Macroeconomics: Equilibrium and Fiscal Policy

• These are study notes based on macroeconomic problems regarding economic equilibrium, fiscal policy, and their effects on various economic indicators.

Problem 1: Full Employment Equilibrium and Consumer Confidence

• In a full employment equilibrium, the economy operates at its potential output.
• The Aggregate Demand (AD), Short-Run Aggregate Supply (SRAS), and Long-Run Aggregate Supply (LRAS) curves intersect at this point.
• The intersection point shows the equilibrium price level and real GDP.
• The full employment output is labeled as YF, with the equilibrium marked as Point A.

Impact of Increased Consumer Confidence

• When consumer confidence improves, households increase spending.
• The aggregate demand increases and shifts rightwards.

Effects of the AD Shift

• Curve Shift: The AD curve shifts right (increases).
• Price Level: Increases due to higher demand for goods and services.
• Real GDP: Increases as firms increase production to meet the higher demand.
• Unemployment Rate: Decreases as firms hire more workers to increase production.

Graphical Representation

• Impact on Price Level: Increases.
• Impact on Real GDP: Increases.
• Output Gap: An inflationary gap results as the economy exceeds its full employment output.
• The new equilibrium is labeled as “B”.

Problem 2: Inflationary Gap and Fiscal Policy

• Curtisland is experiencing demand-pull inflation.

Government Tax Policy to Close Inflationary Gap

• Implementing a contractionary fiscal policy is used to close the gap.
• An increase in taxes leads to lower disposable income for households.
• Lower disposable income decreases consumption spending.
• Decreased consumption spending leads to a lower aggregate demand.
• Lower AD leads to lower real GDP and price levels, reducing the inflationary gap.

Transmission Mechanism

• Higher taxes reduce disposable income, decreasing consumption.
• Decreased consumption reduces aggregate demand.
• Lower aggregate demand leads to lower real GDP and price levels, reducing the gap.

Federal Reserve Influence

• When contractionary policy is implemented, the feds IORB, discount rate, or the fed funds rate may also increase.
• Banks are incentivized to reserve more in the fed and lend out less as well as sell their bonds.
• Banks increase interest rates for loans, because reserving the money is risk-free and they get more money doing so reducing lending.
• The cost of borrowing increases, leading to a decrease in disposable personal income and leading to decreased consumption and investment spending, which decreases overall aggregate demand to close the inflationary gap.

Impact on Government Budget Position

• Increased taxes would cause government revenue to rise.
• If spending remains constant or decreases, this leads to a smaller budget deficit.
• It can even result in a budget surplus if tax revenues exceed expenditures.

Impact on Bond Prices and Nominal Interest Rate

• With higher tax revenue, governments would borrow less.
• Governments wouldn't need to issue as many bonds.
• A Fall in the supply of bonds would cause existing bonds to become more valuable.
• Higher bond values cause bond prices to increase.
• Nominal interests would then decrease, because since bonds have fixed coupon payments - if a bond's price goes up, the same fixed payment is now spread over a higher price, reducing the yield.

Bond Market Graph

• Illustrate the impact of the government’s budget position on the bond market by showing a:
  • Decrease in bond supply, because the government is issuing fewer bonds.
  • Investors subsequently have fewer bonds to buy

Real Interest Rate

• Real Interest Rate = Nominal Interest Rate - Inflation Rate
• Since inflation remains unchanged and the nominal interest rate falls, the real interest rate also falls.
• Inflation erodes/decreases the value of money over time.
• The real interest rate indicates how much someone actually gains/loses in terms of purchasing power.

Impact on Potential Output in the Long Run

• A lower real interest rate encourages investment spending.
• Businesses are willing to borrow as it is less expensive, increasing investment in capital goods and technology.
• Increased investment raises the economy's production capacity, shifting the LRAS to the right, thereby raising potential output in the long run.

Automatic Fiscal Policy Stabilizer

• A progressive income tax system is an automatic stabilizer used to close the inflationary gap.
• As incomes rise during an inflationary gap, people move into higher tax brackets and pay more in income taxes.
• This automatically reduces disposable income and lowers consumer spending, slowing down aggregate demand.
• This helps control inflation without passing new tax laws.

Discretionary Stabilizer

• It is a deliberate action by the government to influence the economy.
• To close an inflationary gap, the government could decrease spendings on infrastructure, roads, etc to reduce total demand shifting aggregate demand to the left

Automatic Stabilizer for Recession

• Unemployment benefits would help close a recessionary gap.
• When a recession hits, more people lose jobs and qualify for unemployment aid.
• This automatically provides an increase in government transfer payments, giving people money to spend, boosting consumer spending and shifting aggregate demand right.

Study notes on macroeconomic equilibrium and fiscal policy. Covers effects on economic indicators. Includes impact of consumer confidence, shifts in aggregate demand, price levels, real GDP, and unemployment.