Economics - Tax and Fiscal Policy

Summary

Taxes are an integral part of your life as an American. Each April you spend countless hours pouring over records and receipts, or paying an accountant to do this, in preparation for income taxes. Similarly, in most states whenever you purchase something, like clothing or a car, you are required to pay sales tax. These are just two of the most common taxes faced by the American people. Others include luxury tax, inheritance tax, and corporate income tax. What is all of this tax money used for? Why does the amount of tax change from place to place and from year to year?

Tax revenues are used to support government spending. Health care, defense, social security, and politicians' salaries are all government expenses. From an economic standpoint, it is reasonable to think of the American government as one large company. The total amount of government spending is dictated by the governmental budget, just as the spending of a company is dictated by the budget.

Through taxes and government spending, the American government has a direct hand in the workings of the economy. By changing either taxes or government spending, the government affects the amount of money available to the public. Changes in taxation and in government spending are called fiscal policy. The government actively uses fiscal policy to steer the American economy. In this SparkNote, you will learn both how and why the government utilizes fiscal policy.

But fiscal policy is not the only means that the government possesses to steer the economy. Through monetary policy, the Fed is able to affect output. The key factor that the Fed uses to affect the economy is the interest rate. Because the growth of the economy is dependent upon the interest rate, by manipulating this variable the Fed can effect an increase or decreases in output to help maintain stable growth and low inflation. The workings of monetary policy will also be revealed in this SparkNote. Together, monetary policy and fiscal policy work together as reigns to steer the mighty horse of the economy in the right direction.

 Terms

Money

Terms

Bartering - The trading of one good for another. This requires the double Coincidence of wants, a condition met when two individuals each have different goods that they other wants.

Commodity Money - Money that has an intrinsic value, that is, value beyond any value given to it because it is money. An example of this would be a gold coin that has value because it is a precious metal.

Compound Interest - Interest that is paid on a sum of money where the interest paid is added to the principal for the future calculation of interest. Click here to see the Formula.

Consumption - The purchase and use of goods and services by consumers.

Currency - The form of money used in a country.

Defaulting on the Loan - When a borrower fails to repay a loan leaving the lender without the money loaned.

Demand for Money - The amount of currency that consumers use for the purchase of goods and services. This varies depending mainly upon the price level.

Equilibrium - The state in a market when supply equals demand.

Fiat Money - Money that has no intrinsic value, that is, its only value comes from the fact that a governing body backs and regulates the currency.

Fischer Effect - The point for point relationship between changes in the money supply and changes in the inflation rate.

Inflation - The increase of the price level over time.

Interest - Money paid by a borrower to a lender for the use of a sum of money.

Interest Rates - The percent of the amount borrowed paid each year to the lender by the borrower in return for the use of the money.

Liquidity - The ease with which something of value can be exchanged for the currency of an economy.

Medium of Exchange - An item used commonly to trade for goods and services.

Money Supply - The quantity of money in an economy. In the US this is controlled through policy by the Fed.

Nominal GDP - The total value of all goods and services produced in a country valued at current prices.

Nominal Interest - The percent of the amount borrowed paid each year to the lender by the borrower in return for the use of the money not taking inflation into account.

Nominal Value - The value of something in current dollars without taking into account the effects of inflation.

Output - The amount of goods and services produced within an economy.

Price Level - The overall level of prices of goods and services in an economy. This is used in the calculation of inflation rates.

Purchasing Power - The real value of a dollar. This describes the quantity of goods and services that can be purchased for a dollar, taking into account the effects of inflation.

Quantity Theory of Money - The theory that says that the value of money is based on the amount of money in circulation, that is, the money supply.

Real Interest - The percent of the amount borrowed paid each year to the lender by the borrower in return for the use of the money adjusted for inflation.

Real Value - The value of something in taking into account the effects of inflation.

Store of Value - A good that holds a value in such a way that its price is fairly insensitive inflation.

Unit of Account - Something that is used universally in the description of money matters such as prices. The unit of account most commonly used in the US is the dollar.

Value of Money - The purchasing power of the dollar. The amount of goods and services that can be purchased for a fixed amount of money.

Velocity - The speed with which a dollar bill changes hands. The higher the velocity of money, the quicker that a given piece of currency will be traded for goods and services.

