You are on page 1of 16

Economic growth occurs-technology improves or capital per hour worked increases

Financial System: the system of financial intermediates through which firms acquire funds from
households.
Financial Markets: markets where financial securities, such as stocks and bonds, are bought and sold.
A financial security is a document that states the terms under which funds pass from the buyer of a
security to a seller
Stock: a financial security that represents partial ownership of a firm
Firms can raise funds by selling shares of stock in a primary market.
The original buyers of stocks may resell them in a secondary market, where most daily trading takes
place.
Bond: A Financial security that represents a promise to repay a fixed amount of funds (seller promises to
pay buyer back plus interest)
firms and government running budget deficits can borrow funds by selling bonds in a primary market
Bonds are bought for the resale value plus interest
Financial intermediaries: Firms, such as banks, mutual funds, pension funds, and insurance companies
that borrow funds from savers and lend them to borrowers.
A closed economy does not engage in international trade of goods and services or in international
borrowing and lending, while an open economy does.
Saving has two components, private saving and public saving
Private saving is equal to what households retain of their income after purchasing goods(C) and services,
and paying taxes(T)
S
private
=Y+TR-C-T
Households receive income from supplying the factors of production to firms, and from transfer payments
from the government
Public saving is equal to what the government retains of its tax revenue(T) after purchasing goods and
services(G) and making transfer payments(TR)
S
public
=T-G-TR
When the government spends less than it collects in taxes, there is a budget surplus.
Savings=investment in a closed economy
Market for Loanable Funds: the interaction of borrowers and lenders that determines the market interest
rate and the quantity of loanable funds exchanged.
The quantity of loanable funds is the real interest rate because it reflects the true cost of borrowing and
the true return of lending
Demand for loanable funds comes from the firms that want to borrow for investment.
Holding all else constant, the quantity of loanable funds supplied increases as the real interest rate
increases and vice versa, so the supply of loanable funds slopes upward.
A surplus of loanable funds causes lenders to compete for borrowers, driving the real interest rate down,
while a shortage of loanable funds gives lenders an incentive to raise the real interest rate.
At the equilibrium real interest rate(I) the quantity of loanable funds demanded equals the quantity
supplied.
S=I at L*
L* is the quantity of saving and investment that actually occurs in the economy
When L* increases, the economy’s capital per hour worked increases and or technology improves, so the
economy’s productivity and standard of living increase.
The government can encourage an increase in the economy’s L* by:
• Increasing households’ incentive to save(by lowering the tax rate on interest income, by
switching from taxing nominal interest to taxing real interest, or by switching from an income tax
to a consumption tax)
• Increasing firms’ incentive to invest(by providing tax credits for investing)
• Reducing or eliminating a government budget deficit(a government budget deficit decreases the
economy’s total saving and, therefore decreses L*, “crowding out investment”)
Over time the US economy has experienced economic growth and economic recession but it has not been
constant
The Us economy has experienced the
Business Cycle: alternating periods of economic expansion and recession
Expansion: the period of a business cycle during which total production and total employment are
increasing
Recession: the period of a business cycle during which total production and total employment ate
decreasing
Business cycles are irregular and unpredictable: the lengths of the expansion and recession phases and
which sectors of the economy are most affected are different during each business cycle
However certain statistical series known as leading economic indicators tend to begin to turn upward or
downward before the overall economy does
One important leasing economic indicator is stock indexes, which are averages of stock prices
Dow Jones Industrial Average – 30 large US Firms
S&P 500 – 500 large firms
NASDAQ is >3000 firms, mainly high tech
A Recession typically begins with a decline in spending by firms on capital goods and by households on
consumer durables.
Near the end of a recession, the inflation rate usually falls in response to weak demand for consumer
goods, stock prices usually continue to fall in response to pessimism, and the interest rate usually falls in
response to weak demand for investment
At some point savers decrease their purchases of bonds because their interest rates are low and increase
their purchases of stocks because their prices are low.
The increase in demand for stocks causes the upward movement in stock prices that usually begins before
an expansion begins (this is why stock indexes are a leading economic indicator)
The lower interest rate gives both firms and households an incentive to borrow to finance new spending
An increase in spending by firms on capital goods and by households on consumer durables ends the
recession and begins the expansion
The resulting increase in sales causes firms to increase production and employment, though the
unemployment rate does not decrease until the latter part of an expansion because
• Firms increase the hours of their existing workforce, some of whom are unemployed, before they
hire new workers
• Discouraged workers often return to the labor force during an expansion
Rising profits and, eventually, falling unemployment increase income, causing further increases in
spending
Near the end of an expansion, the inflation rate usually rises in response to strong demand for consumer
goods, stock prices usually continue to rise in response to strong demand for investment.
At some point, savers decrease their purchases of stocks because their prices are high and increase their
purchases of bonds because their interest rates are high.
The decrease in demand for stocks causes the downward movement in stock prices that usually begins
before a recession begins
The higher interest rate gives both firms and households an incentive to stop borrowing to finance new
spending.
This leads to the decline in spending by firms on capital goods and by households on consumer durables
that ends the expansion and begins the next recession
Chapter 13~Aggregate Demand and Aggregate Supply Analysis
April 11, 2014
Aggregate demand and aggregate supply model: A model that explains short-run fluctuations in real
GDP and the price level
Aggregate demand (AD) curve: A curve that shows the relationship between the price level and the
quantity of real GDP demanded by households (C), firms (I), the government (G), and rest of the world
(NX).
Slope of AD: When the price level increases (decreases), the quantity of real GDP demanded decreases
(increases).
We assume that G is fixed by policy (Chapter 16), so AD is downward sloping because of the way C, I,
and NX respond to changes in the price level.
• The wealth effect explains how a change in the price level affects consumption(C).
A household’s wealth is the difference between the value of its assets and the value of its debts.
When the price level increases (decreases), the purchasing power of household wealth decreases
(increases).
This encourages households to spend less (more), so the quantity of goods and services demanded by
households (C) decreases (increases).
• The interest-rate effect explains how a change in the price level affects investment
Households can either spend or save their after-tax income/
When the price level increases (decreases), households require more (less) money to make their regular
purchases of goods and services, so they spend more (less) and save less (more) of their after-tax
income.
This decreases (increases) the supply of loanable funds, which increases (decrease) the equilibrium real
interest rate in the market for loanable funds.
This encourages firms to borrow and invest less (more), so the quantity of goods and services demanded
by firms (I) decreases (increases).
• The international-trade effect explains how a change in the price level affects net exports (NX).

