Download Macroeconomics – Unit 4 Effects of Fiscal and Monetary Policy I

Macroeconomics – Unit 4
Effects of Fiscal and Monetary Policy
I.
Monetary Policy
a. Definition – policies of a central bank (e.g. the Federal Reserve) which adjusts the
quantity of money in the economy
i. Goals
1. Keep inflation in check
2. Maintain full employment
3. Moderate the business cycle
b. Review monetary policy actions:
i. Open market operations
ii. The reserve requirement
iii. The discount rate
iv. The federal funds rate
v. The term auction facility
c. Expansionary Monetary Policy
i. What do we mean by “expansionary?”
1. “easy money policy” – expanding the money supply to make money
“cheaper” to obtain
ii. To increase output (Real GDP) by lowering the interest rate to bolster borrowing
and spending
1. Increase aggregate demand
2. Expand real output (GDP)
iii. Actions to expand the money supply:
1. Target a lower Federal Funds Rate
a. Open market operations – buy bonds from banks and the public
b. Supply of reserves increases, lowering the federal funds rate
c. Larger supply of money causes downward pressure on other
interest rates
i. Prime interest rate – the benchmark used by banks as a
reference point for a wide range of interest rates
charged on loans to businesses and individuals
d. Lower interest rates causes a right shift in aggregate demand as
consumption increases due to “cheaper” money
e. Real output increases
d. Restrictive Monetary Policy
i. What do we mean by “restrictive?”
1. “tight money policy” – contracting the money supply to make money
“harder” or “more expensive” to obtain
ii. To combat effects of rising inflation (the price level) by increasing the interest
rate to discourage consumption
1. Slow down expansion of aggregate demand
2. Hold down price-level increases
iii. Actions to contract the money supply:
1. Target a higher Federal Funds Rate
a. Open market operations – sell bonds to banks and the public
b. Absorb reserves in the banking system
c. Supply of reserves decreases, raising the federal funds rate
d. Smaller supply of money causes upward pressure on other
interest rates
i. The prime rate increases
e. Higher interest rates causes a left shift in aggregate demand as
consumption decreases due to “more expensive” money
f. Expansion of real output slows down thus slowing the rise in the
price level
e. Effects of Monetary Policy on Real GDP and the Price Level
i. Expansionary Monetary Policy
1. Usually in response to periods of higher than desired unemployment
and a recession (review: RECESSIONARY GAP)
2. Desired effect is to increase Real GDP
3. How?
a. Fed buys bonds, lowers reserve ratio, lowers the discount rate
b. Excess reserves increase
c. Federal Fund Rate falls
d. Money Supply rises
e. Interest rate falls
f. Investment spending increases
g. Aggregate demand increases
h. Real GDP rises
4. What we don’t know
a. How much the interest rate falls is not exact or can be fully
anticipated: increase in money supply might be too small to
have any effect
b. Interest rate falls by “enough” – investment spending increases,
interest rates falls by a little – undetermined about the increase
in investment spending
ii. Restrictive Monetary Policy
1. Usually in response to periods of rising inflation (review: INFLATIONARY
GAP)
2. Desired effect is to reduce or slow down the rise in the price level
a. How?
i. Fed sells bonds, increases reserve ratio, raises the
discount rate
ii. Excess reserves decrease
iii. Federal Funds Rate rises
iv. Money supply falls
v. Interest rate rises
vi. Investment spending decreases
vii. Aggregate demand decreases
viii. Inflation declines
b. What we don’t know?
i. Will restriction of money supply decrease AD too much?
1. Fall further than full employment resulting in
lower GDP
f.
II.
Monetary policy as stabilization policy
i. Advantages
1. Speed and flexibility
2. Isolation from political pressure
ii. Problems
1. Lags
a. Fed may not be able to recognize quickly the economic
indicators which would trigger monetary policy actions
b. Once actions are taken, there may be an operational lags as the
actions begin to take the desired effect
2. Cyclical Asymmetry
a. Monetary policy is less reliable in pushing an economy from a
severe recession
b. Restrictive monetary policy could cause banks to reduce the
volume of loans too much
c. Added reserves may not be loaned out by banks or borrowed by
businesses
Fiscal Policy
a. Definition
i. Use of the federal budget to encourage sustained economic growth and the
business cycle
b. Types
i. Discretionary – a fiscal action that is initiated by an act of Congress (e.g.
increase in defense spending or a cut in the income tax) (main type of fiscal
action)
ii. Automatic – a fiscal action that is triggered by the state of the economy (e.g.
increase in unemployment causes increase in unemployment benefits paid out
by gov’t or a fall in income reduces tax revenue)
c. Expansionary Fiscal Policy
i. When a recession occurs, the gov’t will take a fiscal policy action to try to
increase expenditures/consumption to bring GDP back to full-employment
ii. Fiscal Policy Actions
1. Increase Gov’t spending
a. Demand side effects
i. Gov’t spending multiplier – a magnification effect of a
change in gov’t spending on aggregate demand
b. Supply side effects
i. Gov’t spending increase production possibilities (by
making workers/businesses more productive for
instance)
ii. Gov’t spending that increases the quantities of
productive services and capital, increases potential
GDP, and increases aggregate supply
2. Tax Reductions
a. Demand side effects
i. Tax multiplier – a magnification of a change in taxes on
aggregate demand
1. A decrease in taxes results in an increase in
disposable income
2. Marginal propensity to consume increases, thus
raising aggregate demand
b. Supply side effects
i. Taxes are disincentives to work, save, and provide
entrepreneurial services
ii. Creates less production possibilities (lower potential
GDP, aggregate supply)
iii. Tax reductions increases potential GDP and increases
aggregate supply
3. Combined gov’t spending increases and tax reductions
a. Mix gov’t spending and tax reductions to get the desired effect
on aggregate demand/aggregate supply
d. Contractionary Fiscal Policy
i. When inflation occurs, the gov’t will take a fiscal policy to try to control the rise
of prices
ii. Fiscal Policy Actions
1. Decrease Government spending
a. Demand side effects
i. Gov’t spending multiplier – reduces the effect of gov’t
spending on output by the spending multiplier
b. Supply side effects
i. Gov’t spending cuts decrease production possibilities
ii. Gov’t spending cuts decrease potential GDP and
decreases aggregate supply
2. Tax increases
a. Demand side effects
i. Reduce consumption spending by reducing the amount
of disposable income available to
households/businesses resulting in slower rising prices
b. Supply side effects
i. Tax increases reduce potential GDP and decrease
aggregate supply resulting in slower rising prices
3. Combined gov’t spending decreases and tax increases
a. Mix gov’t spending cuts with tax increases to get the desired
effect on the rate of inflation
e. Fiscal policy as stabilization policy
i. Advantages
1. Can have a direct and immediate effect on aggregate
demand/aggregate supply
2. Preserves gov’ts essential role in the economy
ii. Problems
1. Law making time lag
a. The amount of time it takes Congress to pass the laws needed
to change taxes or spending. Very politicized process!
2. Estimating Potential GDP
a. It is not easy to tell where real GDP is below, above, or at
potential GDP so a discretionary fiscal action might move real
GDP away from potential GDP
3. Economic forecasting
a. Fiscal policy takes a long time to become effective
b. Requires accurate forecasting of where the economy will be in
the future
c. Forecasting is better but it is also inexact and subject to error