Fiscal Policy Study Guide PDF

Chapter 13: Fiscal Policy => Fiscal policy is comprised of government spending and tax revenue The government funds many programs through tax revenue => Government transfers: Payments by the government to households and no goods/services are provided in return => Social insurance programs: gove...

Chapter 13: Fiscal Policy => Fiscal policy is comprised of government spending and tax revenue The government funds many programs through tax revenue => Government transfers: Payments by the government to households and no goods/services are provided in return => Social insurance programs: government programs intended to protect families against economic hardship => Social security => Medicare => Medicaid => The Affordable Care Act Sources of Tax Revenue Personal income tax (BIGGEST SOURCE OF TAX REVENUE) Social insurance tax Other taxes Corporate profit tax Government Spending: Government purchases: national defense & education are the biggest categories Government transfers GDP = C + I + G + X - IM => Government controls G and indirectly affects C and I. How? Households income are affected by taxes and transfers, business investment is affected by taxes and regulations => GOVERNMENT CAN SHIFT AD CURVE => Fiscal policy: the uses of taxes, government transfers, or government purchases of goods/services to shift the AD curve => Expansionary Fiscal Policy: fiscal policy that increases aggregate demand (provides extra fuel for economy) Increase in government purchases of goods/services Cut it taxes Increase in government transfers Expansionary policy can close a recessionary gap => Contractionary Fiscal Policy: a fiscal policy that decreases aggregate demand. A reduction in government purchases An increase in tax A reduction in government transfers => Contractionary policy can close an inflationary gap  ? Can expansionary policy really work: - Critics argue that: Claim 1: government spending crowds out private spending => it’s wrong because it assumes zero-sum game and it assumes resources is always being used at full employment Claim 2: Government spending crowds out investment spending => it’s wrong because it depends upon whether the economy is depressed Claim 3: government budget deficits reduce private spending => Definition of Ricardian Equivalence? => What is the big challenge with fiscal policy? There are significant lags 1. Realize the recessionary or inflationary gap by collecting and analyzing economic data 2. Develop a plan 3. Implement the action plan THE MULTIPLIER => Multiplier idea introduced by Keynes Example: consider multiplier effect of an increase in government spending Recall: 1 / 1 - MPC (assume no tax or trade) Example: $50 billion of new government spending create in terms of change in GDP if MPC = 0.5 AGDP = EMPC AAAS - multiplier = 0 5. = 2 4 AEDP = 2x$50 = $100 billion Formulas Key Multiplier *) Govt Spending multiplier formula : 1 1 - MPC *) Transfer Muliplier : MPC t 1 - MPC  * Tax meliplier - MPC 1 - MPC *) Government Spending with taxes t = tax rate 1 Calways in decimal term ( 1 - [MPC (1-t)]. *) The size of the shift in the AD line depends on type of fiscal policy the * Changes in gort purchases. have a more powerful impact than changes in taxes or transfers Automatic Stabilizers : G govt, spending and taxation rules that cause fiscal policy to be automatically expansionary when the economy contracts and it automatically contracts when the economy expands Discretionary fiscal policy G deliberate actions by policy makers rather than rules Budget Balance * Recall Sport T G TR - - : = Ca = surplus T : tax rev ⑦ = definit TR : transfers E : gout spending , * Discretionary expansionary fiscal policy decrease budget balance *) Discretionary contractionary fiscal policy increase budget balance  * Cyclically adjusted budget balance : G of the the estimate at budget balance if economy is potential output = to find , you must use budget balance formula : Sport. = T - G - TR total debt= add all budget balance for all years Chapter 14 : Money , Banking , and Fed Reserve System *) US Central Bank = Fed Reserve Bank *) 3 key entities : ① Fed Reserve board of Governors ② 12 Fed Reserve Banks ③ FedOpen market committe *) Key Vocab ① Money Q Currency in Circulation  ③ Checkable bank deposits ⑦ Money Supply A) Money must function as : ① Medium of exchange ② A store of value ⑤ A unit of account *) Types of money ⑦ Commodity money ② Commodity-backed money ③ Fiat money *) Measuring Money Supply > money aggregate : an overall measure of the money supply MA and M2 are two measures of money supply = > M1 ? => M2 ?  * M1 : ⑦ Travelers check ② Currency in circulation ③ Checkable bank deposits * M2 : ⑦ money market funds ② savings deposit ③ time deposits ⑦ M1 *) What banks do ? = banks are financial intermediaries that use liquid assets to finance the illiquid investments of borrowers G they also make money * How does the banking system create ? money => Financial institutions operate as part of fractional reserve banking system G bank the you deposit money when in a account , part of it bank its vaults is required to hold a in as cash and the rest as lans bank *) The problems of runs worried about the bank => as people get losing money 4 Bank the bank depositors try run : many of to withdraw their funds because they fear a bank failure * ) Bank regulations : ⑦ Deposit Insurance ② Capital Requirements ③ Reserve Requirement ④ Discount window *) Limits to Bank Regulation investment bank Shadow banks insurance companies & I hedge fund companies money market fund companies X) How banks create money : count F Liabilities Loans : $900 , 000 Deposits : $1 , 000, 000 Reserve : $100 , 000 ⑰ RR Bank Reserve ? Reserve Ratio ? Excess Reserves ? > - let's assume a bank has $1000 in excess reserve , we can this summarize effect : = 1000 + [1000x(1 - rr)] + [1000x(1 - rr)2] +... + [1000x(1 vr)"] - * Key formula an infinite series can be simplified to : $1000 ur A) Total increase A in Reserve X = money multiplier in Deposit  = 1000X Ex : Deposits = $250 , 000 RR = 10 % Assets Liabilities Loan : $225 , 000 Deposit $250, : 000 RR :$25 , 000 A) The Base Monetary monetary base M1 (money - ( Checkable supply) Be a , i in currency circulation *) The Reality money multiplier in = In reality , the money multiplier is the ratio of money to the supply monetary base  MSC = money supply) Money Multiplier = MB ( = monetary base) = in normal times , the money multiplier for US M1 range from 1 5 to 3 0.. leaks less money created x) More = * The Fed Reserve System The Fed Reserve is bank it a central , oversees and regulates the banking system and controls monetary base C has 12 branches around the US A) Federal Funds Market => allows banks that fall short of the reserve requirement to borrow funds from banks with excess reserves Discount RateCusually than Fedfund rate *) higher G is the rate of interest to discourage the Fed charges the borrowing from the Fed) on loans to banks ⑪ If Fed wants to inc. money supply , it will BUY T-bills ① When Fed sells T-bills : ① The reserves of buyer decrease & The amount of loans will decrease because of  fewer reserves ③ The money supply will decrease * Open market operations : 4 the purchase and sales of govt. securities i) to increase supply buy. money , you govt securities , which will increase amount of reserves Chapter : 15 Monetary Policy - for money the demand Veab artificate of deposit (CD) ! : A) Short-term interest rates : G the interest rates on financial assets that mature within a month or less A) Long-term interest rates: S the interest rates on financial assets that mature in years in the future ① General Rule I the higher the interest rate , the higher the opportunity cost of holding money I the lower the interest rate, the lower the cost opportunity  The demand money curve r MD (money demand) Quantity of money demand x) Money curre 4 shows the relationshiptw the quantity of money demanded and the interest rate. * Shifts in Money Demand ~ Cleftshift) ~ (right shift) r..,; Mn M3 M2 Qof money A) Shifts in Real Money Demand ① Changes in aggregate price level G higher prices money (right shift) need more I ② Changes in Real GDP G goods/services produced more I more money needed Cright shift)  ③ Changes in technology ④ Changes in Institutions * How does the Fed control interest rate ? the I demand = interest rate is determined by supply of money show how the i money supply curre nominal quantity of : money supplied the Fed with by varies interest rates *) The Fed can control the money supply : G Fed chooses level assume of money supply vertical line MS r m -- H E rE- · · - MB ( Q of money ⑪ Remember that monetary policy is set by the Fed P the sets target Fed funds rate and takes appropriate open-market operations Fed Funds A) Target Rate ② Open-market purchase of T-bills Ms , MS2 v > - - · ↓ - ⑳ MD 1 M, + M2 