Key Concepts Last Week: Monetary Policy

a.k.a. “loose” or “easy”

monetary policy

In each of these steps, the changes are relative to what

would have happened without the monetary policy.

a.k.a. “tight”
monetary policy

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What would we learn from the course?
GDP Inflation Unemployment
(Production/ Income)
 Measuring Unemployment and Inflation
 GDP: Measuring Total Production and Income
 Economic Growth, the Financial System, and Business Cycles
 Long-Run Economic Growth: Sources and Policies

Short-Run Fluctuations/
Business Cycle Key Markets for Analysis
 Aggregate Expenditure and Output - Demand
in the Short Run - Supply
 Aggregate Demand and Aggregate - Equilibrium: Price & Quantity
Supply Analysis - Dynamics

Macroeconomic Policy
to Reduce Short-Run
Fluctuations International Economy
 Money, Banks, and the Federal Reserve System
 Monetary Policy ❑ Macroeconomics in an Open Economy
❑ Fiscal Policy ❑ The International Financial System
❑ Inflation, Unemployment, and Federal Reserve Policy
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Lecture
CHAPTER

Fiscal Policy; Inflation, Unemployment,

8 and Federal Reserve Policy

Outline
1 What Is Fiscal Policy?
2 The Effects of Fiscal Policy on Real GDP and the Price Level
3 Fiscal Policy in the Dynamic Aggregate Demand and
Aggregate Supply Model
4 The Government Purchases and Tax Multipliers
5 The Short-Run and Long-Run Phillips Curves
6 Expectations of the Inflation Rate and Monetary Policy
7 Practice Exercises

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1. What Is Fiscal Policy
Fiscal policy refers to changes in federal taxes and purchases that
are intended to achieve macroeconomic policy objectives.
Government purchases (G) is a component of real GDP:
Y = C + I + G + NX
Increase in government purchases may increase output—and hence
other relevant economic variables like employment.
Some forms of government spending and taxes automatically
increase or decrease along with the business cycle; these are
automatic stabilizers.
Example: Unemployment insurance payments are larger during a
recession.
Discretionary fiscal policy, on the other hand, refers to intentional
actions the government takes to change spending or taxes.

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Discretionary fiscal policy

Discretionary fiscal policy is passed by the

legislative branch (i.e., Congress) and signed into
law by the executive branch (i.e., the president).

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What Does the Federal Government Spend Money On?

Federal purchases consist of

defense spending and “everything
else”, like salaries of FBI agents,
operating national parks, and
funding scientific research.
Around half of federal
expenditures are spent on
transfer payments, like Social
Security, Medicare, and
unemployment insurance.
The rest is spent on grants to
state and local governments to
support their activities, like crime
prevention and education; and on
Figure 16.3 Federal government
paying interest on the federal expenditures, 2012
debt.
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Where Does the Federal Government Get Money From?

The majority of federal

revenues come from taxes on
individual employment:
individual income taxes and
“payroll taxes” earmarked to
fund Social Security and
Medicare.
Taxes on corporate profits
constitute about one-seventh
of federal receipts.
The remainder of federal
revenue comes from excise
taxes (on cigarettes, gasoline,
etc.), tariffs on imports, and Figure 16.4 Federal government
revenue, 2012
other fees from firms and
individuals.
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Countercyclical Policies in Economic Fluctuations

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Expansionary Policy

Expansionary policy
aims to reduce the
severity of an
economic recession by
shifting labor demand
to the right and
“expanding”
economic activity (GDP). It is meant to “heat up”
the economy.

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Contractionary Policy

Contractionary policy is used to slow down the

economy when it grows too fast, or “overheats.”

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2. The Effects of Fiscal Policy on Real GDP and the Price Level

Expansionary fiscal policy

involves increasing
government purchases or
decreasing taxes.
• Increasing government
purchases directly
increases aggregate
demand.
• Decreasing taxes indirectly
affects aggregate demand
by increasing disposable
income, and hence
Figure 16.5a
consumption spending.
If the government believes real GDP will be below potential GDP, it
can enact expansionary fiscal policy in an attempt to restore long-
run equilibrium—decreasing unemployment.
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Contractionary Fiscal Policy in the AD-AS Model
Contractionary fiscal policy
involves decreasing
government purchases or
increasing taxes.
• This works just like
expansionary fiscal policy,
only in reverse.
• A decrease in aggregate
demand will result in both
real GDP and the price
level decreasing in the
short-run equilibrium. Figure 16.5b

If the government believes real GDP will be above potential GDP, it

can enact contractionary fiscal policy in an attempt to restore long-
run equilibrium—decreasing inflation.
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Summarizing Fiscal Policy
Actions by Congress
Problem Type of Policy and the President Result
Recession Expansionary Increase government Real GDP and the price
purchases or cut taxes level rise.
Rising inflation Contractionary Decrease government Real GDP and the price
purchases or raise taxes level fall.

