Chapter_10 - Chapter 10 Fiscal Policy and Monetary Policy...

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Unformatted text preview: Chapter 10 Fiscal Policy and Monetary Policy Motivation for fiscal and monetary policies • When desired spending changes, aggregate demand shifts, causing short-run fluctuations in output and employment. • Monetary and fiscal policy are sometimes used to offset those shifts and stabilize the economy. Supply Side versus Demand Side Policies The AS/AD model separates long-run aggregate supply from short-run aggregate demand and aggregate supply forces. – Demand-side policies (monetary and fiscal policy) shift the AD curve. – Supply-side policies in the short run shift out the SRAS curve and in the long run work by increasing potential output. either shift the SRAS or the LRAS curve if it shifts because of labor it is self regulation, if it occurs in the supply curves because o another reason then it is supply side policy. Demand-Side and Supply-Side Policies LRAS Price Level Supply-side policies shift the LRAS and SRAS curves. SRAS AD Demand-side policies (monetary and fiscal policies) shift the AD curve YP Real output fiscal means to spend Fiscal Policy The use of government spending and taxes to influence GDP, employment, and the price level. Recall, AD = C + I + G + (X-M) T Thus, taxes affect GDP/AD through changes brought about in C and I. can divide each expansion or contraction into either discretionary or automatic, discretion is a gov sit down and plan out the economy, automatic is when the government doesnt step in and the economy takes care of itself. Fiscal Policy Definitions • Expansionary Fiscal Policy: Increases in government expenditures and/or decreases in taxes to achieve particular economic goals. this is to increase output or increase employment used during a recession, to do this • Contractionary Fiscal Policy: Decreases in government expenditures and/or increases in taxes to achieve macroeconomic goals. the goal of this is to reduce price during a inflationary gap, to do increase Taxes or reduce G the goal of decrease Taxes or increase G you can • Discretionary Fiscal Policy: deliberate changes of government expenditures and/or taxes to achieve particular economic goals. • Automatic Fiscal Policy: changes in government expenditures and/or taxes that occur automatically without (additional) congressional action. Two Key Assumptions • Only deal with discretionary fiscal policy. • Any change in government spending is due to a change in government purchases and not to a change in transfer payments. net of government spending is transfer payments such as social security, and other programs, this is g - transfer payment = net gov spending Demand-Side Fiscal Policy increase taxes and C goes down, thus ad goes down... an drop in taxes the C goes up and ad goes up Through taxes: When the government cuts personal income taxes, it increases households’ take-home pay. -Households save some of this additional income. Households also spend some of it on consumer goods. -Increased household spending shifts the AD curve to the right. Through government spending: When the government alters its own purchases of goods or services, it shifts the AD curve directly. this is a combo ch 6 and ch 7 the low slope of the SRAS curve shows that there is some stickyness of wages and prices but also allows for the flexablity of the modern people, this is the modern kaynesians Keynesian Policy: Recession • Keynesians believe that allowing for the market to self-adjust may be a lengthy and painful process. • Expansionary fiscal policy (increasing G or reducing T) stimulates demand and directs the economy to full-employment much quicker. the market has self regulation, but it is a slow process because of the rigidity of the market, but if the go steps in then the ad curve SRAS1 Price will shift must faster into LRAS Level eq. SRAS2 P2 P1 P3 2 1 3 AD1 Q1 QN AD2 Real GDP most of the time during inflationary gap, the economy is left to self regulation because no firm is going resist its own prices rising Keynesian Policy: Inflation • Keynesians believe that allowing for the market to self-adjust may be a lengthy and painful process. • Contractionary fiscal policy (decreasing G or increasing T) de-stimulates demand and directs the economy to full-employment much quicker. SRAS2 SRAS1 Price Level LRAS P3 P1 P2 3 1 2 AD2 QN Q1 AD1 Real GDP Marginal tax rate = change in t/ change in i t is the change in taxes while i is the change in taxable income this is when the public expenditures push out the private expenditure, meaning it goes down The Crowding Out Effect • Fiscal policy may not affect the economy as strongly as predicted by the multiplier. • An increase in government purchases causes the interest rate to rise. • A higher interest rate reduces investment spending. • This reduction in demand that results when a fiscal expansion raises the interest rate is called the crowdingout effect. • When the government increases its purchases by $20 billion, the aggregate demand for goods and services could rise by more or less than $20 billion, depending on whether the multiplier effect or the crowding-out effect is larger. if the US interest rates go up they ae going up as compared to the rest of the world. when the US interest rat are more attractive, the