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Chapter 16&18

The document discusses monetary and fiscal policy principles in macroeconomics, highlighting the challenges faced by the Federal Reserve in managing the economy, particularly in response to negative shocks. It outlines the trade-offs between inflation and economic growth, as well as the limitations and lags associated with fiscal policy implementation. Additionally, it introduces concepts like Ricardian equivalence and automatic stabilizers that influence government spending and economic fluctuations.

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4 views

Chapter 16&18

The document discusses monetary and fiscal policy principles in macroeconomics, highlighting the challenges faced by the Federal Reserve in managing the economy, particularly in response to negative shocks. It outlines the trade-offs between inflation and economic growth, as well as the limitations and lags associated with fiscal policy implementation. Additionally, it introduces concepts like Ricardian equivalence and automatic stabilizers that influence government spending and economic fluctuations.

Uploaded by

cullencribbins11
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Chapter 16 & 18

MONETARY POLICY / FISCAL POLICY


PRINCIPLES OF MACROECONOMICS
Monetary Policy
1. Suppose a negative shock to AD
occurs, shifting AD to the left.
2. Although the economy will recover
and return to the steady state growth
level, the Fed can speed it up.
3. Specifically, they can: increase the
rate of growth of the money supply or
reduce interest rates and encourage
more borrowing.
Monetary Policy
•Monetary policy is difficult because:
The fed operates in real time when data
regarding state of economy is unknown
Fed’s control of money supply is incomplete
Uncertain lags

•Sometimes the Fed overstimulates the


economy, increasing AD too much.
•On the other hand, disinflation will cause
nominal wage growth to be high, causing
layoffs.
Monetary Policy
•Credible monetary policy: a monetary policy is
credible when it is expected that a central
bank will stick with its policy.
•Market confidence: one of the Fed’s most
powerful tools – that is, its influence over
expectations.
To reduce fear, the Fed increased lending to
banks from $34 million to $45.5 billion following
September 11th attacks.
Monetary Policy Dilemma
•Suppose a negative real shock hits, such as a
rapid oil price decrease.
•This causes LRAS curve to shift left, increasing
inflation and decreasing GDP growth.
•Reducing money supply lowers inflation rate,
but at a cost to economic growth.
•Fed can increase AD by upping money supply
•But the economy is less productive than
before, so most of the increase will be
inflation.

Tradeoff: Too low a rate of growth (w/ high unemployment rate) vs. high rate of inflation
Estimated Estimated
Multiplier: Multiplier:
Type of Activity Low High
Estimate Estimate

Fiscal Policy Purchase of goods and


services by the federal
government
0.5 2.5

•Fiscal policy: Federal government policy on taxes, Transfer payments to state 0.4 2.2
spending, and borrowing that is designed to and local governments for
infrastructure
influence business fluctuations.
Transfer payments to state 0.4 1.8
•Crowding out: The decrease in private spending and local governments for
other purposes
that occurs when government spending increases.
Transfer payments to 0.4 2.1
•Multiplier effect: The additional increase in individuals
spending caused by the initial increase in Two-year tax cuts for lower- 0.3 1.5
and middle-income people
government spending.
One-time payments to retirees 0.2 1
One-year tax cut for higher- 0.1 0.6
income people
Fiscal Policy
•Suppose consumer spending growth falls
•It is equivalent to
•AD shifts to the left, and point b represents a
recession.
•Because consumers want to hold more
money, inflation decreases.
•Since wages are sticky,
•Although wages will adjust and return just like
the economy, the government can offset by
Definitions & Situations
•Ricardian equivalence: when people see that
lower taxes today means higher taxes in the
future and so, instead of spending their tax
cut, save it to pay future taxes.
Counter-cyclical fiscal policy: Fiscal policy that
runs opposite or counter to the business cycle—
spending more when the economy is in a
recession, and spending less when the economy
is booming.
Limits to Fiscal Policy
• Government spending does not change very much
from year to year in percentage terms
• Most of the federal budget is determined well in
advance
• Fiscal policy is subject to many lags:
1.Recognition lag: The problem must be recognized.
2.Legislative lag: Congress must propose and pass a
plan.
3.Implementation lag: Bureaucracies must implement
the plan.
4.Effectiveness lag: The plan takes time to work.
5.Evaluation and adjustment lag: Did the plan work?
Have conditions changed?
Limits to Fiscal Policy
• Tax cuts—the other major form of fiscal policy—also
involve lags and uncertainties.
• Monetary policy is subject to lags as well, but these
are generally much shorter than those for fiscal policy.
• Fiscal policy is rarely adjusted in response to changes
in economic conditions. The only place where fiscal
policy might have an advantage over monetary policy
is through the effectiveness lag.
• Automatic stabilizers are built right into the tax and
transfer system.
• They take effect without significant lags.
2017 Trump Tax Cuts • Automatic stabilizers: Changes in fiscal policy that
stimulate AD in a recession without the need for
explicit action by policymakers.

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