When the U.S. price level increases (decreases), U.S. goods and services become relatively more
expensive (cheaper) and foreign goods and services become relatively cheaper (more expensive).
This decreases (increases) U.S. net exports and increase (decreases) U.S. imports, so the quantity of
goods and services demanded by the rest of the world (NX) decreases (increases).
The AD curve shows the relationship between the price level and the quantity of real GDP demanded,
holding all else constant.
If the price level changes, the economy will move along a stationary Ad curve to a new quantity of real
GDP demanded; if any other relevant variable changes, the Ad curve will shift.
We will learn in Chapters 15&16 that the federal government uses monetary policy and fiscal policy to
shift the AD curve.
Monetary policy: The actions the Federal Reserve takes to manage the money supply and interest rates
to pursue macroeconomic policy objectives.
An increase (decrease) in the money supply decreases (increases) interest rates (chapter 15).
When interest rates decrease (increase) firms borrow more to invest in capital and households borrow
more to invest in new housing and to spend on consumer durables.
This increases (decreases) I-investment and C-Consumption, which shifts the AD curve right (left).
If interest rates change because of a change in the price level then the economy will move along a
stationary aggregate demand curve to a new quantity of real GDP demanded; if interest rates change
because of a change in the money supply, then the AD curve will shift.
Fiscal Policy: changes in federal taxes and purchases that are intended to achieve macroeconomic policy
objectives.
When G increases (decreases), the AD curve shifts right (left)
When personal income taxes decrease (increase) households have more (less) after tax income to spend,
so they increase (decrease) C – consumption, which shifts the AD curve right (left)
When business taxes decrease(increase) firms have more(less) after tax profits to spend, so they
increase(decrease) I – investment, which shifts the AD curve right (left)
When households are optimistic (pessimistic) about their future income they increase(decrease) their
current consumption, which shifts the AD curve right (left)
When firms are optimistic(pessimistic) about their future profits, the increase(decrease) their current
Investment, which shifts the aggregate demand curve Right(left)