Table 16.1 Countercyclical fiscal policy

The federal government’s actions described on the previous slides

constitute a countercyclical fiscal policy.
Bear in mind that:
• The effects described assume everything else is staying the same,
including monetary policy.
• Contractionary fiscal policy is not really causing prices to fall; it’s
causing inflation to be lower than it otherwise would have been.

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3. Fiscal Policy in the Dynamic AD-AS Model
Expansionary Fiscal Policy:
Initially, the economy is in long-
run equilibrium.
• The federal government
projects that aggregate
demand will not rise by
enough to maintain full
employment.
• It enacts an expansionary
fiscal policy to increase
aggregate demand,
hopefully to the full
employment level.
The price level is higher than it
Figure 16.6 An expansionary fiscal
would have been without the policy in the dynamic model
expansionary fiscal policy.
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Contractionary Fiscal Policy in the Dynamic AD-AS Model

The economy starts once

more in long-run equilibrium.
• The federal government
projects that aggregate
demand will rise so
much that employment
is beyond the full-
employment level,
causing high inflation.
• It enacts a contractionary
fiscal policy to decrease
aggregate demand, again
ideally to the full
employment level. Figure 16.7 A contractionary fiscal
policy in the dynamic model

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4. The Government Purchases and Tax Multipliers
If the government
increases its
spending on goods
and services, then
aggregate demand
increases
immediately. This Figure 16.8
is the autonomous
The multiplier
increase in effect and
aggregate aggregate
demand
demand.
But then people receive this increased spending as increased income and
increase their consumption spending accordingly.
This is the induced increase in aggregate demand.
• The series of induced increases in consumption spending that results from the
initial increase in autonomous expenditures is known as the multiplier effect.

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Multiplier Effect of an Increase in Government Purchases

Suppose each increase in

spending induces half again as
much consumption spending.
• Over time, a $100 billion
increase in government
purchases will result in an
additional $100 billion in
induced consumption
spending.
Figure 16.9 The multiplier effect of an increase
in government purchases
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Multipliers for Government Purchases and Taxes
We can describe the total effect of a change (increase or decrease) in
government purchases or taxes by measuring the change in
equilibrium real GDP.
Change in equilibriu m real GDP
Government purchases multiplier =
Change in government purchases
Change in equilibriu m real GDP
Tax multiplier =
Change in taxes

The tax multiplier will be a negative number: an increase in taxes will

decrease equilibrium real GDP, and vice versa.
We expect the tax multiplier to be smaller (in absolute value) than the
government purchases multiplier.
• Why? A $100 billion increase in purchases initially increases
spending by $100 billion, but a $100 billion tax cut is partially spent
and partially saved.

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Caution about Tax Rates and Negative Multipliers
The tax multiplier applies to changes in the amount of taxes, without
changes in tax rates. Example: In 2009 and 2010, the federal
government enacted the Making Work Pay Tax Credit: a $400
reduction in taxes for working individuals ($800 for households).
Decreases in tax rates have a slightly different effect:
1. Increasing the disposable income of households, leading them to
increase their consumption spending.
2. Increasing the size of the multiplier effect, since more of any
Increase in income becomes disposable income.

The Multipliers Work in Both Directions

An increase in government purchases and a cut in taxes have a
positive multiplier effect.
A decrease in government purchases and an increase in taxes have
a negative multiplier effect.
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Example
Fiscal Policy Multipliers
Briefly explain whether you agree with the following statement:
“Real GDP is currently $14.2 trillion, and potential real GDP is $14.4 trillion.
If Congress and the president would increase government purchases by $200 billion
or cut taxes by $200 billion, the economy could be brought to equilibrium at potential GDP.”