rest of the world will invest in the US, because these have to be in Dollars, everyon will want the USD to invest, this raises the demand for the dollar, and then the price of the USD will go up, means the USD has appreacitaed in value against the rest of the wolrd's money, this makes imports cheaper, so exports go down, imports go up, therefore the nx has fallen. this all happens because the public gov spending raises the interest rate causing nx to fall and private expendature to get crowded out. Types of Crowding Out • Complete Crowding Out: A decrease in one or more components of private spending completely offsets the increase in during this there is no or 0 multiplier governmenteven though its goal was to increase AD, G+ 10, C- 10 spending. effect when G spends the ad has no change • Incomplete Crowding Out: The decrease in one or more components of private spending only partially offsets the increase in government spending. during this there is some multiplier effect the gov spends more, there is a fall in c, but the change in c, i, and nx is smaller than the rise in g, therefore there is some multiplier • Zero Crowding Out: No change in private spending. during this you get the complete multiplier effect when the g goes up by 10 then ad goes up by 10, this is saying that c, d, nx = 0 Diagrammatically….. this is base on people looking into the future, be financed by borrowing,this is called deficit is because of rational expectations because the the parents of today will save today to give their kids more for them to pay back taxes The New Classical View of FP Current consumption will fall as a result of expansionary fiscal policy we assume that there is no tax revenue, gov spending can only finance, any increase in G leads to an increase in taxes. this government will raise taxes in the future to repay the debt. in the future, so the parents consume less today, • When G increases, the government borrows to finance G and lands up in a situation of debt. In order to repay this debt, T-rate in the future will go up. Thus, individuals save more today to be able to pay higher future taxes. • Deficits do not necessarily bring higher interest rates Increase in G shifts out the demand curve in the loanable funds market (as the government relies on borrowing to finance G). At the same time, anticipating higher future taxes, individuals increase their savings today and so the supply curve for loanable funds shifts out. The net effect is that the interest rate remains unchanged. • Implication: Fiscal Policy is ineffective or impotent (advocated laissez faire/self regulation) Diagrammatically….. If higher future taxes were unanticipated, AD would shift out to AD2 these are all sequential in nature so the data lag is before the wait and see, and so on and so forth freedman said that all the lags take so long that by the time you put into effect the change, the government starts to correct itself, so the government causes the sras and ad curve to shift at the same time causing the economy to go from a recessionary gap to an inflationary gap Lags And Fiscal Policy • • • • • The Data Lag The Wait-And-See Lag The Legislative Lag The Transmission Lag The Effectiveness Lag it takes time for the data to come in how long is this going to last so the people lag behind people collect data and then wait and see how long it is going to last, if they figure out that this is going to be a long one, they then design and enact policy this comes at the implementation stage, so putting it into place causes a lag once everything has been put in place, it will take time for the effect to take place, it could take weeks, months, years? Implication: Fiscal Policy may de-stabilize the economy Summary of Demand Side FP • Policymakers can influence aggregate demand with fiscal policy. • An increase in government purchases or a cut in taxes shifts the aggregate-demand curve to the right. • A decrease in government purchases or an increase in taxes shifts the aggregate-demand curve to the left. • When the government alters spending or taxes, the resulting shift in aggregate demand can be larger or smaller than the fiscal change. • The multiplier effect tends to amplify the effects of fiscal policy on aggregate demand. • The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand. Supply Side Fiscal Policies AS = Land Labor Capital Permanent tax cut shifts out both SRAS and LRAS curves. T to figure out whether the shift is because of the gov or because of laise faire check to see if the change is because of labor or more artificial changes The Laffer Curve • Shows that the amount of revenue the government collects is a function of the tax rate. • There are two tax rates at which zero tax revenues will be collected – 0 and 100%. • When tax rates are very high, an increase in the tax rate could cause tax revenues to fall. Similarly, a cut in the tax rate could generate enough additional economic activity to cause revenues to rise. up until the midpoint of B increasing taxes increases tax revenue the fed is not allowed to control the interest rate, the interest rate fluctuates based on the money supply, the fed influences the interest rate by controlling the money supply Monetary Policy • Monetary policy changes money supply, which affects interest rates. • In the short run, interest rates are set by