Modern Macroeconomics: Fiscal Policy

Modern Macroeconomics: Fiscal Policy

Explain how fiscal policy affects aggregate demand and aggregate supply.

Fiscal expansion: An increase in government spending or a decrease in taxes (i.e., a budget deficit) leads to an increase in GDP and an increase in prices. Fiscal restriction or contraction: A decrease in government spending or an increase in tax leads to lower prices and lower output/GDP. (The aggregate demand curve shifts left.) Counter cyclical: Change in policy (i.e., budget deficit or surplus) by government will offset changes in aggregate spending by consumers and investors and lead to smooth fluctuations in the business cycle. For example, if an economy is in recession then plan a budget deficit.

Describe why fiscal policy should be timed properly and why timing is difficult.

There's usually a time lag between when policy is needed and when its recognized by policy makers; there's also a lag between when the need is recognized and when its instituted, and a lag between when policy is adopted and when its impact is felt. The use of fiscal policy to calm the business cycle is very difficult; it may accentuate the corrective action of the economy rather than correct the problem for which it was intended. Automatic stabilizers are built in fiscal devices which ensure deficits in a recession and surpluses during a boom. Three types: unemployment compensation; corporate profit taxes and progressive personal taxes (e.g. In a recession, when tax receipts are low, increasing transfer payments and reducing tax revenue will cause an automatic deficit to occur and therefore help to alleviate high unemployment).

Discuss the impact of expansionary fiscal policy based on:

The basic Keynesian model: An increase in government spending and/or a decrease in taxes (i.e., a budget deficit) will be magnified by the multiplier process and lead to an increase in aggregate demand. If the economy is operating below full capacity, this will lead to an increase in GDP and employment.

The Crowding-Out model: The effect of an increase in the budget deficit will be dampened as borrowing for the deficit will increase interest rates and crowd out private spending and investment, leading to a decrease in investment. In an open economy the increase in interest rates leads to an increase in foreign investment--capital inflow--and an increase demand for domestic dollars, producing an increase in exchange rates--currency appreciation--and a decline in net exports and a decrease in aggregate demand.

The New Classical model: The effect of an increase in the budget deficit will be dampened because households will anticipate higher future taxes implied by the debt and reduce their spending and increase their saving to pay for them; this will crowd out private spending. An alternative explanation - an increase in government spending leads to increase in aggregate demand, which is crowded out by a decrease tax effect. A decrease in taxes leads to an increase in savings (as consumers expect tax to increase) and therefore leads to a decrease in consumption. A decrease in taxes leads to an increase in loanable funds, leading to an offset government demand for money. A decrease in taxes leads to unchanged aggregate demand and interest rates.

The Supply-Side model: A decrease in marginal tax rates leads to increase in investment and savings, an increase in work and productivity, a decrease in leisure, and a decrease in tax sheltering, leading to an increase in aggregate supply in the long run (LR), an increase in GDP, a decrease in unemployment and a decrease in prices.

Keynesian model: Increase in government spending or decrease in taxes will be magnified by the multiplier and lead to an increase in aggregate demand.

Crowding out model: Effect of increase government spending is dampened because borrowing to finance the budget deficit will push up interest rates and crowd out private spending and investment.

New classical model: Effect of increase government spending is dampened because households anticipate higher future taxes implied by the debt and reduce their spending to pay for them, which will crowd out private spending.

Supply-side model: A decrease in marginal taxes will increase the increase the incentive to earn and improve the efficiency of resource use, leading to an increase in output in the long run.

Identify the relationships among budget deficits, inflation, and interest rates.

An increase in government spending (i.e., a budget deficit) leads: (1) to an increase in the demand for loanable funds, placing upward pressure on the real rate of interest (according to crowding out model) and (2) with higher expected taxes, to a decrease in spending and the stimulation of savings, thereby permitting government to expand its borrowing at an unchanged interest rates (according to New Classical model). There is a mixed opinion on the relationship between a budget deficit and interest rates.

Money and the Banking System

Define money: Medium of exchange; measure of value and store of value.

Define money supply:

M1=Currency in circulation+demand (checkable) deposits+traveller's cheques. M2=M1+savings deposits+time deposits<$100K+money market mutual fund shares. M3=M2+time deposits>$100K+big mutual funds+overnight loans from customers+ eurodollar deposits of US residents.

Describe the fractional reserve banking system.

For each USD deposited at a bank a small percentage is held as reserves and the rest is lent as loans. Money is created when banks make loans.

The Deposit Expansion Multiplier = 1/Required Reserve Ratio.

If banks are required to hold 25% of deposits as reserves, then a new deposit of $1,000 will potentially expand the money supply by (1/0.25) x $1000 = $4000. If excess reserves are increased by $1000 (when there were no existing excess reserves) then the money supply could increase by a maximum of $4000.

Question: Reserve Requirement is 10%. Say banks currently have (1) cash (and deposits with the Fed of) $25 million (mn); (2) loans and securities equal to $175mn; (3) demand deposits equal to $200mn. How much more can the banks legally lend?

Answer: Deposit of 200mn x reserve requirement of 10% = required reserves of $20mn.

Actual reserves are currently $25mn, minus required reserves of $20mn = excess reserves of $5mn. Therefore the bank can loan out its excess reserves, or a further $5mn.

Explain how a central bank can use monetary tools to effect monetary policy.

A central bank (e.g. the FED) (1) regulates banks and (2) implements monetary policy via the use of tools:

1.  The Required Reserve Ratio allows the FED to increase the money supply by a decrease of this ratio.

2.  Open Market Operations. The FED buys/sells treasury bonds/notes/bills to control the monetary base - this is the FED's main avenue for control of the money supply (e.g. FED sells bonds which decrease the money supply).