Solving the Problem

Step 1: Review the chapter material.
Step 2: Explain how the necessary increase in purchases or cut in taxes is less than
$200 billion because of the multiplier effect.
The statement is incorrect because it does not consider the multiplier effect.
Because of the multiplier effect, an increase in government purchases or a decrease in taxes
of less than $200 billion is necessary to increase equilibrium real GDP by $200 billion.
For instance, assume that the government purchases multiplier is 2 and the tax multiplier
is −1.6.
We can then calculate the necessary increase in government purchases as follows:
Change in equilibriu m real GDP
Government purchases multiplier =
Change in government purchases

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Example
Fiscal Policy Multipliers

$200 billion
2=
Change in government purchases

$200 billion
Change in government purchases = = $100 billion
2

And the necessary change in taxes:

Change in equilibriu m real GDP

Tax multiplier =
Change in taxes

$200 billion
− 1.6 =
Change in taxes

$200 billion
Change in taxes = = −$125 billion
− 1.6

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Crowding Out in the Short Run—Money Market
Fiscal policy may be less effective
than monetary policy since:
• Timing fiscal policy is harder,
because of Legislative or
implementation delay
• Government spending might
crowd out private spending
Crowding out: A decline in
private expenditures as a result of
an increase in government
purchases
A temporary increase in
government purchases will cause
the demand for money, and
hence the interest rate, to rise. Figure 16.11 An expansionary fiscal
But with the higher interest rate, policy increases
interest rates
consumption, investment, and net
exports all fall. 22 of 36
Crowding Out only in Short Run—AD-AS Model
A temporary increase in
government purchases will cause
the demand for money, and hence
the interest rate,
to rise in the short run. With the
higher interest rate, consumption,
investment, and net exports all fall.
So the initial increase in spending
is partially offset by the crowding
out.
In the long run, the increase in
government purchases will have
no effect on real GDP. Why?
Because in the long run, the
economy returns to potential GDP,
Figure 16.12 The effect of crowding
even without the government’s out in the short run
intervention.

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5. The Short-Run and Long-Run Phillips Curve

Figure 17.2
In the AD-AS model, a stronger aggregate demand increase
Using
leads to lower unemployment but higher inflation in the short aggregate
run. So there is short-run trade-off between unemployment demand and
aggregate
and inflation, known as the short-run Phillips curve: higher supply analysis
levels of inflation are associated with lower levels of to explain the
unemployment, and vice versa. Phillips curve
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The Long-Run Phillips Curve
The long-run aggregate supply
curve was vertical at the
potential GDP. It implied that
the long-run Phillips curve is
also vertical. Unemployment,
in the long run, goes to its
natural rate, when the output
returns to potential GDP. At
this output level, there is no
cyclical unemployment; but
there does remain structural
and frictional unemployment.
These latter two are not Figure 17.3b A vertical long-run aggregate supply curve
means a vertical long-run Phillips curve
predictably affected by inflation
Natural rate of unemployment: The unemployment rate that exists
when the economy is at potential GDP.
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6. Expectations of the Inflation Rate and Monetary Policy
The short-run trade-off appears to exist because workers and firms
sometimes expect the inflation rate to be either higher or lower than it
turns out to be. Example: Ford and the United Auto Workers (UAW)
Nominal Wage Expected Real Wage Actual Real Wage
Expected P2016 = 105 Actual P2016 = 102 Actual P2016 = 108
$34.65
per hour Expected inflation = 5% Actual inflation = 2% Actual inflation = 8%
for 2016 $34.65
 100 = $30.00 $34.65 $34.65
(P2015 = 100) 105  100 = $ 30. 88  100 = $29.17
102 108
Table 17.1 The effect of unexpected price level changes on the real wage

If the expectations about inflation are correct, the real wage will be
$30 as expected; Ford will hire its planned number of workers. But:
If… then… and...
actual inflation is greater the actual real wage is less
the unemployment rate falls
than expected inflation, than the expected real wage
actual inflation is less the actual real wage is greater
the unemployment rate rises
than expected inflation than the expected real wage

Table 17.2 The basis for the short-run Phillips curve

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A Short-Run Phillips Curve for Every Expected Inflation Rate

Each expected
inflation rate generates
a different short-run
Phillips curve.
In each case, when
the inflation rate is
actually at the
expected level, the
unemployment level is
at its natural rate—i.e.
the long-run Phillips
curve.