GDP=Income

When the growth rate of the US GDP decreases(increases) relative to the growth rates of foreign GDP’s,
US spending grows more slowly(faster) than foreign spending
Therefor US exports grow faster(slower) that US imports, so US net exports increase (decrease), which
shifts the Ad curve right(left)
When the value of the dollar decreases (increases) relative foreign currencies, foreign goods and services
become more expensive(cheaper) to US buyers and Us goods and services become cheaper (more
expensive) to foreign buyers.
This increases(decreases) US imports, so US Net Exports increases(decreases) which shifts the AD curve
right(left)
Potential GDP: the level of real GDP attained when all firms are producing at capacity.
In this context, the capacity of a firm is not the maximum output the firm is capable of producing; it is the
firm’s production when operating on normal hours, using a normal operating force.
Potential GDP is the economy’s output when the unemployment rate is equal to the natural rate of
unemployment.
Long Run aggregate Supply curve: a curve that shoes the relationship in the long run between the price
level and the quantity of real GDP supplied
In the long run, real GDP equals potential GDP
SLOPE OF LRAS: potential GDP is determined by the economy’s quantities of capital and labor and its
level of technology. These factors are not affected by changes in the price level, so the LRAS is a vertical
line
In the long run, changes in the price level do not affect the quantity of real GDP supplied
Shifts of LRAS: an increase (decrease) in the quantity of capital and/or labor shifts the LRAS curve
right(left), and an improvement in technology shifts the LRAS curve right.
Short run aggregate supply curve(SRAS): a curve that shoes the relationship in the short run between
the price level and quantity of real GDP supplied by firms.
SLOPE OF SRAS: in the short run, when the price level increases(decreases) the quantity of real GDP
(final goods and services) that firms are willing and able to supply increases(decreases)
In the short run, changes in the price level do affect the quantity of real GDP supplied.
In the short run changes in the price level do affect the quantity of real GDP supplied.
SRAS is upward sloping for two reasons:
• Some input prices change more slowly than the prices final goods and services.
Contracts make some wages and input prices “sticky” (fixed for the length of the contract)
Wages can be especially sticky because they are often adjusted annually or even less frequently, and
because firms are often slower to cut wages than to raise them because the negative effect of a wage
cut on morale and productivity.
If wages and/or input prices are fixed by contract and the price level increases (decreases), then the
increasing (decreasing) prices of final goods and services increases (decreases) firms’ profits.
This gives firms an incentive to increase (decrease) the quantity of real GDP supplied.
(2) Some firms adjust the prices of final goods and services more slowly than other firms.
Menu cost: The costs to firms of changing prices.
Menu costs make some prices of final goods and services sticky.
As the price level increases (decreases), some firms are slow to adjust the prices of their final goods and
service relatively cheaper (more expensive) than other firms’ final goods and services.
This increases (decreases) the slow firms sales and profits, which gives them an incentive to increase
(decrease) the quantity of real GDP supplied.
The short run is the period between the change in the price level, which creates profit opportunities,
and the renegotiation of contracts and/or the incursion of menu costs, which eliminate those profit
opportunities.
At the end of the short run, the quantity of real GDP supplied returns to potential GDP because profits
return to their original levels (i.e., the long run arrives when all prices have adjusted).
The SRAS curve shows the short-run relationship between the price level and the quantity of real GDP
that firms are willing and able to supply, holding all else constant.
If the price level changes, the economy will move along a stationary SRAS curve to a new quantity of real
GDP supplied; if any other relevant variable changes, the SRAS curve will shift.
The forces that shift LRAS also shift SRAS:
• An increase (decrease) in the quantity of capital and/or labor shifts the SRAS curve right (left).
• An improvement in technology shifts the SRAS curve right.

When workers and firms producing inputs renegotiate contracts, they consider two things:
• The expected future price level
• The actual price level compared to the expected price level the last time they negotiated
contracts

