ECON 0110 1st Edition Lecture 24AUTOMATIC STABILIZERS:Changes in tax revenue or government spending that occur AUTOMATICALLY as theeconomy grows which reduce the size of the growth or which occur automatically whenthe economy contracts to reduce the size of the contractionAutomatic stabilizers are effects which occur AUTOMATICALLY and which reduce themagnitude of swings in the business cycle.BENEFICIAL EFFECT OF AUTOMATIC STABILIZERS DURING A RECESSION:During a recession, government spending on items such as welfare, food stamps, andunemployment compensation increases automatically. This increased government spendingtends to boost the consumption spending of households and reduces the size of the economy’scontraction.During a recession, as incomes fall, the amount that the government takes from us in taxes willdecrease. The reduction in taxes boosts our remaining disposable income a bit and helpsreduce the magnitude of the economy’s contraction.Automatic stabilizers are beneficial during a recession.These notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.NEGATIVE EFFECT OF AN AUTOMATIC STABILIZER DURING AN EXPANSION(FISCAL DRAG)During an expansion, household incomes increases and government tax revenue increases. Thisdampens the potential increase in disposable income and thereby dampens the potentialincrease in consumption expenditures. This causes the expansion to be moderated.Also, during an expansion, government spending on welfare and unemployment compensationwill decrease. This reduction in government spending will again dampen the increase inconsumption spending and will cause the expansion to be moderated.REFINANCING THE NATIONAL DEBTWhen government bonds mature, the government must pay the principal that is due to thelenders (the bondholders).If the Treasury has a surplus, which occurs very rarely, the Treasury can use the excess taxrevenue to pay off the principal to some of the bondholders. The bond would now be cancelledand the National Debt would decrease.If the Treasury has a deficit, the Treasury must find some new way to obtain money so it can paythe principal to the bondholders whose bonds have matured. Frequently, the Treasury obtainsthe “new” money by “refinancing the debt”.“Refinancing the debt”, or “rolling over the debt”, occurs when Treasury issues new bonds togenerate enough revenue to pay off maturing bondsSHOULD WE PAY OFF THE NATIONAL DEBT?Suppose the Federal government has a surplus.The Treasury could use the extra cash to retire some outstanding bonds.In that case, the national debt decreasesAs a result, some future interest payments will decrease.This means that less tax revenue is needed in the future to pay interest on the debt.Also, as Treasury pays off debt, more funds become available for other borrowers.As a result, market interest rates might tend to decreaseThis could stimulate consumer and business borrowing and spending.MANY TAX PAYERS PREFER TAX CUTS TO PAYING OFF THE FEDERAL DEBTWhen the Treasury has a surplus, it can use the surplus funds to pay off part of the NationalDebtWhen the Treasury has a surplus, it is collecting more money from taxpayers than is needed tofund the government’s current expensesIn this case, many taxpayers would prefer cutting current taxes instead of reducing the NationalDebt.President Bush followed this scenario in 2001.SOME OF THE NATIONAL DEBT IS OWNED BY THE FEDERAL RESERVE SYSTEMThe FED can buy government bonds from bond holders.The Federal Reserve System issues checks (i.e., it creates new money when it purchases bondsfrom the public). This causes the nation’s money supply to increase.The Fed now would own the government bonds and would be entitled to the interest paymentsand the principal at maturity.The Fed is a nonprofit organization and returns much of the interest and principal back to theTreasury Department.Thus, the bonds owned by the Fed have basically been removed from the National Debt!When the Fed purchases bonds from the public, new money is inserted into the economy andthe money supply increases.It is illegal for FED to purchase bonds directly from the TreasuryThis prevents the Treasury from colluding with the Fed to have an unlimited source of funds topay for a vast expansion of government projectsThis helps prevent hyperinflation.A FED purchase of bonds causes the money supply to increaseThis is called an OPEN MARKET OPERATION.The FED owns about 40% of the total national debt.When the Treasury pays interest to the FED, the FED uses some of the interest to pay its bills.Then, the FED returns excess interest to the Treasury.Thus, part of the national debt owned by the FED is interest free.“COST” OF THE NATIONAL DEBTThe “true” COST of the national debt is the interest that must be paid on the Treasury securitiesCurrent taxes would be lower if there were no Federal debt.THE BENEFIT OF THE NATIONAL DEBTThe “BENEFIT” of the national debt is the fact that current taxpayers have been spared theburden of paying for many of the goods, services, and transfer payments that have beenprovided by the government.Current bondholders provided the money by lending to the government.The national debt never needs to be paid off as long as the Treasury can convince new investorsto buy bonds and refinance the debt.THE FEDERAL OPEN MARKET COMMITTEE (FOMC)12 members7 members of the BOARD OF GOVERNORSPresident of the New York Federal Reserve Bank4 Presidents from the other 11 district banks (on a yearly rotating basis)FOMC meets 8 times a year (about every 6 weeks)FOMC decides MONETARY