Macroeconomics Study Guides

Fiscal Policy

Tools

The government has two tools for regulating fiscal policy: a change in government spending or changes in taxes. The government can also use both if it thinks the economy needs it.

Inflationary Situation

If the inflation is demand-pull inflation, the government should use a contractionary fiscal policy. It can decrease government spending, increase taxes, or both. The government is aiming for a budget surplus, where tax revenues are larger than government spending.

Both increased taxes and decreased government spending reduces consumption spending, which causes a decrease in aggregate demand (first graph). Then, if prices are flexible downward, the decrease in aggregate demand causes the equilibrium price level to decrease, ending the inflation. If prices are not flexible downward (because of the ratchet effect), the policy will stop price level from increasing. Since inflation usually occurs in the vertical range of the aggregate supply curve, GDP shouldn't decrease by much.

 Recessionary situation

The government now needs to use an expansionary fiscal policy. The aim of the policy is to increase aggregate demand, which shifts the AD curve to the right and will cause an increase in real GDP.

The government has two tools to use: it can increase government spending or decrease taxes (or both). Increasing government spending will increase aggregate demand (since $\mathrm{AD}=\mathrm{C}+\mathrm{I}_{\mathrm{g}}+\mathrm{G}+\mathrm{X}_{\mathrm{n}}$). Decreasing taxes will increase consumption spending (it increases it by the tax increase times the MPC), which will also increase aggregate demand (graph l).

Then, since aggregate demand is increased (rightward shift of AD curve), equilibrium GDP will either increase (if the economy is in the horizontal or intermediate ranges) or stop declining (if the economy is in the vertical range).

If the economy is on the horizontal range, the full effect of the multiplier will be felt: when AD increases by an amount, GDP will increase by the multiplier times that amount.

The final equilibrium will have a higher GDP and the same or slightly increased price level since recession usually means the horizontal range of the AS curve.

Impact of policies on AD/AS equilibrium

An expansionary fiscal policy shifts (or tries to shift) the Aggregate Demand curve to the right. This will shift the equilibrium GDP up (as long as the economy isn't in the vertical range) and shift the price level up (as long as the economy isn't in the horizontal range). Usually, the government uses an expansionary fiscal policy when the economy is in the horizontal range, so the policy only shifts equilibrium GDP up.

A contractionary fiscal policy shifts the Aggregate Demand curve to the left. This will lower equilibrium price level (when it's not in horizontal range) and lower equilibrium GDP (when it's not in vertical range). However, the economy is usually in the vertical range when the government uses this policy, so the policy usually only shifts price level down.

G vs. C, I

G can be directly changed "on whim", since fiscal policy can quickly be enacted to change government spending. However, C and I are much more uncontrollable, since they both depend on confidence, which is a hard thing to change.

They both, however, increase aggregate demand, and increase GDP by the amount times the multiplier.

Issue of Debt and Deficits

Deficit spending is expansionary, and it counters recession. There's two ways of financing a deficit. The government can enter the money market and borrow, competing with private business borrowers for funds. This might cause a crowding-out effect, "taking up" some space for investment spending and consumer spending. The crowding-out effect reduces the expansionary impact of the deficit spending. The government can also make more money, making spending increase without any harm done to investment. However, making more money can have an inflationary effect too. To counter demand-pull inflation, fiscal policy has to involve making a budget surplus. However, a surplus can do one of two things: debt reduction (paying off debt, but then it might offset the anti-inflationary impact because the government is putting money back into circulation), or impounding (keeping the surplus funds, doing nothing with them; this way, the full extent of the anti-inflationary policy will be met).

Debt can actually be inflationary because if the government tries to pay it off quickly, there will be inflation because the money supply increases.

Crowding Out Effect

If the government were to finance a deficit (expansionary fiscal policy) by entering the money market and borrow money, it would make less room for investment, since as the government's share of the "pie" grows, everyone else's becomes smaller. Then, investment spending decreases, causing aggregate expenditures to not increase as much.

Balanced Budget Multiplier

Equal increases in government spending and taxation increase the equilibrium GDP.

If G and T are both increased by an amount, the equilibrium GDP will rise by the same amount, regardless of what the multiplier is.

This happens because a change in government spending has more of an impact on AE than a tax change. This is because government spending has a direct effect on AE. i.e. a $20 increase in government spending will result in a $20 increase in AE. However, since if people are taxed, their consumption only decreases by a fraction of the tax (since the tax affects both savings and consumption). For example, a $20 increase in taxes in an economy with a MPC of .75 only results in $15 added to AE.

Then, let's look at how much these values affect equilibrium GDP. Since the multiplier is 4. the $20 increase by GDP results in a $80 increase in GDP. Also, the $15 decrease by taxes results in a $60 decrease in GDP. Therefore, the net increase in GDP is 80- 60 which is $20, the same as how much G and T were changed.

Monetary Policy

Who controls?

The Board of Governors of the Federal Reserve System ("Fed") is responsible for controlling the U.S banking system (and the money supply). The Board of Governors has seven members, appointed by the President with confirmation of the Senate. It directs the activities of the 12 Federal Reserve Banks, which then control the nation's banks.

There are several entities that help the Board of Governors. The Federal Open Market Committee (FOMC) is made up of the 7 members of the BoG plus 5 of the presidents of the Federal Reserve Banks. It sets the Fed's monetary policy and directs open-market operations. There are also three Advisory Councils (made of private citizens) that meet with the BoG to give their views on banking and monetary policy.

Required reserve ratio

This is how much percent of a bank's reserves must keep on deposit with the Federal Reserve Bank or as vault cash.

