Section 6

A . Fiscal and
monetary policies
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◦
◦
◦

1 . Demand-side effects
2 . Supply-side effects
3 . Policy mix
4 . Government deficits
and debt
B . The Phillips curve
◦ 1 . Short-run and longrun Phillips curves
◦ 2 . Demand-pull versus
cost-push inflation
◦ 3 . Role of expectations
Module 30
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
Government decisions about tax rates and
spending levels.
Two types:
◦ Expansionary – Grows the economy/increases deficit
 Decrease Taxes
 Increase Spending
 Increase transfers
◦ Contractionary – Slows the economy/reduces deficit
 Increase Taxes
 Decrease Spending
 Decrease Transfers

The budget balance is the difference between
the government’s tax revenue and its
spending, both on goods and services and on
government transfers, in a given year.
◦ A budget surplus is a positive budget balance and a budget deficit is a
negative budget balance.

the budget balance (or savings by the
government) is defined by:
◦ SGovernment = T - G – TR
 T is the value of tax revenues
 G is government purchases of goods and services
 TR is the value of government transfers.


Expansionary Policies reduce the budget
balance for the year
Contractionary Policies increase the budget
balance for the year



Expansionary fiscal policy is
in order.
3 options:
◦ Cut taxes.
◦ Increase transfers.
◦ Increase government
spending.
These three policies should
increase AD and reverse the
recession, but will cause the
budget balance to decrease.
This means either a smaller
surplus or a bigger deficit.

Contractionary fiscal policy
is in order. 3 options:
◦ Increase taxes.
◦ Decrease transfers.
◦ Decrease government
spending.

These three policies should
decrease AD and reverse
the inflation, but will cause
the budget balance to
increase. This means either
a bigger surplus or a
smaller deficit.

Changes in the budget balance don’t always
perfectly reflect changes to fiscal policy.
◦ Just because the balance is decreasing does not mean an
expansionary policy is being implemented

Two important reasons why it is more complicated.
1. Two different changes in fiscal policy that have equal-size
effects on the budget balance may have quite unequal
effects on the economy.
 Example: If government spending increases by $1000, it will have a larger
impact on real GDP than a tax decrease of $1000. The budget balance would
change by $1000 in each case, but the impacts would be different.
2. Often, changes in the budget balance are themselves the
result, not the cause, of fluctuations in the economy.
1. Problems of Timing
• Recognition Lag- Congress must react to
economic indicators before it’s too late
• Administrative Lag- Congress takes time
to pass legislation
• Operational Lag- Spending/planning
takes time to organize and execute
(changing taxing is quicker)
2. Politically Motivated Policies
• Politicians may use economically
inappropriate policies to get reelected.
• Ex: A senator promises more public
works programs when there is already
an inflationary gap.
3. Crowding-Out Effect
•
•
If the government spends more money, and needs to
increase borrowing, it will lead to increased interest rates
This may “crowd out” business and individuals and
decrease investment spending which will in turn reduce
economic growth
Module 31

Actions taken by the Federal Reserve (or a central
bank) to control the supply of money

Two types:
◦ Expansionary – Lowers interest rates/grows the
economy/increases inflation
 OMO: Buy bonds
 Lower Reserve Requirement
 Lower Discount Rate
◦ Contractionary – Increases interest rates/slows the
economy/reduces inflation
 OMO: Sell Bonds
 Increase Reserve Requirement
 Increase Discount Rate

Main tool of stabilization policy in practice
◦ Like Fiscal Policy, there are lags BUT Central Banks
are able to act more quickly then the government in
implementing changes.


Fed Funds Rate – Interest rate banks charge
other banks for loans (based on Discount
Rate)
Every 6 weeks, when the FOMC meets, a
Target FFR is set.
◦ This target rate is reached through Open Market
Operations carried out at the New York branch.
 This alters the supply of money and allows the FED to
drive rates up or down.

Expansionary Policy
◦ Lower interest rates = higher investment spending
◦ Higher investment spending = higher GDP
◦ Higher GDP = more consumer spending

Contractionary Policy
◦ Higher interest rates = lower investment spending
◦ Lower investment spending = lower GDP
◦ ….

Central Banks tend to
engage in
expansionary policies
when real GDP is
below potential
output (recessionary
gap) and
contractionary
policies when real
GDP exceeds
potential (inflationary
gap)

Rule proposed in 1993 by Stanford economist
John Taylor
◦ Federal Funds Rate = 1 + (1.5x inflation) + (0.5 X
output gap)
◦ This rule is the best way of predicting the Federal
Reserve’s behavior when it comes to setting the
discount rate
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

Used by some central banks outside the US
Central Banks set a target for inflation, and
implement a monetary policy to hit that
target.
Two Advantages
◦ The public knows the objective of the bank for the
year
◦ The central bank’s effectiveness can be judged by
how close they are to hitting their target yearly

Disadvantage
◦ Some argue this is too restrictive and reduces
flexibility to act in a crisis.
Module 32

In the short-run an increase in the
money supply will reduce interest
rates, increases investment
spending, and increases consumer
spending
◦ Output and prices increase as AD shifts
right

As a result of the expansionary
monetary policy, output is now
ABOVE potential
◦ This will cause nominal wages to rise,
and the SRAS curve to shift to the left

THE LONG RUN EFFECT OF AN
INCREASE IN THE MONEY SUPPLY IS
JUST AN INCREASE IN PRICE LEVELS


monetary neutrality: changes in the money
supply have no real effects on the economy.
In the long run, the only effect of an increase
in the money supply is to raise the aggregate
price level by an equal percentage.
◦ If MS grows by 50%, prices will grow by 50%
◦ If MS decreases by 25%, prices will drop 25%

Economists argue that money is neutral in the
long run.


A change in the money
supply lowers interest
rates in the short run
However, as price
levels rise, the demand
for money increases
◦ This shifts the MD curve
to the right, bring
interest rates back to
where they began
Module 33

Hyperinflation
◦ Extremely high inflation. Usually caused by a
government printing out too much fiat money

Cost-push inflation
◦ Inflation caused by a negative supply shock
◦ AKA Stagflation

Demand-Pull inflation
◦ Inflation caused by increased demand in the
economy

Remember:
◦ YP = Potential Output (Assumes economy is at full
employment)
◦ Short Run eq left of YP = Recessionary Gap
 Unemployment is high, inflation is low
◦ Short Run eq right of YP = Inflationary gap
 Unemployment is low, inflation high
Module 34

In the short run there is a negative
relationship between unemployment and
inflation.
◦ First theorized by economist Alban Phillips

Reminder: Supply Shocks
◦ Sudden changes in SRAS

Supply Shocks can cause the SRPC to shift
◦ Positive, shifts down
◦ Negative, shifts up

Increase in expected inflation shifts the
SRPC up

In the long run, employment is not impacted
by inflation.
◦ Therefore the Long-run Phillips Curve is vertical at
the Natural Rate of Unemployment