Qof money ② open-market sale of T-bills. r MS2 Ms - ⑳ - ↑ r - & , MD, M2 < My Qofmoney *) Target vs Market - the market determines IR rate , not the Fed (the Fed adjusts the money supply to achieve its target interest rates) * Long-term interest rates Grates on bonds / loans that mature in several years. * Expansionary Monetary Policy I that aggregate demand increase monetary policy x) Contractionary Monetary Policy G monetary policy aggregate demand that reduces A) How expansionary monetary policy cycle works ⑦ Increase in money supply ② Lower the interest rate ③ Higher investment spending raises income ⑪ Higher consumer spending due to increase in income ⑤ Dendgoal : Increase agg demand. sheft AD to the right *) How contractionary monetary policy cycle works ① Decrease in money supply ② Higher interest rate ③ lower investment spending ④ lower spending consumer  ⑤ End goal : decrease in agg. demand shift AD to the left * How does the Fed choose expansionary or contractionary ? = policy makers try to fight recessions , as well as ensure price stabilityi low inflation Actual GDP - Potential output gap = X 100 potential ⑪ Fedfund rate rises when the output gap rises , and falls when output gap falls ① Fed fund rate is high when inflation is high , and low when inflation is low * Taylor Rule Ex : 2 07. + 1 28 x. inflation - 1 45. x unemploy rate rate (nodecimal form ( *) Inflation Targeting PCentral banks explicit target for the inflation setting an rate and use monetary policy to hit that target *) Inflation Targeting vs. Taylor rule ⑦ Inflation forward looking targeting is (forecast inflation ( ② Taylor rule is backward looking Clook at past inflation Zero lower bound *) problem zero-lower bound Pinterest rate cannot below O without issues go causing and limiting the power of monetary policy the Fed tried > - "quantitative easing" Y (buying long-term govt bonds. = they hope that it would drive down interest rate and have expansionary effect * Money , output , and prices in Long-run ⑮ Money is neutral in long-run since it cannot alter potential output Chapter 16 : Inflation , disinflation and deflation => Money and Prices ⑪ 21st country century with highest inflation in => Argentina Al Money neutrality : G leads to what the classical model price level us or posits Real Quantity of money M nominalmoney support *) Effectiveness of Monetary Policy = if due to monetary money supply increases policy , the long-run effect is price levels increasing A) Money Supply Growth and Inflation ⑪ In general inflation , and money supply more together , especially during periods of inflation *) The cost of inflation : S what prevents a , govt from paying for its expenses by printing money ? > NOTHING  Consequences : by printing , the govt supply which. increase money , leads to inflation and inflation erodes the , purchasing power of money * seigniorage the revenue generated by the govt's right to :. print money. The x) inflation tax : the reduction in the real value of money held by the public caused by inflation Inflation tax = inflation rate X money supply high & O inflation - ② people reduce real money holding ⑳to hyrion ↓ · govt increase growth ↑. G rate of money growth in supply money - ⑤ supply leads to even higher inflation ① Worst record of hyper inflation : Hungary +) Output gap Positive inflationary gap = (the actual unemployment rate is below the natural rate) t NEGATIVE Output gap = recessionary gap (the actual rate) unemployment rate is above the natural *) Okunis Law G there's predictable negative relationship btw a the output gap and the unemployment rate => arise in output gap of 1% reduces the unemployment 0 5% rate by. Predicted natural rate = - 10. 5 X output gap) unemployment of unemployment rate *) Short-run Phillips Curve G the negative short-run relationship between the and the rate unemployment rate inflation inflation rate O unemployment rate *) Short-run Phillips Gurve Shifts inflation rate ↑ O ↓ SRPC unemployment rate  ① Supply shock i negative supply shock = SRPC shifts up +) positive supply shock = SRPC shifts down ① Inflation Expectations : GSRPC shifts upward by the amount of increase in expected inflation Phillips Curve *) Long-run G the relationship btw unemployment and inflation after expectations of inflation have had time to adjust H #RU non-accelerating inflation : rate of unemployment B Er.. A & E SRPC ? +) Natural Rate Hypothesis +) Deflation ? + Disinflation ?