The Government’s involvement in the American economy extends beyond industry regulations. It encompasses supervision of economic activity to uphold stable prices and high employment rates. This is accomplished through two primary approaches: fiscal policies, which dictate taxation and expenditure levels; and monetary policies, which manage the money supply.
Fiscal policy and monetary policy have an impact on economic activity by adjusting government expenses and taxes. These policies can be used to respond to recessions or inflation. The creation of fiscal policy is a complex process that involves the president presenting an annual budget to Congress. Congress then evaluates the suggestions, starting with decisions on spending and taxation levels.
The budget process is a complex procedure that involves categorizing the overall figure into various areas such as national defense, health and human services, and transportation. Congress then examines specific appropriations bills to decide how funds will be allocated in each category. For these bills to take effect, they need the president’s signature. This thorough process typically spans an entire session of Congress, beginning with the president’s proposals in February and concluding when Congress completes drafting appropriations bills in September or beyond.
The income tax on individuals is the main source of funding for the federal government’s expenses, making up about 48% of total federal revenues in 1999. Payroll taxes have become more important because of the growth of Social Security and Medicare programs. In 1998, one-third of all federal revenues came from payroll taxes, with both employers and workers contributing 7.65% of their wages up to $68,400 per year.
The federal government obtains 10% of its revenue from corporate profit taxes and the rest from different types of taxes. On the other hand, property taxes are the main source of tax revenues for local governments. While state governments used to heavily rely on sales and excise taxes in the past, income taxes have become more important since World War II. Over time, lawmakers have introduced exemptions and deductions in income tax to encourage specific economic activities.
Individuals can benefit from various tax advantages, such as being able to deduct the interest paid on home loans from their taxable income. Lower- and middle-income taxpayers have the opportunity to save money in special Individual Retirement Accounts (IRAs) that are not subjected to taxation. These savings can be used for retirement expenses or their children’s college education.
The Tax Reform Act of 1986 brought significant changes to the U.S. tax system. It resulted in lower income tax rates and eliminated certain deductions while retaining deductions for home mortgage and IRAs. The act also simplified the tax system by reducing the number of tax brackets and lowering the top tax rate, providing additional relief for many low-income Americans.
In the later years of the 20th century, there was a notable shift in how the overall economy was managed. The main focus moved from fiscal policy to monetary policy, although it is important to note that the budget still remained significant during this transition. “The Fed,” also known as the Federal Reserve System, an independent U.S. government agency, now assumes responsibility for monetary policy. This system consists of 12 regional Federal Reserve Banks and 25 Federal Reserve Bank branches. All nationally chartered commercial banks must be members of the Federal Reserve System, while state-chartered banks have the choice to join or not.
The Federal Reserve System serves as a regional bank for member banks by utilizing the Reserve Bank in their respective regions. It is managed by the Federal Reserve Board of Governors, which consists of seven members appointed by the president for overlapping 14-year terms. The key decisions regarding monetary policy are made by the Federal Open Market Committee (FOMC), comprised of the seven governors, the president of the New York Federal Reserve Bank, and presidents from four other rotating Federal Reserve banks.
The Federal Reserve System operates independently from Congress and the president as required by law, while still being obligated to periodically report to Congress. To enhance this autonomy, significant policy discussions of the Fed are held privately and later made public after a designated period. Moreover, all operational expenses of the Fed are funded through investment earnings and service fees. The Federal Reserve employs three primary tools for managing the money supply and credit in the economy.
The Federal Reserve’s main method for impacting the money supply is known as open market operations. This procedure consists of purchasing and selling government securities. When the Fed wants to increase the money supply, it purchases government securities from banks, businesses, or individuals using newly printed money. As these checks are deposited in banks, new reserves are created. Banks can then lend or invest a portion of these reserves, which in turn increases the amount of circulating money. Conversely, when the Fed intends to decrease the money supply, it sells government securities to banks and collects reserves from them.
As a result of diminished reserves, banks are obligated to diminish their lending activities, which leads to a reduction in the money supply. Additionally, the Federal Reserve possesses authority over the money supply by dictating the reserves that deposit-taking institutions must possess as either currency within their vaults or deposits at regional Reserve Banks. When reserve requirements are raised, banks must retain a greater portion of their funds, resulting in a decline in the money supply. Conversely, lowering requirements has an opposite effect of expanding the money supply. Overnight, banks frequently engage in interbank lending to fulfill their reserve requirements.
The “federal funds rate” is a crucial gauge of the strictness or leniency in monetary policy. It signifies the interest rate that Reserve Banks impose on commercial banks for borrowing. Through manipulating this rate, the Federal Reserve can influence borrowing, thus impacting banks’ access to loan funds. These mechanisms empower the Federal Reserve to manage the supply of money and credit in the U.S. economy.
If the money supply increases, it is known as loose credit which leads to lower interest rates, increased spending from businesses and consumers, and higher employment rates. However, if the economy is already operating at its maximum potential, an excess of money can result in inflation or a decrease in the dollar’s value. Conversely, when the money supply decreases, credit becomes tight causing interest rates to rise and spending to stabilize or decline while inflation diminishes. In cases where the economy is functioning below capacity, tight money can cause unemployment to increase.