When the expected future price level decreases (increases), workers and firms producing inputs
negotiate lower (higher) wages and input prices.
This decreases (increases) the production costs and increases (decreases) the profits of firms producing
final goods and services, so they increase (decrease) production, which shifts the SRAS curve right (left)
When the actual price level is lower (higher) than they expected it to be the last time they negotiated
contracts, workers and firms producing inputs correct their error by negotiating lower (higher wages and
input prices this time.
Again, this decreases (increases) the production costs and increases (decreases) the profits of firms
producing final goods and services, so they increase (decrease) production, which shifts the SRAS curve
right (left).
When the price of an important input, such as oil, decreases (increases) unexpectedly, production
becomes more (less) profitable, so firms increase (decrease) production, which shifts the SRAS curve
right (left).
Supply shock: An unexpected event that causes the SRAS curve to shift.
An adverse supply shock occurs when the price of an important input increases unexpectedly, and a
favorable supply shock occurs when the price of an important input decreases unexpectedly (almost
never happens).
In long-run macroeconomic equilibrium, the AD and SRAS curves intersect at a point on the LRAS curve,
so the economy is at potential GDP.
In short-run macroeconomic equilibrium, the AD and SRAS curves intersect at a point off the LRAS curve,
so real GDP is temporarily above (expansion) or below (recession) its potential level.
The economy is rarely in long-run macroeconomic equilibrium because of business cycle fluctuations,
which are caused by shifts in AD or, occasionally, SRAS.
A Decrease in AD (most likely caused by pessimism)
When the AD curve shifts left, the short-run macroeconomic equilibrium occurs at a point below
potential GDP (recession and positive cyclical unemployment) and below the original PL* (deflation or,
more likely, lower inflation).
Why is deflation bad?
• Buyers postpone spending as they wait for even lower prices, which exacerbates the recession.
• Firms rarely cut wages because of the negative effect of a wage cut on morale and productivity,
so firms fight falling revenues and high wages costs by cutting production and/or workers’
benefits or hours.
• Unanticipated deflation causes the real interest rate to be higher than expected, which makes
debt more burdensome, households and firms borrow and spend less, which exacerbates the
recession.
If the government takes no action, then the decrease in the expected future price level (the AUTOMATIC
MECHANISM) shifts the SRAS right, adjusting the economy back to the potential GDP in the long run.
It may take the economy several years to return to potential GDP at a lower price level.
An Increase in AD (most likely caused by optimism)
When the AD curve shifts right, the short-run macroeconomic equilibrium occurs at a point above
potential GDP (expansion and, eventually, negative cyclical unemployment) and above the original PL*
(inflation).
If the government takes no action, then the increases in the expected future price level (the
AUTOMATIC MECHANISM) shifts the SRAS curve left, adjusting the economy back to potential GDP in
the long run.
It may take the economy several years to return to potential GDP at a higher price level.
A DECREASE IN SRAS (most likely caused by an adverse supply shock)
This is an exceptional case because it doesn’t follow the business cycle patterns described in Chapter
10.3.
When an unexpected increase in the price of an important input causes the SRAS curve to shift left, the
short-run macroeconomic equilibrium occurs at a point below potential GDP (recession and positive
cyclical unemployment) and above the original PL* (inflation).
Stagflation: A combination of inflation and recession, usually resulting from a supply shock.
If the government takes no action, the economy will eventually return to the original long-run
macroeconomic equilibrium.
Initially, the increase in the expected future price level may shift the SRAS curve even further left (wage-
price spiral).
Eventually, however, the recession and its accompanying increase in unemployment and decrease in
sales will cause workers to accept lower wages and firms producing inputs to accept lower input prices,
which will shift the SRAS curve right.
It may take the economy several years to return to potential GDP at the original price level.
The government cannot successfully fight both components of stagflation simultaneously.
Try to fight inflation, make the recession worse.
Since the mid-twentieth century, the U.S. government has taken action to fight the business cycle,
opting not to wait for the macro economy to return to potential GDP in the long run (John Maynard
Keynes: “in the long run, we are all dead.”).
Chapter 14
Money and Banks
• The Fed can make both large and small open market operations
• The Fed can implement open market operations quickly, with no administrative delays or
change in rgulations

