Macro_Notes3

Macro_Notes3 - Lecture Notes 3 Principles of Macroeconomics...

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Lecture Notes 3 Principles of Macroeconomics Chapter 16 – The Influence of Fiscal and Monetary Policy on Aggregate Demand -If we are in a recession, we know the economy will eventually return to the natural rate of output on its own. But why wait!?! It could take a long time for that transition to happen naturally in an economy. “In the long-run we are all dead!” – John Maynard Keynes Monetary Policy If we are in recession, the Fed can stimulate the money supply, which will lower interest rates, which will stimulate investment demand… **We can come out of the recession more quickly! Graph depicting the effect of an increase in the money supply on the federal funds rate (the interest rate banks charge each other for very short-term loans): Notes on changes in the federal funds rate over the last 20 years or so:
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Deskins, Lecture Notes 3 2 Fiscal Policy (“Keynesian” Policy) If we are in a recession, the Congress (with the president‟s signature) can either raise government spending (which will stimulate AD in itself) or cut taxes (which will stimulate consumption demand). **Again, the idea is that this will help bring us out of a recession more quickly! Further information on the effect of a fiscal stimulus (through in increase in government spending) in a recession: 1. Multiplier effect – Consider an increase in government spending of $100… This directly increases AD by $100. However, the person who receives this money now has $100 of additional income and will spend a portion of this extra income, which represents a further increase in AD… Overall: Increase in G * multiplier = overall increase in AD Multiplier = 1/(1-MPC) or 1/MPS. If government spending goes up by $100 and MPC is 90 percent, overall increase in AD is $1,000! 2. Crowding-out effect – Deficit raises I reduces investment demand. So the increase in AD generated by the increase in G and the multiplier effect is at least partially “crowded-out.” **The usefulness/potential benefits of Keynesian Policy should be obvious *** The use of fiscal policy is one factor behind how the economy started to come out of the Great Depression in the 1930s (under the Roosevelt administration). Fiscal policy was also used in this manner in the early to mid-1960s (under the Kennedy/Johnson administration). Other times as well… **By the mid-1960s, we were in the midst of the Keynesian Revolution
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Deskins, Lecture Notes 3 3 Problems with the use of fiscal policy to stabilize GDP in the short-run. 1. Time Lag (inside) **Using fiscal policy in this manner can have the perverse effect of exaggerating fluctuations in GDP! 2. Can lead to a permanent budget deficit, due to imperfections in the political system. 3.
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Macro_Notes3 - Lecture Notes 3 Principles of Macroeconomics...

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