Econ Final Review - Government Debt Not everyone holds the...

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Government Debt Not everyone holds the debt (+/-) o If bondholders are only the rich, then they alone receive the interest payments. They will receive more in interest than they pay in taxes, so they will gain. o If poor individuals do not hold many bonds, they may end up having to pay more in taxes than they are receiving in interest payments Debt promotes overconsumption (-) o By regarding their bond holdings as part of their savings, individuals feel they can afford to spend more on consumption o By holding bonds, many end up undersaving and overconsuming Debt can create inflation (-) o If the gov. decides to finance its debt by issuing bonds that are purchased by the Federal Reserve, inflation may result o The reason is that the Fed pays for bonds by creating an equivalent deposit in the Treasury’s account at the Fed, which causes the economy’s money supply to rise Crowding out private investment (+/-) o If, to sell its bonds, the gov. raises the interest rate on the bonds it offers, it forces private businesses to raise the rates they offer on their corporate bonds o As a result, gov. debt may end up crowding out private investment and slowing economic growth in the private sector Inflation Who benefits? o Debtors - those in debt will gain from an increase in the amount of money on the market—easier for them to pay off their debt o Those who can adjust their prices/wages ahead of inflation Who loses? o Creditors - those who are owed money will lose from a decrease in the amount of money on the market—less likely for them to get paid back o People on fixed incomes Monetary Policy Fast implementation, flexible, since it is a technical process (made by the FED) More effective during times of inflation During Recession o Increase money supply : decrease interest rates o This is not very effective though, since consumers and investors don’t respond much to changes in interest rates during times of uncertainty, such as a recession During Inflation o Decrease money supply : raise interest rates o Raising interest rates is effective because it will increase aggregate demand, and then prices o It may reduce the pressure on prices directly (M *V=P *Q)
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Fiscal Policy Slower implementation because it requires a slow political process to take place (made by Executive and Congress), which involves the issue of what gov. expenditures or taxes to alter More effective during times of recession During Recession o Decrease taxes, increase gov. expenditures o This is effective because people respond to lower taxes and has a quicker impact on aggregate demand During Inflation o Increase taxes, decrease gov. expenditures o This is not as effective because many people are opposed to higher taxes Some Terms Budget Deficit = Government Expenditure – Tax Revenues (if G>T) Budget Surplus = Tax Revenues – Government Expenditure (if G<T) Supply Side Economics Taxes o Lower taxes = higher profits for firms = more investment and
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This note was uploaded on 04/29/2008 for the course ECON 103 taught by Professor Petry during the Fall '08 term at University of Illinois at Urbana–Champaign.

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Econ Final Review - Government Debt Not everyone holds the...

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