While the United States is accurately characterized as a capitalistic
system in which the ups and downs of the market are largely dictated by
the economic transactions of individuals and groups, the United States
Government nonetheless plays a significant role in regulating the nation's
economy. The government's economic policies can generally be broken down
into two major categories: monetary policy and fiscal policy.
Constitution grants Congress the authority to coin money and to establish
its value. The federal government's monetary policies are aimed at managing
the economy by regulating the money supply. By making monetary adjustments,
the government attempts to keep inflation and unemployment under control.
The primary mechanism used for this purpose it the Federal Reserve Board's
control of the "discount rate" on which banks base their interest
rates. The Federal Reserve Board (often called the "Fed") is
a private-public banking regulatory body established in the early 1900s.
During difficult economic times, the Federal Reserve will usually lower
interest rates to encourage investment in the economy. When the economy
is booming, the Fed will sometimes raise interest rates to keep inflation
under control. (PHOTO at Right: The New York Stock Exchange. Stock
prices (and the world economy) are sensitive to U.S. monetary and fiscal
policy. What happens on Washington more often than not has a direct impact
on Wall Street).
The Federal Reserve System
The Federal Reserve acts as an independent central bank--its decisions
do not have to be affirmed by the President or the Congress. While the
Congress retains ultimate authority to coin and print money and to set
its value, it delegated this authority to the Federal Reserve Board with
the Federal Reserve Act of 1913. Fearful that the Federal Reserve was growing
too independent, the Congress passed the Humphrey-Hawkins Act of 1978 requiring
the Federal Reserve to submit a report on the state of the economy to Congress
twice a year. The report is presented by the Chairman of the Federal Reserve
Board of Governors at hearings before committees in the U.S. Senate and
House of Representatives.
The Federal Reserve System was explicitly empowered by the Congress "to
provide for the establishment of Federal Reserve banks, to furnish an elastic
currency, to afford means of rediscounting commercial paper, to establish
a more effective supervision of banking in the United States, and for other
The Federal Reserve System is made up of a Board of Governors and twelve
regional Federal Reserve Banks located in major cities throughout the country.
There are seven members that sit on the Board of Governors. Each member
must be nominated by the President of the United States and confirmed by
the Senate. Members are appointed to serve 14-year nonrenewable terms.
The President also nominates members of the Board to serve as Chair and
Vice Chair for four-year renewable terms. These appointments must also
be confirmed by the Senate.
The most important policy making body of the Federal Reserve System is
the Federal Open Market Committee (FOMC). It is composed of the seven Governors,
the president of the Federal Reserve Bank of New York, and four other Reserve
Bank presidents that serve on a rotating basis.
The FOMC can effect monetary policy through the use of three tools:
- Open market operations--the buying and selling of U.S. government securities
- Altering reserve requirements--the amount of funds that commercial
banks must hold in reserve against deposits
- Adjusting the discount rate--the
interest rate charged to commercial banks
These tools can be used to tighten or expand the money supply. For example,
if the FOMC wants to control inflation, it can restrict the nation's money
supply by selling government securities and raising the amount of money
that banks need to set aside for reserve requirements. Both of these actions
would take money out of circulation. In theory, a smaller supply of money
would lead to less spending which would lead to lower prices. The FOMC
can also raise interest rates to help control inflation. By making money
more expensive to borrow, consumers would be more likely to save money
rather than spend it. This could also lead to lower prices.
The FOMC meets eight times during the year to consider economic developments
and to vote on policy. In the year 2000 Federal Reserve officials raised
interest rates several times. In May the committee voted to raise short-term
interest rates by half of a percentage point to 6.5%, the highest level
since 1991. This was done in an effort to slow the pace of the U.S. economy
and keep inflation at a low, manageable level. By early 2001, however,
the Federal Reserve cut interest rates to stimulate a stagnant economy.
"Forecasting the Fed"
One good indicator of the Fed's likely actions is the "Beige Book" it
releases two weeks before each of its policy meetings. The Beige Book is
a survey of economic conditions across the country and is used as a reference
for Fed officials when considering monetary policies, such as interest
rate hikes. The Federal Reserve is primarily concerned about inflation
and many speculate that higher inflation may lead to another increase in
Fiscal policy is established by the Congress and the President through
the federal budget process. Through this process, the federal government
determines who will be taxed, what types of income and activities will
be taxed at what rates and what will be done with the money that is collected.
