Fiscal and Monetary Policy Combinations

• Units 5 & 6 cover a variety of topics related to AD/AS (Aggregate Demand/Aggregate Supply) in macroeconomics.

Combining Fiscal and Monetary Policy

• Fiscal and monetary policies can be used together to achieve specific economic goals in the short run, like decreasing interest rates without causing inflation.
• Fiscal policy is uses government spending and taxes to influence AD (Aggregate Demand).
• Increasing spending or lowering taxes shifts AD to the right and decreases unemployment.
• Decreasing spending or raising taxes shifts AD to the left and decreases the price level.
• Monetary policy involves manipulating AD by changing interest rates.
• Decreasing interest rates shifts AD to the right and decreases unemployment.
• Increasing interest rates shifts AD to the left and decreases the price level.

Policy Combinations Effects

• Expansionary fiscal and expansionary monetary policies both increase AD, real output, and the price level, while decreasing interest rates.
• Contractionary fiscal and contractionary monetary policies both decrease AD, real output, and the price level, while increasing interest rates.
• Expansionary fiscal and contractionary monetary policies causes AD, real output and the price level to increase, and interest rates increase.
• Contractionary fiscal and expansionary monetary policies causes AD, real output and the price level to decrease, and increase interest rates.

Phillips Curve

• The short-run Phillips Curve (SRPC) shows the inverse relationship between inflation and unemployment.
• Movement along the SRPC indicates a change in the rate of inflation and unemployment due to AD/GDP changes.
• Shifts in the SRPC occur when AS (Aggregate Supply) changes.
• Increases in AD increase inflation and decrease unemployment.
• The long-run Phillips Curve (LRPC) shows that changes in AD/AS corrects to restore to long run equilibrium.
• Equilibrium occurs where SRPC and LRPC intersect.
• The natural rate of unemployment is at full employment.
• The Non-Accelerating Inflation Rate of Unemployment (NAIRU)is the lowest unemployment rate an economy can have.
• The NAIRU occurs without causing inflation to rise and maintains a balance between unemployment and inflation.

Quantity Theory of Money

• Defined as PY=MV
• M = money supply
• V = velocity of money, which measures how many times each dollar changes hands in a year.
• P = price level
• Y = real output
• P*Y = nominal GDP
• In the long run, with Y and V constant, changes in M (money supply) directly cause changes in P (price level).

Government Budget

• A deficit is when spending exceeds income.
• A surplus is when income exceeds spending.
• A balanced budget is when income equals expenses.
• Government income primarily comes from taxes.
• Government expenses come from spending and transfers.
• Expansionary fiscal policy tends to create deficits by lowering taxes and increasing government spending.
• Contractionary fiscal policy can lead to surpluses by raising taxes and lowering government spending.
• Increased demand for dollars occurs to finance deficit spending and debt interest.
• Government borrowing can lead to "crowding out" in the loanable-funds market.
• Crowding out is when government deficits increase interest rates and reduce investment, due to expansionary fiscal policy.
• In recessionary gaps, expansionary fiscal policy is implemented.
• Results of policy actions are seen in the ASAD model and the loanable funds market.
• Government deficit spending increases borrowing.
• Crowding out reduces private investment spending, decreasing interest-sensitive spending in the short run.
• In the long run, higher interest rates from crowding out reduce borrowing and capital purchases.
• Less borrowing leads to less capital accumulation.