• discount policy

Banks that cannot meet the reserve requirement and cannot borrowin the federal funds market can
borrow from the Fed.
Discount loans: Loans the Federal Reserve makes to banks.
Discount rate: The interest rates the Federal Reserve charges on discount loans.
The discount rate (.75%) is always larger then the federal funds rate (0-.25%) to encourage banks to use
the Fed only as a lender of last resort.
This means that changes in the federal funds rate target may be accompanied by changes in the
discount rate.
TO decrease the money supply, the Fed increases the discount rate, which discourages banks from
borrowing from the Fed and encourages banks to increase their excess reserves to ensure they can meet
the reserve requirement.
When banks increase their excess reserves, they decrease loans, which decreases checking account
deposits, which decreases the money supply.
To increase the money supply, the Fed decreases the discount rate, which encourages banks to borrow
from the Fed.
As banks borrow more from the Fed, they increase loans, which increases checking account deposits,
which increases the money supply.
• Reserve requirements
To decrease the money supply, the Fed increases the required reserve ratio.
To meet the higher reserve requirement, banks decrease loans, which decreases checking account
deposits, which decreases the money supply.
This results in some required reserves becoming excess reserves, so banks increase their loans, which
increases checking account deposits, which increases the money supply.
The Fed rarely uses this tool because of the disruptions it would cause in the banking industry.
Since WWII, the Fed has carried out an active Monetary policy: The actions the Federal Reserve takes
to manage the money supply and interest rates to pursue macroeconomic policy objectives.
The Fed has four macroeconomic policy objectives that are intended to promote a well-functioning
economy:
• Price stability: rising prices erode the value of money as a medium of exchange and a store of
value
• High employment: unemployed workers and underused capital reduce GDP below its potential
level
• Stability of financial markets and institutions: a well-functioning financial system generates an
efficient flow of funds from savers to borrowers
• Economic growth: Stable prices, high employment, and a well-functioning financial system
promote economic growth, which raises living standards

To fight a recession caused by a decrease in AD, the Fed conducts Expansionary monetary policy: The
Federal Reserve’s decreasing interest rates to increase real GDP.

Lower interest rates
• Encourage households to borrow to purchase consumer durables, which increases C
• Discourage households from saving, which increases C
• Encourage firms to borrow to purchase capital and adopt new tech., which increases I
• Encourage households to acquire mortgages to purchase new homes, which increases I

Asset: Anything of value owned by a person or a firm.
Money: Assets that people are generally willing to accept in exchange for goods and services or for
payment of debts.
In barter economies, people trade goods and services directly for other goods and services.
Barter requires a double coincidence of wants (two individuals must each have precisely what the other
wants), which causes inefficiency when it forces intermediate trades and/ or discourages specialization.
Money does not require a double coincidence of wants, so money makes exchange easier and increases
efficiency by allowing individuals to specialize based on comparative advantage.
Money serves four functions:
• Money serves as a medium of exchange when sellers accept it in exchange for goods and
services.
• Money serves as a unit of account when it is the common unit by which everyone measure
prices and values in an economy.
• Money serves as a store of value when it transfers purchasing power form the present to the
future.
Liquidity refers to the ease with which an asset can be converted into the economy’s medium of
exchange.
There is often a trade-off between usefulness as a store of value and liquidity.
For example, money is the most liquid asset available because it is the economy’s medium of exchange,
but money is not the best store of value because of inflation, while an original painting by Vincent Van
Gogh is a good store of value, but it is not very liquid.
• Money serves as a standard of deferred payment when it is used to record and repay debts.