Taxation & Spending
Detailed information about the federal government's spending is available
in The Federal Budget.
The table below provides an overview of the impact of the federal budget
on the nation's economy. The impact of government,
however, is not limited to federal taxing & spending policies. Individuals
and corporations are generally required to pay additional state and local
income taxes. State and local governments also collect a variety of other
taxes, most notably sales taxes and property taxes.
Federal Taxation & Spending
The table below summarizes federal government income and expenditures relative
to the nation's Gross Domestic Product (GDP). GDP is a measure of the overall
size of the nation's economy. Note that all figures are in billions
The impact of federal government taxation and spending on the nation's economy
is significant. Most obviously, the federal budget accounts for about 20% of
the entire national economy. Also notice that expenditures exceed
income for all years represented in the chart. While the federal government
ran sourpusses in the late 1990s, a sagging economy has led to lower tax revenues.
Without corresponding cuts in spending, the government has return to running
deficits each year. As the economy
rebounds, however, the deficit for 2005 is projected to be much smaller than
originally anticipated. If the economy continues to grow, a return to annual
budget surpluses is possible.
|Federal Income, Expenditures & GDP
*2005 amounts are estimated. Source: http://www.gpoaccess.gov/usbudget/fy05/pdf/budget/tables.pdf
When taxes are discussed, much of the debate centers on tax "fairness." How
much should an individual or corporation be required to pay in taxes?
Should wealthy people be required to pay a higher percentage of their
income than those that are less well off? Should the government redistribute
income by taxing the rich and giving some of that money to the poor?
None of these are easily answered questions, but they must be addressed
and answered--at least tentatively--when the federal government establishes
their taxation policies each year.
Some people believe a tax is fair when it is progressive, i.e. tax rates
increase as income increases. For example, under a progressive tax system,
an individual who earns $20,000 a year would be taxed at a lower rate
than would an individual who earns $100,000 a year. Others believe that
fairness means tax rates are "flat" or proportional, i.e. all
individuals are required to pay the same percentage of their incomes,
regardless of how much they earn each year. Over the past several years
many politicians have called for a flat, or at least "flatter," tax
system in the United States.
While most Americans support either a progressive or proportional tax
system, few if any are explicitly in favor of a regressive tax system,
one in which individuals with lower incomes are taxed at higher rates
than wealthier individuals.
There are, though, examples of such taxes in the American system. Local
taxes on food, for example, tend to be regressive. Given a sales tax
on food of 5% and an income of $30,000, a family that spends $4,000 a
year on food would pay $200 in food taxes a year, or .7% of its annual
income. Comparatively, a wealthier family with an annual income of $150,000
that spent $8,000 a year on food would pay $400 in food taxes, or .3%
of its annual income. The wealthier family is effectively taxed at less
than half the rate of the lower-income family. Many states that collect
taxes on food offer tax credits or rebates to low-income families to
mitigate the regressive nature of such taxes. Another example of a regressive
tax in the United States is the payroll tax (FICA) because no social
security taxes are assessed on income over $80,400.
Terms & Concepts
fiscal policy Policies and programs establishing
budgetary policy, including types and rates of taxation and types and
amounts of spending.
flat tax Tax collected at the same rate or percentage
regardless of income level.
monetary policy Policies aimed at controlling
inflation and unemployment through manipulation of the money supply
and interest rates. Primarily established by the Federal Reserve
progressive tax Tax collected at increasingly higher
rates or percentages as income level increases.
regressive tax Tax
collected at increasingly lower rates or percentages as income level
Think About It
In your opinion, what kind of tax (progressive, regressive or proportional)
is the most fair?
Why is monetary policy controlled by an independent,
nonpolitical body (the Federal Reserve Board) while fiscal policy
is made by the President and Congress?
Read about Current Tax Policy
Budget Surpluses & Tax Cuts Tax policies are almost
always controversial. Policy makers in Washington constantly argue
over the wisdom of cutting or raising taxes. If there are budget
surpluses, should some of the money the government has raised be "refunded" to
the people, or should be spent to reduce the debt and stabilize
Social Security and Medicare? Or should the government pursue both
policies--cut taxes and set aside some of the surplus money for
Economic Policy Resources on the Web