Money multiplier

Since banks lend their excess reserves, a system of banks will "magnify" original excess reserves into a larger amount of new demand-deposit money, causing the money supply to grow by more than the original excess reserves.

It is equal to $\dfrac{1}{\text { Required reserve ratio }}$.

The maximum demand-deposit creation (money created) equals the excess reserves that can be lent out by commercial banks times the money multiplier.

For example, if someone deposited S100 into a bank, and the required reserve ratio was 0.2. then the bank's excess reserves would increase by $80. and since the money multiplier is t/O.2-5, the money supply will be increased by 80*5-400.

Tools of Monetary Policy

It has three tools:

1. Open-market operations - these are the most important means the Fed has to control the money supply. It refers to the buying and selling of government bonds (securities) by the Federal Resene Banks. Buying bonds increases the money supply; selling them decreases it.
2. The reserve ratio - the Fed can also increase or decrease the Reserve ratio. Increasing the Reserve ratio decreases banks' excess reserves, causing the money supply to decrease. Decreasing it increases banks' excess reserves, increasing the money supply. This is really powerful, and so it is not used very often.
3. The discount rate - the discount rate is the rate that Federal Reserve Banks charge for loans to commercial banks. When commercial banks borrow from FRBs, their reserves increase. Therefore, if the discount rate increases, banks are less encouraged to borrow, keeping their excess reserves the same and therefore restricting the money supply. 

Open-market operations - difference between buying/selling to the public and buying/selling to banks

If the Fed buys or sells securities to the public, the money supply will increase/decrease less than if the Fed buys or sells them to banks. This is shown in the following examples:

Let's assume that the required reserve ratio is 0.2. The money multiplier is then 5.

If the Fed buys $1000 worth of securities from commercial banks, the excess reserves will increase by $1000. Then, the money supply will increase by $1000*5= $5000.

If they buy securities from the public, the public gets more money, and when they deposit it into banks (whether directly or indirectly), bank reserves increase. However, since the required reserve ratio is 0.2, the bank needs to put $200 of the money in the Federal Reserve Bank, and so excess reserves only increase by $800. Then, the money supply will increase by $800*5=$4000.

If the Fed sells $1000 worth of securities to commercial banks, then excess reserves will decrease by $1000, so the money supply will decrease by $1000*5=$5000.

If the Fed sells $1000 of securities to the public, then after the transaction is cleared, the hank will have $1000 less in securities. $200 of that money can be taken from Federal reserves, and so excess reserves only decrease by $800, causing the money supply to decrease by $800*5=$4000.

Checking account money

Most of it comes from demand deposits, which are deposits in commercial banks that are meant to be checkable.

M1, M2, M3

Ml is the narrowest definition of money supply. It includes currency (coins * paper money) and checkable deposits (demand deposits in banks or thrifts).

M2 includes Ml plus near-monies (highly liquid financial assets which do not directly function as a medium of exchange but can be readily convened into currency or checkable deposits without risk of financial loss). Near-monies are noncheckable savings accounts, money market deposit accounts, small time deposits, and money market mutual funds.

M3 is M2 plus large time deposits.

Change in composition of money

It does not necessarily impact stock of money in the economy, as it can still be considered money (because it can be redeemed for purchasing power at a later date).

Transaction demand for money

This is the amount of money people want to use as a medium of exchange; varies directly with nominal GDP. It has no relationship with the rate of interest, so its qty demanded vs. interest rate graph is a vertical line.

Asset demand for money

This is the amount of money- people want to hold as a store of value; varies inversely with rate of interest. Its qty demanded vs. interest rate graph has a negative slope.

Interest rate graph

If supply of money decreases, then the rate of interest increases. Then, when the rate of interest increases, the amount of investment decreases.

Then, since investment decreases, aggregate expenditures $\left(\mathrm{C}+\mathrm{I}_{\mathrm{g}}+\mathrm{G}+\mathrm{X}_{\mathrm{n}}\right)$ decreases. That then shifts the GDP down by the change times the multiplier. Finally, when GDP decreases, price level will drop (since the economy most likely is in the vertical range of the aggregate supply curve) and therefore inflation will decrease.

Recessionary Situation

In this situation, we want a loose money policy. To do this, we can 1) buy government securities, 2) decrease the reserve ratio, or 3) decrease the discount rate. All three of these will increase the supply of money. Our graphs will be as follows:

If supply of money increases, then the rate of interest decreases. Then, when the rate of interest decreases, the amount of investment increases.

Then, since investment increases, aggregate expenditures $\left(\mathrm{C}+\mathrm{I}_{\mathrm{g}}+\mathrm{G}+\mathrm{X}_{\mathrm{n}}\right)$ increases. That then shifts the GDP up by the change times the multiplier. Finally, when GDP increases, price level will stay about the same (since this economy most likely started in the horizontal range). Now since the GDP is increasing, we are out of a recession.

Net export effect

Easy money policy → decreased foreign demand for dollars → dollar depreciates → net exports increase (AD increases, strengthening the easy money policy)
Tight money policy → increased foreign demand for dollars → dollar appreciates → net exports decrease (aggregate demand decreases, strengthening the tight money
policy)

Both fiscal and monetary

Summary: recessionary

Fiscal policy: increase government spending, decrease taxes

Monetary policy: loose money policy - buy government securities, lower reserve ratio,

lower discount rate

Summary: inflationary

Fiscal policy: decrease government spending, increase taxes

Monetary policy: tight money policy - sell government securities, raise reserve ratio, raise discount rate