3.  Discount Rate. The rate it charges banks for loans (e.g. a decrease in the real rate of interest leads to cheaper money and an increase in the money supply).

Expansionary monetary policy can be produced: Lower the discount rate or lower the required reserve ratio or buy bonds. Restrictive monetary policy is caused by the reverse of the above.

Modern Macroeconomics: Monetary Policy

Identify the determinants of the demand for and supply of money.

Demand - Desire of people to hold wealth in cash, checking account, highly liquid asset - determined by the cost of money. The demand for money is inversely related to the real rate of interest. The supply of money is determined by monetary authorities and unrelated to the real rate of interest.

The Quantity Theory of Money suggests that a change in the money supply will cause a proportional change in the price level because velocity and real output are unaffected by the quantity of money. A change in the money supply leads to a proportional change in prices. The velocity of money is the average number of times per period (years) a dollar is used to buy goods and services (G&S).

Nominal GDP = M x V=P x Q => MV=PQ: Money(M) times Velocity(V) equals Price(P) times Quantity of G&S(Q). V and Q are determined by factors other than the (fixed) money supply. E.g. If M increase then P increase.

Explain how monetary policy affects interest rates, output, and employment.

Expansionary MP - implemented by the FED by Open Market Operations (OMO), i.e., buying bonds, which in the short run (SR) will force the price of bonds up and their rate of return down. Therefore the expansionary policy results, first, in a lower real rate of interest. This lower rate will spur investment and consumer demand. Thus aggregate demand will increase and cause the aggregate demand curve to shift to the right resulting in higher prices and increased output at least in the SR, and an increase in employment if expansionary MP was unexpected.

Factors which lead to an increased aggregate demand (GDP):

-The decrease in the real rate of interest produces an increase in consumption and investment now, compared to the future.

-A lower the real rate of interest lead to a depreciation of the dollar which make exports more attractive to foreigners (i.e., an increase in net exports).

-A lower real rate of interest cause asset prices to increase, leading to an increase in wealth and purchasing power of households holding those assets.

-An increase in bank reserves make more loans available to small businesses.

If the increase in the money supply was unexpected then in the SR it brings output back to full employment (as mentioned above). This is because costs rise less than prices in the SR.

N.B. for the exam: A restrictive MP or tightening of the money supply will have the opposite SR effects.

Discuss whether anticipating the effects of monetary policy affects the policy.

When monetary policy (MP) changes are anticipated beforehand both the SR and long run (LR) effect will be higher prices and wages and higher nominal interest rates (to their LR equilibrium); it has no impact on real economic activity, i.e., GDP output is unchanged and unemployment is unchanged. (i.e., wages increase due to inflation).

Describe the short-run and long-run effects of expansionary and restrictive monetary policies on the inflation rate, interest rates, real output, and employment.

In the SR an unanticipated increase in the money supply will reduce the real rate of interest and increase the availability of credit, thereby triggering an increase in the demand for goods and services. This will increase aggregate demand which will expand real output and employment.

In the LR the major effects of an unanticipated increase in the money supply are inflation and higher nominal interest rates. Rapid monetary growth will neither reduce unemployment or stimulate real output in the LR. Alternatively, in the LR an increase in the money supply will result, in the LR, in (1) higher prices, and (2) higher nominal interest rates. Also, an expectation of an increase in future inflation, leads to an increase in nominal interest rates. The SR effects on GDP and employment are reversed in the LR, hence in the LR neither real output nor unemployment are effected. (The real rate falls in the SR and nominal rate rises in the LR.)

Nominal interest rate equals the real rate plus expected inflation. With inflationary expectations the real interest rate falls in the SR and the nominal rate rises in the LR.

Short run - unanticipated / Short/long run - anticipated
Impact of expansionary MP: / -- / --
Inflation rate / Only a small increase / Increase
Real output & employment / Temporary increase unless excess capacity exists / No change
Money (nominal) interest rate / Probably decline / Increase
Real interest rate / Decrease / No change
Impact of restrictive MP: / -- / --
Inflation rate / Small decrease / Decrease
Real output & employment / Decrease / No change
Money (nominal) interest rate / Short term rates probably decrease / Decrease
Real interest rate / Increase / No change

Expectations, Inflation, and Unemployment

Explain the role expectations play in determining the effectiveness of fiscal and monetary policy.

If an increase in the growth rate of the money supply is fully anticipated, then prices, wages and interest rates will rise--adjust--quickly in response and there will be no change in output (GDP) or unemployment. If the increase in the money supply is unanticipated, there will be a temporary but real increase in output and a decrease in unemployment, as the increase in money supply will at first be thought of as an increase in demand.

Identify how individuals form expectations.

Using Adaptive Expectations people base their future expectations on actual outcomes observed during recent periods. Using Rational Expectations people weigh all available information about the probable effects of current and future economic policy when they make decisions about future economic events - given all available data today, individuals will make rational decisions regarding the future based on today's information, and sound economic reasoning, not historical data.

Discuss the trade-off between unemployment and inflation in view of expectations.

The Phillips curve shows an inverse relationship between the inflation (prices and money wages) and unemployment rates.

Under adaptive expectations changes in policy (e.g., expansionary MP) leading to inflation will be unanticipated so inflation (an increase in prices) will reduce workers' real wages, causing an increase in the demand for labour and a reduction in the unemployment rate. Under rational expectations changes in inflation will be fully anticipated so there won't be a inflation and unemployment trade-off - inflation will be expected and nominal wages will rise along with prices; unemployment and output won't change.