the equilibrium of money demand and money supply. • Changes in interest rates due to changes in money supply will eventually affect AD through the channels of C and I. the fed requires that smaller banks that they must keep a certain amount in hold to sustain itself during a bank run, in which people come and get all their money during a recession, as the required reserve ratio increases, then the money supply will go down, and vise versa. the fed can affect the money supply through the federal funds rate, is th rate at which a commericial bank can borrow from the fed. they also use open market opperations they affect it as well Money Demand • People choose to hold money instead of other assets that offer higher rates of return because money can be used to buy goods and services. • The opportunity cost of holding money is the interest that could be earned on interest-earning assets. • An increase in the interest rate raises the opportunity cost of holding money. • As a result, the quantity of money demanded is reduced. Thus the money demand curve is downward sloping. Money Supply • The money supply is controlled by the Fed. • Because it is fixed by the Fed, the quantity of money supplied does not depend on the interest rate. • This fixed money supply curve is represented as a vertical sloping line. Diagrammatically….. Interest Rate Money supply r1 Equilibrium interest rate r2 0 d M1 Money demand Quantity fixed by the Fed d M2 Quantity of Money MP and a Recessionary Gap MP and an Inflationary Gap MP and the Activist–Nonactivist Debate • Activists: argue that monetary and fiscal policies should be deliberately used to smooth out the business cycle. • Nonactivists: argue against the deliberate use of fiscal and monetary policies. They believe in a permanent, stable, rules-oriented monetary and fiscal framework. they are anti kaynesian, they are against the use of gov intervention The Case for Activist MP • The economy does not always equilibrate quickly enough at Natural Real GDP. Activist monetary policy works; it is effective at smoothing out the business cycle. Activist monetary policy is flexible; nonactivist (rules-based) monetary policy is not. • • The Case for Nonactivist MP • • In modern economies, wages and prices are sufficiently flexible for self regulation Activist monetary policies may not work (anticipated vs unanticipated) this was put forward by the classical economists • Activist monetary policies are likely to be destabilizing rather than stabilizing; they are likely to make matters worse rather than better unanticipated is when the policies is when it implies sticky information that is unknown to the person, anticipated is when the policy is known by the people and that they know that prices will rise and they arent fooled, therefore they ask for higher wages right now therefore they bug their employers. point two will never be reached if all policies are all anticipated, while there is a move to point 2 under a unanticipated policy john Taylor came from the laize faire school of thought, so he came up with the Taylor rule, he believed the central bank as a policy maker, and it faced two trade-offs in policy making and they were inflation variability and output variability, he came up with the Taylor curve which illustrates the trade-off between the output and inflation, the points on the curve represent the weight that a policy maker attaches to that point, a policy maker that cares about inflation is called a hawk, and a policy maker that does not care that much about inflation is called an inflation dove. Nonactivist Monetary (rules – based) Proposals • Constant-Money-Growth-Rate Rule: the annual money supply growth rate will be constant at the average annual growth rate of Real GDP. use mv=pq or change is m + change in v = change in p + change in q, which means that change in m = change in q...this means that v and p are stable • Predetermined-Money-Growth-Rate Rule: the annual growth rate in the money supply will be equal to the average annual growth rate in Real GDP minus the growth rate in velocity. Middle-Ground Monetary Proposals (Taylor Rule) he thought the federal funds rate is this Federal funds rate target = inflation + equilibrium real federal funds rate + ½(inflation gap) + ½ (output gap) where – Inflation: current inflation rate. – Equilibrium real federal funds rate: nominal federal funds rate adjusted for inflation – Inflation gap: the difference between the actual inflation rate and the target inflation rate – Output gap: percentage difference between actual Real GDP and its full-employment level. what GDP is now vs what its natural rate is Thus any Expansionary Policy…. • Goal – increase output and employment • Monetary Policy: increase money supply – Example: Buy bonds/securities on the open market • Fiscal Policy: – Increase government spending – Reduce Taxes Thus any Contractionary Policy…. • Goal – reduce inflation (by decreasing output) • Monetary Policy: contract money supply – Example: Sell bonds/securities on the open market • Fiscal Policy: – Reduce government spending – Increase Taxes ...
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This note was uploaded on 11/28/2010 for the course ECON 201 taught by Professor Dr.sharma during the Spring '08 term at Ohio State.

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