Figure 17.6 A short-run Phillips

curve for every
expected inflation rate

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Implications for Monetary Policy
By the 1970s, most economists agreed
that the long-run Phillips curve was
vertical; it was not possible to “buy” a
permanently lower unemployment rate
at the cost of permanently higher
inflation.
• In order to keep unemployment
lower than the natural rate, the Fed
would need to continually increase
inflation.
• Or it could decrease inflation, at
the cost of a temporarily higher
unemployment rate.
Since any rate of unemployment other
than the natural rate results in the rate
of inflation increasing or decreasing,
the natural rate of unemployment is
sometimes referred to as the non- Figure 17.7 The inflation rate and the
accelerating inflation rate of natural rate of unemployment
unemployment, or NAIRU. in the long run

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Example: Oil Price Shocks in the 1970s

Figure 17.9

A supply shock
shifts the SRAS
curve and the
short-run Phillips
curve
The graphs show the U.S. economy in 1973: moderate but
anticipated inflation, hence unemployment at its natural rate.
• In 1974, OPEC caused oil prices to rise dramatically. This was a
supply shock, decreasing short-run aggregate supply.
• Unemployment rose but so did people’s expectations of inflation—
a higher short-run Phillips curve.
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The Fed’s Response

Figure 17.9

A supply shock
shifts the SRAS
curve and the
short-run Phillips
curve
What could the Fed do? It wanted to fight both inflation and
unemployment, but the short-run Phillips curve makes clear that
improving one worsens the other.
• The Fed chose expansionary monetary policy: reducing
unemployment, at the cost of even more inflation.
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Example
Using Monetary Policy to Lower the Inflation Rate
Consider the following hypothetical situation:
The economy is currently at the natural rate of unemployment of 5 percent.
The actual inflation rate is 6 percent, and, because it has remained at 6 percent for several
years, this is also the rate that workers and firms expect to see in the future.
The Federal Reserve decides to reduce the inflation rate permanently to 2 percent.
How can the Fed use monetary policy to achieve this objective?
Be sure to use a Phillips curve graph in your answer.

Solving the Problem

Step 1: Review the chapter material.

Step 2: Explain how the Fed can use monetary policy to reduce the inflation rate.
To reduce the inflation rate significantly, the Fed will have to raise the target for
the federal funds rate.
Higher interest rates will reduce aggregate demand, raise unemployment,
and move the economy’s equilibrium down the short-run Phillips curve.

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Example
Using Monetary Policy to Lower the Inflation Rate
Step 3: Illustrate your argument
with a Phillips curve graph.
How much the unemployment rate
would have to rise to drive down
the inflation rate from 6 percent to
2 percent depends on the steepness
of the short-run Phillips curve.
Here we have assumed that the
unemployment rate would have to
rise from 5 percent to 7 percent.

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Example
Using Monetary Policy to Lower the Inflation Rate
Step 4: Show on your graph the
reduction in the inflation rate from
6 percent to 2 percent.
For the decline in the inflation rate to be
permanent, the expected inflation rate
has to decline from 6 percent to 2 percent.
We can show this decline on our graph.
Once the short-run Phillips curve has
shifted down, the Fed can use an
expansionary monetary policy to push
the economy back to the natural rate
of unemployment.
The downside to these policies of
disinflation is that they lead to significant
increases in unemployment.
According to the new classical
macroeconomics approach, however, the Fed’s policy announcement
should cause people to revise downward their expectations of future inflation from 6 percent to
2 percent because the economy’s short-run equilibrium would move down the long-run Phillips
curve by that amount, while keeping the unemployment rate constant at 5 percent.
Still, many economists are skeptical that disinflation can be brought about so painlessly.

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7. Practice Exercises
7.1: Identify whether each of the following events in the
U.S. is an example of an expansionary fiscal policy, an
contractionary fiscal policy, or not a fiscal policy.
#1: The Fed buys Treasury securities
#2: The U.S. Congress and the president enact a temporary
cut in payroll taxes
#3: The amount of unemployment insurance paid by the
government decreases during an expansion
#4: The Fed increases the target for the federal funds rate
#5: The U.S. Congress passed a $152 billion stimulus
plan in response to the recent recession.
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7.2: Use the following graph to answer the questions:
i. If the government takes no
policy actions, what will be the
value of real GDP and the price
level in 2017?
ii. What actions can the
government take to bring the
real GDP to its potential level in
2017?
iii. What will the inflation rate be in
2017
• if the government takes no policy
actions?
• if the government takes fiscal
policy actions to keep real GDP
at its potential level?
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7.3: In 2014 Hong Kong, the real GDP equals $2,145 billion
(of 2012 HK dollars). Suppose that the potential GDP equals
$2,200 billion, the government purchases multiplier equals
2, and the tax multiplier equals -1.6.
#1: Holding other factors constant, by how much will
government purchases need to be increased to bring the
economy to equilibrium at potential GDP?
#2: Holding other factors constant, by how much will taxes
need to be cut to bring the economy to equilibrium at
potential GDP?
#3: Construct an example of a combination of increased
government purchases and decreased taxes that will bring
the economy to equilibrium at potential GDP.
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