Commodity money: A good used as money that also has value independent of its use as money.
Fiat money: Money, such as paper currency, that is authorized by a central bank or governmental body
and that does not have to exchanged by the central bank for gold or some other commodity money.
Paper currency has little to no value unless it is used as money, so it is fiat money.
A society’s willingness to use paper currency as money makes it an acceptable medium of exchange.
M1: the narrowest definition of the money supply: The sum of currency [paper money and coins] in
circulation [not held by banks or the government], checking account deposits in banks, and holdings of
travelers’ checks.
While there are other definitions of the money supply, we will use the M1 definition because it
corresponds most closely to money as a medium of exchange.
Because checking account deposits are included in the money supply, banks play an important role in
increasing and decreasing the money supply.
Reserves: Deposits that a bank keeps as cash in it is vaults or on deposit with the Federal Reserve.
Required reserves: Reserves that a bank is legally required to hold, based on its checking account
deposits.
Required reserve ratio (RR): The minimum fraction of deposits banks are required by law to keep as
reserves.
Excess reserves: Reserves that banks hold over and above the legal requirement.
Banks accept deposits, hold a percentage of those deposits as required reserves, sometimes hold a
portion of those deposits as excess reserves, and lend the rest to household and firms.
When borrowers make purchases with the loans, sellers deposit the funds in their banks, which repeat
the process.
Every repetition of this process increases checking account deposits and, therefore, the money supply.
Example: The required reserve ratio is 20% (RR=.2), and banks do not hold excess reserves.
$1000 is deposited into first national bank (money supply=$100 in checking account deposits).
First national bank keeps $200 of the deposit as required reserves and lends the remaining $800.
The borrower makes a purchase with the $800.
The seller deposits the $800 into second national bank (money supply=$1800 in checking account
deposits).
In this way, bank creates money (but they do not create wealth because loans are debt).
The creation of money does not stop at this point: Second national bank keeps $160 of the 800 deposit
as required reserves and lends the remaining $640, the borrower makes a purchase with the $640, the
seller deposits the $640 into third bank (money supply=$2440 in checking account deposits).
This process continues until banks can make no additional loans, at which point the total change in
checking account deposits will be $5000.
Simple deposit multiplier=1/RR=1/.2=5
Total change in checking account deposits= (initial deposit)(simple deposit multiplier)=($1000)(5)=$5000
The simple deposit multiplier is the maximum value the deposit multiplier can take.
In reality, banks do hold some excess reserves, and people do hold some loan money as currency, so the
real-world deposit multiplier is less then 1/RR.
Nonetheless, whenever banks gain deposits, they make new loans and the money supply increases, and
whenever banks lose deposits, they reduce their loans and the money supply decreases.
Chapter 15
Federal Reserve system and Monetary Policy
Fractional reserve banking system: A banking system in which banks keep less than 100 percent of
deposits as reserves.
On a typical day, about as much money is deposited as is withdrawn from any given bank, so fractional
reserve banking is not usually a problem.
Bank run: A situation in which many depositors simultaneously decide to withdraw money from a bank.
It is possible for one bank to handle a run by borrowing from other banks.
Today, most deposits are guaranteed through the Federal Deposit Insurance Corporation (FDIC), so bank
runs are rare.
Bank panic: A situation in which many banks experience runs at the same time.
An economy’s central bank (the government agency that regulates the money supply) can help stop a
bank panic by acting as a leader of last resort to banks that cannot borrow funds elsewhere.
Federal Reserve (“the Fed”): The central bank of the United States.
The Fed was established by Congress in 1913 to stop bank panics, but today its main roles are to control
the money supply, to act as a bankers’ bank, and to regulate the financial system.
The U.S. is divided into 12 Federal Reserve districts, each of which has its own Federal Reserve Bank that
provides services to banks in that district.
• Encourage savers to purchase stocks instead of bonds, which increases stock prices, which sends
a signal to firms that the future profitability of investment projects has increased, which
increases I
• In the U.S. relative to foreign countries decrease the demand for dollars to purchase U.S.
financial assets, which causes the value of the dollar (the exchange rate) to fall, which makes
U.S. exports cheaper and U.S. imports more expensive, which increases U.S. exports and
decreases U.S. imports, which increases U.S. NX

The increases in C, I, and NX shift AD right.
Expansionary policy causes real GDP and the price level to raise, relative to what they would have been
without the policy
Keeping recessions shorter and milder than they would otherwise be is usually the best the Fed can do;
the Fed does not have a realistic hope of eliminating the business cycle and achieving absolute price
stability.
To fight inflation caused by an increase in AD, the Fed conducts Contractionary monetary policy: The
Federal Reserve’s increasing interest rates to reduce inflation.
Higher interest rates
• Discourage households from borrowing to purchase consumer durables, which decreases C
• Encourages households to save, which decreases C
• Discourage firms from borrowing to purchase capital and adopt new technologies, which
decreases I
• Discourage households from acquiring mortgages to purchase new homes, which decreases I
• Encourage savers to purchase bonds instead of stocks, which decreases stock prices, which
sends a signal to firms that the future profitability of investment projects has decreased, which
decreases I
• In the U.S. relative to foreign countries increase the demand for dollars to purchase U.S.
financial assets, which causes the value of the dollar (the exchange rate) to rise, which makes
U.S. exports more expensive and U.S. imports cheaper, which decreases U.S. exports and
increases U.S. imports, which decreases U.S. NX