Wage - The amount of money paid to workers by employers valued in current dollars.

Velocity of Money

M * V = P * Y where M is the money supply, V is the velocity, P is the price level, and Y is the quantity of output. P * Y, the price level multiplied by the quantity of output, gives the nominal GDP. This equation can be rearranged as V = (nominal GDP) / M. It can also be converted into a percentage change formula as (percent change in the money supply) + (percent change in velocity) = (percent change in the price level) + (percent change in output).

Compound Interest

First, calculate the value of the loan, by adding one to the interest rate, raising it to the number of years for the loan, and multiplying it by the loan amount. Then, to calculate the amount of interest, simply subtract the original loan amount from the total due.

Real Interest Rate

The real interest rate is equal to the nominal interest rate minus the inflation rate.

Terms and Formulae

Terms

Base year - The year from which constant prices or quantities are taken in calculations of such indices as real GDP and CPI.

Bureau of Labor Statistics - The government organization responsible for regularly gathering data about the economic status of the population.

Consumer price index (CPI) - A cost of living index that measures the total cost of goods and services purchased by a typical consumer within a country.

Fixed basket - A set group of goods and services whose quantities do not change over time. This is used, for instance, in the calculation of the CPI.

Gross domestic product (GDP) - The sum of the market values of all final goods and services produced within a particular country during a period of time.

Gross domestic product deflator (GDP deflator) - The ratio of nominal GDP to real GDP for a given year minus 1. The GDP deflator shows how much of the change in the GDP from a base year is reliant on changes in the price level.

Gross domestic product per capita (GDP per capita) - GDP divided by the number of people in the population. This measure describes what portion of the GDP an average individual gets.

Gross national product (GNP) - An alternative measure of economic activity to GDP. GNP is the sum of the market values of all goods and services produced by the citizens of a country regardless of their physical location.

Nominal gross domestic product (nominal GDP) - The sum value of goods and services produced in a country and valued at current prices.

Real gross domestic product (real GDP) - The sum value of goods and services produced in a country and valued at constant prices, calibrated from some base year. Real GDP frees year-to-year comparisons of output from the effects of changes in the price level.

Formulae


Gross Domestic Product GDP = [(quantity of A X price of A) + (quantity of B X price of B) + ... + (quantity of N X price of N)] for every good and service produced within the country

GDP = (national income) = Y = (C + I + G + NX)

GDP Growth Rate GDP growth rate = [(GDP for year N) / (GDP for year N-1)] - 1

GDP Deflator GDP deflator = [(nominal GDP) / (real GDP)] - 1

GDP Per Capita GDP per capita = (GDP) / (population)

Measuring the Economy

Macroeconomists use a variety of different observational means in their effort to study and explain how the economy as a whole functions and changes over time. One such method relies on personal experience. It is relatively simple to notice that your company is producing more than it has in the past or that a paycheck does not go as far as it used to. Yet while personal observations do provide information about the economy, that information can often be localized rather than universal, and may not accurately reflect the state of the economy as a whole.

In order to move beyond the limitations inherent in personal experiences, macroeconomists begin by systematically measuring the basic elements of the economy in order to derive standard and comprehensive statistics. This data provides information about the entire economy rather than simply about a single household or firm. Two of the most fundamental elements macroeconomists study are the total output of an economy (GDP) and the cost of living within an economy (CPI). Gross domestic product, or GDP, is an indicator of economic performance that measures the market value of goods and services produced within a country. This measurement is of great importance to consumers since it also equals the total income within an economy. The consumer price index, or CPI, is a cost of living indicator; it measures the total cost of goods and services purchased by a typical consumer within a country. This index allows economists and consumers to see just how much purchasing power a dollar yields, and to compare that power between different years and eras. Together, GDP and CPI show how much income exists within an economy and how much this income can purchase.

The concepts of GDP and CPI open the door to a scientific understanding of the functioning of the economy on a large, or macro, level. These are the most basic tools of measurement used by macroeconomists, policy makers, and consumers to understand and describe the economy. In fact, GDP and CPI are published and discussed regularly in the media. Through understanding the concepts of GDP and CPI, the world of macroeconomics begins to unfold...