Economic Growth

• Economic growth increases real GDP per capita over time, shown by outward shifts of the PPC (Production Possibilities Curve) and LRAS (Long-Run Aggregate Supply).
• An outward shift in the PPC mirrors a rightward shift of the LRAS curve.
• Economic growth is determined by changes in capital stock formation and technology.
• Physical capital, human capital, and technology increase productivity, leading to economic growth.
• Investment in capital stock formation (new technologies) increases productivity and economic growth.
• Increasing economic growth increases productivity and capital stock.
• Long-run economic growth is measured by GDP per capita.
• Factors influencing economic growth including interest rates and investment.
• Lower interest rates increase borrowing, investing, and GDP.
• Higher interest rates make borrowing more expensive, decreasing GDP.
• Investing in machinery, technology, and infrastructure increases the economy's capacity to produce and increases productivity.
• Investing in education, skills, and training creates a more skilled workforce, improving productivity and innovation.
• Policies can encourage economic growth.
• Increasing human capital per worker through government spending on education, job training, and tax credits (e.g., Headstart, job corps, student loans).
• Increasing spending on technology and tax credits for research and development (e.g., renewable energy).
• Increase physical capital per worker through government spending on infrastructure and or tax credits for investment spending on physical capital (e.g., electric grids, highways).
• Increasing productivity and the labor force participation rate (LFPR) increase when individuals can collect retirement benefits, and increase the number of individuals to enter labor force with tax credits, increase spending on programs for older workers to continue working
• Households benefit from income tax cuts and reduced taxes on savings.
• Tax cuts lead to more disposable income and consumption, increasing AD.
• Tax cuts increase savings, increasing the supply of loanable funds and lowering interest rates.
• Lower interest rates lead to more investment, capital formation, and economic growth (SRAS and LRAS increase).
• Business benefits from policies that make creating and running a business more efficient.
• These policies can increases GDP and create growth.
• Business benefits from corporate or business income tax cuts, profit tax, income from savings, and capital gains tax.
• Deregulation removes regulations.

International Trade

• Classifying Balance of Payment transactions includes Current Account (CA) vs. Financial Account (FA).
• In the Current Account net exports, money transfers, investment income, and net unilateral transfers are recorded.
• Examples include the purchase or sale of goods between countries, earning income from assets owned in another country and sending or receiving income from another country.
• CA is not always balanced.
• Net exports = trade balance = exports minus imports.
• The Financial Account reflects the balance of payments for assets between countries.
• Financial capital transfers are recorded on the FA.
• Examples include purchase and sale of CDs, bonds, other interest-bearing assets, foreign exchange market transactions (purchase/sale of physical assets) and foreign direct investment.
• FA is not always balanced.
• Financial capital flowing into an economy is a surplus (inflow).
• Financial capital flowing out of an economy is a deficit (outflow).

Balance of Trade

• The balance of trade (net exports) is measured as exports = credit and imports = debit.
• A surplus occurs when exports > imports.
• A deficit occurs when imports > exports.
• A trade deficit does not necessarily mean a deficit in the current account.
• Debits are outflows/money out, and credits are inflows/money in.
• Money flowing in is a credit, and money flowing out is a debit.
• The sum of all credit entries should match the sum of all debit entries.
• An increase in the CA balance must be offset by a decrease in the FA balance.
• CA = - FA (BoP = CA + FA = 0)
• Therefore CA + FA = 0

Foreign Exchange Market

• Involves modeling currency appreciation vs. depreciation.
• Currency appreciation occurs when a currency becomes more valuable in terms of other currencies.
• Currency depreciation occurs when a currency becomes less valuable in terms of other currencies
• The foreign exchange market is where buyers and sellers exchange the currency of one country for another.
• Currency demand is determined by foreign demand for the country's goods and services, and foreign demand for the country's assets (financial or physical).
• Currency supply is influenced by fiscal and monetary policy, domestic demand for other country’s goods and services, domestic demand for other country’s assets and protectionist policies (tariffs, quotas).
• Changes in the FX market impact other economic models, like impacting the AD/AS model, Phillips curve, and Loanable Funds market
• Higher interest rates in the FX Market leads to currency appreciation.
• Currency appreciation in the AD/AS Model results in decreased net exports, shifting the AD curve to the left, potentially lowering output and prices.
• Increased unemployment due to lower output can lead to a decrease in inflation, moving along the SRPC
• An influx of foreign investments increases the supply of loanable funds, domestic demand for loans may decrease, influencing interest rates
• Changes in capital flows impact other models, impacting the Loanable Funds market, AD/AS model, Phillips curve, and FX market
• Increased savings and capital inflow in the Loanable Funds market impacts the interest rate.
• Reduced Consumption/Investment leads to a leftward AD shift leading to lower output and price levels in the AD/AS model.

Phillips Curve Trade Off

• Higher Unemployment/Lower Inflation leads to movement along the Phillips curve, illustrating short-term trade-offs between inflation and unemployment.
• Higher demand for domestic currency in the FX market occurs as capital flows into the country.

Combining fiscal and monetary policies helps achieve economic goals. Fiscal policy uses government spending and taxes to influence Aggregate Demand. Monetary policy involves manipulating Aggregate Demand by changing interest rates to manage unemployment and inflation.