demand for money

─ The demand for money is related with peoples intensions to hold (save) or spend the money.

─ There are three reasons why people wish to save/spend:─ Transactions demand: demand for day-to-day money by

firms and households for buying goods and services.─ Precautionary demand: demand for money by firms and

households caused by the wish to save money in case of unexpected.

─ Speculative demand: this is demand for money as financial asset for investment opportunities.

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How much money should be in the economy?

─ The theory by Irving Fischer:

─ M-money in circulation,─ V-velocity of circulation,─ P-average price level in transactions made,─ T-number of transactions.

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PTMV

Direct (administrative) tools of the monetary policy

─ tools limiting and influencing banking sector market. ─ These tools are used as exceptional and short term:

─ Mandatory structure of assets and liability for commercial banks.

─ Credits, loans limits. One of the most tough direct tool. ─ Obligatory deposits – obligation for state institutions to

have account at the central bank (for example revenues authorities, ministries, etc.).

─ Gentleman's agreements between central bank commercial banks

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Indirect tools of the Central Bank

─ Tools are influencing all participants of financial market; they could be used without time limitation.

─ Basic tools:─ Setting the Discount Rate─ Reserve Requirements─ Open Market Operations─ Foreign exchange market operations

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Discount Rate

─ This is the interest rate the CB charges to banks that borrow funds from the CB (bank rate). ─ ↑ discount rate > raise price of money > commercial

banks are lending lower amount of money > money are „suck out“ from economy > money circulation slow down – (anti-inflation) restrictive monetary policy;

─ ↓ discount rate > reduce price of money > commercial banks are lending higher amount of money > money are „suck in“ economy > money circulation speed up – expansive monetary policy

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Required Reserves (RR)

─ This is the ratio of reserves to deposits required by law. RR is very powerful and affects all banks equally (as small change results in a large change in money supply). ─ ↑ RR raise price of money > money are „suck out“ from

economy > money circulation slows down – (anti-inflation) restrictive monetary policy;

─ ↓ RR > reduces price of money > money are „suck into“ economy > money circulation speeds up – expansive monetary policy

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Open Market Operations

─ Central national bank buying and selling of bonds (e.g. government securities) in the open market.

─ NB sells bonds, commercial banks pay money to the NB, decreasing reserves. ─ CB´s sells bonds > raise price of money > money are

„suck out“ from economy > money circulation slow down – (anti-inflation) restrictive monetary policy;

─ CB´s buy bonds > reduce price of money > money are „suck in“ economy > money circulation speed up – expansive monetary policy

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Foreign exchange market operations

─ National Bank influences the national currency exchange rate by using the direct market interventions.─ When the market experiences the lack of foreign currency >

the exchange rate tends to rise > the national currency becomes cheaper > the CB enters the market and sells it’s foreign currency reserves therefore supporting the exchange rate.

─ When the exchange rate of national currency tend to become very high due to the excess of foreign currency or due to market agent’s expectations > the CB enters the market and buys the foreign currency, increasing the demand and therefore the price for foreign currency.

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Thank you for attention!

Refernces:SAMUELSON, P. A., NORDHAUS, W. D. Ekonomie 18. vydání. Praha: Svoboda, 2005.

KRAFT, J., RITSCHELOVÁ, I. Ekonomie pro environmentální management. Ústí n. L.: UJEP, 2003.

MCDOUGAL LITTELL. Economics: Concept and Choices. Canada: McDougal Littell, 2008.

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