The decreases in C,I, and NX shift AD left
Contractionary policy causes real GDP and the price level to fall, relative to what they would have been
without the policy
Chapter 16 – fiscal policy
The Employment Act of 1946 committed the federal government to intervening in the economy
“to promote maximum employment, production, and purchasing power.”
Consequently, the fed closely monitor the economy, the FOMC meets at least 8 times per year
to decode whether to change monetary policy, and at any time congress and the president may
decide to change fiscal policy.
Fiscal Policy: changes in federal taxes and purchases that are intended to achieve
macroeconomic policy objectives.
There are two types of fiscal policy,
1 – Automatic stabilizers : require no action be the government. Government spending and
taxes that automatically increase or decrease along with the business cycle.
NOTE: the automatic stabilizers affect the AD, while the automatic mechanism affects SRAS.
• The most important automatic stabilizer is the tax system.
• During a recession, income and profit fall and in an expansion they rise.
The amount of tax paid to the federal government depends on the levels of households’ income
and firms’ profit, so tax payments decrease during a recession and increase during an expansion
Lower[higher] tax payments leave more[less] after tax income to spend on consumption and
more[less] after tax profit for firms to spend on investment, so AD does not decrease[increase]
as much as it otherwise would have, preventing the recession[inflation] from being worse

2 – Discretional Fiscal Policy: requires action by congress and the president.
Government spending on transfer payments is also an automatic stabilizer.
During a recession (expansion), more (less) households are eligible for transfer payments, such
as unemployment insurance and welfare.
The increase (decrease) in transfer payments leaves the recipient households with more (less)
income to spend on consumption, so AD does not decrease (increase) as much as it otherwise
would have, preventing the recession (inflation) from being worse.
Congress and the President may choose to make additional changes to government purchases
and / or taxes by implementing discretionary fiscal policy.
President Bush’s 2008 tax rebates and President Obama’s 2009 American Recovery &
Reinvestment Act are examples of discretionary fiscal policy.
To fight a recession caused by a decrease in AD, Congress and the President may conduct
expansionary fiscal policy, which could include:
• Increasing G to shift AD right (think of the federal government as a spender of last
resort).
• Decreasing personal income tax rates to increase households consumption spending (C)
and shift AD right.
• Decreasing business tax rates increases firms’ investment spending (I) and shifts the AD
right
Expansionary fiscal policy looks the same as expansionary monetary policy on an AD-AS graph
Expansionary policy causes real GDP and the price level to rise, relative to what they would
have been without the policy.
To fight inflation by an increase in AD the president and congress may conduct contractionary
fiscal policy, which would include
• Decreasing G to shift AD left
• Increasing personal income tax rates to decrease households’ consumption spending
(C) and shift AD left
• Increasing business tax rates to decrease firm’s investment spending (I) and shift the AD
left
Contractionary fiscal policy looks the same as contractionary monetary policy on an AD-AS
graph
Contractionary policy causes real GDP and the price level to fall, relative to what they would
otherwise have been without the policy
Monetary policy and fiscal policy cannot eliminate the business cycle; the best these policies
can do is keep recessions and periods of inflation shorter and milder than they would otherwise
be
Poorly times monetary and or fiscal policies can do more harm than good
If the fed and or congress and the president implement policies too late (after the automatic
mechanism has already adjusted the economy back to long run macroeconomic equilibrium)
they destabilize the economy.
A procyclical (late) policy increases the severity of the business cycle, while a countercyclical
(stabilizing) policy reduces the severity of the business cycle
The fed and Congress and the president try to use countercyclical monetary and fiscal policies
to offset the effects of the business cycle on the economy, but they don’t always succeed.
Procyclical expansionary policy meant to fight recession will cause inflation, relative to the new long run
macroeconomic equilibrium
Procyclical contractionary policy meant to fight inflation will cause recession relative to the new long run
macroeconomic equilibrium.
Fiscal policy is more likely to be procyclical than monetary policy because obtaining approval from both
the house and the senate for a new fiscal policy can be a very long process and it can take months for an
authorized increase in spending to actually take place.
In contrast, the FOMC can act immediately, so monetary policy is used more frequently than fiscal policy
to fight the business cycle.
Budget Deficit: the situation in which the government’s expenditures are greater than its tax revenue.
Budget Surplus: the situation in which the government’s expenditures are less than its tax revenue.
Holding all else constant budget deficit [surplus] occur automatically during recessions [expansions]
because the automatic stabilizers lead to lower [higher] government tax revenue and higher [lower]
government spending on transfer payments.
Although many economists believe that it is a good idea for the federal government to have a balance
budget when the economy is at potential GDP, few economists believe that the federal government
should attempt to balance its budget every year:
• To balance the budget during a recession, the government would have to raise taxes and or
decrease government spending, which would decrease AD and make the recession worse.
• To balance the budget during an expansion, the government would have to cut taxes and or
increase government spending, which would increase AD and make inflation worse.